It’s Time to Give Your Financial Planner a Call

Right now, financial planners are just as scared of an economic crisis as the rest of us. If you work with a financial planner, he or she may be offering up plenty of advice right now that majorly differs from what they’ve told you before. Unfortunately, a lot of that advice may be bad — based on getting your cash out of the market as fast as possible.

In good economic times, financial planning can be relatively easy: find some investments with growth potential, sit back and watch the cash roll in. I’m over simplifying, but keeping a client from losing money in an economic downturn can be much harder.

Doing Their Best

Financial planners are in a pretty tough position when investments dip even a little bit: if a client opens a monthly statement and sees that his investment’s value has dropped by even a small amount, his financial planner will be hearing about it. So financial planners have to make sure that their clients believe that they’re doing everything they can think of. In a down market, that might involve moving money in and out of investments rapidly.

It isn’t your financial planner’s fault if market prices drop the value of your investments. But if your financial planner knows his business, even a major change in the market won’t require a lot of changes in your portfolio. Your investments should be based on your financial goals and needs — and those investments should be fundamentally sound. Sure, if you’re invested in the banking and credit industries, you may need to be making a few changes. Your investments should, hopefully, be diversified. That means not all of your money should be invested in those two industries — and those other investments should be fine, even if the price has dropped a bit.

Keep In Touch

A good financial planner probably isn’t calling you every day or every week to get permission to change your portfolio. That doesn’t mean that you should keep in touch. One of the services you pay a financial planner for is explaining how market changes will affect you and your investments. Your financial planner is a good source of reassurance about your investments — ask why they’re still good and your planner should be able to explain why those companies are still solid.

It’s worth the effort to make sure that you understand every step your financial planner takes. You may not be able to locate those steps on your own — if you could, why would you want a financial planner? — but it’s perfectly possible to understand the logic behind a particular set of investments. If your financial planner can’t explain why a certain set of investments better matches your goals than another, perhaps it’s time to research another financial planner. Give your financial planner a chance to talk you through things first, though. It’s easy to overreact when you are shocked by the current value of your investments.

Watching A Scary Stock Market

I’ve own a few stocks and, right now, I’m sweating. If you own any stocks, even through mutual funds or retirement plans, you know the feeling. Basically every industry is feeling some pain now. As an investor, it’s pretty typical these days to be wondering if it’s time to get off the stock market roller coaster: sell, even at a loss, and put your money into something safer.

But is it really time to sell off your stocks?

The ideal way to invest in stocks is to buy low and sell high. That rule is based on the fact that stock prices fluctuate. They don’t grow steadily — if they did, the rule would be buy now, sell later. Instead, if you want to earn money as an investor, you need to ride out the low periods.

Now, we happen to be in a low period. I know you’re thinking that we’re in a particularly low period — but that doesn’t change the rules. It just means that you shouldn’t sell stocks right now if you can avoid it. A few companies are probably going to go under due to financial difficulties — if you know in advance, yes, get what’s left of your money out now (and give me a head’s up as well!). If you don’t have psychic powers, though, it’s probably best to leave your money where it is… doing otherwise would be buying high and selling low — the opposite of a good investment strategy.

Why do you want to sell?

If you’re seriously considering selling your stocks right now, I’d like you to step back, take a deep breath and ask yourself why you really want to sell. Do you actually know that something is wrong with a company you have invested in? Or have you just seen the price falling, day after day and gotten worried? I know that watching my stocks’ prices tick downwards is terrifying. Just the same, I’ve invested in fundamentally solid companies. Though their prices have dropped, there is not even a rumor of bankruptcy, layoffs or other troubles. I’ll be holding on to my stocks, even as I’m holding my breath to see how low stock prices drop.

When do you need the money?

Not all of this holds true if you need your money soon. If you were planning on cashing out of the stock market fairly soon, you may not be able to afford to wait. I encourage you to wait if you can, but we’re talking about a wait of years, not months. I know that’s not a feasible length of time for some people to wait, and if you’re among them, perhaps it would be better to get out of the stock market before anything else happens.

There’s no guarantee that the stock market will go one way or the other. I have no special insight one way or the other. All I can say is that I think that staying in the market is better than selling, at least for the moment.

The Secret To The Stock Market

Not too long ago, CNN Money posted “The smartest advice I ever got.” The article is really just a list of forty really good pieces of financial advice. In that list, Whitney Tilson described the secret to learning how to invest — the secret of the stock market:

About 12 years ago I was trying to learn more about personal investing. My good friend Bill Ackman, currently a hedge fund manager for Pershing Square Capital Management, told me, “Read all of Warren Buffet’s Berkshire-Hathaway shareholder letters. That’s all you need to know.”

The Berkshire-Hathaway shareholder letters are available as PDFs from Berkshire Hathaway’s website. They date from 1977 and were all written by Warren Buffett. If you aren’t familiar with the ‘Oracle of Omaha,’ the simplest explanation is his net worth: $62 billion. Buffett’s father was a stock broker — comfortable, but not exactly rich.

I can’t recommend enough that you take the time to read these letters. Investing in the stock market seems like black magic, but in addressing his shareholders, Buffett boils down the matter to the principles of sound investing.

