Sunday, June 13, 2010

General Stock Picking Strategies: Don't Use Them!

Here at The Catholic Investor, I try to make you a more informed investor.  There are many theories, strategies, and products out there that cater to "dumb" investors, shall I say?  Mutual funds are definitely one of them.  They mostly use a "buy and forget" strategy.  Sadly, after 2008, most people who owned mutual funds did indeed want to forget about their investment!  It's quite a funny phenomenon, but many of us do more research when buying a TV or computer or fridge than when we decide where to place our money to invest.  The ramifications of not doing proper research is HUGE!  You can look back to my retirement post and see what kind of difference a few percent makes in the long term.

So recently, I've becoming somewhat intrigued by dividends (I'll save this topic for another day) and read a relatively old book called The Dividend Rich Investor.  It's an introductory book on dividends.  The reason I mention it is not because I wanted to do a book review or talk about dividends.  In one of its chapters, it talked briefly about the various strategies in buying dividend stocks and mentioned James O'Shaughnessy's What Works on Wall Street: A Guide to the Best-Performing Investment Strategies of All Time.  I haven't actually read O'Shaughnessy's book, but it's very popular and many people have read it.   I do know what it is about.  In a few sentences, here's a summary of what he wrote in the book.  O'Shaughnessy examined many general stock picking strategies and put them head-to-head against each other to see which one wins out.  When I say "general stock picking strategies", what I mean is you set a criterion and look at the performance of all of the stocks that fall into this one criterion (e.g. low P/E ratio, high P/E ratio, etc.)  In the end, he showed that buying stocks with low price-to-sales (P/S) ratios was one of the most successful strategies.

General Stock Picking Strategies
I know you know I'm going to totally trash this strategy, but I do want to highlight its advantages and tell you who should use these strategies (hint: I'm not one of them).  First, O'Shaughnessy's strategy is data backed.  He selected stocks based on his strategies and ran years of data to find out which is the best.  Second, it's based on key ratios used by fundamental analysts.  It's the closest thing to fundamental analysis that a lazy person can use.  If you are this lazy person, build your portfolio around a low P/S strategy, and you may have a chance of outperforming the market.

Now, here is the reason why you shouldn't use the strategy: this strategy requires you to diversify. When people hear the word "diversification", one immediately associates this word with the idea of being responsible and prudent.  To these two words, I would also add the word "underperforming".  Since the P/S strategy just tells you to buy stocks with low P/S ratios, it does not discriminate between good and bad companies.  A company with a low P/S ratio may be on the verge of bankruptcy and that is why its price is so low.  So, to mitigate this risk, you must diversify and buy a large number of stocks.  Most of us don't have millions of dollars, and so, we can either i) buy a limited number of stocks, ii) buy a large number of stocks but with small amounts in each, or iii) buy a mutual fund that uses O'Shaughnessy's strategies.  Obviously, the problem with i) is that you do not diversify.  The problem with ii) is that commissions will erode the gains that your stocks make very quickly, since you can only purchase a small amount of the many stocks that you hold.  With iii), you get hit with fees and have little control of what stocks are held in the fund.  The latter could make an ethical investor nervous because morally questionable companies may sneak into your portfolio.  Moreover, a large majority of mutual funds underperform the overall market (think > 95% of them).

Diversification - Good or Bad?
Diversification, in its most commonly held way, is a concept that is rammed down our throats by mutual fund companies.  They want us to believe that ordinary investors have no way of picking good stocks, and so, the only way to make money is to diversify, i.e., buy mutual funds.  It is true that if you blindly pick a few stocks to buy, their prices could tank and you would lose a lot of money.  However, if you have done research and know that the several companies you have bought are rock solid companies at bargain prices, you do not have to be afraid of market gyrations.  Your main enemy in diversification (and also its main purpose) is the averaging effect.  Yes, you will average out the losers in your portfolio, but don't forget that you also average out your winners.

This is not to say that you should buy one stock only.  After all, we are human and even after countless hours of research, we may still err and pick the wrong stock.  Or worse yet, your company could be doing well, but an unexpected disaster may occur that could easily wipe out half the worth of your company's stock (BP is a very good example).  You still need to diversify, but in its strictest sense (i.e. buying more than one stock), and not just buying many stocks for the sake of it.  I would augment diversification with good fundamental analysis.  Check out Rule #1 Investing for a methodical way of evaluating a company's intrinsic value.  You need to pick 5-10 high quality stocks in different industries to provide you with diversification in your portfolio.  That way, you are averaging out the performance of several high gainers, and not just arbitrarily throwing different stocks into your portfolio.

One way of thinking about the stock picking strategies is by using the bell curve.  The whole market is one big bell curve.  By using the general stock picking strategies, you are simply splitting up the market into various smaller bell curves.  Some strategies will perform better, some worse.  By employing any one of these strategies, you will need to buy all of the stocks in that bell curve, even the bad ones.  On the other hand, if you use, say Rule #1 Investing, you look at the big bell curve of the market, and you only pick the ones on the good end of the curve, and leave the bad ones behind.  If I haven't lost you yet, you will know that the latter is the superior method.

