Memoire Online - Stock Market Success for Beginners

This section will outline the strategy that this paper will propose for investing. At first, it will outline the market philosophy that the authors of this paper will rely upon in order to develop the strategy. Afterwards, it will discuss the different kinds of risk that can exist for an investor and how an investor should know him or herself and his or her financial position in order to responsibly adjust his or her portfolio for the amount of risk that he or she can take. Furthermore, it will discuss how an investor can overcome the hype caused by financial porn⁴⁵ and so-called market gurus and control for his emotions when he or she is investing in the market. Following this, it will provide information on finding companies and evaluating them, as well as how to organize the information, and to create an investment thesis. It will finish by discussing buying and selling strategies.

This paper makes the assumption that markets are inefficient. It rejects the Efficient Market Hypothesis by asserting that it is possible to beat the market by picking undervalued stocks and selling them at higher prices. The main premise of this strategy will be to combine growth and value investing in such a way that the investor will be looking for strong growth companies at value prices, therefore getting into growth companies when they are undervalued and selling them when the market recognizes their potential and performance. The strategy will also attempt to control for the investor's natural ability to «be human» therefore being prone to error and emotion. In addition, it will try to time the market on a certain level by using technical charts at their most basic level only as value indicators, but not placing too much emphasis on them. In addition, the strategy will be designed to help the investor organize the numerous amounts of information he or she will collect about each company in a manner that would help make the overall analysis and the creation of an investing thesis and strategy easier. Furthermore, it will help the investor increase his or her performance by evaluating it and as such learning his flaws and trying to account for them.

Before investing, it is necessary for the investor to understand him or herself and his or her financial position in realistic terms. This section will outline different factors that will influence the strategy of each i nvestor.

Investing in the market does not come without risks, and it is a necessity to understand that. It is virtually impossible to eliminate risk for any investor in the stock market no matter how skillful. However, it is possible to control the level of risk that is undertaken on any investment. In order to understand how much risk an investor is willing to undertake, there are certain criteria that he or she needs to evaluate about his personal financial position.

The first thing that an investor needs to evaluate is how much money can be invested in the stock market. Managing of personal finances is out of the scope of this strategy, but it is necessary to mention that

45 The overwhelming amount of financial information on television and the news, much of which is useless and promises to make a lot of money in a very little time.

the investor must not be tied to any high interest debt such as credit cards while investing in the stock market. The returns gained in the market will rarely outweigh the interest compounding as an obligation to credit card debt, therefore before investing it is necessary to be free of such debts. Furthermore, it is necessary for the investor to understand that money he or she is investing in the stock market should be highly illiquid assets. This strategy will recommend long term investment and due to market volatility, the longer term, and the better. Remember Warren Buffett's quote, «In the short term the market is a popularity contest, but in the long term it is a weighing machine.»⁴⁶ It is necessary to understand that any investments undertaken need to be taken for the long term. Therefore, for example if the investor has a house purchase planned in the near future, it is wrong for him or her to put the money in the market because in cou ld devalue by the time he or she has to pull it out.

A full discussion of personal investment risk is outside the scope of this paper as it is up to the individual investor to decide how much risk he or she can take based on numerous different factors. Another aspect of investing that must be understood is how much time the investor has to perform research on each stock. He or she must make a decision about whether to be an active investor or a passive investor. An active investment strategy will require more research, while a passive investment strategy may just invest in an index, compromising a lower rate of return for lower volatility and less research.

A certain part of the investment portfolio should be kept in low risk assets such as bonds. The size of that part must be determined by the investor him or herself after carefully assessing his financial situation and future prospects. The part of the portfolio that can be used for investing in the stock market can also be adjusted for risk by certain factors. Several indicators such as market capitalization can be used to determine the general risk level of a given company's stock. For example, small cap companies offer a a greater chance of return for a higher amount of risk, while mega cap stocks such as the ones in the DOW offer lower amounts of risk for lower returns. It is necessary for the investor to adjust his portfolio according to the amount of risk he or she is willing to take.

