Most of us are intimidated by stocks. Too many of us have memories of the tech bust. Or a parent or relative that has a story about a stock investment gone wrong. Add to that the armies of financial advisors whose recommendations often don’t beat the market, and it’s not hard to understand why we’re afraid of stocks. So the common wisdom goes, buy real estate instead, it never goes down. Or just put your money in a mutual fund, or an index fund that moves with the market.
Unfortunately, the common wisdom can be pretty far off the mark, as many of us are finding out today. Real estate doesn’t go down? Tell that to the people whose houses are now in foreclosure. And I would say it isn’t over yet. It’s still going down. What about the “just buy an index” strategy? Well, over very long periods of time it works. But had you bought the Dow in 2000, you would have had to wait until 2007 before it returned to that same level. So you still have to figure out when there’s a top, and when there’s a bottom. And that’s assuming you buy the right index.
Seem hopeless? Far from it. What’s amazing about stocks is how much you can do with just a little bit of work. And the truth is, there is no better time to be an investor. Today, opening a stock account is as easy as opening a bank account. In fact, even easier, because you can do it online, at home. And now, there’s more information than ever. It wasn’t long ago that you had to drop a bunch of money at a major brokerage firm and pay major fees just to get research and trade your stocks. Now you can turn on CNBC, scour the internet, and buy stocks for as little as $7 a trade.
Buying the Cycle
There’s lots of ways to make money as an investor. The challenge for the individual is to sort through all the different approaches, to sort through the flood of information, and find a method that works for you. And that’s exactly what I’m going to propose to you.
In an earlier article, we talked about “Making Money While You Sleep.” In that piece, I highlighted an approach called, “Buying the Cycle.” Let me give you the highlights of that method:
Everything moves in cycles.
Stocks go up, then they go down. So does real estate (if you still think real estate doesn’t go down, we’ll discuss this in another article). So do companies. They do well, they stumble, they regroup, and get back on track.
When you’re looking at cycle, keep in mind that a company has to have a track record to figure out where it is in its cycle. And companies with a track record are safer. You can also make money off companies that a newer and growing quickly (a “growth” stock, of course), but they are harder to evaluate. Without as much of a track record, they can also be riskier. We’ll cover looking at growth stocks in another article.
Buy companies protected by high barriers to entry
You’ll often hear people say, look for companies that have a “wide moat”. Basically, this means that it’s very hard for a competitor to come in and duplicate what that company does. Take Boeing, a stock we talked about in an earlier article.
Boeing makes airplanes, and that’s a very hard thing to duplicate. It took a consortium of six countries to create Airbus, the European airplane maker. China plans to make planes, but it’ll take decades before they become close to what Boeing can do.
In contrast, consider the airlines themselves
There’s competition everywhere. Don’t like Northwest? Fly United Airlines. Don’t like United? Fly American. For every route, there are several options. A whole different ballgame. You ever wonder why American airlines are always in bankruptcy every few years? Competition, that’s why.
So how do you spot a company protected by high barriers to entry?
Usually they’re monopolies (a single company that dominates an industry), an oligopoly (several companies that dominate an industry), or an industry leader (often called “best of breed”) with significant advantages. Another key hint: a brand that consumers just can’t do without.
Examples are everywhere. Coke, Pepsi, Boeing, Intel, Microsoft. Look around your home, look even in the most arcane businesses, there’s always a known brand that is “best” or demanded by the customer.
Buy the company at a discount; the bigger the discount, the better.
Okay, how do you know a company is discounted?
There’s lots of ways, and many, many pages have been written on the subject. As a starter approach, you can look at the PE ratio (mentioned in the last article). PE ratios change over time; they increase and decrease. If the PE ratio is historically low, or low relative to the company’s competitors, then that’s a good initial sign.
You can also look at the company’s chart and see where it is relative to the year high or year low. This is just one of many indicators, because a company at year low isn’t necessarily a buy, and a company at a year high isn’t necessarily a sell. Take this at one of many data points that will lead to a buy or sell decision.
Look for a trend or a catalyst that will spur growth
This is key. If you can identify a driver for growth, then you have a framework for understanding where the company will go. For example, Boeing has been offering a new, more fuel-efficient next generation plane made of lighter materials. Apple has the iphone, and allowing Windows to operate on Mac systems should increase demand for Mac computers.
If you understand the catalyst for growth, then you will also know when the cycle will end. The catalyst will be something that drives demand; when that demand tapers off, it’s time to sell the stock.
Look for strong management
You want your money to be in good hands. You wouldn’t hand cash to just anyone, you’d evaluate the person you’re giving money to. Evaluate management the same way. And how do you do that? The same way you evaluate a person you meet or might work with. Look at their background, or where they come from. Look at what other people say about them. And look at how they handle situations that come up. When there’s a problem at the company, do they fix it? When there’s a setback, are they honest and open with the public? When they make claims, do they deliver? See, exactly the same way you would evaluate people in your own life.
Why Use This Approach?
Because it’s ideally suited for beginners and people who are investing in their spare time. If you look carefully at each criterion above, you’ll realize that each indicator is just another way to reduce the risk of the investment. That also increases the probability of a good return.
Also note that this is a longer-term strategy. If you think about it, businesses don’t really change that quickly. It takes months, sometimes years, to set the stage for growth. And you’ll find that the drivers of growth are usually longer term as well. Most cycles last years, not months. So you know what? You don’t have to look at your stock portfolio every day, or every minute if you’re buying the cycle. Isn’t that a relief? Go, sleep, I highly recommend it. All you have to do is to make sure that the trend, the catalyst / driver of growth hasn’t disappeared.