One of the reasons that I think Berkshire Hathaway has done so well under Buffett’s leadership is the fact that he can look at investments clearly. As a rule, most investors let their emotions — at least their optimism — affect their decisions. But Buffett can simply state facts and move on. Consider his predictions for insurance (the cornerstone of Berkshire Hathaway’s ability to generate revenue) for 2008:

That party is over. It’s a certainty that insurance-industry profit margins, including ours, will fall significantly in 2008. Prices are down, and exposures inexorably rise. Even if the U.S. has its third consecutive catastrophe-light year, industry profit margins will probably shrink by four percentage points or so. If the winds roar or the earth trembles, results could be far worse.

Personally, my first reaction to the idea that the best part of my investment will soon be facing trouble is to worry. Maybe I should sell. Maybe it won’t be too bad. Maybe I should never have made that investment in the first place.

Maybe I should just calmly consider the situation and look at the numbers. Buffett spends two pages explaining how Berkshire Hathaway becaame so heavily involved in the insurance business — and why it was a good move. He is confident in the company’s overall investments because he has done the research to know not only what makes a good investment, but also what factor affect an investment and how strongly.

Buffett saw the housing bubble coming. Personally, I’m willing to bet that insurance companies are going to have a tough time in the next couple of years, too. That doesn’t mean I’m going to assume that insurance makes for a bad investment. I’ve been listening to Buffett: “If you’re an investor, you’re looking on what the asset is going to do, if you’re a speculator, you’re commonly focusing on what the price of the object is going to do, and that’s not our game.”

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Responsible Investing – Putting Your Money To Good Use

Investing hard earned money is something that many Americans tend to shy away from. There are a variety of reasons why, perhaps it’s too risky, too complicated, or we think we don’t have enough money to invest at all. Our attitude towards investing needs some adjustment. We shouldn’t look at investing as something power hungry suit wearing tycoons from the 80’s do, rather we should look at it as an opportunity to help out companies and causes that have the same ideals we do.

Companies We Can Believe In
The first thing we should realize when we start investing is that we are giving our money to someone else. Generally, we wouldn’t give money to someone we didn’t like, right? So supposing you were against Big Oil, would you give your money to an oil company? No, you would most likely give your money to an alternative energy company, like solar or wind power. The reason why some people hesitate to do this however, is that the cash return on investment with solar or wind power would be significantly less than returns from an oil company.

As investors, we need to determine what our goals are. Are we trying to make money, or are we trying to help out a cause we believe in? If we are simply trying to make money, then we don’t have to worry about what those companies are doing with our investment money, as long as we get our return. If we’re investing in something we believe in, then return on our investment may not come in the form of dividends, but as advances in the field we bought into. My choice to invest in solar power may not net me much in cash returns, but hopefully in the future the technology will have developed enough to change the way this nation uses energy. Personally, I find that outcome much more rewarding than a check for a few dollars every month.

Returns Other Than Cash
The term ‘investing’ often conjures the image of climbing stock market charts and cash returns. But when you think of it in broader terms, investing can take many forms. Investing something implies that you are willing to help out a cause simply because you agree with its goals. Whether it be your time, your money, or your resources, investments are sometimes the only way those causes can realize those goals.

Nonprofit organizations are a major player in world change, and often they are solely supported by the contributions of individuals of like mind. If your goal is the same as these organizations, you may consider investing in them. Benefits from the government like tax credits are of course a major benefit, but more than that you’re working to help a cause that otherwise couldn’t succeed without your help. Investing doesn’t mean you have to give money to corporations, it means you give money to anyone who you deem worthy.

Are Green Stocks The Next Dot Com Boom?

Wall Street is buzzing these days with talk about environmentally responsible companies and alternative sources of energy. Investment companies are starting to realize that the old adage “you can save your money or you can save a tree” doesn’t apply anymore. These new Green companies are working on ways to produce clean energy and products, and are turning a very nice profit doing it. But some investors are weary. Will these “Greenchip” stocks be the next Dot Com boom?

Green Isn’t Just For Hippies Anymore
With the oil crisis in full swing and the well being of the environment finally in the public eye, Green companies are finding it easier than ever to find support from investors. However, more than just investment brokers looking for a buck are buying. Through easy access to online trading, individuals are putting their money into companies that have the same environmental concerns as they do. People who have long said that Green technology and energy are the future are now able to put their money where their mouths are.

Get In On The Ground Floor
Often these companies are still in the startup phases, and their initial offering prices are very affordable. This makes them very attractive to investors who may not have the capitol to buy larger stocks. Despite being cheap, these stocks have very bright projections from analysts. Solar power in particular is a field that is seeing massive growth, and solid return projections. It is estimated that in the next few years, almost 10% of the total power produced in the world will be solar. In addition, the technology behind solar power is well established, having decades of well funded research behind it. Now we’re seeing less and less experimental solar power applications, and more and more practical solar applications. Research in this field has turned from “how can we get it to work” to “how can we make it work better.”

Another Dot Com Fiasco?
Like the Dot Com boom in the late nineties, there are many small startup companies with a lot of potential to choose from. The question is, of course, which one to choose? A form of natural selection occurred in the Dot Com era, where some companies became stronger and put the smaller, weaker companies out of business quickly. Nervous traders, eager to make a quick buck, also added to the problem. If a company was having difficulties, the investor money would dry up, plunging the stock price and sending the business under. Eventually only the very large companies, Google, Yahoo, and eBay to name a few, were left standing. So what’s to stop that from happening in the upcoming Green boom?

