Important Stock Checklist

Here is a list of Important characteristics a stock should have

-Low leverage and financial flexibility to execute allocation strategy
-High Earnings Yield relative to growth (opposite of P/E Ratio) earnings/market cap
-Strong business fundamentals to fend off competition and market share loss
-Strong Free Cash Flow- best way to stregnthen balance sheet and make investments
-Management has "skin in game"---incentive to increase shareholder value
-Margin growth- fundamental improvement in margins (not just cyclical)
-future growth through new products or geographic expansion

If your stock embodies most of these qualifications, you are in great position to outperform the stock market

How to beat the market consistently over the long term

A select few individuals will have the success of beating the market consistently over an extended period of time. Most investment managers do not add any value whatsoever to their clients. In fact, an average person would no doubt be better off just putting their savings in a low cost index fund and just leave it. There are very low transaction costs with minimal risks. However, I will explain how I think the best way to consistently beat the market over the long run.

The sad truth when it comes to investing is that the bottom 50 percent of the people will be in the bottom 50 percent of performance. There is just no way for a large number of people to beat the market. The market is just too efficient in pricing stocks. However, luckily, when you take the full investment community, you can be the smarter stock picker. Most of these clients are forced to be in the market at all times and are forced to invest diversified portfolios using techniques such as sector rotation based on the sectors they feel are most attractive. This just doesn't work over the long run and you cannot repeatedly earn above average returns.

If you want to be part of the select few that earn above average returns you have to pick your spots. You need to bet heavily on your best ideas. Think about sports betting. Do you know any sports gamblers that make a lot of money by betting sports every day. Most likely you don't as there are only a minuscule amount of individuals capable of doing that. If you want to have any kind of success in sports betting you probably should pick one or two games out of the year where you think the betting public just simply has the odds wrong. That alone still doesn't guarantee that you win because of the importance luck plays in the sports world.

In the world of stocks, luck plays less of a role. As the successful companies are generally successful with or without luck. They invest wisely and have key products with amazing pricing power.

Therefore, in order to beat the market you have to pick stock selectively and run a concentrated portfolio. On top of that, it is essential, that of the select few stocks you pick, those stocks have to be great stocks. Naturally, if you are being selective, those stocks should inhibit characteristics that illustrate their appeal. So I would strongly argue that running a concentrated portfolio where you pick stocks does not guarantee you success. In fact, it could leave you in a rough situation. The key is that of the stocks you pick that they are great stocks. So going back to my previous postings, it is essential that the stocks you pick are undervalued and are mispriced.

The stock market is the greatest wealth builder the world has ever seen. My advice to you is if you want to have success in your endeavor of building and preserving wealth that you either simply buy an index fund or that you take my advice and run a concentrated portfolio full of stocks that are fundamentally undervalued by the market. The latter of the two is the one that will give y0u the ability to truly earn outsized returns in the market.

How to find Mispriced Stocks

For those of you that believe the market is efficient in pricing stocks then I suggest you read no further. Those people, the efficient market believers, must truly think that humans are emotionless creatures that do not have ulterior motives. Stocks get mispriced by the market constantly and I will explain the many different reasons this can occur.

It is vital that once you spot an undervalued stock that you ask yourself why the stock got so undervalued. If you fail to come up with a reason then chances are your stock isn't undervalued and the market is properly pricing it.

The most common reason a stock sways from its intrinsic value is because of a general decline in the overall market. Unfortunately, this occurrence generally will not help an investor. When the overall market drop it naturally brings down most stocks with it. Therefore, the stocks that you are currently holding in your portfolio will probably face similar declines to the stock you are looking at. The only way to take advantage of an overall market decline is by having cash on the sidelines to deploy.

Human nature has played a big role in equity pricing over the last century and you can be certain that it will continue to play a role in the future. Just as you can be sure that when you show your dog a treat, he will sit. It is instinctual and built into our DNA. The most successful investors are experts in taking advantage of human instincts.

