Before You Buy

Before getting too excited about buying stocks, be sure you have funded your brokerage account.  The days of having to buy round lots (buying shares in multiples of 100) are over – you can get started with as little as $500.  Be sure the money has cleared your account and is ready to use for purchasing stocks.

You need a strategy.  Without a strategy you might as well hit the tables at the nearest casino – your chance of success will be equal.  Most strategies fall under one of two theories:  1) Value Investing and 2) Growth Investing.  Success can be found in either strategy, although historical test have shown Value Investing has outperformed Growth Investing on a long-term basis.  The next blog installment (101.4) will address choosing a strategy.

Selecting Stocks

I recommend building a list of at least five candidates.  I never buy the first undervalued stock I find, and sometimes I won’t buy any.  When I have cash to invest I will conduct my research without time constraints.  Do not rush a stock purchase just because the price is increasing; take one day or even one week to research your candidates before making a purchase.

Know what you are purchasing.  Describe the company to your friend, spouse, or even better, to your kid.  If you cannot accurately describe what this company does you should not buy it, regardless of how good it looks on paper.  There are plenty of opportunities in industries and companies you can understand.  Also avoid companies whose value is derived from financial assets such as loans and derivatives.  The true value of these companies can be very difficult to calculate.  We saw during the Lehman Brothers collapse in 2008 that financial companies can tank your portfolio due to the difficulty of truly understanding their assets.

Baby Steps. It's a Big World of Investing.

Know your selling price…before you buy.  This is the most common mistake made by investors of all levels of experience.  Regardless of your strategy know at point you will exit this stock.  Make the exit point a price, not a time, as you cannot predict market forces.  All things equal, choose the company with the most attractive exit price.

Making the Purchase

Once you have selected your stock you will need to enter your purchase request.  You will most likely see two prices for your company:  the “bid” price and the “ask” price.  Be sure you understand the difference:

Bid:  The bid is the price that you can sell your stock for.

Ask:  The ask is the price that you can buy a stock for.

Learn more about Bid and Ask.

Ensure you have enough money in your account to cover the purchase plus commission.  For example, you want to purchase shares of ABC.  You have $1,000 to spend and you want to spend it all on ABC.  Your broker charges a commission of $7.99 on purchases and sales.  The “ask price” of ABC, or the price it is selling for, is $23.34 per share.

$1,000 – $7.99 = $992.01

$992.01 / $23.34 = 42.5, or 42 shares

You can purchase up to 42 shares of ABC (I do not recommend purchasing fractional shares).

All online brokers will have a “Trade” command.  This command will contain options such as stocks, bonds, mutual funds, EFTs and options.  Choose “Stocks” and select “Buy”.  Enter the ticker symbol of the stock you wish to purchase and the appropriate number of shares.  Be sure order type is “Market”, which will result in an immediate purchase of your company at the current market price.  Those who are sensitive to any movements in purchase price can choose a “Limit” order and stipulate the ask price to buy at, but be aware that with Limit orders your purchase may not happen if your ask is not meet, even if it is only a penny or two away from the market price.  All brokers allow you to review the order for between 30 and 90 seconds.  I stress reviewing the ticker symbol and estimated purchase total during this time; you don’t want to purchase the wrong company.  Confirm your order and you are a proud owner of stock.

Monitoring Your Purchase

I recommend keeping your portfolio to 12 companies or less.  For the same reason as only buying companies I understand I also like to keep my portfolio easily manageable.  You should always know which companies you are invested in.  Check your portfolio at least once a week and pull up your stocks in Yahoo! Finance or Google Finance at least once per week, reviewing the headlines of your companies for anything newsworthy.  Review your selling price every quarter, updating it as necessary.

A cool feature offered by most online brokers is an automatic buy/sell feature.  I use TD Ameritrade, where they are called “Trade Triggers™”, and I take advantage of these on every stock I buy.  These auto-commands can protect you from missing your exit price.  Using the ABC example above, say you plan on selling ABC at $58.00 per share.  Enroll ABC in an auto-sell command with $58 as your condition for selling; when ABC hits $58 your shares are automatically sold.  This is great for those who occasionally check their accounts or spend hours each day away from their computer.  I set my commands to expire each quarter, which forces me to revalue my holdings and enter my updated selling price as a trigger.  I also enjoy tracking my purchases in a custom Excel Spreadsheet, which allows me to see all my lifetime of purchases, returns, dividends and more in one location.

Selling

Your stocks will be sold either through the automatic triggers (if enacted) or a process very similar to the buying process described above.  If manually selling you will choose “Sell” and enter the ticker and number of shares you wish to sell (you will be selling all shares in the specific company).  On manual sells I sell on “Market” orders rather than “Limit” orders, although you can argue that my enacted Trade Triggers are really preset limit orders.  During business hours the transaction is completed immediately and the sale proceeds are available for a subsequent purchase.

