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.

Stuck on an Island- FREE CASH FLOW

Everybody remembers the question if you were stuck on an island and had to bring a movie, what would it be? If someone were to ask me if I were stuck on an island and had to bring one financial document, what would it be? In a heartbeat, I would reply the Cash Flow Statement. It incorporates the income statement and the balance sheet together.
The Cash Flow Statement provides the investor with a clear picture of its operating performance in a truly accurate way. The Net Income on the Income Statement could be somewhat manipuulated by using accounting gimmicks. Yet just as important, the Cash Flow statement also supplies the investor with how that newly formed profit is being put to work.
The best companies in the world are not only the ones that generate tons of cash, but they are the companies that generate high returns on that cash. The cash flow statement illustrates whether that cash is being invested back into the company or returned to investors via dividends or share buybacks.
When it comes to determining the true financial health of a company nothing is a subsititute for the balance sheet. However, the cash flow statement does an excellent job of previewing what that balance sheet will look like. A talented investor can usually take an educated guess about the company's financial health by simply looking at the Cash Flow statement. This is because if a company is generating a lot of Cash, then they can fund their expansions internally, without having to access finances externally.
So if for some wierd reason you are stuck on an island and are only allowed one financial statement to make an investment, make sure it is the Cash Flow Statement! You never know, maybe that investment will earn you enough returns to be able to pay for a private plane to find you and fly you back home!

High Margins and Stock Picking

I am of the opinion that a stock with high margins does not make it more valuable then a company with lower margins. Lets assume that company A has margins of 20 percent and company B margins of 10 percent. If both companies double there sales, company A and company B both have identical growth in profit. Margins play a vital role in making an investment decision, but for other reasons then a company simply having high margins.

The best scenario when dealing with margins is that a company is growing there margins. However, it is important to distinguish whether the margin increase is more of a cyclical or fundamental nature. If the growth in margins is coming cyclically, then it is more of a temporary increase because of the business cycle. The optimal choice for margin growth is that it is of a fundamental nature. This is when the higher margins come about from some sort of operational improvement in the business. The reason why the fundamental margin growth makes for a better investment because the increase in margins has more of a sustainability and did not just come from the whim of the business cycle.

I have to stress that if you are dealing with a company that has consistently had high margins, you should look at the company skeptically. Because you could see a reverse in margin growth and of the fundamental nature. One of the first things you learn in Economics 101 is that companies with high margins will not keep them for long because it invites other companies to compete and mimic the product/service. The only way a high margin business is sustainable is if the company has a gigantic moat to protect against competition. Coca Cola for example has such a strong brand name that it would be very difficult for a start up to compete and chip away at margins. However, Abercrombie and Fitch has a much better chance of seeing margin deterioration in the future.

Back Blogging---Stock Market appears fairly valued

The stock market appears at the moment to be fairly valued. However, if the economic recovery appears to be sustainable it could very well go much higher. This current enviornment is great for stock pickers like myself. Over the last year, a monkey could have returned in excess of 50 percent by simply throwing a dart at a random list of stocks. In fact, it was the "junky" companies that rose the highest. These are the companies with horrific balance sheets and murky operating prospects.
A great deal of stocks to me seem to be fairly valued or even over valued by the market. But when you dig deeper there are many bargains throughout many industries. So this is the time when the stock picker really shows his true value.

Look for Margin of Safety

With all of the fear going on in the stock market over the last year it is even more important then ever to invest in companies with a high margin of safety. The near term future of the global economy is still murky. Nobody in their right mind can tell you when the bloodshed will subside. You will have a hard time sleeping at night if you have your money invested in a company with a weak balance sheet. Companies with large cash positions is vital right now. It is important because normally if a company gets in trouble they can sell of some assets for cash or they can issue their own stock. However, asset prices are so low right now that it is very difficult to turn a struggling balance sheet into a stellar balance sheet.

A company is not always safe just because it has a lot of cash on hand with very little debt. That can evaporate very quickly if a company is burning through cash. Although, I normally like to see a company put that cash to use via a stock buyback or an acquisition, I am very content for the time being to see a company hold onto their cash. An even worst case to see would be the cash rich company burning cash through their operations. At least when a company is using cash to make investments, that money does not dissappear. Cheap multiples are around everywhere. It is important, however, to limit your downside risk and look for companies that will have the ability to emerge from the downturn even stronger when the economy begins to recover.

