2009-03-30

Learn from Buffett's error --- Don't focus on charts and Technical analysis!!

There's one stock-picking strategy many people have tried. In fact, Warren Buffett spent eight years working with it before discarding it as worthless. What investment strategy is that? Technical analysis.

Invest like a lemming
Technical analysis is the practice of predicting where stocks will trade based on charts of historical pricing and volume information. Technical analysts look at the past charts of prices and different indicators to make inferences about the future movement of a stock's price. It is the polar opposite of fundamental analysis, and there's a certain logic to it. Stocks trade based on supply and demand, which is greatly influenced by investors' attitudes about the stocks. The charts should reflect those attitudes and might predict where the individual stocks will go.

It's an attractive idea. Clorox (NYSE: CLX) has bounced between $55 and $65 quite a few times in the past few years. Why not buy at the low, and sell at the high? Or look at Green Mountain Coffee Roasters' (Nasdaq: GMCR) chart. Clearly, investors love the stock. Its rise from $24 to $48 seems unstoppable. Why not jump aboard and profit?

Technical analysis is a simple yet compelling strategy. You can see why Buffett spent years early in his career trying to master it.

An expensive mistake
But Buffett discovered one small problem. Technical analysis didn't work. He explained, "I realized that technical analysis didn't work when I turned the chart upside down and didn't get a different answer."

After eight years of trying, he concluded that it was the wrong way to invest. Then he focused on the teachings of Ben Graham, which stressed business fundamentals, finding a strategy that both made sense and, more importantly, worked.

Three simple rules
The billionaire discussed that strategy at the 2008 Berkshire Hathaway (NYSE: BRK-A) general meeting. When he was asked how to avoid the crowd mind-set, he said he simply followed Graham's three most important lessons:

1. Buy stocks with a margin of safety.
2. A stock is part of a business.
3. The market is there to serve you, not instruct you.


The first lesson usually makes the headlines. It means that you should buy stocks for less than they're worth. But when Buffett talks about the second and third lessons, he's basically admitting that he wasted eight years of his investing life.

Buying a business
After all, thinking about a stock as part of a business is the opposite of what technical analysis is all about. Technical analysis focuses on trading securities. It doesn't matter whether the security is a share of Suncor Energy (NYSE: SU), with its oil sands, natural gas, energy marketing, and refining segments; or whether that security is a derivative promising the delivery of three tons of Italian meatballs. It's all the same because technical analysis doesn't care about the business -- or the fundamentals.

In Graham's second lesson, stocks are far more than just pieces of paper or lines on graphs, and to understand them, you need to understand the business. If you're looking at Under Armour (NYSE: UA), ignore whether the stock has been up three days in a row, and focus instead on how the company plans to address its inventory management issues.

Ways to serve man and woman
Similarly, when Buffett says the market isn't there to instruct, he's saying the movements in the market aren't telling you how to invest.

When Wells Fargo (NYSE: WFC) fell under $2 per share in 1990 (adjusted for splits and dividends), the market was saying that poor-performing California residential loans would sink the company.

When McDonald's hit $13 in 2003, the market was announcing that the Big Mac would end up in the Museum of Neat Ideas Gone Wrong, alongside the tapeworm diet, land wars in Asia, and Paris Hilton's home videos.

But in both cases, the market was wrong.

So, instead of listening to the market, Buffett seeks to take advantage of it. Sometimes, the market will offer to buy a stock for far more than it's actually worth. Other times, it'll offer you the chance to buy shares of a great company for far less than its fair value. An investor who understands the true value of a business will be able to profit when the market offers great companies on sale.

The Foolish bottom line
You can learn from Buffett's error -- don't focus on charts. Instead, understand businesses and seek excellent stocks that the market offers at low prices. These days, the market is particularly treacherous. Some stocks that seem cheap will turn out to be very expensive. Others that are simply beaten down by negativity will post amazing returns.

2009-03-29

Technology and Emerging markets: The biggest losers would be the best buys

Wall Street is not in the spiritual realm, but it does cherish at least one verse from the book of Matthew: "So the last shall be first, and the first last."
The market's biggest losers habitually return in the role of top dog. That's happening right now to two of last year's most beaten-down groups, technology and emerging markets. And both seem likely to continue to outpace other stocks, both because they have good prospects and because they're still relatively cheap.

"You always look at two sides -- not only the (investment) concept but the price of buying that concept reasonably," says Lew Alfest, president and chief investment officer of LJ Altfest & Co. in Manhattan.

The technology sector and developing nations have little in common except that they both are unusually risky. Last year, when risk was punished without mercy, both groups declined much more than broader markets. The average tech-sector fund lost 43.5% of its value, according to Morningstar, while the S&P 500 Index ($INX) declined 37%. Emerging markets funds tumbled 54.4%, while developed foreign markets sank 43.1%.

This year those relationships have been reversed. Tech funds are actually up 2%, as of March 19, while domestic large-cap funds are down 11.5%. Emerging markets funds are down 3.7%, compared with the 13.7% decline of foreign large-cap funds.

Technology: Flush with cash
Technology companies are benefiting currently because they are displaying relatively high resistance to the troubled financial sector.

"Balance sheets for large-capitalization technology companies are phenomenal," says Robert Stimpson, manager of Black Oak Emerging Technology Fund (BOGSX). "They don't have a lot of debt, and they don't have big working-capital needs."

Rather, technology firms have held on to relatively high cash flows, which furnishes their working capital. Last week, IBM (IBM, news, msgs) showed its financial strength by bidding to acquire Sun Microsystems (JAVA, news, msgs), the developer of high-end computer servers.

"Within large-cap technology, there is a persistent characteristic that during times of economic distress, the strong get stronger," Stimpson says. Technology also continues to provide productivity improvements to its customers, enabling them to do more with less. And it continues to innovate, enabling successive waves of new business creation.

Technology was one of the first sectors for which mutual funds were designed, and there are hundreds of them. Among the best are Ivy Science & Technology (WSTAX), Seligman Communications & Information (SLMCX) and T. Rowe Price Global Technology (PRGTX).

Emerging markets: Growing, while the developed world shrinks
Emerging markets, too, are benefiting from partial immunity to the financial crisis.

"Emerging market financial companies have generally not had the exposure to toxic assets like they have in developed markets," notes Craig Shaw, manager of Harding Loevner Emerging Markets Fund (HLEMX).

And while growth has turned negative in developed economies, many developing nations continue to enjoy growth, albeit at a slower rate than last year. Gross domestic product is expected to fall 2.2% this year in the United States, 2.4% in the euro zone and 5.3% in Japan. In China, however, it is forecast to grow 6%, and in India 5%. In Russia it is expected to ebb only 2%, and in Brazil a slender 0.4%.

But after last year's huge losses, stock prices in emerging markets are lower than in developed-nation stock markets. "They're trading at a price-earnings multiple of roughly 10," Shaw says. The comparable numbers in developing nations are 12 to 14. "So you're getting a big discount on a number of really good companies out there with good long-term growth prospects and strong financials."

In addition to the Loevner portfolio, outstanding emerging-markets mutual funds include Acadian Emerging Markets (AEMGX) and Oppenheimer Developing Markets (ODMAX).

Calling a bottom
The recovery in these two groups could presage a stronger market overall, says Jeff Mortimer, chief investment officer of Charles Schwab Investment Management.

"During bear markets, the baby does get thrown out with the bath water, especially toward the end," he says. "And as things start to turn green, what typically happens is the risky stuff will do relatively better. The junk runs first."
Mortimer believes things started to turn green on March 9, when the S&P 500 ($INX) plunged to 656.73, its lowest level in more than 12 years. It immediately rallied sharply, and closed at 823 on Monday.

"It seems to me (March 9) was very significant," he says. "There was incredible pessimism, a sell-at-any-price mentality. Markets make emotional lows, and that to me was a severely emotional day."

Mortimer expects stocks to "meander down here for awhile" rather than continue to rally hugely. But he also expects the March 9 low to hold, meaning the bear is out of ammunition and it's safe to venture back into equities.

Of course, if the last truly shall be first, that means the financial sector should shoot up like a beach ball held underwater. And indeed financial sector funds were the No. 1 performer during the month ended March 19, sprinting ahead 8.8%, compared with the 6.7% gain of technology and the 6.5% advance of emerging markets. So do you feel lucky? After all, the book of Matthew is gospel.


Source from:By Tim Middleton MSN Money

What Are Mutual Funds

As you probably know, mutual funds have become extremely popular over the last 20 years. What was once just another obscure financial instrument is now a part of our daily lives. More than 80 million people, or one half of the households in America, invest in mutual funds. That means that, in the United States alone, trillions of dollars are invested in mutual funds.

In fact, to many people, investing means buying mutual funds. After all, it's common knowledge that investing in mutual funds is (or at least should be) better than simply letting your cash waste away in a savings account, but, for most people, that's where the understanding of funds ends. It doesn't help that mutual fund salespeople speak a strange language that is interspersed with jargon that many investors don't understand.