A company reports earnings four times a year and the market is very shortsighted when looking at those earnings. So if you see a stock that drops because of poor earnings dig a little deeper to find out the reason for the bad numbers. You want to see if the company can correct the problem or if the problem is more of a fundamental nature. If the numbers are bad because of fundamental business economics of the company then you want to stay away from that investment.

My favorite type of mispricing occurs because of the brokerage industry and the mentality of those in the industry. The mispricing occurs because of a downgrade of the stock. I find it comedic that at the top of bull markets the analysts have a majority of buy ratings out on the stocks and during the trough of bear markets the analysts have a majority of sell ratings on the stocks. In reality, the brokerage firms make your job of finding mispriced stocks even easier. They generally tend to downgrade stocks after their stock price has already been beaten up. Subsequent to the downgrade, the stock price drops even further, providing you with a greater margin of safety then before the downgrade. What a gift!

Institutional investors are another great place to look for reasons as to why a stock might be mispriced. Institutional investors are the big Mutual Funds and Pension Funds that run billions of dollars. These guys are invested in every sector and tend to use asset allocation and as a consequence pay very little attention to the fundamentals of the individual company they are invested in. So when you see a major institution selling a stock you are in, don't be so fearful. In fact, there is a good chance that they gave you a better and cheaper entry point into the stock. One reason an Institution might sell a stock is that they are allocating more funds to a different industry and need to sell stock to obtain capital. Another reason could be that the Institution is having redemptions. (investors in fund pulling out their money) The fund is forced to liquidate some of their positions in order to pay back their investors. This forced liquidation occurred in 2008 as fear drew so many people to pull money from their Mutual Funds.

There are countless other reasons why a stock might get mispriced. Just remember to do your research and try and figure out an estimate of what a particular company is worth. When the stock falls well below that value it is generally a great time to buy that stock. Just picture that you are at a car auction and see your favorite car the Ferrari Enzo. Let's say that if you went to a car dealership to buy the car you would pay 1 million dollars. But at this auction, for whatever reason, nobody is bidding on the car, and the opening bid is for 500,000 dollars. Of course, you are going to put in a bid and buy the car. Did the value of the car change because there were no bidders? Of course not. Same thing with investing.

Concentrated Portfolio

In order to have consistent success in outperforming the market, you must have a concentrated portfolio. If you are a good stock picker then it makes sense to have high positions in your highest conviction stock picks. Having a diversified portfolio where you have stocks in every industry just makes not sense to me. If you are going to go that route or have someone run your money that goes that route you would be much better off simply buying an index like the S&P 500.

Bruce Berkowitz, manager of a very successful hedge fund, puts it best when he says something to the extent of, "why put money in your 35th or 36th best idea when you could put money in your first and second best ideas." I would argue that if you are an outstanding stock picker that having a concentrated portfolio could actually lower your risk. If you buy stocks that are so drastically undervalued, when the market goes down, chances are those stocks will outperform. It is important to note that you have to still own a fair amount of stocks, say five or six, in order for that to work. If you run too concentrated a portfolio then you could really get caught if one of your few stocks faces an unforeseen or unlikely event.

If you are looking to beat the market year after year then make sure that you have a concentrated portfolio made up of stocks that are so undervalued that you have a large margin of safety. My next post I will talk about how to find stocks that are undervalued.

Always keep Cash on Sideline

It is important for an investor to keep cash on the sidelines just as it is vital for a police officer to carry around with him extra ammunition. Many investors think and act counter intuitively when it comes to how much cash to hold on the sidelines. During the peak of bull markets, it is well characterized, that most investors hold very little cash on the sidelines. This is ludicrous as the risk/return ratio works against you when stock prices are high. Just like clockwork, at the end of a bear market, most investors hold too much cash on the sidelines out of fear.