Buying and Selling Intelligently

The next education post will help you choose a strategy for selecting stocks and calculating your exit price.

One of these is Joel Greenblatt.

Joel Greenblatt

Joel Greenblatt built most of his wealth from the late 1980’s to the early 2000’s.  He graduated from the The Wharton School at the University of Pennsylvania in 1979 and received an MBA in 1980.  Joel Greenblatt and John Petry founded the Value Investors Club, a website where investors are approved through an application process.  The members exchange formulas, analysis and special situation investment ideas.  Membership in this highly prestigious group is capped at 250 members, and the club awards $5,000 to the member who submits the best idea each week.

In 1985, while serving as the chairman of the board for Alliant Techsystems, he founded the hedge fund Gotham Asset Management with $7 million.  While managing Gotham is became famous for his generic-titled “Magic Formula”.  The idea of this formula was to create a quantitative investment strategy for picking stocks.  The formula was made public in his best seller “The Little Book that Beats the Market”, published in 2005 (after he had already millions with his strategy).  The Magic Formula produced returns of 30.8% from 1988 to 2004, beating the S&P 500’s return of 12.4%.

Investment Strategy

Greenblatt buys “cheap and good companies” with a high earnings yield and a high return on invested capital.  He finds these companies by looking at the return a company generates on its capital and at the firm’s earnings yield, which is similar to the inverse of its P/E ratio.  According to Greenblatt, beating the market is not complicated if an investor maintains a consistent approach, exercising discipline, patience and confidence when picking stocks to purchase.

Greenblatt’s Magic Formula

 His formula is not so much a valuation formula, but better used as a stock screener or potential value indicator (much like Tobin’s Q).  This formula ranks stocks from 1 to 50 with 1 being the most attractive stock and 50 being the least attractive.  This formula can be both a stand-alone stock screener or combined with other screeners.

The first step is to exclude certain companies.  The exclusion criteria is:

• Exclude all companies with a Market Cap less than $50 million
• Exclude all companies in the Financial sector.
• Exclude all companies in the Utilities sector.
• Exclude all foreign companies.

Once the above exclusion criteria is in place, the next step is to determine the remaining company’s Earnings Yield and Return on Capital:

• Earnings Yield = EBITDA / Enterprise Value.
• Return on Capital = EBITDA / [Fixed Assets + (Total Current Assets – Total Current Liabilities)].

The next step is to rank the remaining companies by highest earnings yield and highest return on capital.  The rank order will be determined by:

• Add the earnings yield and return on capital together for each company.
• Sort by highest to lowest.
• Assign a numerical value to the top 50 companies.  1 will represent the top company, then 2, and so on.

Current Status

 Greenblatt’s formula is still widely used by funds and financial journalists searching for long ideas.  Much like Warren Buffett’s philosophy, Greenblatt’s common-sense conservative screen is applicable in any type of market.  The team at ValueMyStock uses it behind the scenes on some of our own purchases and are incorporating it into a robust combined formula we will roll out in 2012.  I encourage you to set aside two hours, open up Excel and see what you find using the Magic Formula.  I’m sure you will find some real gems to consider.

To refresh on brokers, here is an excerpt from my previous entry:  “Stocks are purchased through a broker.  The broker acts a middleman between the stockholder and the rest of the market.  With today’s technology the concept of a “stockbroker” is changing from a flesh-and-body broker to an automated system.  Online stockbrokers, commonly known as “discount brokerage houses”, dominant today’s broker market.  All offer discounted stock trading, generally for $9.99 or less per trade.  Most offer research tools and investor education, although the value of these tools and education is subjective.  An investor can hold both regular and retirement accounts, such as IRAs, with these brokers.  All accounts can be used to purchase stocks and mutual funds.”

Choosing a Broker

In 99.9% of all cases I recommend investors open an online brokerage account instead of a live stockbroker.  Your costs will be much lower and the amount of control you exercise over your investments much higher.  Choosing an online broker can be daunting for the beginner, as they all claim to have the best tools, trading platforms, and so on.  Barron’s, a well-respected financial publication, publishes a review each year of the top online brokers.  I highly recommend reading through their March 2011 review before selecting a broker.  Here is a list of some of the most popular online brokers – if you don’t have the time to research you can just pick one off of this list.  Each one should satisfy your needs:

- E*Trade

-TD Ameritrade

-Scottrade

-Fidelity

-Schwab

Most of the major online brokers will also have small offices throughout the U.S., although I use TD Ameritrade and have never visited an office.  Scottrade has a number of offices and probably has one close to you.  The others tend to be in major metro areas.