Originally, mutual funds were heralded as a way for the little guy to get a piece of the market. Instead of spending all your free time buried in the financial pages of the Wall Street Journal, all you had to do was buy a mutual fund and you'd be set on your way to financial freedom. As you might have guessed, it's not that easy. Mutual funds are an excellent idea in theory, but, in reality, they haven't always delivered. Not all mutual funds are created equal, and investing in mutuals isn't as easy as throwing your money at the first salesperson who solicits your business.

The Definition of mutual funds
A mutual fund is nothing more than a collection of stocks and/or bonds. You can think of a mutual fund as a company that brings together a group of people and invests their money in stocks, bonds, and other securities. Each investor owns shares, which represent a portion of the holdings of the fund.

You can make money from a mutual fund in three ways:
1) Income is earned from dividends on stocks and interest on bonds. A fund pays out nearly all of the income it receives over the year to fund owners in the form of a distribution.
2) If the fund sells securities that have increased in price, the fund has a capital gain. Most funds also pass on these gains to investors in a distribution.
3) If fund holdings increase in price but are not sold by the fund manager, the fund's shares increase in price. You can then sell your mutual fund shares for a profit.

Funds will also usually give you a choice either to receive a check for distributions or to reinvest the earnings and get more shares.

Advantages of Mutual Funds:
• Professional Management - The primary advantage of funds (at least theoretically) is the professional management of your money. Investors purchase funds because they do not have the time or the expertise to manage their own portfolios. A mutual fund is a relatively inexpensive way for a small investor to get a full-time manager to make and monitor investments.

• Diversification - By owning shares in a mutual fund instead of owning individual stocks or bonds, your risk is spread out. The idea behind diversification is to invest in a large number of assets so that a loss in any particular investment is minimized by gains in others. In other words, the more stocks and bonds you own, the less any one of them can hurt you (think about Enron). Large mutual funds typically own hundreds of different stocks in many different industries. It wouldn't be possible for an investor to build this kind of a portfolio with a small amount of money.

• Economies of Scale - Because a mutual fund buys and sells large amounts of securities at a time, its transaction costs are lower than what an individual would pay for securities transactions.

• Liquidity - Just like an individual stock, a mutual fund allows you to request that your shares be converted into cash at any time.

• Simplicity - Buying a mutual fund is easy! Pretty well any bank has its own line of mutual funds, and the minimum investment is small. Most companies also have automatic purchase plans whereby as little as $100 can be invested on a monthly basis.

Disadvantages of Mutual Funds:
• Professional Management - Did you notice how we qualified the advantage of professional management with the word "theoretically"? Many investors debate whether or not the so-called professionals are any better than you or I at picking stocks. Management is by no means infallible, and, even if the fund loses money, the manager still takes his/her cut. We'll talk about this in detail in a later section.

• Costs - Mutual funds don't exist solely to make your life easier - all funds are in it for a profit. The mutual fund industry is masterful at burying costs under layers of jargon. These costs are so complicated that in this tutorial we have devoted an entire section to the subject.

• Dilution - It's possible to have too much diversification. Because funds have small holdings in so many different companies, high returns from a few investments often don't make much difference on the overall return. Dilution is also the result of a successful fund getting too big. When money pours into funds that have had strong success, the manager often has trouble finding a good investment for all the new money.

• Taxes - When making decisions about your money, fund managers don't consider your personal tax situation. For example, when a fund manager sells a security, a capital-gains tax is triggered, which affects how profitable the individual is from the sale. It might have been more advantageous for the individual to defer the capital gains liability.


2009-03-27

Great opportunities of Investing in Smartphone Market

A freshly issued market analysis from mobile ad vendor AdMob raises some interesting questions about how the burgeoning smartphone sector is evolving, both here and around the world.

AdMob serves advertising to more than 6,000 websites, and it collects statistics about every mobile device that serves up one of its banners. While this measurement method isn't perfect, overweighting certain geographical regions, it should give a reasonably accurate picture of how people are using those fancy everything-plus-the-kitchen-sink smartphones to access the Internet today.

According to this data, Nokia (NYSE: NOK) is the undisputed king of mobile Internet usage, with a 30.2% global market share. You don't think of Nokia as a smartphone giant? Maybe that's because the Finnish company holds a mere 3% of the U.S. market. Here, Apple (Nasdaq: AAPL) is the unsurprising champion; its devices claim 27.1% of all domestic mobile ad views. Investing in Apple makes good sense because of it's platform, vison, and corporate strength.

The Android smartphone platform, blessed by Google (Nasdaq: GOOG), grabbed a 5% traffic share in the first three months of its young public life. It is among the top Web-using devices on Deutsche Telekom's (NYSE: DT) T-Mobile network. The trickle of Android models is poised to turn into a torrent of Samsung, Motorola (NYSE: MOT), and LG Electronics offerings, which should expand the Android's market clout considerably.

The Research In Motion (Nasdaq: RIMM) BlackBerry line is another American overachiever. A 22% U.S. traffic share translates into a 10% slice of the global cake, leaving lots of room for improvement. One bright note for RIM shareholders is that BlackBerry users seem to buy new phones on a regular basis -- 97% of their ad requests come from very modern versions of the BlackBerry operating system (v. 4.2 or higher).

By contrast, 12% of Microsoft's (Nasdaq: MSFT) Windows Mobile users are stuck with the nearly four-year-old 5.0 version, which was really aimed at the Pocket PCs that ruled mobile computing back then. Version 5 will lose its "mainstream support" status next year.

It's hard to tell from AdMob's data whether the varying phones just offer a more user-friendly online experience than their competitors, or if they simply outsold the competition. But if it ain't broke, don't fix it. What works for mobile data surfers today should be an indication of what they might want tomorrow. Based on this report, I'd take a long, hard look at Nokia for its foreign strengths, at Apple for its domestic dominance, and at companies with a finger in the Android pie, like Google.

The smartphone market ain't dead. In fact, it's still a mere toddler. There's plenty of growth ahead. Explore and make good use of the opportunity.

2009-03-26

Is Warren Buffett AIG-Proof?

Who needs six degrees of Kevin Bacon when you can play six degrees of AIG (NYSE: AIG) instead?

Since the witch hunt continues for anyone linked to the maligned insurer's money, isn't it really just a matter of time before public scrutiny begins to rain down on the companies that benefited the most from the $170 billion that AIG has received?

Here is where even Warren Buffett himself risks becoming an accidental tourist. Berkshire Hathaway's (NYSE: BRK-A) (NYSE: BRK-B) hands are completely clean, but his company's investment in Goldman Sachs (NYSE: GS) late last year places Buffett just two degrees of separation from the AIG fiasco.

AIG didn't just receive $170 billion in bailout money. The government lodged explosive dye packs into the stash, and now it's starting to blow up in the pockets of everyone who's holding it.

If retention bonus recipients are being vilified for being handed $165 million of the bailout funds in contractual back pats, how much longer will it be before the hounds start sniffing around Goldman Sachs? After all, AIG handed over nearly $13 billion of the now tainted bailout proceeds to Goldman Sachs to settle a score.

Yes, Goldman Sachs is loaded. It probably didn't need the $10 billion in TARP proceeds that it was talked into swallowing down back in October. It also probably didn't need the $5 billion it scored a month earlier in selling high-yielding preferred stock to Berkshire Hathaway a month earlier.

In fact, yesterday's New York Times is reporting that Goldman Sachs is now considering paying back its $10 billion in TARP funds within the next month. After watching companies like Citigroup (NYSE: C) and now JPMorgan Chase (NYSE: JPM) get crucified over corporate jet orders, and nearly every TARP recipient being scolded for executive compensation practices, one can't blame Goldman Sachs for getting out of dodge while the stagecoaches are still running.

However, Goldman's clearly not going to return the nearly $13 billion it got from AIG. It's money that rightfully belongs to Goldman Sachs, though one has to wonder how much of that it would have seen if the government had let AIG collapse under its own weight last year before deeming it too big to fail.

If no one sees that that is where the public anger is going to next, I'll draw you a map.

So, let's go back to Buffett. Berkshire Hathaway's investment in Goldman Sachs was practically bulletproof. Collecting 10% on "perpetual" preferred stock seems like a risk-free bet, as long as Goldman Sachs is still in business. However, it also scored warrants in the deal to snap up $5 billion of Goldman Sachs at $115 over the next few years. Goldman Sachs has to not only survive -- but thrive -- for that to be valuable.

So, Buffett is positioned to likely laugh all the way to the bank on this one, but Berkshire Hathaway will clearly have more money to lug to said bank if Goldman Sachs can keep the bloodthirsty mob away.

They're inching closer, though, so watch out.

