How to invest

All value investors aim to find the perfect value stocks and make that purchase.

What I define as value has been ridiculed and called speculation many times. Vice versa, what I deem speculation has been embraced by others.

I’ve gone over how to find the best value stocks and special situations, but the following are a few things I look for in any value stock investment.

Value Stock Criteria

Butt Ugly

I love the butt ugly stocks. The uglier it is, the more I like it. I consider myself an investment softie so if a company is neglected, rejected, abused and thrown to the curb by analysts and investors alike without good reason, I like to nurture it in my portfolio.

These are the types of companies that many people assume will go bankrupt, fail or never recover. A little deep analysis shows that they are far from ch 11. These companies are also cigar butt type net net stocks where there is always one or more good remaining puffs.

The thing is, most people just assume they know a company will do this or that without actually digging in. A majority of people just read the press release and news headlines to grasp an overview of the company.

Now this is your advantage, your playing field. You control the court and define the rules… Only because no one is there to play with you

Keep it Simple

Buffett has said to invest only in what you know. i.e. circle of competence.

Let me take it further to explain why I think I’ve been able to do so well this year.

Invest in companies that are so cheap, you don’t need to understand what it does.

Of course it’s a good idea to know what they do but you don’t have to understand every single detail about the company. The simpler the investment scenario, the less risky. The less risky, the more capital you will invest. The more money you put, the more conviction you have.

It all leads to higher returns. This is also what value investors define as concentration.

Most of my multi-baggers this year only required 1 or 2 questions before I made a decision to buy.

e.g. Q. Will the company go bankrupt?

A. No

e.g. Q. What’s the margin of safety?

A. A lot

This is why I don’t invest in growth and story stocks. Too many variables to figure out in order to make money.

Keep the ideas simple and don’t over complicate or cloud it with unnecessary facts.

Correct data + incorrect data = incorrect data.

Downside Protection

I like to look for companies where the downside is protect by the assets. The higher the liquidity and quality of the assets, the better the investment potential. It reduces the risk of a sudden erosion in the margin of safety.

e.g. if a company has a high amount of accounts receivables or inventory, there is a good chance that a substantial amount could be written off which immediately affects the margin of safety.

On the other hand, while cash can be burnt at a fast rate, cash can never be subject to impairment charges.

I prefer to keep the downside protection based off current and short term assets. Not long term assets such as patents or buildings and equipment.

Understand the Definition of Risk in Investing

• Probability of losing all your money
• Having too many scenarios, too many variables and over complicating
• Not protecting the downside

Some Value Stock Ideas

What about these potential ideas for you to consider? They are all on my to do list. Need to find time to go through them.

• TSR Inc (TSRI)
• Champion Industries (CHMP)
• Dry Clean USA (DCU)
• List of 20 net net stocks

Disclosure

Not positions in any stocks mentioned

The latest stock analysis spreadsheet available now!

I’ve generally never held more than 15 stocks in my portfolio at any one time.

I first started investing with $3000 and with each trade costing $12.95, it didn’t make much sense to break it up into 10 positions each making up $300.  Although my portfolio has grown as I kept adding cash along with the capital appreciation, I have never felt the need to add more stocks or re-balance my positions. It was either sell the entire position or keep it.

Recently I’ve liquidated two of my positions which I will detail when it comes time for a July portfolio update but one reason for the sale was that I was finding it hard to fully understand and keep up with the business. I must admit that I didn’t perform as much due diligence on that one and I preferred to sell something I wasn’t so sure about.

This leads to the discussion on concentrating a portfolio or diversifying, which Peter Lynch called deworsifying.

I don’t over concentrate by investing in only 2-3 stocks where the size of one position may be greater than 50% but I do prefer to hold anywhere between 10 to 20 stocks.

Diversify or Concentrate?

The common adage is “not to place all your eggs in one basket” because when something goes wrong and you drop it, a majority of the eggs will break, but then again, a few may not.

But what happens if you place every egg into its own basket? How do you carry 50 baskets? You are just as likely to drop 40 of them.

However, although value investors most often have concentrated portfolios, other types of investors such as pure dividend income investors, safety seekers, mutual fund investors and bond investors are best to diversify as people following this type of strategy tend to dislike volatility.

Diversify or concentrate.. it’s a common argument between many people so I’ll just end this section with a good reason for diversification.