Opening Your Account

All brokers have links on their home pages for opening an account.  You do not need any money to open an account, but you will want to fund it pretty quickly, so I advise waiting until you have your funds ready before opening an account.  I suggest starting a new account with no less than $500.  You can also rollover a current or previous 401(k) into a Traditional IRA and enjoy all the privileges of owning stock in your retirement account.

You will have to choose what type of account and what services you will need.  Unless you are opening or rolling over a retirement account (IRA) you should select a regular taxable account.  You will be asked if you want to trade options and trade on margin.  I do not recommend beginners trade options or trade on margin, so decline these choices.  You will be asked a number of personal questions, especially related to your knowledge of finance and employment.  Most of these are post-September 2011 controls put in place by Homeland Security to prevent funding of terrorist cells.  If you are married I suggest opening your account as a joint account with survivorship; this will ensure your spouse can handle your account in the case of hospitalization or death.

Once you have entered your personal information you will be asked how you want to fund your new account.  The easiest (and fastest) way is to have the funds in your checking account and choose to ETF your funds from your checking to your new broker account.  Linking the two accounts will allow you to transfer funds back and forth at will in the future.

If you are opening your account via rolling over a previous retirement plan into an IRA there are a few more steps involved.  Upon opening the account either you or your broker (you will be informed which one) will need to contact the company holding your retirement plan – this company and the broker will execute the rollover.  DO NOT withdraw a check from your current retirement account manager, as this could result in an “early withdraw” triggering taxes and a 10% penalty from the IRS.

Coupons and Promotions

Many online brokers offer promotions to entice new customers.  These promotions include a number of free trades, cash back or premium services.  I highly recommend researching on Google any brokers you are interested in (for example, search “Scottrade Promotion Coupon New User”).  You can probably save yourself $50 to $100 with a five minute search.  Also check with friends who may already trade stocks, as most brokers offer referral programs that can benefit both you and your friend.

Buying Your First Stocks

Once your account is open and funded you are ready to begin trading.  Stay tuned for the next entry, where I discuss selecting and buying stocks.

The average reader, and probably quite a few investors, would guess Barack Obama.

The answer is Ron Paul.

On the surface Ron Paul embodies the very core of pure free enterprise:  lower regulation, lower taxes, leaner government and free trade.  I myself believe our country would be better if some of Paul’s less-radical ideas were adopted.  But when investors look deep into their souls and really study what makes this country great, their insides turn at a few of Ron Paul’s deeply-held convictions.

A perennial presidential candidate, each year Paul’s support base grows and his donations climb upward.  Placing third in the Iowa primary and notching a solid second place in the New Hampshire primary, only to have the mainstream press and the “establishment” still snub him, outraging his supporters and solidifying the “us against them” attitude embodied by his followers.  The truth is Ron Paul will never be President of the United States.  The leaders of this country know it, the (educated) media know it, and the “smart money” investors know it.  There is no systematic conspiracy to shut out Ron Paul, just a fear that giving him airtime and attention will fan the flames of Paul’s populist and dangerous ideas.

Let’s take a look at two of these dangerous positions that unsettle the investment community and will keep Paul out of the White House.

Two Ideas Investors Wish Paul Would Drop Like a Hot Potato

Paul is not ashamed, not wishy-washy, not a flip-flopper.  He is concise and clear in his message and his personal life and decisions reflect his stated political views – virtues we like in our leaders.  The problem is the positions, not the man.  Two of Ron Paul’s positions, as copied from his official campaign website:

“As President, Ron Paul will lead the way…by”:

• “Fighting to fully audit (and then end) the Federal Reserve System, which has enabled the over 95% reduction of what our dollar can buy and continues to create money out of thin air to finance future debt.”

• “Legalizing sound money, so the government is forced to get serious about the dollar’s value.”

Why Auditing and Keeping the Federal Reserve is Good for All

I do not know anyone who disagrees with regular audits of the Federal Reserve–we can all agree with Paul on this point, but abolishing it would send America’s economy back to the 19^th Century.

The Federal Reserve (“Fed”) is the central banking system of the United States.  The Fed was created in 1913 as a result of 100 years of boom-and-bust cycles.  Imagine every decade going through swings more intense than 2007 through 2010.  This is what America experienced before the Fed was created.  The worst period spanned the end of the Civil War to 1907.  There was no FDIC insurance, no SEC, no government agency monitoring the economy.  We had the Treasury who printed money and Congress who spent money.  During these wild swings account holders would make a “run on the bank”, withdrawing all of their funds.  Done out of fear, this led to a number of bank collapses, which only fanned the flames of more fear and panic.  Families lost their entire savings, small investors lost the benefits of banking functions, farmers lost the ability to borrow money—it was not a happy time for the average American.  This pattern helped created the great wealth disparity of the early 20^th century.  A few wealthy individuals (Rockefellers, du Ponts, Vanderbilts) were able to profit from these wild swings while the rest of America teetered on the edge of poverty.