Source from:http://www.fool.com/investing/general/2009/03/24/is-warren-buffett-aig-proof.aspx

2009-03-25

How to pick stocks: GARP Investing strategy

Do you feel that you now have a firm grasp of the principles of both value and growth investing? If you're comfortable with these two stock-picking methodologies, then you're ready to learn about a newer, hybrid system of stock selection. Here we take a look at growth at a reasonable price, or GARP.

What Is GARP?
The GARP strategy is a combination of both value and growth investing: it looks for companies that are somewhat undervalued and have solid sustainable growth potential. The criteria which GARPers look for in a company fall right in between those sought by the value and growth investors. Below is a diagram illustrating how the GARP-preferred levels of price and growth compare to the levels sought by value and growth investors:

What GARP Is NOT
Because GARP borrows principles from both value and growth investing, some misconceptions about the style persist. Critics of GARP claim it is a wishy-washy, fence-sitting method that fails to establish meaningful standards for distinguishing good stock picks. However, GARP doesn't deem just any stock a worthy investment. Like most respectable methodologies, it aims to identify companies that display very specific characteristics.

Another misconception is that GARP investors simply hold a portfolio with equal amounts of both value and growth stocks. Again, this is not the case: because each of their stock picks must meet a set of strict criteria, GARPers identify stocks on an individual basis, selecting stocks that have neither purely value nor purely growth characteristics, but a combination of the two.

Who Uses GARP?
One of the biggest supporters of GARP is Peter Lynch, who has written several popular books, including "One Up on Wall Street" and "Learn to Earn", and in the late 1990s and early 2000 he starred in the Fidelity Investment commercials. Many consider Lynch the world's best fund manager, partly due to his 29% average annual return over a 13-year stretch from 1977-1990.

The Hybrid Characteristics
Like growth investors, GARP investors are concerned with the growth prospects of a company: they like to see positive earnings numbers for the past few years, coupled with positive earnings projections for upcoming years. But unlike their growth-investing cousins, GARP investors are skeptical of extremely high growth estimations, such as those in the 25-50% range. Companies within this range carry too much risk and unpredictability for GARPers. To them, a safer and more realistic earnings growth rate lies somewhere between 10-20%.

Something else that GARPers and growth investors share is their attention to the ROE figure. For both investing types, a high and increasing ROE relative to the industry average is an indication of a superior company.

GARPers and growth investors share other metrics to determine growth potential. They do, however, have different ideas about what the ideal levels exhibited by the different metrics should be, and both types of investors have varying tastes in what they like to see in a company. An example of what many GARPers like to see is positive cash flow or, in some cases, positive earnings momentum.

Because a variety of additional criteria can be used to evaluate growth, GARP investors can customize their stock-picking system to their personal style. Exercising subjectivity is an inherent part of using GARP. So if you use this strategy, you must analyze companies in relation to their unique contexts (just as you would with growth investing). Since there is no magic formula for confirming growth prospects, investors must rely on their own interpretation of company performance and operating conditions.

It would be hard to discuss any stock-picking strategy without mentioning its use of the P/E ratio. Although they look for higher P/E ratios than value investors do, GARPers are wary of the high P/E ratios favored by growth investors. A growth investor may invest in a company trading at 50 or 60 times earnings, but the GARP investor sees this type of investing as paying too much money for too much uncertainty. The GARPer is more likely to pick companies with P/E ratios in the 15-25 range - however, this is a rough estimate, not an inflexible rule GARPers follow without any regard for a company's context.

In addition to a preference for a lower P/E ratio, the GARP investor shares the value investor's attraction to a low price-to-book ratio (P/B) ratio, specifically a P/B of below industry average. A low P/E and P/B are the two more prominent criteria with which GARPers in part mirror value investing. They may use other similar or differing criteria, but the main idea is that a GARP investor is concerned about present valuations.

By the Numbers
Now that we know what GARP investing is, let's delve into some of the numbers that GARPers look for in potential companies.

The PEG Ratio
The PEG ratio may very well be the most important metric to any GARP investor, as it basically gauges the balance between a stock's growth potential and its value.

GARP investors require a PEG no higher than 1 and, in most cases, closer to 0.5. A PEG of less than 1 implies that, at present, the stock's price is lower than it should be given its earnings growth. To the GARP investor, a PEG below 1 indicates that a stock is undervalued and warrants further analysis.

PEG at Work
Say the TSJ Sports Conglomerate, a fictional company, is trading at 19 times earnings (P/E = 19) and has earnings growing at 30%. From this you can calculate that the TSJ has a PEG of 0.63 (19/30=0.63), which is pretty good by GARP standards.

Now let's compare the TSJ to Cory's Tequila Co (CTC), which is trading at 11 times earnings (P/E = 11) and has earnings growth of 20%. Its PEG equals 0.55. The GARPer's interest would be aroused by the TSJ, but CTC would look even more attractive. Although it has slower growth compared to TSJ, CTC currently has a better price given its growth potential. In other words, CTC has slower growth, but TSJ's faster growth is more overpriced. As you can see, the GARP investor seeks solid growth, but also demands that this growth be valued at a reasonable price. Hey, the name does make sense!
GARP at Work
Because a GARP strategy employs principles from both value and growth investing, the returns that GARPers see during certain market phases are often different than the returns strictly value or growth investors would see at those times. For instance, in a raging bull market the returns from a growth strategy are often unbeatable: in the dotcom boom of the mid- to late-1990s, for example, neither the value investor nor the GARPer could compete. However, when the market does turn, a GARPer is less likely to suffer than the growth investor.

Therefore, the GARP strategy not only fuses growth and value stock-picking criteria, but also experiences a combination of their types of returns: a value investor will do better in bearish conditions; a growth investor will do exceptionally well in a raging bull market; and a GARPer will be rewarded with more consistent and predictable returns.

Conclusion
GARP might sound like the perfect strategy, but combining growth and value investing isn't as easy as it sounds. If you don't master both strategies, you could find yourself buying mediocre rather than good GARP stocks. But as many great investors such as Peter Lynch himself have proven, the returns are definitely worth the time it takes to learn the GARP techniques.

source from:
http://www.investopedia.com/



2009-03-24

Pick the Defense Stocks into Your Portfolio

Has anyone else noticed that defense stocks are at multi-year lows, and that they're trading for ridiculous price-to-earnings ratios of around 8? Such as Boeing, (BA), Northrup Grumond, (NOC). Haliburton which is kind of a defense stock mostly sub contracting though was up over a buck (HAL). Northrup and Boeing are both decent dividend producing stocks too. Both were at new lows or near new lows but did a nice rebound recently. It’s wise to found some high-performing defense companies whose shares have been beaten down well below their true value.

You must be kidding
I’ll bet many people equate investing in a defense stock with arranging potpourri -- a mundane activity. The perception is that despite their cool products, defense firms are slow-growing and somewhat boring businesses. Indeed, defense companies are considered superstars if they can generate 10% annual revenue growth.

What’s worse (the bear argument goes) is that growth will be much harder to come by in the next decade than the last. The past 10 years were phenomenal for contractors, as the defense budget more than doubled from $292 billion in 1999 to an expected $611 billion next year. But there are now major pressures on spending, including possible withdrawal from Iraq and a financial crisis that requires large sums of government money.

Didn't you say you liked defense stocks?
As a member of the Motley Fool Inside Value team who has spent five years analyzing the defense and aerospace industries on Wall Street, I believe now is the time to get excited about defense stocks. You see, investors are so scared they have forgotten why defense is an excellent area to invest. Here are some reasons:

There are huge barriers to entry.
Long product lifecycles mean high visibility of earnings and cash flow.
Defense programs are hard to cut.
Defense is counter-cyclical to the economy.
Unfortunately, the world is not a safe place.

Entry denied
The defense industry has tremendous barriers to entry. It's a bit like the Augusta National Golf Club, which limits the number of members to about 300. It is almost unprecedented to start a new defense company from scratch. You can build a defense company up through acquisitions, like L-3 Communications (NYSE: LLL) did, but unlike Silicon Valley, for example, you won’t see random start-ups like Microsoft (Nasdaq: MSFT) or VMware (NYSE: VMW) taking the industry by storm.

Of course, there is competition amongst defense contractors, but it's usually limited within each market. There are only two makers of submarines, two main ship makers, three aircraft makers, and only one builder of aircraft carriers. Less competition is good for the existing players.

Boring is the new brilliant
Defense products have long lives, and this leads to high visibility of earnings and cash flow. Did you know that not only are Boeing’s (NYSE: BA) B-52 bombers still flying, but they are also projected to last until 2040, for a total of 80 years? Contrast this with salesforce.com (NYSE: CRM), which may be a great company, but is constantly forced to innovate just to maintain market share. Change destroys businesses, and thankfully, the rate of change in defense is relatively slow, often measured in decades, not years.

Defense programs are difficult to cut
Right now, valuations assume deep cuts to the defense budget. While the budget will face pressure, I don't believe it will fall as much as expected. First, defense programs are notoriously hard to cut because Congress must sign off, and contractors account for significant employment in many states. With the economy reeling, it is important to keep jobs in place. Also, even if programs are cancelled, contractors are entitled to termination fees.