We want to have enough good ideas at work that if we’re wrong or unlucky on one or two, we haven’t lost a significant amount of capital. It’s not unusual for us to make a good decision that has a bad outcome – this is a probabilistic business. If you’re really concentrated and have two bad outcomes out of ten perfectly good decisions, 10% of  our portfolio can blow up. I’ve heard the argument that if you have your top ten best investments, why would you want to dilute it with your 11th best investment? But if I had to order my top ten ideas by how much I thought they’d go up, I guarantee you that wouldn’t end up being the top ten in actual performance. So we’re just more comfortable being somewhat more diversified. – Zeke Ashton

Constructing a Portfolio

Whenever I find an opportunity I compare it with what I currently hold. This way, I can decide whether I should sell something to make room for the new idea or to keep everything as it is but include the stock idea as a small starting position and gradually build my way up.

This method also helps me to decide how much capital to allocate to the position relative to the overall portfolio. A mistake I made at first was simply buying the same amount in a stock regardless of the potential.

The following is a quote by David Einhorn which is a much better articulated explanation of how I construct my portfolio.

We believe in constructing the portfolio so that we put our biggest amount of money in our highest-conviction idea, and then we view the other ideas relative to that. We find things that we think are exceptional only occasionally. So if we find something that is really set up, where we think it’s mispriced, where we have a good understanding of why it’s mispriced, where we think the mispricing is very large and the overall risk is very small, we take an outsized position to make sure we give ourselves the chance to be well compensated for getting it right. - David Einhorn

What To Do?

I hate to leave this post open ended but the truth is that asset allocation and portfolio management is up to the individual and knowing thyself. Some people are perfectly content with holding 3 stocks while another person may need 30 to feel safe.

Just putting something out there for you to consider if you haven’t done so.

One of the hardest aspects I find in investing is not searching for value stock ideas, analyzing businesses or even calculating intrinsic value. I find selling to be one of the hardest and something I am terrible at, which explains why this post is only the second I’ve ever written on the subject.

Mostly because I’ve only ever been long in any investment position and partly because I’m a greedy human being.

Basics of When to Sell Stock

You would have already heard the basics to selling stocks (including this blog). The basics to selling is:

• selling once it reaches fair intrinsic value
• acknowledging a mistake in the original thesis
• change in company fundamentals
• better stock idea or any other investment opportunity comes along
• in an emergency

It is Difficult Selling Stocks

The problem is that on far too many occasions, I haven’t sold. My greed caused me to try and pick up pennies in front of a bulldozer. Sometimes, I get away with it but once in a while I’m run over and it hurts. This is precisely what happened with my EMAG arbitrage.

Although I was confident that the deal would go through, other completely out of control external factors caused the merger to blow up and my position with it. Just one day before the deadline, I was risking my 50% return (big position at the time) for a few pennies.

But I look back at the situation, recall how I felt after seeing my portfolio drop by 30%, re-read what I wrote and it is enlightening. It helps in reminding me of the lack of discipline and objectiveness.

Learning from Mistakes

With good mid to long term companies that I own, although it reached fair value, I did not sell because I was content with the business operations. This has now become an outdated reason for my continuing to hold.

No matter how good the company, I now prefer to sell once it reaches fair value.

Back when I first purchased KTII and ATW, I was fortunate enough to see the price reach my fair value target within a few months. I held on hoping for it to continue its upward trend. Then the market turned and rather than being cashed out and having a cash balance for new opportunities, these positions dropped like everything else.

This is an example of how holding cash for the next opportunity isn’t so bad.

Selling for Better Opportunities

For someone that goes through quite a number of stocks, I never fully understood how I could go about selling a position each time a better one came along.

If I bought a company one week and next week I come across another equally if not better opportunity, I would have to sell according to the basic rule. But what happens if this occurs every week?

Just like how there will always be someone smarter than you, there is a stock that will always be better than yours.

Selling Losing Positions

When selling losing positions, there are 2 groups of people.

1. A group that waits for the stock to recover so that they do not incur a loss, even if it takes several years to recover
2. Sell even though the return is down 50% because of a new 100+% potential idea

Which would you choose? Most people would say they are number 2 but the majority is in group 1.

I’ve now moved from group 1 to group 2. e.g. Although I like KSWS with its strong balance sheet and experienced management, I sold it and invested in two other positions that have both yielded 20% and 50%.