Stability In The Long Run
The one thing that calms most investors about Green stocks is that this field, while new in its approach, is old in its function. The main focus of the environmentally responsible energy producers is simply to produce electricity, a utility that we all use. Green product manufacturers are using cheap, recyclable materials to make commodities that we use every day, like hairbrushes or TVs. While the approach to producing these things is new, the things they are actually producing are the things we have been using and will continue to use in the future. With a solid base of consumers to back these Green companies, the value of their shares will continue to rise, and one day be as powerful as big oil is today.

One Tool You Can’t Go House Hunting Without

As you prepare to go house hunting, there is one tool that I can’t recommend enough: a digital camera. Odds are that, during your search for the perfect home, you’ll look at enough houses that they’ll quickly start to melt together in your mind. Photographing a house thoroughly can help you remember which house had the gorgeous wood floors, and which needed new carpeting.

You don’t need a big expensive camera, but it may be worth investing in a large memory card: if you’re checking out several houses in a day, you may want to take lots of photos. As long as your camera has a flash, though, it should work just fine. The flash is especially necessary with an empty house — without plenty of light, your camera may not record all the details of a house. And you should be planning to record details: something small, like the placement of a closet, can be a deciding factor between two houses.

Beyond taking pictures of features that stand out in a house, you’ll want to make sure to get clear shots of anything that would need to be repaired — this sort of information is crucial if you do decide that you want a particular house. You may be able to get the sellers to agree to make repairs before turning the house over to you, of you may be able to convince them to accept a lower price for the house. You will do later walk-throughs in order to ensure that you’re getting a house in good condition, but noting such issues now can save you both time and money in the long run. There are plenty of home owners that had to struggle with previous owners to get even small problems repaired.

As you visit each house, start by taking a picture of the house number or address, so that you can tell where pictures of one house end and the next start. You may always want to take a few pictures of the surrounding houses and areas, just so that you have a memory aide when you start trying to narrow down your selection to one house.

Not all sellers will be comfortable with you taking photos of their homes — even if it’s a house they’re in the process of selling. It is, of course, polite to ask, and, if they ask you not to take pictures, you should refrain from doing so. Some real estate agents may be able to provide you with pictures of homes you are interested in, as well, which can save you some effort. However, those photos are usually shot in such a way as to make a house look as good as possible. A seller may not be trying to hide something, but, as a responsible buyer, it’s up to you to look for (and record, when possible) any potential problems with a house.

Five Mistakes Made By Newbie Stock Investors, Part One: They Buy After The Price Rises

This is the first of a five part series on mistakes that I feel are made by new and inexperienced stock investors. I have either personally made these mistakes or seen others who have.

Mistake #1: They buy stocks after the price rises. If the name of the stock investing game is to buy low and sell high, than the single biggest mistake made by newbie investors is buying at a higher price.

You see, the money you make from investing is made when you buy, not when you sell. Smart investors figure out what the investment is worth well in advance - i.e. before they buy. Then, the make sure they buy at a price less than what it’s worth.

This idea of buying at a price less than the stock’s “intrinsic value” guarantees you a profit. It’s like buying a car for half of the sticker price, except a stock can actually help grow your net worth.

Example: I shared a stock pick with a friend last year. I was ecstatic about this particular stock. The friend took note, but did not actually buy the stock when I did.

A few months later, after some movements and gains of more than 300% on this pick, I began selling off a portion of my position to lock in the gains and cash out my original investment capital.

I almost fell out of my chair when, completely out of the blue, my friend said, “I just bought some shares of the stock at price X - what do you think?”

Carnival of Investing, 8th Edition

Welcome to the 8th edition of the Carnival of Investing! For those that are new to it, the Carnival of Investing is a weekly guide to some of the best predictions, strategies, and analysis by financial investment blogs. You can view submission guidelines and the hosting schedule here.

We’ve got a great selection of reading this week. Let’s get started!

Free Money Finance submits Managing Your IRA For Maximum Gain, a discussion of how to get the most out of your IRA.

Pacesetter Mortgage discusses the free market economy and the international traffic watching it, in Bloggers: The World is Watching.

Jim from Blueprint for Financial Prosperity submits Super Bowl Stock Market Indicator. Jim says, “If the Steelers win this week, the stock market will be up on the week… we’re 85% sure of it if past performance is an indicator of future performance (which it isn’t). And the Steelers will win.”

Amanda from Young and Broke examines the foolishness of purchasing lottery tickets in Lottery, Investing at odds.

Ironman from Political Calculations offers Exploiting Child Interest Income - a new tool to help you run some numbers to see if you can cut your tax bill by investing on behalf of your kids.

Dan at Search Light Crusade says that nearly every adult that buys life insurance buys the wrong policy at the wrong time for the wrong reason. Read Life Insurance - Proper Prior Planning Prevents..

Barry from The Other Bloke’s Blog discusses some Hot Topics, noting, “some say our financial behaviour may be governed by our brain’s pleasure centres, just like sex.”

Harrison from Journey to Financial Freedom submits Invest to Financial Freedom - Put Your Money Into Bank if You Lost Your Direction!

Michael from Bike Mike’s Contrarian Investing Blog submits Why I Blog About Investing.

Mighty Bargain Hunter notes that investing in gold should get more respect than it does, and offers a discussion in The Golden Hoard.

Tom Hanna from Financial Options submits The Week Ahead: Your Financial Roadmap for February 6-10, 2006.