No bailouts needed for these counter-cyclicals
Despite the recent market surge, the economy is expected to remain weak for some time, and defense companies tend to be counter-cyclical to the overall economy, which helps to insulate them from recessions. Even some of our strongest consumer brands like PepsiCo (NYSE: PEP) and Church & Dwight (NYSE: CHD) are not nearly as immune to the current economic environment.

Defense companies have risks such as underfunded pension plans, but on the whole, business results should be steady over the next few years. Indeed, one Wall Street analyst forecasts all of the "big five" defense contractors will increase their earnings in 2010 compared to 2009. I'll take that in this environment.

Are we safe?
Even though valuations have declined enormously, it's hard to argue the world is suddenly a much safer place that it was last year. Many significant threats to our security exist, and just one incident could increase the public's willingness to fund defense programs. Defense spending as a percentage of GDP is historically low at only 4.5%, compared to peaks of 6.2% in 1986 and 10% or so in the 1960s. And while it won't set any speed records, growth has been surprisingly strong -- defense spending has grown at a 5.4% annual clip over the past 50 years.

Excited yet?
It’s time to get excited about defense. Investors appear to be overlooking the many positives of this important industry and have pushed down the sector's valuation, making this a good time to get into an industry with a stable long-term outlook. Paying only 8 times forward earnings for that privilege appears very tempting.

2009-03-23

How to pick stocks: Growth Investing

In the late 1990s, when technology companies were flourishing, growth investing techniques yielded unprecedented returns for investors. But before any investor jumps onto the growth investing bandwagon, s/he should realize that this strategy comes with substantial risks and is not for everyone.

Value versus Growth
The best way to define growth investing is to contrast it to value investing. Value investors are strictly concerned with the here and now; they look for stocks that, at this moment, are trading for less than their apparent worth. Growth investors, on the other hand, focus on the future potential of a company, with much less emphasis on its present price. Unlike value investors, growth investors buy companies that are trading higher than their current intrinsic worth - but this is done with the belief that the companies' intrinsic worth will grow and therefore exceed their current valuations.

As the name suggests, growth stocks are companies that grow substantially faster than others. Growth investors are therefore primarily concerned with young companies. The theory is that growth in earnings and/or revenues will directly translate into an increase in the stock price. Typically a growth investor looks for investments in rapidly expanding industries especially those related to new technology. Profits are realized through capital gains and not dividends as nearly all growth companies reinvest their earnings and do not pay a dividend.

No Automatic Formula
Growth investors are concerned with a company's future growth potential, but there is no absolute formula for evaluating this potential. Every method of picking growth stocks (or any other type of stock) requires some individual interpretation and judgment. Growth investors use certain methods - or sets of guidelines or criteria - as a framework for their analysis, but these methods must be applied with a company's particular situation in mind. More specifically, the investor must consider the company in relation to its past performance and its industry's performance. The application of any one guideline or criterion may therefore change from company to company and from industry to industry.

The NAIC
The National Association of Investors Corporation (NAIC) is one of the best known organizations using and teaching the growth investing strategy. It is, as it says on its website, "one big investment club" whose goal is to teach investors how to invest wisely. The NAIC has developed some basic "universal" guidelines for finding possible growth companies - here's a look at some of the questions the NAIC suggests you should ask when considering stocks.

1. Strong Historical Earnings Growth?
According to the NAIC, the first question a growth investor should ask is whether the company, based on annual revenue, has been growing in the past. Below are rough guidelines for the rate of EPS growth an investor should look for in companies of differing sizes, which would indicate their growth investing potential:
Although the NAIC suggests that companies display this type of EPS growth in at least the last five years, a 10-year period of this growth is even more attractive. The basic idea is that if a company has displayed good growth (as defined by the above chart) over the last five- or 10-year period, it is likely to continue doing so in the next five to 10 years.

2. Strong Forward Earnings Growth?
The second criterion set out by the NAIC is a projected five-year growth rate of at least 10-12%, although 15% or more is ideal. These projections are made by analysts, the company or other credible sources.

The big problem with forward estimates is that they are estimates. When a growth investor sees an ideal growth projection, he or she, before trusting this projection, must evaluate its credibility. This requires knowledge of the typical growth rates for different sizes of companies. For example, an established large cap will not be able to grow as quickly as a younger small-cap tech company. Also, when evaluating analyst consensus estimates, an investor should learn about the company's industry - specifically, what its prospects are and what stage of growth it is at.

3. Is Management Controlling Costs and Revenues?
The third guideline set out by the NAIC focuses specifically on pre-tax profit margins. There are many examples of companies with astounding growth in sales but less than outstanding gains in earnings. High annual revenue growth is good, but if EPS has not increased proportionately, it's likely due to a decrease in profit margin.

By comparing a company's present profit margins to its past margins and its competition's profit margins, a growth investor is able to gauge fairly accurately whether or not management is controlling costs and revenues and maintaining margins. A good rule of thumb is that if company exceeds its previous five-year average of pre-tax profit margins as well as those of its industry, the company may be a good growth candidate.

4. Can Management Operate the Business Efficiently?
Efficiency can be quantified by using return on equity (ROE). Efficient use of assets should be reflected in a stable or increasing ROE. Again, analysis of this metric should be relative: a company's present ROE is best compared to the five-year average ROE of the company and the industry.

5. Can the Stock Price Double in Five Years?
If a stock cannot realistically double in five years, it's probably not a growth stock. That's the general consensus. This may seem like an overly high, unrealistic standard, but remember that with a growth rate of 10%, a stock's price would double in seven years. So the rate growth investors are seeking is 15% per annum, which yields a doubling in price in five years.

An Example
Now that we've outlined the NAIC's basic criteria for evaluating growth stocks, let's demonstrate how these criteria are used to analyze a company, using Microsoft's 2003 figures. For the sake of this demonstration, we'll discuss these numbers as though they were Microsoft's most current figures (that is, "today's figures").

1. Five-Year Earnings Figures

Both of these are strong figures. The annual EPS growth is well above the 5% standard the NAIC sets out for firms of Microsoft's size.

2. Strong Projected Earnings Growth

The projected growth figures are strong, but not exceptional.

3. Costs and Revenue Control
There are two ways to look at this. The trend is down 5.08% (50.88% - 45.80%) from the five-year average, which is negative. But notice that the industry's average margin is only 26.7%. So even though Microsoft's margins have dropped, they're still a great deal higher than those of its industry.

4. ROE
Again, it's a point of concern that the ROE figure is a little lower than the five-year average. However, like Microsoft's profit margin, the ROE is not drastically reduced - it's only down a few points and still well above the industry average.

5. Potential to Double in Five Years
The average analyst projections for Microsoft suggest that in five years the stock will not merely double in value, but it'll be worth 254.7% its current value.

Is Microsoft a Growth Stock?
On paper, Microsoft meets many NAIC's criteria for a growth stock. But it also falls short of others. If, for instance, we were to dismiss Microsoft because of its decreased margins and not compare them to the industry's margins, we would be ignoring the industry conditions within which Microsoft functions. On the other hand, when comparing Microsoft to its industry, we must still decide how telling it is that Microsoft has higher-than-average margins. Is Microsoft a good growth stock even though its industry may be maturing and facing declining margins? Can a company of its size find enough new markets to keep expanding?

Clearly there are arguments on both sides and there is no "right" answer. What these criteria do, however, is open up doorways of analysis through which we can dig deeper into a company's condition. Because no single set of criteria is infallible, the growth investor may want to adjust a set of guidelines by adding (or omitting) criteria. So, although we've provided five basic questions, it's important to note that the purpose of the example is to provide a starting point from which you can build your own growth screens.

Conclusion
It's not too complicated: growth investors are concerned with growth. The guiding principle of growth investing is to look for companies that keep reinvesting into themselves to produce new products and technology. Even though the stocks might be expensive in the present, growth investors believe that expanding top and bottom lines will ensure an investment pays off in the long run.

source from:
http://www.investopedia.com/university/stockpicking/stockpicking4.asp

2009-03-22

How to Spend Money In a Recession

It's important to save where you can, but it's just as critical to spend where you should.

When times are tough, most people think they should spend less and save as much as possible. That's good advice in many situations, but there are exceptions. Maybe we can call it spend money on the right time at the right place. Here are seven of them:

Home improvements: A recession is a great time to do work on your home. Materials will be discounted, since demand will be low. Labor is plentiful and cheap. And if the work increases the value of the house, spending extra money to get them done when times are tough makes financial sense.

Your health: Your health is always important, but it is even more crucial during dour economic times. You can't afford to miss work for an extended period without placing your job at risk. Preventive measures, even if they cost extra, are important. In addition, you need to quickly address ailments so they don't turn into something major later on.

Quality food: Food tends to be one of the few budget items that can be juggled to save money here and there. The problem is that people often choose to buy poorer quality food, which isn't as healthy. The food you eat will determine your energy level and resistance to colds and illnesses. Also, learn the tricks of the coupon trade so you can get quality food and save money at the same time.