The media, internet and magazines are full of advertisements for the next big thing, and the «10 Best Stocks.» In addition, friends and coworkers are always excited about the next Furby doll or another next big thing. As an investor, it's hard not to listen to the bombardment of information that is thrown around. However, it is possible to use that information advantageously in a responsible way. Before hitting that «buy» button, the investor needs to have a well defined entry and exit strategy as well as reasons for doing so. This strategy will outline how to evaluate stocks and companies behind them while trying to control for the investor's human emotions and flaws.

Finding Stocks

Even though Warren Buffett respects Bill Gates highly as a manager and entrepreneur, he never had a position in Microsoft stock. The reason for that is because technology companies are outside of Buffett's «circle of competence.» This concept is best described as the area of business you already know. For example, Tony would know the IT industry best, while Buffett would concentrate on the insurance industry. Within that circle of competence, the investor should perform thorough research to understand what the next trends are and what companies are positioned for success.

As described above, investors are bombarded with «hot» stock tips, ideas from coworkers, and other sources. In addition, it's always easy to see the next biggest trends as long as the investor keeps his eyes open. For example, anyone who noticed the Abercrombie and Fitch trend when it first started would have made a very good amount of money by investing in the company. Seeing what people are buying, which industry gets interest and other such factors could point you to successful companies. However, as previously pointed out before, no investments should be made without due research into the company's fundamentals.

After thinking about personal experience, and thinking about the hot stock tips the investor has received from his friends and coworkers, if the investor can't really find any good stocks, many websites provide a very useful tool called a stock screener. With this tool, it is possible to set several criteria and then obtain a result that shows several stocks that fit these criteria. Our advice to set some non-negotiable criteria that the investor will not compromise on. A suggestion would be to specify these factors:

The higher the cap, the lower the risk, in most cases. The definitions of market capitalizations as assumed by this strategy are as follows.

It is important to note that these definitions are not set in stone, and change from time period to time period for many reasons. In order to give a feel for returns of these companies, we have provided a table of their returns:

Returns by Capitalization
Capitalization	Index	1-Year	3-Year	5-Year
Large	MLCP	-4.27%	8.34%	10.43%
Mid	MMCP	-6.7%	10.83%	15.56%
Small	MSCP	-11.39%	8.22%	14.11%

It's obvious to see that mid-caps provide more volatility than large-caps, less volatility than small caps, and seem to provide the best return out of all three over a long time period. But as can be seen from the one year data, the market did not do so well over the past year, and the returns here are negative. This is important to understand and goes back to the previous discussion of risk. This strategy will propose to pick mostly mid-cap stocks because of their increased return and medium level volatility. In addition, it will strongly suggest against companies capitalized at less than $350 million dollars at all, even if looking for high volatility, because it seems that these companies have a much higher chance of failure.

Low dollar volume on a stock suggests that institutional investors have not noticed the stock yet and will not touch it because since they are trading a large number of shares per trade they need high volume in order to move their stock. The investor can use this to his or her advantage because if a small cap stock has not been noticed by institutions yet and it is a fundamentally strong company, it will eventually and when it does, the stock price will increase. The other thing to keep in mind is that if the volume is too low, that means the volatility is extremely high, and there is a chance of inability to sell the shares. Therefore, this strategy will suggest a minimum daily dollar volume of $50,000 per day, and no lower than that under any circumstances.

PEG is the ratio of P/E divided by Earnings Growth Rate. In the previous discussion about earnings and creative accounting, this paper has mentioned that it is possible to manipulate earnings. Therefore, it would also be possible to manipulate P/E. However, if the P/E is used in conjunction with growth rate, the ratio itself cannot be manipulated. Following is a table of PEG Ratio of companies in 2003. The returns were calculated as of April 2006.

PEG Ratio	Number of Companies (1,316 total*)	Median Return	Average Return
Below 0.00	213	43.9%	69.4%
0.00 - 0.99	583	154.1%	225.2%
1.00 -1.50	193	78.4%	92.6%
1.51 - 2.00	102	60.5%	79.0%
More Than 2.00	225	44.4%	69.4%

*Includes U.S. companies trading on major exchanges with market caps greater than $500 million for which data was available.