David Jackson from Seeking Alpha submits The Most Important Two Minutes From Google’s Conference Call.

From Old Niu’s Blog we have Statistical Investing Using the Magic Formula, a discussion of the most controversial points of Joel Greenblatt’s “Magic Formula”.

Ed from Daily Dose of Optimism compares American versus Japanese CEO salaries, and discusses Graef Crystal’s 1991 book, “In Search of Excess”, in Graef Crystal - International CEO Comp Comparison.

And last but certainly not least, Kirby on Finance submits An ETF Primer, Part #1, the first in a series that will cover the basics of investing in exchange-traded funds.

Thank you for reading the Carnival of Investing. Next week’s Carnival will be hosted at Trader Mike.

Thanks to everyone that contributed to the carnival this week! It was a pleasure hosting!

From The Mail Bag: How People Pick Stocks

M.S. sent me this e-mail about a week ago. It is a loaded question, but really got me thinking about the stock market.

Alexander: If you folks say to learn to pick your own stocks, how do you do it? I have subscribed to the IBD for about 2-3 months now and I have not yet figured out how to pick stocks from the newspaper. I also need to learn how to read the charts before I invest. How do I do that? With so many stocks to chose from, I get confused and just end up doing nothing. Besides I really don’t have time to spend hours on the PC every day going over stock picks. So what shall I do? Are you against all stock picking services? I am sure that some research firms are legitimate. Thanks.

What you’ve asked is a loaded question. There are a million ways to pick stocks, and everybody has a different answer. So I’ll take my own crack at it. Please remember, though, that I’m just an amateur investor and not a financial advisor.

The way I see it, there are three possible paths someone could take to pick stocks.

#1: PEOPLE BUY STOCKS BECAUSE SOMEONE ELSE SAYS TO BUY.

This covers the majority of people in today’s stock market. Whether you got the idea to buy from SmartMoney Magazine, your uncle, or your favorite primate’s stock-picking service, most people don’t understand stocks. So they usually buy a stock when someone tells them to.

This might work sometimes - heck, it works a lot of the time - but there are a few problems with this strategy.

1. A lot of people might be “listening” to the story. The guys on CNBC can move stock prices. That’s not necessarily because they picked a great investment, but because people that listen often buy. I’m not against any stock picking services, but I think they can be misleading; if everyone on Wall Street subscribed to their service and did what they said, who would profit?
2. You might not understand the story. Are you familiar with the company’s business? Do you know how they make their widgets, and how their business could be affected by everything in the news? A thirty second soundbyte is not the same as reviewing a year of 10Q and 10K filings.
3. There might be “cracks” in the story. Your resource might have analyzed the company’s discounted cash flow or noticed that it was highly leveraged. But it might not have, and so there might be things about the company you don’t know.

How could I do something so foolish–taking the advice of someone who calls himself the Gorilla? … I have no idea why I purchased the damn stock in the first place. And this is galling because it makes me feel helpless. I mean, I’m not even making my own mistakes. I’m making someone else’s mistakes.
-from “Just Monkeying Around” by Andrew Feinberg, Kiplinger’s Personal Finance, May 2004

4. If the story changes - when will you find out? The company might report a great deal in the works. But it could say that its largest wholesale customer just fired them. When you are following their story, news like this could signal a time to buy - or it could mean you should sell. So, the million dollar question is: who is keeping their finger on the pulse of your investment? Do you keep an eye on these factors? And, if you follow someone else’s advice - do they?
5. There is a lot of uncertainty. Since you may not understand why the stock is a good buy, you might have even more difficulty understanding it if you see it drop in price. If you are overcome by fear, you might unload it just before the market sends it soaring. Can you handle the idea that you might never feel calm and confident about what is happening to your investments?
6. When do you sell? Investing is all about buying low and selling high. But if you don’t understand the company and its business, you might never know when things are too good. If you wait until the folks on TV tell you, you’ll probably be selling too late. Some investors wait until it drops, and others sell when they believe it is overvalued. But if you buy just because someone else tells you to, you’ll probably never know when to sell - because you never understood why to buy in the first place.

#2: PEOPLE BUY STOCKS BASED ON TRENDS, MOMENTUM, AND TECHNICAL INDICATORS.

This could mean it has an upward trend, its candlestick charts look great, it is below its moving average, or that an alphabet soup of technical indicators all point to the stock. The big picture is the same - some people invest based on what they believe the market is telling them about one particular stock.

This also works - hedge funds and day traders make a living of this type of analysis. But there are a few problems, too:

1. The indicators can change quickly. Hundreds of millions of shares trade each day. Most active traders are tuned in to the market continuously.
2. To excel, you must really understand it. If you want to work with candlestick charts, you need to understand the reversal patterns, what they are telling you, and which ones are more reliable than others. If you look at price and volume data, you need to understand what the data is telling you so you can take immediate and decisive action if necessary. That is not impossible - plenty of people make money doing this type of analysis - but it will take time and effort.
3. You’ll spend more in fees. Depending on the data you’re looking for, you might need access to additional market data. You’ll also be trading stocks more often. This will cost you more; but it is a moot point if you’ll be making more money.
4. The more trades you make, the more mistakes you are likely to make. Let’s say that you were the world’s greatest investor, and that every time you made a trade, there was a 99% chance you were right. That also means there is a 1% chance you were wrong per trade - and, after five trades, it multiplies to a 5% chance you were wrong. This statistical probability of error can build quickly if you are trading every day.