Retirement: If you have the money, now's the time to buy stocks and other investments, especially if your timeline for needing the money is decades away. While people feel more secure when the stock market is rising, that's when equities are more expensive. Stocks today are less than half of what they were at their peak -- a bargain.

Products that save you money: More than ever, it makes sense to spend money on appliances and gadgets that will save you money in the long run. Price tags and labor are cheaper, and the extra efficiency will pay off in the long run.

Costs to relax: When the economy turns sour, it brings on stress. Stress is not only bad for your health, it can ruin relationships, cause a decline in job performance and affect decision-making when it comes to finances. The key is to know what reduces stress and figure out a way to keep or increase that activity in your budget. For example, a gym membership may seem like a luxury when there isn't enough money to go around, but exercise is a known stress reliever. Perhaps painting is your stress relief. Whatever the activity may be, don't scrimp.

Repairs and maintenance: Lengthen the life of what you have and avoid spending money on brand-new equipment. The amount you spend may be a fraction of the replacement cost.

Source from: thestreet.com

2009-03-20

China's Stimulus Package is getting to work

We know that China has revealed its stimulus package and some relevant policy. This week, the Chinese stocks market gave people new hope, with rising 0.68 percent on Friday, led by nonferrous and petroleum shares. The benchmark Shanghai Composite Index added 0.68 percent, or 15.33 points, to 2,281.09. The Shenzhen Component Index rose 0.29 percent, or 25.04 points, to 8,647.51.


For years, the Chinese funded the U.S. debt fueled spending spree by heavily investing in our economy via U.S. Treasury bonds. On November 10, the tides turned when China announced it would be spending $586 billion to invest in its own country. The plan was warmly welcomed by the market and since the unveiling, the Shanghai Composite has risen some 20%.

But is Premier Wen Jiabao's stimulus package strong enough to lift China out of this global recession, achieve its target of 8% growth this year, and keep the Chinese market rally alive?

A promising plan
In contrast to the U.S. stimulus packages that have created much controversy, China's efforts look very promising. Sitting amid piles of cash, the country is fiscally strong enough to finance the anticipated expenditures. And as a country that is still in the middle of transforming itself into a more modern and industrialized nation, significant development is needed.

China's leaders wasted no time in getting down to business. In January and February of this year, they increased total fixed investment by 30% year over year. Railroad investment tripled in the same time frame. And Chinese banks lent more in the past three months than in the previous twelve.

Still, the real challenge still rests in the hands of the Chinese consumer. China is a production powerhouse economy, but its consumers are conservative spenders and the country leans on its exporting activity for growth. Consequently, the global financial crisis and consumption cutback from its major importers has left a deep hole in the economy. Filling this hole is necessary for the country to achieve economic recovery and to further decoupling from the rest of the world. In other words, China's leaders must transform the economy from an export-driven one into a more self-sustaining system.

Spend, China, spend
Premier Wen outlined a strategy targeting this notion earlier this month when he addressed the National People's Congress. His plan calls to raise the proportion of national income that goes to wages, and ultimately increase consumption in areas such as culture, recreation, tourism, and the Internet. This won't be an easy feat since the Chinese maintain a high personal savings rates and are notoriously reluctant to spend frivolously, even during prosperous booms.

However, we have reasons to believe that Wen's plan has potential to propel China out of the downturn. Explain now.

Threefold rationale
First, while China is on its way toward building a similar economic model as the United States, it currently doesn't operate with the same capitalistic structure that should theoretically limit government intervention. Secondly, the Chinese, like their government, are cash rich. In other words, China and its people actually have the means to spend and stimulate their economy. Lastly, while the U.S. government is busy plowing capital into ailing businesses like AIG (NYSE: AIG) and Citigroup (NYSE: C) that will likely never generate long term economic growth, the Chinese are making meaningful investments.

For example, nearly half of China's stimulus package is earmarked to build infrastructure and another 25% will be allotted to rebuilding parts of the Sichuan Province that was devastated by the earthquake in mid 2008. In comparison, just 5% of President Obama's plan will be invested in infrastructure.

The ultimate competitive advantage
Like many financially sound and vibrant domestic companies facing headwinds from the U.S. recession, China's great potential is being masked by the global downturn. In turn, stock valuations are selling at valuations extremely low in comparison to recent years.



However, the recent rally suggests that investors may be warming up to China again. Even Marc Faber – otherwise known as Dr. Doom – has a bullish outlook on China's market.

It is too soon to tell if the rise in China's market will hold in the near term. But with the help of the stimulus package, I believe that China is in the position to use this turbulent time to build a competitive advantage and emerge from this crisis stronger than ever

Source from: fool.com ,by Kristin Grahama

2009-03-19

3 Stocks on Buffett's Wish List?

Today I receive a letter from The Motley Fool. Here is the content:

"A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread." -- Warren Buffett, Oct. 16, 2008

It was a tough year for the world's richest man -- according to data from Forbes, Warren Buffett's net worth declined in value by a staggering $25 billion in 2008.

So let's not be too hard on ourselves if we, too, owned a few stocks that lost substantial portions of their value last year. Instead, let's pay close attention to what masters like Buffett are doing on the heels of such a dismal market year.

Let's cut to the chase
Buffett has been using the $44 billion cash hoard he had at the end of 2007 to buy stocks ... in the midst of an economic crisis.

Sure, Buffett may be insane, but as the world's richest man, his record speaks for itself. So when he wrote in a recent New York Times editorial that he's buying now because it is likely that "the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up," Fools would do well to take heed.

These opportunities
What opportunities might The Oracle see today? According to Berkshire Hathaway's (NYSE: BRK-A) most recent 10-K filing, Buffett is interested in buying companies at a fair price that have:

At least $75 million of pre-tax earnings.
Consistent earnings power.
Good returns on equity with limited or no debt.
Management in place.
Simple, non-techno-mumbo-jumbo, business.

These criteria are designed to ensure that the stocks on Buffett's watch list are large, well run, understandable, and possessing durable moats -- sustainable competitive advantages that allow a company to maintain high levels of profitability and growth over long periods of time. Those are the rare companies that you want to buy when they're cheap, then hold for a long time as they continue to grow and prosper.

To try to identify the stocks that may be populating Buffett's wish list, I built a screen based on these traits using Capital IQ, an institutional software database. My research turned up 78 stocks. Confirming that we're on the right track, several of the companies that popped up are already owned by Berkshire Hathaway.

Here are three more candidates:

But you can do better
Unfortunately, large companies attract lots of coverage from Wall Street analysts -- those 78 stocks have 21 analysts following them, on average -- which, as I've explained in an earlier column, makes them less likely to be mispriced. Even though Buffett's excited about all the opportunities he sees today, he's well aware that small companies offer greater upside.

So given that $26 billion US Bancorp (NYSE: USB) is on the smaller end of Buffett's major holdings, why does he stick with such large stocks?

Berkshire's overall portfolio was more than $120 billion at last count, which means that any new investments Buffett makes will have to be big -- such as his 2008 multibillion-dollar purchases of General Electric (NYSE: GE) and ConocoPhillips (NYSE: COP) -- in order to have much of an impact on his bottom line. Only huge companies can support the kind of volume he brings to the table. So Buffett has to look for the market's best large caps, rather than the market's best stocks.

He freely acknowledges this fact:

Berkshire's past record can't be duplicated or even approached. Our base of assets and earnings is now far too large for us to make outsized gains in the future [original emphasis].

Cue sympathetic "aww" ...

Why Buffett may wish he had less money
Buffett once famously boasted that he would be able to earn 50% annual returns ... but only if he had a whole lot less money. Why? Because he'd be able to freely buy and sell small stocks that the hot shots on Wall Street don't adequately cover.

So if you're like me and have less than $120 billion to invest, it makes sense for you to look at some of the stocks Buffett wishes he could buy -- small stocks.

If we strip away Buffett's $75 million pre-tax earnings requirement and focus on small caps, our list of candidates grows to 162. Better still, these companies have just eight analysts covering them on average, which increases our chances that Wall Street's missing something.

Here are three small-cap stocks that Buffett may wish he could buy.

Of course, these aren't my (or Buffett's) official recommendations. But they share the most important qualities he says he screens for, and they are interesting places for further research.

Some more ideas
Yes, it's been a tough year for all of us. But the world's richest man -- who has made bundles of money through wars, oil shocks, recessions, and a number of market panics and sell-offs -- believes that now is the time to invest and make money: "If you wait for the robins, spring will be over."

2009-03-18

How to pick stocks: Value Investing

In the previous article understand-what-kind-of-stock-investors you are,we mentioned that there are roughly three kind of investors, value investor, growth investor and income investor. Now here is the detail for value investing.