Stocks with a PEG ratio between 0 and 1 have provided the highest average and median returns. It is necessary to note that this study is not statistically correct because there is no such thing as negative PEG unless earnings growth rate is negative, which is why the companies with PEG less than 0 provided lower returns. In addition, this usually works better for value stocks rather than growth stocks. Therefore, this will help us find value stocks, and we will use other factors to narrow them down to ones that are growth.

Buffet looks for return of equity of at least 20%. Our ideal measure for this value would be above 25%, but if the company seems to have other good fundamentals, and debt is extremely low, then 20% is acceptable.

We are looking for companies whose management can keep them out of debt. Therefore, we are looking for this number to be as small as possible. We will not accept stocks with more than 10% debt to total capitalization, and we will look for ideally for less than 5%.

To be able to successfully invest, it is necessary not only to find information and understand it, but it is also important to present a clear picture of the company. This strategy would like to propose a system for doing so. The system would consist of several spreadsheets to help the investor analyze and narrow down companies that he or she is interested in. There are several phases:

Once the criteria has been run the first stock screener, the companies that are left after elimination will enter Analysis Phase 1 where they would enter the first spreadsheet. Here the spreadsheet will contain quantitative factors that are the most important and the investor must look at

	Analysis Phase 1

Criteria	Significance
Date	When data was collected
Company Name & Ticker	To know what company this is
Current Price	Current price of stock
52 Wk High / Low	Used to judge point based volatility and trading range
Market Capitalization	Company size
Daily $ Volume	Liquidity and volatility
Debt / Total Capitalization	How much capitalization of the company consists of debt.
Industry Debt / Total Capitalization	In order to compare the company to industry levels
Return On Equity - ROE ?	How well the company put capital to work in order to make money for investors. Bigger Is Better and should be increasing over past 5 years.
Industry ROE ?	Compare to industry.
Insider Ownership %	How much of the company is owned by insiders. Bigger Is Better
Stock Buyback Plan	If there is a stock buyback plan that is significant. Yes is better.
5yr Price Appreciation	How much the price changed over the past 5 years.
Current P/E	How high is the price of the company to current earnings. Lower is better.
Avg 5 Year P/E	In order to compare current p/e and see if it's overpriced. Current P/E should be lower
Industry P/E	Average industry P/E. Current P/E should be lower
Price to Sales ?	How is the company priced according to estimated core earnings. Should be lower, and increasing over past 5 years

It is necessary to be aware of recent stock splits as those could influence price appreciation, P/E, and other ratios. Here the investor would look at the companies and make a decision about which to keep and which he or she would not move on to the next level of analysis. Since further analysis takes time, it is necessary to narrow down companies that are not good investments as early as possible before moving on to Analysis Phase 2.

Here the investor will perform more detailed analysis on a smaller list of companies that the first list should have filtered out. He or she will look at:

	Analysis Phase 2

Criteria	Significance
Earnings Per Share ?	Earnings should be increasing.
Core Earnings Per Share ?	EPS adjusted for non-recurring revenues. Should be increasing.
EPS - Core EPS	Difference between EPS and core EPS. Reflects on the honesty of accounting and predicts volatility.
Core P/E	P/E based on core earnings
Net Earnings Growth ?	Growth of core earnings should be increasing
Industry Earnings Growth ? Projected Earnings Growth ?	Is the industry growing as fast as company or is the company pushing to the top of the industry. What are the projected earnings for the company.
Quick Ratio ?	How much more cash does the company have than debt due in the next 12 months, excluding inventories. Should be 1 and hopefully going up.
Current Ratio ?	How much more cash does the company have than debt due in the next 12 months, excluding inventories. Should be 2 and hopefully going up.
Industry Quick Ratio ?	How does the company compare to industry
Industry Current Ratio ?	How does the company compare to industry
Dividend Yield ?	A company with a good dividend yield could be a good investment, but we are not looking for dividends since we are looking for growth.
Sales Per Share ?	How well is capital being put to use.
Free Cash Flow ?	How much free money does the money have available to expand?
Net Cash Flow ?	How much money actually moves through the company that's cash.
Projected High / Low	What are the projections for the high and low prices. Lowest projection should be higher than current price.
Value Line Timeliness	Should be 1 or 2. How well the stock should perform relative to all other stocks in the next 12 months.
Value Line Safety	Should be 1 or 2. How safe is the stock compared to all other stocks in the next 12 months.
S&P Stars Rating	Should be 4 or 5. This is a measure that S&P uses to select for their platinum portfolio.
S&P Fair Value Rating	Should be 4 or 5. The lower the number, the more overvalued the stock is.