The Federal Reserve was partly established so that the average person could have faith in their bank.  The Fed monitors the health of the banking system and holds funds for emergency lending to banks that are prone to collapse (ie, bailouts).  The country needed a central bank that could provide liquidity to the financial system.  But the Fed does not print money.  America’s banking and currency structure is unique – the Treasury prints money and the Federal Reserve handles how it is distributed.  Despite being added to the U.S. Government over 100 years after the birth of the US, the Federal Reserve fits nicely into the system of checks and balances envisioned by the founding fathers.

The Federal Reserve has two high-level responsibilities, or a “dual mandate”–maximize employment and keep prices (inflation) stable.  The Fed does not exert direct control over these two responsibilities; it cannot tell private companies when to hire nor what prices to charge.  The Fed has limited and indirect control over the economy through the manipulation of interest rates, bank reserves and buying bonds from private banks.  When Ron Paul claims the Fed “creates money out of thin air” he is referring to the three tools available to the Fed:

1)  Raising or lowering short-term interest rates.  Setting interest rates is the most visible and important tool because it essentially sets the “wholesale” cost of money. When money is cheaper (interest rates are low), it tends to move more quickly through the system. So when the economy is sluggish, a rate cut perks things up. When the economy is thriving, raising rates prevents the economy from picking up too much speed. An economy moving too fast has too much money in the system, which feeds inflation.

2)  Raising or lowering the amount of reserves that banks are required to hold in their accounts. Raising reserves means banks have to hold onto more money, which tends to tighten credit. This works fine as long as the borrowing under management is coming from banks. These days, most credit is coming not from banks but from the global money markets, where bonds are bought and sold and the market sets interest rates.

3)  “Open Market” transactions.  Open market transactions are more limited, but have a more immediate impact. The Fed turns to these when the financial markets get into trouble, as they did during the recent financial crisis. The specific mechanics of open market moves are simple.  The Fed operates a trading desk in New York through which is can buy or sell bonds. If it buys bonds, the dealer that sold them gets cash in return. That cash then flows through the system. If the Fed wants to reduce the amount of money, it sells bonds from its account — taking cash from the dealer that bought them and taking it out of the system (or “draining” money.) The Fed maintains its own account, so any money being “injected” into the system is not coming directly from the tax dollars collected by the Treasury.

It is incorrect to say the Fed “creates money out of thin air.”  The Fed’s tools only allow it to manipulate the current tender, not print money.  When interest rates are lowered and borrowing becomes easier it can seem that money is being created.  The reality is people are spending more instead of keeping their money in savings, leading to more money in the system.  When the Fed buys bonds on the open market, it is injecting actual cash into the system – but the money already existed, as the Fed obtained that money by previously selling bonds.

Just like any government agency the Fed is not a perfect entity.  It was highly criticized for not acting swiftly enough during the Great Depression.  It is now criticized for acting too broadly during the 2007 recession.  Like America’s history it is an ebb and flow of forward progress.  The Fed should be audited just as any private company should since they serve the needs of both the public and private for-profit banks.  The Fed is an important part of our economy and for the most part has performed a commendable job of keeping inflation and employment stable.  Paul’s rants against the Fed are firmly rooted in populism—Paul knows the average American has no idea what the Fed does and can use that lack of knowledge to build fear about the Fed.  The Fed has managed a level of prosperity (1940 to present) unprecedented in the history of the world.  “Smart money” investors know that ending the Fed would send the country’s monetary management into chaos and end any chance for America continuing this tenure of prosperity.

The Gold Standard

Paul calls it “sound money” but the street term is the “gold standard.”  The gold standard refers to a requirement that every US dollar be “backed up” by a hard currency, whether coins or bullion.  Whether silver or gold, America operated with a hard-money standard from colonial times until 1931, when the official gold standard was abandoned during the onset of the Great Depression.  Paul claims that the dollar should once again be backed by gold and/or silver – that a currency without a hard-specie backing is bound to crash and burn and leads to hyperinflation.  This is another populist argument used by Paul that would send this country on a crash-course to B.C. times.