Value investing is one of the best known stock-picking methods. In the 1930s, Benjamin Graham and David Dodd, finance professors at Columbia University, laid out what many consider to be the framework for value investing. The concept is actually very simple: find companies trading below their inherent worth.

The value investor looks for stocks with strong fundamentals - including earnings, dividends, book value, and cash flow - that are selling at a bargain price, given their quality. The value investor seeks companies that seem to be incorrectly valued (undervalued) by the market and therefore have the potential to increase in share price when the market corrects its error in valuation.

Value, Not Junk!
Before we get too far into the discussion of value investing, let's get one thing straight. Value investing doesn't mean just buying any stock that declines and therefore seems "cheap" in price. Value investors have to do their homework and be confident that they are picking a company that is cheap given its high quality.

It's important to distinguish the difference between a value company and a company that simply has a declining price. Say for the past year Company A has been trading at about $25 per share but suddenly drops to $10 per share. This does not automatically mean that the company is selling at a bargain. All we know is that the company is less expensive now than it was last year. The drop in price could be a result of the market responding to a fundamental problem in the company. To be a real bargain, this company must have fundamentals healthy enough to imply it is worth more than $10 - value investing always compares current share price to intrinsic value not to historic share prices.

Value Investing at Work
One of the greatest investors of all time, Warren Buffett, has proven that value investing can work: his value strategy took the stock of Berkshire Hathaway, his holding company, from $12 a share in 1967 to $70,900 in 2002. The company beat the S&P 500's performance by about 13.02% on average annually! Although Buffett does not strictly categorize himself as a value investor, many of his most successful investments were made on the basis of value investing principles.

Buying a Business, not a Stock
We should emphasize that the value investing mentality sees a stock as the vehicle by which a person becomes an owner of a company - to a value investor profits are made by investing in quality companies, not by trading. Because their method is about determining the worth of the underlying asset, value investors pay no mind to the external factors affecting a company, such as market volatility or day-to-day price fluctuations. These factors are not inherent to the company, and therefore are not seen to have any effect on the value of the business in the long run.

Contradictions
While the efficient market hypothesis (EMH) claims that prices are always reflecting all relevant information, and therefore are already showing the intrinsic worth of companies, value investing relies on a premise that opposes that theory. Value investors bank on the EMH being true only in some academic wonderland. They look for times of inefficiency, when the market assigns an incorrect price to a stock.

Value investors also disagree with the principle that high beta (also known as volatility, or standard deviation) necessarily translates into a risky investment. A company with an intrinsic value of $20 per share but is trading at $15 would be, as we know, an attractive investment to value investors. If the share price dropped to $10 per share, the company would experience an increase in beta, which conventionally represents an increase in risk. If, however, the value investor still maintained that the intrinsic value was $20 per share, s/he would see this declining price as an even better bargain. And the better the bargain, the lesser the risk. A high beta does not scare off value investors. As long as they are confident in their intrinsic valuation, an increase in downside volatility may be a good thing.

Screening for Value Stocks
Now that we have a solid understanding of what value investing is and what it is not, let's get into some of the qualities of value stocks.

Qualitative aspects of value stocks:
Where are value stocks found? - Everywhere. Value stocks can be found trading on the NYSE, Nasdaq, AMEX, over the counter, on the FTSE, Nikkei and so on.
a) In what industries are value stocks located? - Value stocks can be located in any industry, including energy, finance and even technology (contrary to popular belief).
b) In what industries are value stocks most often located? - Although value stocks can be located anywhere, they are often located in industries that have recently fallen on hard times, or are currently facing market overreaction to a piece of news affecting the industry in the short term. For example, the auto industry's cyclical nature allows for periods of undervaluation of companies such as Ford or GM.
Can value companies be those that have just reached new lows? - Definitely, although we must re-emphasize that the "cheapness" of a company is relative to intrinsic value. A company that has just hit a new 12-month low or is at half of a 12-month high may warrant further investigation.

Here is a breakdown of some of the numbers value investors use as rough guides for picking stocks. Keep in mind that these are guidelines, not hard-and-fast rules:
*Share price should be no more than two-thirds of intrinsic worth.
*Look at companies with P/E ratios at the lowest 10% of all equity securities.
*PEG should be less than one.
*Stock price should be no more than tangible book value.
*There should be no more debt than equity (i.e. D/E ratio < 1).
*Current assets should be two times current liabilities.
*Dividend yield should be at least two-thirds of the long-term AAA bond yield.
*Earnings growth should be at least 7% per annum compounded over the last 10 years.

The P/E and PEG Ratios
Contrary to popular belief, value investing is not simply about investing in low P/E stocks. It's just that stocks which are undervalued will often reflect this undervaluation through a low P/E ratio, which should simply provide a way to compare companies within the same industry. For example, if the average P/E of the technology consulting industry is 20, a company trading in that industry at 15 times earnings should sound some bells in the heads of value investors.

Another popular metric for valuing a company's intrinsic value is the PEG ratio, calculated as a stock's P/E ratio divided by its projected year-over-year earnings growth rate. In other words, the ratio measures how cheap the stock is while taking into account its earnings growth. If the company's PEG ratio is less than one, it is considered to be undervalued.

Narrowing It Down Even Further
One well-known and accepted method of picking value stocks is the net-net method. This method states that if a company is trading at two-thirds of its current assets, no other gauge of worth is necessary. The reasoning behind this is simple: if a company is trading at this level, the buyer is essentially getting all the permanent assets of the company (including property, equipment, etc) and the company's intangible assets (mainly goodwill, in most cases) for free! Unfortunately, companies trading this low are few and far between.

The Margin of Safety
A discussion of value investing would not be complete without mentioning the use of a margin of safety, a technique which is simple yet very effective. Consider a real-life example of a margin of safety. Say you're planning a pyrotechnics show, which will include flames and explosions. You have concluded with a high degree of certainty that it's perfectly safe to stand 100 feet from the center of the explosions. But to be absolutely sure no one gets hurt, you implement a margin of safety by setting up barriers 125 feet from the explosions.

This use of a margin of safety works similarly in value investing. It's simply the practice of leaving room for error in your calculations of intrinsic value. A value investor may be fairly confident that a company has an intrinsic value of $30 per share. But in case his or her calculations are a little too optimistic, he or she creates a margin of safety/error by using the $26 per share in their scenario analysis. The investor may find that at $15 the company is still an attractive investment, or he or she may find that at $24, the company is not attractive enough. If the stock's intrinsic value is lower than the investor estimated, the margin of safety would help prevent this investor from paying too much for the stock.

Conclusion
Value investing is not as sexy as some other styles of investing; it relies on a strict screening process. But just remember, there's nothing boring about outperforming the S&P by 13% over a 40-year span!


2009-03-17

How to pick stocks: Qualitative Analysis

Fundamental analysis has a very wide scope. Valuing a company involves not only crunching numbers and predicting cash flows but also looking at the general, more subjective qualities of a company. Here we will look at how the analysis of qualitative factors is used for picking a stock.

Management
The backbone of any successful company is strong management. The people at the top ultimately make the strategic decisions and therefore serve as a crucial factor determining the fate of the company. To assess the strength of management, investors can simply ask the standard five Ws: who, where, what, when and why?

Who?
Do some research, and find out who is running the company. Among other things, you should know who its CEO, CFO, COO and CIO are. Then you can move onto the next question.

Where?
You need to find out where these people come from, specifically, their educational and employment backgrounds. Ask yourself if these backgrounds make the people suitable for directing the company in its industry. A management team consisting of people who come from completely unrelated industries should raise questions. If the CEO of a newly-formed mining company previously worked in the industry, ask yourself whether he or she has the necessary qualities to lead a mining company to success.

What and When?
What is the management philosophy? In other words, in what style do these people intend to manage the company? Some managers are more personable, promoting an open, transparent and flexible way of running the business. Other management philosophies are more rigid and less adaptable, valuing policy and established logic above all in the decision-making process. You can discern the style of management by looking at its past actions or by reading the annual report's management, discussion & analysis (MD&A) section. Ask yourself if you agree with this philosophy, and if it works for the company, given its size and the nature of its business.

Once you know the style of the managers, find out when this team took over the company. Jack Welch, for example, was CEO of General Electric for over 20 years. His long tenure is a good indication that he was a successful and profitable manager; otherwise, the shareholders and the board of directors wouldn't have kept him around. If a company is doing poorly, one of the first actions taken is management restructuring, which is a nice way of saying "a change in management due to poor results". If you see a company continually changing managers, it may be a sign to invest elsewhere.

At the same time, although restructuring is often brought on by poor management, it doesn't automatically mean the company is doomed. For example, Chrysler Corp was on the brink of bankruptcy when Lee Iacocca, the new CEO, came in and installed a new management team that renewed Chrysler's status as a major player in the auto industry. So, management restructuring may be a positive sign, showing that a struggling company is making efforts to improve its outlook and is about to see a change for the better.

