how I pick stocks and my investment strategy

I have a colleague who is somewhat wealthy (at least compared to me). His wife confided in me that they were not confident in investing their money by themselves. I recommended a fee-only investment adviser. My friend asked how I pick stocks, and what my investment strategy is.

The best introduction to investing that I’ve seen is Money Chimp. I highly recommend that you read it. If you like to be talked to like a little child, I would recommend Swensen’s Unconventional Success. Swensen is the investment manager for Yale’s endowment. It took a beating in 2008. I thought when I read the book, that his professional investment style, focusing on illiquid investments like timber, private equity, and real estate would run into problems, and I was right. Swensen does make good points that most investment companies are rocking on your dime (be careful with whom you trust your money), it is important to rebalance*, and you should use low-fee ETFs and mutual funds. I’ve basically summarized the book for you.

My personal investment strategy. I am a value investor. I believe in keeping all of my rollover IRAs in Index ETFs by Vanguard. My current 401K is with Fidelity. Their selections are not great but I pick the funds with the lowest expense ratio which meet my balance criteria.

I’m invested in the following funds with the following percentages for my IRAs:

ETF SYMBOL WEIGHT
VANGUARD SMALL-CAP VALUE ETF VBR 20%
VANGUARD EUROPEAN ETF VGK 10%
VANGUARD PACIFIC ETF VPL 15%
VANGUARD TOTAL STOCK MARKET ETF VTI 33%
VANGUARD EMERGING MARKETS ETF VWO 22%

I use Firstrade to invest my rollover IRAs and do my non-retirement investing. I like Firstrade because its trade fees are low ($6.95 at time of writing), they allow you to do dividend reinvestment (more on that later) with no extra fees, and they don’t charge a monthly account maintenance fee. E-Trade is junk. I invested with them a long time ago and I was constantly hit with fees, minimums, etc. E-trade’s trade fee is $9.99 unless you execute > 150 trades in a quarter and then it’s $7.99. No thanks, I’ll stick with Firstrade.

I use Yahoo’s stock screen to initially screen stocks. There are 3 basic valuation methods for stocks: Discounted Cash Flow (DCF), Relative Valuation — Price to Earnings (PE), Price to Earnings Growth (PEG) — earnings relative to some metric, and Options pricing model. I use a Discounted Cash Flow (DCF) approach to value a company as a tool to help decide if I invest in it or not. The best introductory tutorial I have found on DCF is again at Money Chimp. He shows you variations of 2 of the 3 different valuation methods listed above. The humble “guru” of stock valuation is Aswath Damodaran I recommend you visit his site and at least go through the quick tutorial. He discusses all 3 valuation models in as much detail as you could want. Everything from his books is online and free. Cool!

85-90% of my money is invested according to DCF. I screen stocks for value using the Yahoo screener, do some research on the management, and do a DCF analysis. If the price of the stock is less than the DCF analysis, I buy a position. I have price targets. If a stock exceeds the price target, I seriously evaluate selling it. I need to give myself strong justification keeping a stock that exceeds my price target. If I tripled my money in a stock, I used to sell my entire position, no matter what. After I lost big-time on Apple’s upside, I have decided, when a stock hits 3x what I paid for it, I will sell at least half of it, but not necessarily all of it.

I like companies that pay dividends. Dividends return some of the money the company made to its owners, the shareholders. There have been studies which have said that the reason for equity premium (the increase in yield between stocks and bonds) is due to the dividend rate + the rate of increase in the dividend rate. I’m not sure if that is true, but I do like dividends. I participate in dividend reinvestment. Firstrade offers this service for free. Once you sign up for it, all of your dividends are automatically re-invested in that stock. 11 years ago I was really into DRIPs (dividend reinvestment programs). You buy the stock directly without a broker, and the service automatically re-invests your dividends. I have soured on DRIPs because most DRIPs charge large fees for dividend reinvestment and stock purchases, although some are free. DRIPs are a good way to get started in investing, if you find a company which pays good dividends and pays the reinvestment fee for you. DRIPs allow you to purchase a set dollar amount of stock per month, and get the compounding benefit of reinvestment. One company that offers a fees-paid drip is Exxon Mobil.

The remaining 10-15% is invested in what I call ‘Calculated Risk’ I guess you could call all stock picking calculated risk but this would fall into the category where sophisticated investors would use an option pricing strategy to value the stock (see Damodaran). I use a seat of the pants method. Let me give you an example. Just before Thanksgiving 2008, Ford was around $1.50 a share. My Aunt encouraged me to throw 10 thousand into Ford. I said, “Are you high?”, but she listed the reasons why

  • Ford family owned 20% of the company. Not likely to let it go bankrupt.
  • Ford was well financed vs. GM and Chrysler (none had gone bankrupt at that point)
  • Ford was an international company. More so than GM, and especially Chrysler
  • Bailout and concessions for GM would help Ford in its labor negotiations

my Aunt turned out to be right. She put a substantial sum (but money she could afford to loose) into Ford stock, and rode it to above $11. I wish I had listened to her. Stock market investors hate uncertainty. For the most part, the stock market tends to over-value companies for years at a time. When opportunities like this come along, you can make a lot of money by being a shrewd investor.

I’ll show how I do DCF (it’s less complex than Damodaran’s) for stocks that pay dividends and have little to no debt in the next installment.

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