Mechanical Selling and Trailing Stops

One idea I have been pondering is entering a sell order after my purchase at my fair value. That way if the stock was to run up, it would sell automatically without my intervention.

Other people also swear by the use of trailing stops in protecting gains.

When Should I Sell?

Still asking this question? It may be a hint that you should sell now. Without conviction, there is no reason to be holding.

Disclosure

I hold KTII and ATW at the time of writing

Jae Jun

This is part 2 of the How to Invest in the Stock Market series.

How to Invest in the Stock Market: Part 1 | Part 2 | Part 3 | Part 4 | Part 5

How to Get Started

I found that getting started was the hardest part simply because I just didn’t know where to begin. But I soon found out that learning how to invest is the same as learning anything else. i.e. you have to crawl before you walk and run. There was no shortcut if I wanted to do it properly.

After reading many news and stock tip articles off the internet, everything still made no sense and I remained clueless after spending so much time reading. So I did what we all do when we start learning about a new topic. Identify the basics work up towards the intermediate level followed by advanced techniques.

Basic Level Investing

The following sites will guide you in why you should invest, what should you invest in, how to invest, the different types of stocks, what causes price changes etc etc.

• The Fool.com Investing basics
• Investopedia Basic Investing Tutorial

These two sites alone will provide you with more than enough information on the basics. I spent a considerable amount of time trying to read everything. I still consult Investopedia to this day.

Once the basics were down, I had a strong desire to understand the financial statements and what each line and term meant. I knew by this point that a thorough understanding of the accounting terms and financial ratios was required. With no prior education in accounting or finance, it went over my head at first, but as I kept referring back to it over and over again, it slowly started to make sense.

• Introduction to financial statements
• Beginners guide to financial statements
• Understanding financial ratios

However, you can get a all this information in a clear and concise format in the book Financial Statements: A Step-By-Step Guide to Understanding and Creating Financial Reports. I also wrote a review of the book.

Intermediate Level Investing

After coming to grips with the basics and finally understanding what stocks and investing was all about, it was natural to try and figure out what companies I should buy.

It was at this point I stumbled upon a forum post by Joe Ponzio of F Wall Street and was introduced to the concept of owning a business. Although I had read about a stock being a business in The Intelligent Investor, Joe has to ability to explain it in a clear manner that helps us to visualize the whole process.

It was mind blowing and it completely flipped everything else I was reading on its head. I truly believed that I had to know the technicals and tricks like selling in December and buying in January would produce greater returns.

I came to understand that;

1. buying a stock was owning a tiny piece of the business
2. I had to think like a business owner
   • If you owned your own corner grocery what would you consider important? Is it your EPS is for the quarter or how much cash you have generated for each day? Would you splurge on jets, cruises or pay your cashier $100 an hour? Or would you rather cut useless costs and seek to grow the company?
   • Since we own parts of the business, it is important to identify whether the company you own follows your own ideas of business. e.g. I don’t invest in biotech because I have no knowledge about the industry or business and therefore would be a clueless owner. I also have yet to put my money in financials because I do not understand how one operates.
   • A business owner is also passionate about their business. Are you passionate about your companies?
3. I wanted to be an owner of high quality cash generating businesses
4. there is a price for everything and came to understand fair value or intrinsic value

F Wall Street has an outstanding series of valuing the business which really puts everything in perspective. I have read every single article ever written on F Wall Street which is over 100 and it has been better than any book. (Note that I pre-ordered Joe’s book from Amazon). Visit his How to Value a Business series.

The book I most highly recommend at this stage: Pat Dorsey’s The Five Rules for Successful Stock Investing.

Both F Wall Street and The Fives Rules book introduce the concept of Discounted Cash Flow which was also the starting point of the ongoing investing spreadsheet project available for purchase or free download on this site. I spent hours going through calculations, ratios and formulas and this hands on experience is what I believed to have helped the most.

Then came this blog. I had to force myself to write clear and organized content since it would be scrutinized by all. If I was going to write about something, I had better know what I was writing about. The best thing is, I received constructive criticism which I took to heart and the discussions with fellow like minded readers have helped immensely.

The point is to get involved wherever you can, except Google and Yahoo Finance since it is so abused. Comment and ask questions on high quality content blogs. Discuss with other readers. Start your own blog. The best students were always the ones actively involved.

Coming Up

We’ll be looking at what is involved in advanced investing topics in the next post. Don’t worry it isn’t really advanced.