So Many Cycles
If you had invested this way over the last five years, you would have made a bundle. All by just buying a stock and holding it (also known as the “buy and hold” strategy. Look at how many cycles we’re in, and how many stocks and sectors are near their all-time highs. Had you bought into airplane manufacturer Boeing, defense (driven by the war), investment banks (driven by low interest rates), commodities (driven by international growth), construction (driven by war, business and international growth), international stocks (driven by growth abroad) – “ any of these, you’d be sittin’ pretty, so to speak.
So where to invest now?
On the investment banking front, I’d be careful, we’ve had so many mergers and so much liquidity, I believe this will fade over the next year as world interest rates rise. So caution and defensive plays are the word in interest rate driven stocks. Given that, consumer staples could be very good defensive plays over the next few years.
In certain commodities we’ve had a huge run (tin, copper), but in others, I think we’re in the 6th or t 7th inning (wheat, coal, oil, gas, etc.) On international growth, same thing. These are harder to play, because they don’t trade at significant discounts. As a result, they require more monitoring. We’ll look at these plays in more detail in future articles.
All sounds great, doesn’t it? Now, it’s time to put down some cash. Okay, I can sense the nerves going already. And that’s okay. You might read this article and say it makes sense, but it’s all new, and taking action is a whole other thing.
So here’s what I suggest
Take a stock that fits the above criteria, open up an account, and buy, say… 10 shares. Yep. 10. That’s an easy step. And I’ll even give you a recommendation. One I consider relatively safe. Altria (MO), maker of Marlboro cigarettes. Be advised, I put my money where my mouth is, and I own shares of Altria. Lots (at least for me).
It’s a leader in its industry and has a wide moat. Altria owns just under 50% of the US cigarette market, 15% of the international market. Competitors may nibble at their market share, but it’s going to be hard to put a major dent in their business. Another indicator of their strength is that they can pass on price increases. Years ago, a pack of cigarettes were $2-3. Nowadays, they’re $5-6. So you know there’s pretty loyal demand for the product.
And it’s at the beginning of a cycle.
The last couple years have been dominated by litigation. As the risk of litigation recedes, they’re free to actively manage their business and move things forward. This month, Altria announced that they were testing smokeless tobacco. New products and diversification is a good thing.
Management is solid
They’ve guided the company well over the last few years, and everything seems to indicate that they are taking the proper steps to create growth.
And here’s the bonus
Altria is composed of Philip Morris International and Philip Morris domestic. The company is expected to spin-off a division and split the company into two pieces. The international portion will have strong growth; the domestic portion will focus on innovating and creating new domestic products. Both companies are expected to do well.
No doubt you’ve heard of a piece of land that was split into two smaller pieces. Now, have you ever heard of a case where the two individual pieces were ever worth less than the original bigger piece? The two pieces are always worth more. And the same is true with companies, assuming each piece, on it’s own, is a good company. So with the spin-off, there should be an increase in value. Altria used to be composed of international, domestic and Kraft. Kraft was spun of in March, and that has already proven to be a boon to investors.
When the spin-off happens, you’ll own both international and domestic. You can pick the growth side (international) by selling off domestic, pick the “value” side by selling off international, or hold onto both. In the Kraft spinoff, I held, so I own MO and Kraft today. When the spinoff happens, I plan to hold both international and domestic.
Oh, and there’s the dividend, 3.9%. So basically, just for owning the stock, you’ll collect 3.9%. Almost as much as the bank. Pretty good, huh? Altria deviates slightly from the model I presented because it doesn’t trade at a huge discount. But the dividend and the spin-off bump up the expected return.
As of today, 6/15/07, Altria trades a $72.67. It’s near a high, so when it pulls back a few bucks, buy 10 shares. That’ll be $700 – $750. My guess is that you’ll make 5-10% on this stock over the next year, at least. Good way to start, I think.
Stock Update. In previous articles, I’ve mentioned Boeing (which I own in my personal portfolio), and Whole Foods. Here’s an update on the two:
When we last looked at Boeing on April 10, it was trading at $90.84. As of 6/15/07, Boeing was at $98.15. I will continue to hold Boeing, it’s 787 Dreamliner is the best selling airplane ever, and orders are expected to continue coming in. Also, several American airlines that have just come out of bankruptcy and still have to order planes since their fleets are aging. They may not order this year, but they will have to order new planes over the next couple years.
The question now is whether Boeing can execute. Delays could knock the stock down. All indications are that the plane will arrive on time. We should know over the next couple months, but I’m betting that production issues, if there are any, will not be significant.
In May, when we reviewed Whole Foods, the stock was at $45.84. I thought the PE was too high, and do not own any shares of Whole Foods. Since then, it has dropped to $39.66 today. At today’s PE of 29.5x, I think it’s still too high, especially given weaker growth this year. In other words, its not trading at enough of a discount to be a buy for me.
Thanks for reading, and until the next time, sleep well.
Ming Lo is an actor, director and investor. He has an A.B. from Harvard College, Cum Laude, and an MBA and an MA Political Science from Stanford University. Prior to going into entertainment, Ming worked at Goldman, Sachs & Co. in New York and at McKinsey & Co. in Los Angeles.