Buy China

Many investors should be looking to buy into China because of the growth and stability in the Chinese economy.  The consumers in China are starting grow and have not been too effected by the downturn because of their very high savings rate.  The Chinese government would actually like to see the Chinese people consumer more goods.  The best way to invest in the Chinese market is to buy American companies that have a strong presence in China.  I would disagree with those that would rather buy Chinese equities. (although they are finally a bit more fairly priced)

American companies can not only be trusted more then their Chinese counterparts, but they are much more efficient as well.  The heavily centralized government should definitely make an investor think twice about owning common stock in a Chinese company.  American companies are usually much more diversified and also have proven management that is used to competing on a global stage.  With the markets severely down, I see many quality companies with heavy Chinese exposure that can allow investors to finally get into China without paying a "premium" price.

Stock Pick

Roughly every week or so I'm going to come out with a stock pick to follow. That doesn't mean I think it is going to go up within the week. However, it does mean that I think over time it will greatly outperform the market.

News Corp (NWSA): $6 a share....Owner of Fox News, 20th century fox, myspace, wallstreet journal and many other media outlets. Run by Rupert Murdoch

This stock is greatly undervalued due to the unprecedented slowdown in advertising spending. It will stay undervalued if you believe that advertising will never recover. I happen to be in the camp that feels advertising will live to fight another day. Given that, Rupert Murdoch's company has a war chest of cash to cope with the downturn and is taking pro active measures via cost cutting. One of the greatest investors in the history of the United States, Seth Klarman, has bought a substantial stake in the company. The good news for somebody like you is that you can get in News Corp at prices 50% lower then Seth Klarman was buying at. Downward risks include that the newspaper business takes up too large a portion of their revenue stream.

DOW at levels not seen since 1997

Its funny that people refer to Japan's economic situation during the 1990's as the "lost decade" when the United States has not fared to well over the past decade as the DOW is relatively unchanged from where it was 12 years ago. To be honest, I don't feel too comfortable with the macro conditions and what government has attempted to do to solve the problem. That being said, I am still a buyer of stocks.

Back when I started investing real money after I graduated high school I remembered wishing that the DOW and S&P 500 would get out of the bull market they were in so I could get into equities at depressed levels. I thought it would never happen as it was around 2006 and the bull market was just heating up. I have been very fortunate over the past year as I had a strong cash position in my portfolio blunting me from much of this downturn. In fact, my portfolio sits around 10,000 dollars, up from the 8,0000 dollars that I started with almost 3 years ago. Now my wish has finally come true as I am able to buy stocks at very depressed levels. I guess I am one of the few investors out there that looks at the market and sees opportunities, and has the funds to take advantage.

Best time for Value Investors

The current market conditions are what value investors live for.  Stocks all over the spectrum are trading at well below their intrinsic value.  I doubt that any one of us will be able to guess when the market will bottom, but that is not what we are concerned with.  Timing is of least importance.  Our major concern is of buying stakes in companies at prices well below their fundamental value.  If you had a long term investment horizon, wouldn't you rather be buying stocks when the DOW is at 8,000 rather then at 13,000.  

Most market participants, however, are in a lot of trouble during a market bottom.  Back in 2007, many people were fully invested in stocks as euphoria flooded the market.  Therefore, at the worst possible time to be invested, (when stocks are priced high) almost everybody was a market participant.  Unfortunately, they have no capital left over to invest when prices are cheap towards the end of the bear market, which is precisely the best time to be in stocks.

The best example I can think of right now is billionaire value investor Seth Klarman. Throughout most of 2006 and 2007 Seth Klarman had no more then 50 percent in stocks because he thought stocks were overvalued.  He wasn't worried about timing, as evident in the fact that he was probably over a year late on his call that stocks would greatly diminish in value.  He was worried about capital preservation and that the downside risk was much greater then the high price of equities.  Sure, he could have had greater returns in 2006 and 2007. (although he still generated over 15% return on investment...which is phenomenal given the fact he had only 50 percent of his money in stocks)  However, his returns have drastically beaten the market over the past year as stocks have come off the highs to now multi-year lows.  The best part about it is that Seth Klarman now has ample cash to deploy to currently buy stocks when they are at their lowest levels.  Ironic isn't it.