There are many disadvantages for using a hard-currency backing for the US dollar.  Following our discussion of the Fed, the main disadvantage is that a gold standard limits the flexibility of the Fed’s monetary policy by limiting their ability to expand the money supply, and thus their ability to lower interest rates.  Economic historians blame the gold standard of the 1920’s for prolonging the Great Depression.  Adherence to the gold standard prevented the Federal Reserve from expanding the money supply in order to stimulate the economy, fund insolvent banks and fund government deficits which could “prime the pump” for an expansion. Once the US went off the gold standard, it became free to engage in such monetary endeavors.  It is true that fiat currencies (money that derives its value from government regulation or law, not precious metals) lead to inflation.  But if a country has a strong central bank such as the Fed inflation can be kept in check and allowed to rise at an acceptable rate.  The average rate of inflation in the US over the past 25 years is approximately 4% – an acceptable compromise when considering the disadvantages of the gold standard.

Precious metals such as gold and silver served as early forms of currencies because they were 1) available but not plentiful and 2) had an almost infinite lifespan.  In B.C. times where most business was done between people within a community or between neighboring communities this was fine.  In today’s global environment major economies hold vast reserves of each other’s currencies.  This leads to a shared “peg” of value, meaning that most markets and economies are somewhat dependent on each other, and the value of their currency is supported by the trade done within and between countries.  This is what people mean when they say a “global economy” and why Europe’s current debt crisis is affecting our stock market.

It sounds patriotic and “of the American spirit” to not be reliant on any other currency or economy, but this is one of the best things that happened to world relations.  A leader of one country is much less inclined to declare war on another country if their economies are undeniably intertwined.  Look at the belligerent countries of late, such as North Korea and Iran:  they foster isolationist attitudes regarding trade and currency.

Outside of speculators betting on public fears about the dollar (fears fanned by Paul), our fascination with gold is waning.  Warren Buffett has a great perspective on gold:  “Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”  The only reason gold has any value is people’s fear that their fiat currency may become worthless.  Outside of speculating gold has lost the luster it had with past generations.  As the world emerged from poverty and continues to become middle class people now value things or currencies.  When people have a paycheck flowing into the house they become less interested in the form of the currency, just as long as it will purchase the things they want.  Compare old church hymns (…walk the streets of gold…) to today’s music (…it’s all about the Benjamins…) to see what currency America now holds as desirable.

Returning to a gold or silver standard would put our economy in reverse and set back 100 years of progress, just as ending the Fed would do.  Yes, it would kill inflation and reduce government manipulation, but just the shock of adopting any hard-currency standard (especially when none of our trading partners are on a gold standard) would kill businesses, create unemployment and create uncontrollable runs on banks and necessities such as groceries.  It would guarantee that you, your children and your grandchildren would either live in poverty or constantly teeter on the edge.  We can answer today’s monetary issues with tools less intense than returning to a hard-currency standard.

Love the Man, Hate the Message

There is a lot of love for Ron Paul.  He has energized a disenfranchised base of young, libertarian and curious voters.  He has also taken advantage of their lack of financial education and lack of trust in government.  It is a shame, as he has some great points and could make a fine candidate if he abandoned his populist rhetoric.  I chose just two of his positions – there are others rooted in populism that give financial minds pause, such as refusing to raise the debt ceiling and eliminating the IRS and basically all individual taxes.  They sound good in a debate or in a speech to young, unemployed voters, but some of his other positions would be just as damaging to our economy as the two outlined above.  This is why Ron Paul gets no love from investors.

•  Long-term price stability has been described as the great virtue of the gold standard.  The gold standard limits the power of governments to inflate prices through excessive issuance of paper currency.  Under the gold standard, high levels of inflation are rare, and hyperinflation is nearly impossible as the money supply can only grow at the rate that the gold supply increases.  Economy-wide price increases caused by ever-increasing amounts of currency chasing a constant supply of goods are rare, as gold supply for monetary use is limited by the available gold that can be minted into coin.  High levels of inflation under a gold standard are usually seen only when warfare destroys a large part of the economy, reducing the production of goods, or when a major new source of gold becomes available.  In the U.S. one of those periods of warfare was the Civil War, which destroyed the economy of the South, while the California Gold Rush made large amounts of gold available for minting.
• The stability of the gold standard fosters economic prosperity.
• The gold standard provides fixed international exchange rates between those countries that have adopted it, and thus reduces uncertainty in international trade.  Historically, imbalances between price levels in different countries would be partly or wholly offset by an automatic balance-of-payment adjustment mechanism called the “price specie flow mechanism.”  Gold used to pay for imports reduces the money supply of importing nations, causing deflation and a reduction in the general price level for goods and services, making them more competitive, while the importation of gold by net exporters serves to increase the money supply, causes inflation and an increase in the general price level, making them less competitive.
• The gold standard acts as a check on government deficit spending as it limits the amount of debt that can be issued. It also prevents governments from inflating away the real value of their already existing debt through currency devaluation.  A central bank cannot be an unlimited buyer of last resort of government debt. A central bank could not create unlimited quantities of money at will, as there is a limited supply of gold.
• A gold standard cannot be used for, what economists call, financial repression.  Newly printed money can be used to purchase goods and services, and to discharge debts, at no cost to the printer. This acts as a mechanism to transfer the wealth of society to those that can print money, from everyone else. Financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation, and it can be considered a form of taxation.  In 1966 Alan Greenspan wrote “Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists’ antagonism toward the gold standard.”  Financial repression negatively affects economic growth.
• The gold standard benefits savers by preventing their savings from being devalued or destroyed through inflation, and by rewarding them with higher real (inflation adjusted) interest rates. In the US and United Kingdom, from 1945 to 1980 negative real interest rates have cost lenders an estimated 3-4% of GDP per year on average.
• The gold standard tends to limit credit booms and the resulting boom bust cycle because of the inelastic supply of money. There is no central bank to print ever increasing amounts of money which act as fuel for the boom, and overextended banks fail sooner as there is no central bank to bail them out, causing credit to contract and ending any booms that do occur.