#3: PEOPLE BUYS STOCKS BASED ON PRICE VERSUS PERCEIVED VALUE.

This applies to anyone that looks at a stock, understands it enough to think it is worth more than its current price, and then buys on that reasoning. Some people perform an in-depth analysis of the company’s discounted cash flow, and some people just look at the Price to Earnings (P/E) ratio.

Some people focus on industries that they understand - like restaurants, or pharmaceuticals, etc. It helps if you understand the industry you are investing in because you might have some inside knowledge into the companies you work with. A pharmacist, for example, should invest in pharmaceutical companies and health care businesses because they have inside information the average guy on Wall Street doesn’t have: they know what customers are buying, what pills have bad reactions, and the ‘latest drug’ that area doctors are prescribing. With that kind of industry information staring them at the face every day, why should a pharmacist buy stock in Cisco systems?

Buying what you know about is a very sophisticated strategy that many professionals have neglected to put into practice.
–Peter Lynch, from “One Up On Wall Street”

Other people use screens to come up with a starting list of stocks. One good resource that I use is Morningstar, which has a great stock screener. I also recommend checking out the American Association of Individual Investors (aaii.com).

One screen I use from time to time is John Dorfman’s “Robot” screen. He looks at several criteria, but the last is that he takes the stocks with the lowest P/E values. For more info, see “Robot Portfolio Chugs to Fifth Straight Victory” (PDF).

There is a whole style of investing that fits in this box called “Value” investing. It takes the idea of investing and makes it academic instead of emotional. The whole goal here is to buy stocks at a discount to their value - things the market has not figured out yet. This is the style that Warren Buffett, his mentor Benjamin Graham, and a large number of successful money managers use. Warren Buffett has argued that it is the most successful style of investing.

There are problems with picking stocks this way, too:

1. There is a lot to read and understand. Not everyone can or is willing to commit the time to it.
2. There is a lot of data to sift through. There are lots of screens out there. Some magazines have new screens in each issue. I used to read a month’s worth of personal finance magazines and have dozens of stock ideas to research, and I used to change my screens constantly. You also have to read company filings, look at their balance sheet and cash flow statements, and make sense out of them. This is not easy - but, once you know what to look for, it really isn’t that hard, either. Warren Buffett can do the numbers in his head, and I think this gets easier with experience.
3. Depending on how you come up with your “perceived” value - you could be wrong. Of course, you could be wrong no matter how you pick a stock - unless you buy with a margin of safety.

If I could suggest two books for you to read, they would be:

1. One Up On Wall Street by Peter Lynch
2. The Intelligent Investor by Benjamin Graham - be sure to get the 4th edition with commentary by Jason Zweig.

The first is an easier read than the second, and will give you a lot of ideas on how to pick stocks. The second, however, is Warren Buffett’s favorite investing book, and is definitely worth a read too.

Investing requires work. Successful investors buy things when they are out of favor - so if you don’t have time to think about what could be out of favor, perhaps you shouldn’t be investing?

I’m not against any stock-picking service, but it is my opinion that a stock picking “service” can only get you so far. When you lose money, it will be because you made a decision that wasn’t even your own. And when you do gain, you won’t even understand why - so you have little chance of repeating that performance again and again.

Buying stocks is about taking the time to make clever and educated decisions weeks, months, or years before the chumps on Wall Street come to the same conclusion. By using a stock picking “service”, you are taking away one of your most powerful tools - your brain.

If you can’t spare the time to read a few books, learn a few things, and make educated decisions about your nest egg - you shouldn’t be trying to invest it in individual stocks. Instead, you should put your money into an index fund and hope you can get 10% every year like the rest of the mainstream.

At the end of the day, each of us is on his or her own path. No one knows where we will all end up, but they will all be different places.

But remember, there is no easy path to riches. How many billionaires do you know? How many of them became wealthy by joining a stock-picking service?

McCormick: A Rule #1 Case Study

A few weeks ago, I learned about Phil Town and what he is teaching with his Rule #1 style of investing.

I like Phil’s approach and his emphasis on minimizing risk, and I know a lot of his readers do too. Although I haven’t gotten my hands on his book Rule #1 (it comes out in March), I have been studying the Rule #1 style of investing through articles Phil has written on his blog.

Phil has been kind enough to offer mentoring to anyone that wants it. I’m not a billionaire yet, so I can definitely still learn a thing or two; I took him up on the offer.

A few weeks ago I wrote up a case study on whether or not to buy shares of spice maker McCormick & Co’s stock, MKC. I sent the case study to Phil and he sent it back with his comments. I am posting it here.

Incidentally, the stock was $30.45 then, and has barely moved in the month or so since I started running the numbers.

What follows is a series of answers, notes, and data points that I have put together (and Phil Town has been kind enough to provide feedback on) based on the method of analysis he talks about in his upcoming book, Rule #1. I put this case study together based on Phil’s discussion here and here.

To learn more about Rule #1 investing, a good place to start is Phil Town’s blog.

*** BEGIN CASE STUDY ***

1. Do I want to own the stock? Yes. McCormick is the world’s largest spice manufacturer. We use their products, and nearly all of the spices at my local Wal-Mart happen to be made by them. So I like the company from an ethical point of view.

Phil says: Good reason to own a business.