Number 1 Reason to Buy Stocks Now

Analysts estimates have finally been cut enough to come in line with the earnings that the companies are reporting.  Next quarter we aren't really going to be getting any crazy surprises. Companies, through cost cutting, have been able to make the proper adjustments.  The drop in commodities prices have also been a positive for companies because transportation costs are down as well as basic material costs.  Stocks have to be bought at this level because pessimism has nowhere left to go but up.

Warren Buffett's Portfolio

A lot of critics of Warren Buffett have been complaining that he has been contradictory as of late with his portfolio.  He wrote on op-ed in the New York Times several months ago saying buy American stocks now.  When looking into his recently filing with the SEC, we see that he has in fact trimmed stakes of some major American companies such as Procter & Gamble and Johnson & Johnson.  People are looking at this from the wrong perspective.  The fact that he is selling his stakes in P&G and JNJ actually do signal that he is bullish on US equities.  Most people buy stocks such as P&G and JNJ as defensive stocks because they generally hold up well during a recession.  Buffett is adding shares to some of his oil holdings and financial companies signaling that he is putting his money to work in companies that do well in a growing economy.  Buffett's critics are looking at his recent moves from the wrong point of view and in reality Buffet is sticking to the strategy of buy American.

The Right Manager for These Times

First of all, I always like to see the CEO of a company have a substantial amount of shares in the company.  The CEO will have more of a vested interest in the company.  The next major quality that I like to see is when the CEO takes more of a long term view on the company's success rather then worrying about making the numbers each quarter.  The perfect CEO for these times is Richard Woolcott, the CEO of Volcom.  

Richard Woolcott just so happens to be the founder of Volcom and is currently the Chairman and CEO.  He owns over twenty percent of the company and therefore is on the same team as the common stockholder.  Times are tough right now and almost every company is making job cuts to come in line with the depressed revenue base.  Volcom, not being immune to this crisis, just came out with a reduction in the workforce of around 10 percent.  Richard Woolcott also took a 15% reduction to his salary, which is already under industry standards.  This tells me a lot about the kind of person Mr. Woolcott is and that he is interested in the long term success of Volcom.   A good amount of cost cutting that takes place in the corporate world can greatly impact the long term success of a company.  For example, Volcom can cut some costs by ending some promotional events.  This can effect the long term success of the company. (although probably moderately). Instead, Richard Woolcott decided to take a cut in pay, a move that does not at all impact the long term prospects of Volcom.  For that I greatly respect him.  Especially in a time where all we read about in the news are greedy businessmen with scams happening left and right.

Valuation of the S&P 500

I constantly hear the bears in the market stating that the market is still overvalued.  They point to the fact that earnings for the S&P 500 will probably come in at around $45.  That leaves us with a P/E of around 17.  To the naked eye that does seem overvalued because most believe that a P/E of 17 is expensive when the economy is in free fall.  However, the successful investor sees opportunity in these numbers.

The investors that beat the market continuously might look at these valuations and see the glass half full.  Although earnings for this year will be terrible, eventually the market will recover and things will begin to improve.  Therefore, we like to use normalized earnings, which means how earnings generally are in a normal investing environment.  Basically an environment similar to that of Goldilocks and the 3 Bears.  The porridge is not too hot and not too cold.  In normal economic conditions, the S&P 500 will probably clock in around $100 in earnings. (rather then the $45 that the S&P will probably report)  That leaves us with the S&P having a P/E of 8 rather then the current P/E of around 17.  Now the market looks dirt cheap.  That means that the average company in the S&P is probably trading at around 8 times normalized earnings.   Call me crazy, but at 8 times earnings i'm going to be buying as much stock as I can get my greedy hands on.

Why is the Market Down??

As I am sitting here, the DJIA is sitting at a six year low. As Larry Kudlow says, "earnings are the mothers milk of the stock market." Sure earnings are terrible. But let's dig deeper. There is no clarity in the market. In fact, I don't know if there has ever been a time when there has been less clarity in our nations history. Is the stimulus package too big? Can our nation hold this much debt? When is there going to be a clear and effective plan for getting us out of this financial meltdown?

I believe that as an investor, if you have cash on the sidelines then now is the best time to deploy it into the market. Take advantage of all the fear running amuck on the street. The key is look for companies with strong balance sheets (lots of cash) that will be able to come out stronger when the downturn ends. It's just that simple. Try to block out the fear and uncertainty going on in the market and get into stocks that are trading at valuations we may never see again for the rest of our lives.