Disadvantages

• The total amount of gold that has ever been mined has been estimated at around 142,000 metric tons and arguments have been made that this amount is too small to serve as a monetary base. The value of this amount of gold is over 6 trillion dollars while the monetary base of the US, with a roughly 20% share of the world economy, stands at $2.7 trillion at the end of 2011.  Even in the unlikely prospect that all mined gold could be turned into coin, a return to the gold standard would result in a significant increase in the current value of gold.
• The unequal distribution of gold as a natural resource makes the gold standard much more advantageous in terms of cost and international economic empowerment for those countries that produce gold.  In 2010 the largest producers of gold, in order, are China, followed by Australia, the US, South Africa and Russia.  The country with the largest reserves is Australia.
• Although the gold standard has brought long-run price stability, it has also historically been associated with high short-run price volatility.  It has been argued by, among others, Anna Schwartz that this kind of instability in short-term price levels can lead to financial instability as lenders and borrowers become uncertain about the value of debt.
• Deflation punishes debtors.  Real debt burdens therefore rise, causing borrowers to cut spending to service their debts or to default. Lenders become wealthier, but may choose to save some of their additional wealth rather than spending it all.  The overall amount of expenditure is therefore likely to fall.
• Mainstream economists believe that economic recessions can be largely mitigated by increasing money supply during economic downturns.  Following a gold standard would mean that the amount of money would be determined by the supply of gold, and hence monetary policy could no longer be used to stabilize the economy in times of economic recession.  Such reason is often employed to partially blame the gold standard for the Great Depression, citing that the Federal Reserve couldn’t expand credit enough to offset the deflationary forces at work in the market.
• Monetary policy would essentially be determined by the rate of gold production.  Fluctuations in the amount of gold that is mined could cause inflation if there is an increase or deflation if there is a decrease.  Some hold the view that this contributed to the severity and length of the Great Depression as the gold standard forced the central banks to keep monetary policy too tight, creating deflation.
• James Hamilton contended that the gold standard may be susceptible to speculative attacks when a government’s financial position appears weak, although others contend that this very threat discourages governments’ engaging in risky policy.  For example, some believe that the United States was forced to contract the money supply and raise interest rates in September 1931 to defend the dollar after speculators forced Great Britain off the gold standard.
• If a country wanted to devalue its currency, a gold standard would generally produce sharper changes than the smooth declines seen in fiat currencies, depending on the method of devaluation.
• Most economists favor a low, positive rate of inflation. Partly this reflects fear of deflationary shocks, but primarily because they believe that central banks still have some role to play in dampening fluctuations in output and unemployment. Central banks can more safely play that role when a positive rate of inflation gives them room to tighten money growth without inducing price declines.
• It is difficult to manipulate a gold standard to tailor to an economy’s demand for money, providing practical constraints against the measures that central banks might otherwise use to respond to economic crises.  The demand for money always equals the supply of money. Creation of new money reduces interest rates and thereby increases demand for new lower cost debt, raising the demand for money.

No one is born knowing how to invest in stocks.  Even those born owning stocks (as some lucky kids are) still need to know how to manage them.  Many people talk to me about stocks and investing, but when I press further many of them know almost nothing about investing basics.  According to recent Gallup polls stock ownership in the U.S. is between 54% and 63%.  This misleading study gives the appearance that half the nation invests in stocks.  The truth is that most stock ownership is largely indirect through products such retirement plans and mutual funds; most Americans have never actively managed a portfolio of individual stocks.