2. Do I understand the business? It seems simple enough. They buy spices in bulk as commodities, put it in tiny jars and charge prices that make me cringe. They also sell to restaurants and many other companies in the foodservice industry.

Phil says: Okay. That works.

3. Moat? They have a 40% market share. They are eight times the size of their closest competitor, and are clearly the market leader. Spices are used for virtually every food, and if they raise the price by a few cents it doesn’t seem like it will matter. In that sense, they have both the brand and the pricing power.

   But here’s the kicker about that– I hate buying spices because they are so expensive. So my wife and I tend to buy the cheaper $1 spices we can find at dollar stores and what-not. So there is competition out there. But since they are the big fish I believe they have a wide moat.

Phil says: Best of Breed is always a good thing. But lets dig in on the Moat question and look at the Big Five Numbers plus debt to confirm the moat so we’re not just guessing. First, ROIC. Above 17% and growing. Excellent. But Sales growth kind of sucks at 4%. Red flag. EPS is okay at 16%-18% but it dropped off this year. Cash growth is all over the map. Red flag. And equity growth - the most important one — BVPS is bouncy and less than 10% over the last 10 years but better lately. Pink flag. And debt is high. Hard to conclude this business has a wide moat with these numbers. To buy this I would need to really understand the business since the numbers are not a slam dunk.

And do people need to buy spices like they need to buy razor blades?

Excellent question that goes hand in hand with the confused (but not terrible) numbers.

4. Management? Yahoo says that their corporate governance is better than 5% of the S&P 500, and 48% of Food and Beverage companies. Morningstar gives them a B for stewardship.

Phil says: Meaning they are either in the lowest 5 percentile or the lowest 50%. Either way… uhhh. That said, did you read the management letters
to shareholders to get a sense of whether they are driven and owner-oriented? I couldn’t get them to download off their website. (Note: I haven’t read the shareholder letters. I didn’t take this part any further. Management’s rating isn’t stellar, though.)

5. Margin of Safety? Morningstar says McCormick is worth $33, assuming a 7% annual growth rate. At this rate, their earnings will double in ten years. EPS estimates are $1.60 now, so should be $3.20 in ten years. Therefore, at the current P/E ratio, it will be worth about $64 per share in ten years.

   ==> when I do a present value calculation at a 15% rate of return (i.e. =PV(15%,10,,-64)), Excel tells me that McCormick’s stock is worth $15.82 today, based on my assumptions.

   ==> therefore, there is no margin of safety on McCormick and it appears to be overpriced

Phil says: Morningstar thinks 7%. Analysts think (on average) 10%. What do you think? With Equity growth rate as the best proxy for growth rates we’ve got to go with that 7-10% range, I think. Since ROIC is so strong let’s use 10%. (Note: 10% sounds like a good number to me.)

Since the historical PE is about 20 and if we use 10% growth the default PE is 20, lets use 20!

Current earnings $1.52 growing at 10% with a 20 PE gives us a Future Value of $78 ( a bit higher than your $64 - and yours is the more conservative #. I just don’t know where Morningstar is getting its projection of 7% or I’d use it, too.) Sticker of $20. MOS of $10. (a bit higher than your MOS of $8.).

Stock is selling for $31. Not sure why, but if the analysts are right, the ROI on this one isn’t going to be pretty for today’s buyers at that price.

MY QUESTION FOR PHIL: Buffett defines “intrinsic value” as the present value of all of a company’s future free cash flow. Morningstar says TTM Free Cash Flow for McCormick is $277 million, however the 10 year numbers seem to be all over the place and there does not appear to be a consistent upward trend. Should I use this data in computing the sticker price somehow as a comparison?

Phil’s answer: Sure. Take a look. Morningstar guys aren’t stupid and its interesting. But what does that mean? That its only worth $1.70 per share today? ($227 million / 134 million shares)

6. Mr. Market? The stock recently announced a lower earnings forecast and is hovering near its 52-week low. However, based on the valuation and growth numbers (para 5) it does not seem to be a good enough price. The company should be announcing their earnings on the 28th of September, and the stock could tumble in conjunction with it. It looks to me like Mr. Market has been a bit apprehensive (shares are down 20% this year)– but could the worst be yet to come?

Phil says: Nice call. I agree that there is more bad news. This stock price seems to be way ahead of the business.

7. Yield = Annual EPS/Price = $1.60/$30 = 5.3%. If 7% annual EPS growth, EPS will be $3.14, therefore yield will be $3.14/$30 = 10.4%.
8. What is the history of EPS Growth? EPS has grown 250% in the last ten years. Current EPS estimates for this year are $1.60. Yahoo is saying their year over year quarterly earnings growth are - 0.1%.
9. Return on Equity? TTM ROE 26%. They have had more than 20% return on equity each year since 2000, possibly longer (I couldn’t find the data before 2000 on Morningstar). Overall, shareholder’s equity has increased by 60% in the last ten years.
10. Dividend? Shares pay 16 cents per quarter. This has increased each year for the last 16.

Phil says: I get very nervous about businesses with bouncy numbers that have nice steady dividends. That is designed to mislead investors, in my opinion.

11. Stock repurchase plan? Diluted shares have decreased by 30 million over the past ten years.

Phil says: Considering how overvalued they are, this is a sign that management may not be on our side at all since, if they are buying back overvalued stock they are throwing good money after bad.

12. Debt to equity ratio? .859

Phil says: Oh oh. That’s where they’re getting the money for dividends and stock buy backs. Both are bs in this case.