Why?
A final factor to investigate is why these people have become managers. Look at the manager's employment history, and try to see if these reasons are clear. Does this person have the qualities you believe are needed to make someone a good manager for this company? Has s/he been hired because of past successes and achievements, or has s/he acquired the position through questionable means, such as self-appointment after inheriting the company?

Know What a Company Does and How it Makes Money
A second important factor to consider when analyzing a company's qualitative factors is its product(s) or service(s). How does this company make money? In fancy MBA parlance, the question would be "What is the company's business model?"

Knowing how a company's activities will be profitable is fundamental to determining the worth of an investment. Often, people will boast about how profitable they think their new stock will be, but when you ask them what the company does, it seems their vision for the future is a little blurry: "Well, they have this high-tech thingamabob that does something with fiber-optic cables" If you aren't sure how your company will make money, you can't really be sure that its stock will bring you a return.

One of the biggest lessons taught by the dotcom bust of the late '90s is that not understanding a business model can have dire consequences. Many people had no idea how the dotcom companies were making money, or why they were trading so high. In fact, these companies weren't making any money; it's just that their growth potential was thought to be enormous. This led to overzealous buying based on a herd mentality, which in turn led to a market crash. But not everyone lost money when the bubble burst: Warren Buffett didn't invest in high-tech primarily because he didn't understand it. Although he was ostracized for this during the bubble, it saved him billions of dollars in the ensuing dotcom fallout. You need a solid understanding of how a company actually generates revenue in order to evaluate whether management is making the right decisions.

Industry/Competition
Aside from having a general understanding of what a company does, you should analyze the characteristics of its industry, such as its growth potential. A mediocre company in a great industry can provide a solid return, while a mediocre company in a poor industry will likely take a bite out of your portfolio. Of course, discerning a company's stage of growth will involve approximation, but common sense can go a long way: it's not hard to see that the growth prospects of a high-tech industry are greater than those of the railway industry. It's just a matter of asking yourself if the demand for the industry is growing.

Market share is another important factor. Look at how Microsoft thoroughly dominates the market for operating systems. Anyone trying to enter this market faces huge obstacles because Microsoft can take advantage of economies of scale. This does not mean that a company in a near monopoly situation is guaranteed to remain on top, but investing in a company that tries to take on the "500-pound gorilla" is a risky venture.

Barriers against entry into a market can also give a company a significant qualitative advantage. Compare, for instance, the restaurant industry to the automobile or pharmaceuticals industries. Anybody can open up a restaurant because the skill level and capital required are very low. The automobile and pharmaceuticals industries, on the other hand, have massive barriers to entry: large capital expenditures, exclusive distribution channels, government regulation, patents and so on. The harder it is for competition to enter an industry, the greater the advantage for existing firms.

Brand Name
A valuable brand reflects years of product development and marketing. Take for example the most popular brand name in the world: Coca-Cola. Many estimate that the intangible value of Coke's brand name is in the billions of dollars! Massive corporations such as Procter & Gamble rely on hundreds of popular brand names like Tide, Pampers and Head & Shoulders. Having a portfolio of brands diversifies risk because the good performance of one brand can compensate for the underperformers.

Keep in mind that some stock-pickers steer clear of any company that is branded around one individual. They do so because, if a company is tied too closely to one person, any bad news regarding that person may hinder the company's share performance even if the news has nothing to do with company operations. A perfect example of this is the troubles faced by Martha Stewart Omnimedia as a result of Stewart's legal problems in 2004.

Don't Overcomplicate
You don't need a PhD in finance to recognize a good company. In his book "One Up on Wall Street", Peter Lynch discusses a time when his wife drew his attention to a great product with phenomenal marketing. Hanes was test marketing a product called L'eggs: women's pantyhose packaged in colorful plastic egg shells. Instead of selling these in department or specialty stores, Hanes put the product next to the candy bars, soda and gum at the checkouts of supermarkets - a brilliant idea since research showed that women frequented the supermarket about 12 times more often than the traditional outlets for pantyhose. The product was a huge success and became the second highest-selling consumer product of the 1970s.

Most women at the time would have easily seen the popularity of this product, and Lynch's wife was one of them. Thanks to her advice, he researched the company a little deeper and turned his investment in Hanes into a solid earner for Fidelity, while most of the male managers on Wall Street missed out. The point is that it's not only Wall Street analysts who are privy to information about companies; average everyday people can see such wonders too. If you see a local company expanding and doing well, dig a little deeper, ask around. Who knows, it may be the next Hanes.

Conclusion
Assessing a company from a qualitative standpoint and determining whether you should invest in it are as important as looking at sales and earnings. This strategy may be one of the simplest, but it is also one of the most effective ways to evaluate a potential investment.


source from:investopedia.com

2009-03-16

How to pick stocks: Fundamental Analysis

Ever hear someone say that a company has "strong fundamentals"? The phrase is so overused that it's become somewhat of a cliché. Any analyst can refer to a company's fundamentals without actually saying anything meaningful. So here we define exactly what fundamentals are, how and why they are analyzed, and why fundamental analysis is often a great starting point to picking good companies.

The Theory
Doing basic fundamental valuation is quite straightforward; all it takes is a little time and energy. The goal of analyzing a company's fundamentals is to find a stock's intrinsic value, a fancy term for what you believe a stock is really worth - as opposed to the value at which it is being traded in the marketplace. If the intrinsic value is more than the current share price, your analysis is showing that the stock is worth more than its price and that it makes sense to buy the stock.

Although there are many different methods of finding the intrinsic value, the premise behind all the strategies is the same: a company is worth the sum of its discounted cash flows. In plain English, this means that a company is worth all of its future profits added together. And these future profits must be discounted to account for the time value of money, that is, the force by which the $1 you receive in a year's time is worth less than $1 you receive today.

The idea behind intrinsic value equaling future profits makes sense if you think about how a business provides value for its owner(s). If you have a small business, its worth is the money you can take from the company year after year (not the growth of the stock). And you can take something out of the company only if you have something left over after you pay for supplies and salaries, reinvest in new equipment, and so on. A business is all about profits, plain old revenue minus expenses - the basis of intrinsic value.

Greater Fool Theory
One of the assumptions of the discounted cash flow theory is that people are rational, that nobody would buy a business for more than its future discounted cash flows. Since a stock represents ownership in a company, this assumption applies to the stock market. But why, then, do stocks exhibit such volatile movements? It doesn't make sense for a stock's price to fluctuate so much when the intrinsic value isn't changing by the minute.

The fact is that many people do not view stocks as a representation of discounted cash flows, but as trading vehicles. Who cares what the cash flows are if you can sell the stock to somebody else for more than what you paid for it? Cynics of this approach have labeled it the greater fool theory, since the profit on a trade is not determined by a company's value, but about speculating whether you can sell to some other investor (the fool). On the other hand, a trader would say that investors relying solely on fundamentals are leaving themselves at the mercy of the market instead of observing its trends and tendencies.

This debate demonstrates the general difference between a technical and fundamental investor. A follower of technical analysis is guided not by value, but by the trends in the market often represented in charts. So, which is better: fundamental or technical? The answer is neither. As we mentioned in the introduction, every strategy has its own merits. In general, fundamental is thought of as a long-term strategy, while technical is used more for short-term strategies.

Putting Theory into Practice
The idea of discounting cash flows seems okay in theory, but implementing it in real life is difficult. One of the most obvious challenges is determining how far into the future we should forecast cash flows. It's hard enough to predict next year's profits, so how can we predict the course of the next 10 years? What if a company goes out of business? What if a company survives for hundreds of years? All of these uncertainties and possibilities explain why there are many different models devised for discounting cash flows, but none completely escapes the complications posed by the uncertainty of the future.

Let's look at a sample of a model used to value a company. Because this is a generalized example, don't worry if some details aren't clear. The purpose is to demonstrate the bridging between theory and application. Take a look at how valuation based on fundamentals would look:

The problem with projecting far into the future is that we have to account for the different rates at which a company will grow as it enters different phases. To get around this problem, this model has two parts: (1) determining the sum of the discounted future cash flows from each of the next five years (years one to five), and (2) determining 'residual value', which is the sum of the future cash flows from the years starting six years from now.