Stocks have been traded for over 200 years.  The modern idea of publicly traded stocks began in 1792 at a meeting between twenty four large merchants. At the meeting, the merchants agreed to meet daily on Wall Street to daily trade stocks and bonds, thus creating the New York Stock Exchange (NYSE).  Stock trading is monitored by the Securities and Exchange Commission (SEC).  The SEC makes sure public companies report their financial results properly and ensures fair trading practices.

This is the first entry in what is a series of blogs educating the first-time investor.  Readers are not required to have a background in finance or even be a college graduate.  A little self-education and common sense will grow your wealth much more so than savings accounts and mutual funds.

Ownership

Stock is literally ownership.  Stockholders own some percentage of a company’s assets and earnings.  Stockholders are also referred to as shareholders since stocks are sold by the share.  The percent of ownership is calculated by dividing the Number of Shares Outstanding by the Number of Shares held by the investor.

Companies can raise money by issuing bonds (debt financing) or selling stock (equity financing).  Debt is a future obligation for the company since the debt must be paid back, plus interest.  Equity means ownership, which does not have to be paid back.  Stock ownership lasts as long as the company remains publicly traded or until the stockholder sells their shares.

Owning stock comes with some privileges, such as voting rights in company matters and limited liability.  Stock agreements are written so that the passive investor (as opposed to a decision-maker in the company) cannot be held personally responsible for the actions of the company.  An investor who invests in a company that commits a crime or violates environmental law will not be taken to jail or sued.  The value of their investment in the company (their shares of stock) may become worthless, but they are never out more than their investment.

Brokerages

Stocks are purchased through a broker.  The broker acts a middleman between the stockholder and the rest of the market.  With today’s technology the concept of a “stockbroker” is changing from a flesh-and-body broker to an automated system.  Online stockbrokers, commonly known as “discount brokerage houses”, dominant today’s broker market.  Examples include:

• E*Trade
• TD Ameritrade
• Scottrade
• Fidelity

There are many more brokerages.  All offer discounted stock trading, generally for $9.99 or less per trade.  Most offer research tools and investor education, although the value of these tools and education is subjective.  An investor can hold both regular and retirement accounts, such as IRAs, with these brokers.  All accounts can be used to purchase stocks and mutual funds.

Opening an Account

Stay tuned for the next entry, where I will discuss opening a brokerage account and trading stocks.

As everyday investors we try to understand what we invest in, but we do not know the intricacies of industries in which we have never been employed.  Therefore our valuations are a “best guess” based on public information about our target company – which is why I require a minimum margin of safety of 30% to account for potential errors in my valuation.  But what if you do know everything about a specific industry – the suppliers, cost of raw materials, marketing channels and sales outlook?  Wouldn’t you expect to have a much more accurate valuation?  Who does know this much about an industry?

The answer is your target company’s competitors.  Competitors buy each other out quite often. Sometimes it is just to remove a threat to future growth, but often times it is because they can acquire the competitor’s sales at a discount.  In other words, Competitor A is attractive to Competitor B because A is undervalued.  I have had a number of my purchases acquired by competitors for prices fairly close to my own target selling price.  For me, this is excellent confirmation that my approach is accurate.  A couple of my best examples:

1.  Phelps Dodge.  Phelps Dodge (PD) was purchased by Freeport-McMoran in March 2007.  I valued PD at $119 and purchased my shares in July 2006 for $80.02.  A $126.46 per share offer was made on November 20, 2006, sending the stock from around $70 per share to over $120.  I sold on November 20, 2006 for $122.57, a 53% return in four months.

2.  Gehl Company.  Gehl Company (GEHL) was purchased by Manitou BF S.A. in 2008.  I valued GEHL at $25.92 and purchased my shares in February 2008 for $18.33.  A $30 per share offer was made on September 8, 2008.  I sold on September 8^th for $29.52, a 60% return in seven months.

Acquisitions are not quite as plentiful in today’s economic environment due to restrictions on lending and many companies sitting on cash until the economy picks up again.  I anticipate seeing a flurry of acquisitions in the next few years as companies use their excess cash to snap up undervalued peers, which means we will have another measuring stick for value within industries.

1.  Freedom from conflict of interest with commissioned advisors and brokers

2.  Advisors are too expensive

3.  Better performance going at it alone

Relatively New Phenomenon

Financial advisors and stockbrokers enjoyed a meteorical wave of success from the early 1900′s through the early 1990′s.  The nature of the system dictated that there were few true self-directed investors.  To purchase stocks during this period you had to pay through the nose for a human broker, and many brokers were strategically aligned with advisors.   Fast forward to the mid 1990′s and we have the birth of the online discount broker.  Percentage-wise there are more people in the market than ever, thanks to cheap trading and information on-demand (and mostly free).   There are an estimated 26 million self-directed investors in the U.S. alone, and this number is increasing.   The U.S. Bureau of Labor Statistics reported that growth for stock and commodities traders was forecast to be greater than 21% between 2006 and 2016. Trends in the reduction of corporate pensions and decreased reliance on Social Security are expected to drive more individuals into self-directed stock investing.  The trend is not just baby boomers:  a 2010 J.D. Power and Associates study found that 40% of self-directed investors in 2010 were between the ages of 18 to 39, compared with 26% in 2009.