13. Book value per share is $6.02, so the shares seem to be selling at five times book value.

Phil says: By itself not too revealing. But growth of BV, now that’s a good thing to know.

My Conclusion: Avoid

This company is a wide moat company that is a dominant force in its industry. It is the kind of stock I would buy if I could get it at a good price. However, the industry has a relatively low growth rate (2-3%) and the company seems to be cutting costs and making some changes.

Based on my margin of safety calculation, and my calculated “sticker price” of $15.85, this stock is not worth buying. I will keep an eye on it, though, because it could tumble in the upcoming months if earnings remain below the street’s estimates.

Phil says: Nice job. Excellent conclusion that I agree with.

*** END OF CASE STUDY ***

While I was putting this post together, I came across two opposite takes on McCormick. Kiplingers has written that McCormick’s stock “may be one to add to your cupboard for the long haul.” At the same time, The Motley Fool shuns McCormick, saying “if you’re looking to invest in a spice company, read on.”

Obviously, they both can’t be right.

Very many thanks to Phil Town for taking the time to help mentor me and many others. I can’t wait to get my hands on his book!

Ameritrade iZone Review

When it comes to online stock trading, one thing I have learned is that a good online stock broker– with low fees, flexible options, and speedy customer service– is very important.

There are many online brokers to choose from, it is something that affects you every day.

You should definitely take the time to pick a broker that has the features you want. For example:

1. How much human interaction do you need? Can you do all of the trades on your own?
2. How much are you willing to pay for a stock trade? (Ameritrade iZone charges $5 per internet trade, but some other brokers charge a lot more.)
3. Do you need access to pink sheet stocks? (Ameritrade iZone lets me buy pink sheet stocks, but not all brokerages do.)
4. What is the minimum you can invest? (To open an Ameritrade iZone account, you need to invest at least $5,000.)

How I Found Ameritrade iZone

The first stock broker I ever used was Datek Online. The company no longer exists– it was acquired by Ameritrade in 2002.

My Datek account was converted to an Ameritrade account. I didn’t do much stock investing then. But the following year, a family member mentioned Ameritrade’s Freetrade service.

Freetrade was a service of Ameritrade– a hidden service, of sorts. It was a free online stock broker. Anyone with a Freetrade account got 20 free stock trades per month.

Freetrade was great. I absolutely loved it. I wrote these articles about Freetrade, the predecessor to Ameritrade iZone:

1. My Broker Pays Me $2000 Each Year. A brief discussion of Ameritrade’s service.
2. My Broker Gets Even. Almost as if I had created bad karma from my last article, Freetrade then announced it would be shutting down. All Freetrade accounts would be converted to Ameritrade iZone at the end of April 2005.
3. Goodbye, Freetrade. My Freetrade account was converted to Ameritrade iZone. Freetrade was no longer. As of this article, the cheapest discount stock broker I know of is Ameritrade iZone.

I have been using Ameritrade iZone for nearly six months now.

Ameritrade iZone - My Review

I have been trading stocks online for over three years. I used to use Freetrade, but have been using Ameritrade iZone to trade stocks online since April 30, 2005.

I currently use Ameritrade iZone as my online discount stock broker. In general, I am quite happy with the service.

Ameritrade iZone isn’t as cheap as Freetrade used to be. Stock trades are $5 (plus SEC fees of a few cents here and there). And options trades cost $5 plus $0.75 per contract.

However, I am personally finding that Ameritrade iZone’s service is quite fast. iZone executes trades quickly and Ameritrade seems to give me the best prices. I have not had any personal problems with trade execution price or speed as long as I have held an Ameritrade iZone account.

Ameritrade iZone Web Site

Ameritrade iZone’s web site looks great and is a lot more user friendly than Freetrade’s site used to be.

Each option on the upper left side of the screen– i.e. “Trade”, “Portfolio”, “Streamer Suite”, “Research”, and “Account”– are all pull-down menus with multiple options.

Clicking on “Trade”, for example, brings four options– “Stocks”, “Options”, “Mutual Funds”, and “Order Status”.

Getting Started with Ameritrade iZone

Ameritrade iZone requires a $5,000 minimum to open an account. You can transfer this money either by bank wire or by asset transfer if you happen to already have a different Ameritrade account.

In my case, I had some money in an Ameritrade account and sent the rest by bank wire to get over the minimum amount.

Once your Ameritrade iZone account is activated, you can make deposits by bank wire or ACH electronic transfer from a checking account.

Ameritrade iZone credits ACH deposits immediately but puts a five business day hold on these deposits. They will not let you use your deposits to buy pink sheet stocks or non-marginable securities until the hold is cleared.

The Ameritrade iZone web site is fast. Not only do you get free real-time quotes (you can get the latest data using the quote box at the bottom of the page), but you can trade stocks very quickly if you want to. It takes just a few seconds to enter the data and submit a trade.

Ameritrade iZone vs. Scottrade

I don’t like paying $5 per trade when I used to get them for free– the fees can add up very quickly, especially if you trade a lot.

But since I didn’t really have a choice when they shut down Freetrade, Ameritrade iZone is the best online broker for me right now.

I have been considering switching to Scottrade mainly because they offer “trailing stops”– a service that lets you minimize risk. But I haven’t needed that service yet and Ameritrade iZone fits my needs so far.

Also, Scottrade costs $7 per trade. Ameritrade iZone costs $5.