In this particular example, the company is assumed to grow at 15% a year for the first five years and then 5% every year after that (year six and beyond). First, we add together all the first five yearly cash flows - each of which are discounted to year zero, the present - in order to determine the present value (PV). So once the present value of the company for the first five years is calculated, we must, in the second stage of the model, determine the value of the cash flows coming from the sixth year and all the following years, when the company's growth rate is assumed to be 5%. The cash flows from all these years are discounted back to year five and added together, then discounted to year zero, and finally combined with the PV of the cash flows from years one to five (which we calculated in the first part of the model). And voilà! We have an estimate (given our assumptions) of the intrinsic value of the company. An estimate that is higher than the current market capitalization indicates that it may be a good buy. Below, we have gone through each component of the model with specific notes:

*Prior-year cash flow - The theoretical amount, or total profits, that the shareholders could take from the company the previous year.
*Growth rate - The rate at which owner's earnings are expected to grow for the next five years.
*Cash flow - The theoretical amount that shareholders would get if all the company's earnings, or profits, were distributed to them.
*Discount factor - The number that brings the future cash flows back to year zero. In other words, the factor used to determine the cash flows' present value (PV).
*Discount per year - The cash flow multiplied by the discount factor.
*ash flow in year five - The amount the company could distribute to shareholders in year five.
*Growth rate - The growth rate from year six into perpetuity.
*Cash flow in year six - The amount available in year six to distribute to shareholders.
*Capitalization Rate - The discount rate (the denominator) in the formula for a constantly growing perpetuity.
*Value at the end of year five - The value of the company in five years.
*Discount factor at the end of year five - The discount factor that converts the value of the firm in year five into the present value.
*PV of residual value - The present value of the firm in year five.

So far, we've been very general on what a cash flow comprises, and unfortunately, there is no easy way to measure it. The only natural cash flow from a public company to its shareholders is a dividend, and the dividend discount model (DDM) values a company based on its future dividends (see Digging Into The DDM.). However, a company doesn't pay out all of its profits in dividends, and many profitable companies don't pay dividends at all.

What happens in these situations? Other valuation options include analyzing net income, free cash flow, EBITDA and a series of other financial measures. There are advantages and disadvantages to using any of these metrics to get a glimpse into a company's intrinsic value. The point is that what represents cash flow depends on the situation. Regardless of what model is used, the theory behind all of them is the same.

source from:investopedia.com/

2009-03-15

It’s just the right time to Start a Business in a Recession

Everything has bad sides, along with good sides. The economy recession is no exception. While people lose their jobs and many companies went bankrupt, have you been considering about start your business? Here we give the top 11 good reasons to start a business right now.

1. Everything is cheaper. Let's face it: There is great value right now in this and in world markets. This is the right time for fantastic deals in virtually every category, from land and equipment to commercial office space, personnel and labor.

As asset prices have been knocked down, there is no better time to get into the real estate or financial markets, or even heavy equipment and construction. Some people have waited years to find value in these markets -- and now that time has come.

2. You can hire more and better-qualified people. In an era when even Microsoft (MSFT Quote - Cramer on MSFT - Stock Picks) is laying off, you can find great resources at affordable rates. Thinking about getting your high-tech start-up off the ground? There are plenty of engineers waiting to be hired. Thinking about forming a professional services firm? There are many accountants and attorneys looking for their next opportunity.

3. People are looking to change suppliers. From a cost perspective, everything is on the table for most companies. Even if your prices are higher, if you can come in with greater value, you have a good chance at winning new business. You also have the advantage of being the new kid on the block when it comes to pitching your products and services.

Many companies are desperate to find new partnerships with new companies that have a different, better or more innovative way of delivering those products and services.

4. Ownership equals tax incentives. Business ownership offers a variety of tax benefits that aren't available to employees. While taxes should never be the sole reason to go into business for yourself, it should be one reason to add to you "benefits of business ownership" list.

5. Family and friends don't want to (or can't) invest more money into the stock or real estate markets. That means they may be willing to finance a portion of your new venture, or the expansion of an enterprise that has proven itself over time. The main benefit is that they know you and have a relationship with you -- and if you have a solid business plan that delivers real numbers, your chances of raising the capital you need increase exponentially.

6. Suppliers are giving better credit. Because the credit markets have virtually shut down, the B2B credit flows are keeping money circulating out of sheer necessity. That means a bullish outlook for companies looking for good terms on stock and/or inventories. The main advantage is that all parties have more incentive than ever for finding true win-win situations that allow for cash and stock flow. When everyone is looking to survive, great deals can be had.

7. You can get good PR by showing you are going against the trend. The media loves aberrations, and if you are optimistic by expanding or getting into business now, you would be in that category. That means you can generate some great PR by demonstrating your "alternative" view of the market.

8. You can buy everything you need at auction. In addition to everything being less expensive, you can find great deals at auctions, especially in terms of any large equipment and office furnishings. Auctions are also a great place to find hardly used or "gently" used restaurant and bar supplies at great prices. These days, you may even be able to get deals on fleets of vehicles and trucks for a delivery service or hauling or construction company.

9. You can find great "low money" or "no money" down deals. This is simply being aware of good opportunities others have buggered up, and finding deals where you could get an entire business simply by taking over a lease (along with all the equipment). Many business owners want out at any cost, meaning you can negotiate great win-win deals that allow the current owners an escape while giving you an opportunity to turn around what could be, if run right, a very viable business.

10. You've lost your job, and you have to do something. Sometimes, the best business decision is the one you are forced into, and the incentive (as well as need) for income is often enough to push those previously "on the fence" to strike out on their own. There's nothing wrong with being in this position; it simply means there is greater urgency to do something that will start to generate income as quickly as possible.

11.If you start a business in a foreign country like China, you can get more Preferential policies and financial supports from local government. Remember to do some research before you take action.

There you have it: the top 11 reasons to start your business in a recession. After all, the odds are on your side that the expansion will be many times more robust than the present slowdown.

There's no better time to start than the present, especially if people around you are more comfortable with their own list of reasons why they shouldn't start pursuing their own business dreams right now. It only means you'll be facing a lot less competition.

Small Stocks --- The Best Stocks to Buy in This Cold Market

You're probably getting all sorts of conflicting messages these days.

On the one hand, you have gloom-and-doom predictions from luminary economists like Nouriel "Dr. Doom" Roubini, calling an S&P 500 bottom possibly as low as 600 -- more than 20% below yesterday's close.

On the other hand, you have the world's most respected investor, Warren Buffett, saying that now is a good time to buy. Buffett is also putting new money to work, buying shares of Burlington Northern (NYSE: BNI) and Ingersoll-Rand.
Here, with so much debate over what has been roundly dubbed "the worst financial crisis since the Great Depression," we looked back at how various strategies fared during each of the other financial crises since the Great Depression, and try to get some useful guide to go through this economy depression.

To get started, I turned to trusty data from Ibbotson Associates, a leading authority on investment research. I calculated the historical returns for cash, bonds, and stocks for those who invested the year following the start of each recession -- exactly the point at which we find ourselves today -- and measured the five-year annualized return for each period.

Here are the results:

*Data from Ibbotson Associates, Salomon Brothers Long-Term High-Grade Index, National Bureau of Economic Research, Consumer Price Index, author's calculations.
**Returns calculated from 1971-1975.

Rule your recession
Three lessons stand out from this data:

Stocks outperform bonds and T-Bills most of the time, and by large amounts. And remember, these are just averages -- stronger index components like PepsiCo (NYSE: PEP) and Procter & Gamble (NYSE: PG) did even better than the S&P 500 average the last time around.

Unless you need money or plan on investing it, don't park your capital in cash or Treasury bills. If you're bearish enough on stocks to avoid the stock market, history shows that it's much better to be in a diversified batch of long-term, high-grade corporate bonds.

The only period the S&P 500 lost money was the 1930-1934 deflationary death spiral, when deflation ran a chilling 5% annually. Inflation currently sits around 0.4% annually, but so long as it doesn't plunge well below zero and remain there -- something even Roubini, the most prominent stag-deflation advocate, doubts will happen -- investors who are looking to buy a diversified basket of stocks today are well-positioned.

But that's not the whole story
Various studies -- including one of my own -- show that small caps tend to outperform their larger counterparts by a significant margin, particularly in recessions. To confirm this, I ran the numbers once more to include the smallest quintile of stocks:*Data from Ibbotson Associates, Salomon Brothers Long-Term High-Grade Index, National Bureau of Economic Research, author's calculations.
**Returns calculated from 1971-1975.

Small stocks outperformed T-Bills, bonds, and the S&P about two-thirds of the time -- and they did so by a ridiculous margin.

But how much dough are we talking about?
A few percentage points might not seem like much, but remember, these are annualized figures. Here's how much money $1,000 invested and held for each five-year period would be worth today, adjusted for inflation:
The data over 13 recessionary periods and various academic studies reveals a powerful lesson: Small stocks really are the best stocks to consider buying in this market.

Why are small stocks so great?
There are many reasons for why all of the market's best stocks have been small caps. Among the three most prominent are:

Small caps attract less coverage from major brokerage houses and consequently are more likely to be mispriced.

Smaller stocks have more opportunities for growth.

Smaller companies have the ability to be nimbler in tricky situations. Starbucks (Nasdaq: SBUX) has been handling the complex logistics of closing 8% of its more than 7,000 U.S. stores. On the other hand, if tiny Buffalo Wild Wings had to close 8% of its 575 stores and reallocate resources, it could do so relatively easily.

These may also explain why all of the top 30 performers that emerged from the 2001 recession were small or mid caps, including USG, (NYSE: USG), Coach (NYSE: COH), and Research In Motion (Nasdaq: RIMM), which each rose more than 700%.

Source from: fool.com

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