Meet the Self-Directed

The typical self-directed investor is under 40 years of age, male and earns about $70,000 per year.  Men are more likely to be self-directed than women:  Spectrum Group research found that nearly twice as many men as women consider themselves self-directed investors, and nearly half of men under 35 make their investment decisions without a financial advisor.  Older, wealthier investors are not to be left out:  A 2011 Cisco IBSG study found that 30% of wealthy investors (those with more than $1 million in investable assets) do not have a financial advisor.  Gallup found in April 2011 that 87%  of upper-income Americans — those making $75,000 or more annually — own stocks, and those aged 50 to 64 are the most likely of any age group to have money invested in the stock market.

The self-directed conduct their research online.  They use established financial journalism like like Motley Fool and Seeking Alpha and create or subscribe to investing tools such as ValueMyStock.com.  Social media, such as Twitter and Stock Twits, is a huge source of real-time information, as 55% of wealthy investors under 50 have used social networking for investment advice.

Self-Directed vs. The Advised

Intuition tells us that investors with professional advisors should earn higher returns than those who go alone.  The advisor is supposed to keep your portfolio diversified and take the emotional element out of your investing decisions.  The problem is that many financial advisors push mutual funds instead of individual stocks:  they are easier to manage and generally avoid the wild swings of individual stocks.  This translates into less volatility but also lower returns for their clients.  The appetite for risk among self-directed investors more than overcomes the perceived benefit of financial advisors.  Upon researching over 600,000 monthly portfolio returns, Marc Kramer found that investment returns for advised investors vs. self-directed investors were about equal, with a slight edge for self-directed investors (Investment Advice and Individual Investor Portfolio Performance, January 2009).  There are additional studies that show either equal performance for both types or greater returns for the self-directed.  The self-directed also get to avoid the fees paid to advisors, helping to increase their net investing returns.

Only Getting Better

We should be excited about the future for self-directed investing.  As the number of self-directed investors expands we will see an increasing amount of resources available for improving one’s own investing returns.  The original goal of ValueMyStock.com was to automate my approach so that I could make faster investing decisions.  When I saw the sheer number of self-directed investors in the market I knew that at least some would find these tools helpful.  If you are a self-directed investor, I hope you find these tools important to your success.  If you are not a self-directed investor, I suggest taking a hard look at what benefits your advisor is providing and consider self-managing at least a small portion of your investments.

The first step is to find the target company’s most recent annual report.  I prefer to create a spreadsheet of their Income and Cash Flow Statements for each line of business.  I look on the company’s website or on the SEC’s website for access to free filings.  It takes some deep digging but all companies will separate their revenue lines.  Once I have each line of business separated then I find comparables for each line of business.  Once I have valued each line I can combine my intrinsic values together for one correct target price.

We are currently developing a dynamic tool that will allow our users to value Conglomerates.  Until then, be wary of any valuation performed on a company with multiple but different lines of business.

In 2010 the movie studios regarded streaming as insignificant revenue – icing on the cake from DVD revenues.  They essentially gave away licenses for streaming content for free.  Fast forward to 2011 and streaming content is the hottest thing in the industry, with Netflix leading the way and Google (GOOG), Amazon (AMZN) and Hulu stepping on to the platform.  You can bet that the studios are no longer going to give away streaming content.  Netflix’s contracts with Sony and Starz (including Starz’ catalog of Disney movies) expire in 2012, as do most of their contracts with other studios.  Negotiations are continuing but the future does not look good for Netflix.  Analysts have estimated that Netflix’s streaming content licensing costs could rise from $180 million in 2010 to an unreal $1.98 billion in 2012.

So is Netflix worth $300 a share?  No.  Are they worth $78 a share?  Possibly.  I valued Netflix on 2010 earnings and cash flow using our Standard Valuation formulaand they appear to be worth $187.  But this valuation is based on last years’ results – do not expect them to repeat these same results with more competition, less customers and higher costs.  They have taken a hit and just maybe have been overpunished by the market, but we won’t know for sure until the contract negotiations are finished.  They will hover around this new 52-week low for awhile.  Keep it on your watchlist and stay current on your valuation, but I do not see any reason to rush into a position.  Own Netflix?  I would not sell either.  The majority of the selling has taken place.  It should rebound a bit as new customers come on board (forecasts are calling for a slight rebound in December).