Ameritrade iZone is not perfect, however. There are a few things you just can’t buy with your Ameritrade iZone account– like bonds, currencies, or commodities.

Aside from that, I would recommend Ameritrade iZone to anyone that has experience trading stocks online. If you are happy to do your trades and do most of your customer support and questions by e-mail, Ameritrade iZone is for you.

Diversifying Is For Losers

When it comes to investing, it seems that everyone wants to minimize risk. They want great returns but don’t want to lose anything while trying. And they’re even asking billionaires like Warren Buffett and Donald Trump for their secrets on how to do just that.

Well known financial writers like Suze Orman - and, ironically, most financial bloggers as well - claim you need to diversify to reduce your investment risk. If you don’t, they say, you could lose money.

But many wealthy people, including Warren Buffett (one of the wealthiest men in the world) say that when intelligent investors diversify, they WILL lose money.

We think diversification, as practiced generally, makes very little sense for anyone who knows what they’re doing. Diversification serves as protection against ignorance.
-Warren Buffett, at Berkshire’s 1996 Annual Meeting

If you are afraid of losing money, then you obviously don’t know what you’re doing. And, if you don’t know what you’re doing– why are you investing in the first place?

I think the big picture here is that the average investor is not very confident about their investment decisions. This is often because they don’t spend a lot of time researching and investing potential investments before they put their hard earned money on the line.

We are all busy people, but ironically many of us take shortcuts when it comes to investments. Often people spend years earning the money that is in their retirement accounts but will spend an hour, or sometimes just a few minutes before deciding where to invest that nest egg. How can you not be apprehensive about such an investment when it was made so callously?

A different approach to this would be to focus the investments you make on market sectors that you are already familiar with. For example, if you have experience working in restaurants, you should consider investing in restaurant or foodservice companies because you already have a baseline understanding about how that industry works and can perform a more educated analysis of restaurants based on your experience.

If you are a pharmacist, then you might want to consider investing in pharmaceutical and biotechnology companies because you already have a background in the industry and know more about it than the average investor.

Buying what you know about is a very sophisticated strategy that many professionals have neglected to put into practice.
–Peter Lynch, from “One Up On Wall Street”

The big picture idea here is that you should not put your money on the line for an investment if you don’t understand the business or are not familiar with the industry. The most successful investors spend a great deal of time researching possible investments and often stick to industries they are familiar with, and not just the latest buzz they hear about on CNBC.

Warren Buffett says that if you can truly recognize a good investment, diversifying is not a good idea. Or, as Donald Trump might say, it’s “for losers”.

According to Benjamin Graham’s principles, if you can find an investment with a sufficient margin of safety, then you are virtually guaranteed to earn a profit. By this logic, Buffett reasons that you should wait until you understand and analyze all of the information to make a potential investment. And when you do, you should jump in with both feet.

The main mistakes we’ve made , some of them big time, are: 1) Ones when we didn’t invest at all, even when we understood it was cheap; and 2) Starting in on an investment and not maximizing it.
–Warren Buffett, May 2004

Should I Hire A Stock Picking Gorilla?

Please note: GorillaTrades is a registered trademark of GorillaTrades, Inc. Neither WealthJunkies.com, its publisher, nor the authors of these articles have any affiliation with the GorillaTrades service.

In recent months, I have stumbled across many web sites that will pick stocks for you. These are not just a star rating like Morningstar. Most actually send you e-mails recommending when to buy, sell, and short stocks. It is like a stock trader’s version of “paint by number”.

There are probably hundreds, if not thousands of sites that do this. These sites include:

• Shortpicks.com. This site, as the name implies, mainly focuses on stocks to sell short. The resident stock picker, named Varlin, is an M.D. that focuses on biotech companies that are stretching their potential. Cost: $20/month, or $150/year. No free trial, but you can see their results online.
• GorillaTrades.com. This web site’s jungle theme boasts a stock-picking “gorilla” that sends an e-mail to you every day. (My hunch is that it is just a computer program, and that they do not really run a sweat shop full of gorillas.) I have seen them advertised in magazines such as Smartmoney, but that might only explain their price. Cost: $599/year, or $995/ 2 years. 30 day free trial (must sign up and cancel prior to the 30 day mark).
• BefriendTheTrend.com. This web sites offers two separate newsletters. One (”Befriend The Trend”) offers e-mail and instant message alerts for swing traders/day traders, and claims a 815% return since inception in 2002. The other (”Master The Trade”) offers e-mail alerts and claims a 362% return since inception in January 2003. Cost for each: $50 per month, or $130 per quarter. The “Befriend The Trend” newsletter offers a $10 trial for the first month. You can also sign up for their free mailing list.

I have not personally tried any of these services. Although I am curious, I cannot convince myself that any of them are worth it. From what I have seen, each one of these stock-picking web sites picks both winners and losers. But even I can pick losers– so what makes them any better?

Does anyone have any experience with these or any other stock picking services?

(Editor’s Note: We are thinking about trying several of these services for a month and reporting our findings and opinions. If this topic interests you, please let us know.)

Anyone can charge hundreds of dollars per month for their own “premium” stock picks - and not offer a money-back guarantee. It is a great business idea because all they have to do is write a nice disclaimer and send you their picks. They get paid whether or not you lose your money.

Someday, I might even share my stock picking goldfish with the world. But, first - I need to teach it how to write.