The stocks that pass through the analysis of this spreadsheet will move to Analysis Phase 3. This phase looks at specific fundamentals as compared to industry and is an optional analysis:

	Analysis Phase 3

Criteria	Significance
Revenues to Direct Costs ?	How much direct cost does it take to generate revenues.
Cash Ratio ?	How much highly liquid assets does a company have
Gross Profit ?	Should stay constant. How much revenue is left after direct costs are spent.
Gross Margin ?	Ratio of gross profit to revenue. Should stay level
Growth Rate Of Expenses	How much expense does it take to generate revenue.
Growth Rate of Revenues	How fast are revenues growing?
Expense to Revenue Ratio ?	Compare to gross margin to see if overhead is growing
Operating Profit Growth	Core income growth. Use if core earnings are not available.
Working Capital Turnover	How many times the working capital generated its value In revenues.
Bad Debts to Accounts Receivable ?	How much money is lost that is not collected by the company because of defaults by the people that owe the company? Is it increasing?
Accounts Receivable Turnover ?	Should stay level as receivables grow, otherwise the accounting is not very honest.
Average Inventory ?	How much inventory is kept on average.
Inventory Turnover	How often is the entire inventory sold and replaced.
DCF Valuation	Results from running the DCF formula.
Margin Of Safety	How much of a margin of safety the investor feels is needed.

These three spreadsheets should provide a complete evaluation of fundamental analysis of the quantitative factors of the company. Inferences made from this should be put onto the investment thesis, the creation of which will be discussed further. Companies that pass the previous three spreadsheets should be further researched by the investor, but this time in terms of qualitative fundamental factors.

The nature of qualitative factors about a company does not permit them to be organized in a numerical fashion, such a spreadsheet. Therefore, this strategy will propose the creating of an investment thesis, containing such factors about the company. It will permit the investor to keep a clear record of why he or she is invested in the company. It will be look similar to this:

Company Strengths Company

Growth And / Or Value

Is this a value or growth stock?

Hopefully it's both.

Why Buy?

Why invest in this company? Does it have a positive earnings outlook? Is it poised to succeed in this industry? Is the PEG extremely low and all the fundamentals are correct? Is the ROE great?

What are the strengths of this company? Is it poised for growth, does it have

competitive advantages? Does it have good management? Is it an industry leader? Does it own a new great patent?

I ndustry

Price Target

How high do you think this stock will go up before it starts going back down.

Is this a fast growing industry? Is it something that will take off in a few years?

Increase Position Target

If you are using DCA (explained

further) when you should you increase your position? This strategy recommends 10%.

Company Challenges. Industry

Re-Evaluation Point

How much does a stock have to decline in order for you to re- evaluate your position? This strategy recommends 10%

Why Sell?

What would have to happen that would cause you to reevaluate your position or sell? Would the earnings drop significantly? Would ROE have to reach a certain point?

Would oil have to reach a price point where you know the industry will react negatively?

There should be no significant internal weaknesses within the company.

Does the company face fierce competition? Does the rising price of oil affect its growth outlook?

Stop Loss Target

When should you pull out and cut your losses? This strategy recommends at 15%

Stock Market Success for Beginners

Proposed strategy

Introduction

Finding Stocks