I would argue that having cash on the sideline can only improve the risk part of the risk/reward equation. Sure, it is quite possible that you may regret holding the cash when equity prices rally. This is part of the logic as to why when stock prices appear undervalued one should hold less cash on the sidelines. Sure enough when stocks appear overvalued one should hold more cash on the sidelines.

Most investors don't see the benefits that holding cash has to the reward part of the risk/reward equation. However, having cash on the sidelines can be a huge asset to aid in your returns. Nobody is smart enough to time every stock move so having that extra cash as ammunition allows you to add to positions as a stock drops. Therefore, as that cash gets put to work, you are automatically investing in a stock that has better risk/return characteristics.

Average Investor Always Gets Screwed

The average everyday investor has and will continue to earn below market returns. It is ingrained in his mind just as it is ingrained in the mind of a dog to sit when he sees a treat. Human nature will easily defeat logic inside the battle of the average investors head. Throughout history, during boom and bust cycles, the average investor got whiped out during inflection points at bull and bear market cycles.

The past real estate bubble is a perfect example. I remember during the heat of the bubble a friend of mine wanted to buy a second house as an investment. I thought to myself, does he really expect to earn a return on this property when real estate prices had already ran so high and were in severe danger of collapse. Yet the feeling of being left out of probably the greatest real estate bull market in American history was too tough of an idea for my friend to comprehend. He just had to get in. Unfortunately, he did buy that house, and now that house has been foreclosed upon.

There are countless other examples such as the tech bubble bursting at the turn of the millenium and the most recent bear market that the average investor gets screwed. The stock market has rebounded substantially since the market lows of March 2009. Yet the average investor was on the sidelines during this rally. Now consequently, surveys are showing that the average investor is feeling more comfortable about investing in the stock market. However, the time to be fully invested in stocks was at Dow 6600 not Dow 11000.
For an average investor to make above average returns, he simply must be contrarian when it comes to market timing. Buffett sums it up best by saying, "be fearful when others are greedy and greedy when others are fearful."

China Debate

Two of the greatest economic minds of our time have two different views on the Chinese economy. First, Jim O'Neill chief economist at Goldman Sachs who famously coined the term BRIC. He is bullish on the Chinese economy and feels that the global crisis helped China. The other economist is Nouriel Roubini famously called Dr. Doom, who is a little more skeptical of China and possibly rightfully so.

O'Neill feels the global crisis helped the Chinese economy. His main point is that with the global economy coming to a halt, China's export led economy took a hit. But it caused the Chinese to look inward and become less reliant on the American consumer. The number one long term problem for China is getting their consumption rate up. The Chinese sooner rather then later because of the crisis have been forced to become more reliant on there own domestic demand.

Nouriel Roubini on the other hand has the view that the jury is not out on the Chinese economy. During the global recession of 2009, the Chinese managed to grow 8 percent. This astounding growth rate did not come from their usual export growth because the global consumer was no where to be found. More troubling is the fact that consumption as a percentage of GDP stayed the same at a very low 35 percent. Therefore it appears that the bulk of the growth came from fixed asset investment and easy monetary policy. The first is just not a sustainable way to grow the economy. Just ask the leaders of the old Soviet Union. The latter, easy monetary policy, could possibly have lasting implications through inflation and asset bubbles.

These are two of the most original thinkers in economics having pretty much two opposing view points. I think if you look at this from a micro perspective one would tend to want to sign with Roubini and the raw data he provided signaling the consumer in China is still not ready to spend. However, if you look at it from a more macro view, O'Neill's thesis about the crisis helping China is very persuadable.

I tend to feel that there will be many bumps and bruises over the next decade in China. However, the long term growth story in China is intact as the hundreds of millions of rural Chinese start urbanizing and becoming more productive and consumer oriented. The Chinese policy makers are very bright and are beginning to form programs that will instill consumer confidence. Safety nets have to be put in place in order to get the consumption rate up in China. Time will tell which economist is right.