In Conclusion
In summary, general stock picking strategies are merely for the lazy.  In essence, what they tell you to do is just buy a whole bunch of stocks based on one single factor, regardless of the underlying business of the stock.  The stocks may be good or bad, but as long as you diversify, you will hopefully do well.  This is not the way we do it at The Catholic Investor.  We like to get to know the business a little more before throwing our life savings at it.  By buying several high quality stocks, we can outperform the market by a significant margin.  And this is exactly what we will continue to do in this blog!

Monday, June 7, 2010

Solar Demand Very Healthy

I'm a big fan of solar energy and I think it's a megatrend in the making.  There are a lot of doubters out there and thus, the whole solar energy sector has taken a beating over the past few months.  Many solar stocks are near their 52-week lows.  There are various reasons for this.  First, Germany is the biggest solar market right now, mainly because its government was an earlier adopter and introduced subsidies early on.  It is now making cutbacks to those subsidies and that has made ripples in the market.  Second, Europe is also the largest solar market out of all of the continents, and we have all heard of the trouble that is brewing in the Eurozone.  So, I don't blame the naysayers entirely.

However, we need to see through this noise.  Look at the megatrend that is forming.  Look at the BP oil spill.  Do you think the world will still want to rely on fossil fuels after this disaster?  Although oil is not directly linked to electricity generation, it is now very apparent that we, as a civilization, can no longer depend on non-renewable energy.  We just had a temperature record breaking spring.  Whether this warm weather is caused by global warming or not, people are starting to associate climate change with usage of non-renewable energy.

I also read two articles that confirm my suspicion, that solar energy is alive and well.  First, First Solar announces that it cannot meet the demand for 2010.  Then, Suntech (Ticker: STP) also makes the same announcement.  These are two of the biggest solar panel makers in the world and if demand is greater than their capacity, then I think overall demand is probably greater than the overall capacity of the total capacity of all solar panel makers.  It's just a hunch, but I'm not afraid to put some money on this hunch.

Anyway, I believe it's a great time to get into solar.  Stock prices are low and upside potential is huge.  Start your research with First Solar (FSLR), Trina Solar (TSL), and Suntech (STP).

Wednesday, June 2, 2010

The Stock Screener: How I Found My True Religion

Several months ago, I reviewed my portfolio and realized that I had only mid to large-cap stocks, stocks like Google (Ticker: GOOG, current market cap of $154 billion), Garmin (Ticker: GRMN, current market cap of $6.39 billion), First Solar (Ticker: FSLR, current market cap of $9.14 billion).  Peter Lynch, the legendary manager of the Fidelity Magellan Fund in the 1980s, advised buying small-cap stocks (< $1 billion in market capitalization) because of their growth potential.  The idea is that small businesses can growth exponentially much more easily than large companies can.  Take Starbucks for example. Before they had a store on every street corner in North America, there were times when it could grow its business by just doing simply that, opening a new store on the next street corner.  By opening a new store, new revenue can quickly be obtained (assuming the business is managed and run successfully).  Now that Starbucks is everywhere, they have to find creative ways to grow their business, like expanding into untapped, international markets, which may or may not be ideal markets.

So, I decided to search for a small-cap stock for my portfolio.  Yahoo Stock Screener came to the rescue.  A stock screener is simply a filter for stocks.  You can filter out the stocks based on certain criteria, such as market capitalization and P/E ratio.  Yahoo gives you two versions of their screener, the first being a fairly extensive Java-based application, and the second is just a simple HTML-based screener.  I always use the Java-based one because it gives you way more options and is less clumsy than the HTML-based one.  That said, the HTML-based screener will still work.

You guys are quite smart.  So, I will spare any instructions on how to use the screener.  So, what should we screen for?  There are several criteria that Rule #1 investing requires.  The following were my criteria:

  • Market Capitalization ≤ $1 billion
  • Return on Equity ≥ 10% (Rule #1 requires 10% Return on Invested Capital; the screener didn't have ROIC, but ROE was the closest thing)
  • Sales Growth Est Next Year ≥ 10% 
  • Earnings Growth Past 5 Years ≥ 10%
  • Earnings Growth Est Next 5 Years ≥ 10%

It's not exactly a Rule #1 screen, but the point of this exercise was not to come up with a perfect filter.  Rather, we wanted to get some fresh ideas for stock picks.  If I were to run the screen today (June 2, 2010), I would get 52 matches.  Considering there are several thousand publicly traded companies in the US, that's not too bad.  The next part gets a little tedious.  You actually have to go through each one and determine if you want to research further.  By clicking on the symbol, the screener will take you to the Yahoo Finance page of that particular stock.  I like to look at the "Profile" of the company first to see if it interests me.  It gives you an idea of what the company does.  Then, I would go through the "Key Statistics" and "Analyst Estimates" pages to get an idea of where the company is at right now and where it is headed.  Since my portfolio was weighted heavily towards tech, I would skip over any tech companies.  I also didn't like financial companies when I ran the screen.  So, I would skip those as well.  Lastly, I would bypass any pharmaceutical companies because of the ethical risks that are involved.

I don't recall exactly how I ended up looking into True Religion, but I did, after going through a handful of stocks that were produced by the screen.  Perhaps the word "religion" piqued my interest, or maybe I've seen someone wear a True Religion t-shirt before and made the connection.  The important thing is that the more I looked into the company, the more attractive it became.  Thus, I ended up being a shareholder!  There you have entire journey of finding True Religion has been documented in this blog!  Be sure to read the other True Religion posts by clicking on "TRLG" label on the right.