April 2, 2024

'Buy Low, Sell High'

A conversation I often have with a beginner investor about the formula of becoming successful investor in public equities often goes like this:

Beginner Investor: "How do I become a successful investor?"

Me: "Buy low, sell high."

Beginner Investor: "That's all?"

Me: "Yes, that's all."

While it is technically that simple, the reality is much different as there are various nuances to go into which stocks to buy, when to buy them, and when to execute a sell order. Jim Cramer, a financial journalist on CNBC, presents his approach on how to start picking individual stocks. "Stock picking is not simple and requires substantial research, he said, stressing that it's essential not to shoot blindly. Instead, it's wise to invest intentionally and put money into stocks and sectors you’re familiar with.

"'You want to get started? Go small, invest in what you know, research intensely,' Cramer said. 'Back then, I got old data from the public library. Now? It’s as simple as a key stroke, and the information's free — including up to the minute financials, analyst presentations, brokerage research and, of course, the conference calls that I tell you are musts if you want to actually know what you’re doing.'"

Jim Cramer's Guide to Investing contains 25 points to becoming a successful investor. There are a few worth discussing:

6. "Buy and Homework, Not Buy and Hold"

Mr. Cramer explains that within a diversified portfolio, "the facts change, the leaders become followers, the disrupters disrupt, consumer preferences change and so on. The facts change and so must our investment thesis. If you're not doing the homework then how are you going to be sure that what you bought in the past is still what you own today?"

He points out that "The two reasons people often don't do the homework is because they have either (wrongly) convinced themselves that if they hold long enough that ultimately all stocks make a comeback, or that since they don't have the time to do it, nobody does."

I strongly support his assertation that "On the first reason, that's just nonsense. Stocks represent ownership in a business. The notion that a business that is doing poorly will always improve and return
to strength is just silly. If that was the case, there would be no bankruptcies or disrupters displacing leaders. Industry landscapes are always changing, businesses are living, breathing entities and without
proper stewardship will fail. Ultimately, the stock will follow the fundamentals."

With respect to the second point, he says that "you may not have the time, but that's what professionals are paid to do. Make the time. If you can't keep up with the homework— be it because of time restrictions or a lack of understanding when it comes to financial statements—then you either need to own fewer stocks or hand it off to a professional. Tracking companies may not be your day job, but it is a pro's job."

7. No One Ever Made a Dime by Panicking

"Emotion, especially panic, has no place in investing," according to Mr. Cramer. "When we panic, we don't think clearly. And when we aren't thinking clearly, we make mistakes. If you associate the value of what you own with the price a stranger is willing to throw at it, it can be easy to panic when the bids come in low." I support his analogy that "just because someone offers you less for your house today than the price you paid yesterday doesn't mean it is any less valuable. It may simply mean that the current bidders don't see the value you see."

He adds: "When volatility strikes, you should focus more on the value of what you own than the price being put on it. By doing that and keeping level head, you can make rational decisions and perhaps realize that there will be a better time to sell— either when things calm down or your investment thesis materializes and other buyers begin to see the value that you've seen all along."

11. Don't Own too Many Stocks

Following on the importance of doing your homework, Mr. Cramer recommends "One hour of research on each stock per week. That's the rule of thumb on keeping up with the homework. If you can't manage that then you own too many stocks."

12. Cash and Sitting on the Sidelines are Fine Alternatives

Particularly when interest rates for savers were low for so long, many beginning investors thought it was erroneous to have cash in the bank. They pressured themselves into think they should put most, if not all, of their cash in the stock market. As Mr. Cramer notes, "The aversion to cash that most investors have is truly to their detriment. So many are fearful of the 'cash drag' on the way up— meaning that they fear underperforming due to part of their portfolio not being invested, that they fail to think of the positive addition that same cash drag can add to performance in a down market. Believe it or not, you can keep some of your portfolio in cash. If you don't have a feel for the market, step to the sidelines. That's the beauty of a no-called-strike game, you can sit there for as long as you like waiting for that perfect pitch."

What is more, "Some investors believe they should be fully invested, or they'll lose out to inflation. That's not a reason to invest. You only want to take a position, long or short, when you have an edge. If you have nothing compelling to buy, meaning you're only going to find it more attractive if it goes down in price, then step to the side. It's better to lose a few percentage points of buying power to inflation than it is to lose money on a low conviction, no-edge position. The idea that you should
invest so that you have 'enough exposure' is just nonsense. There is one reason and one reason only to invest— to make money."

24. "Be Able to Explain Your Stock Picks to Someone Else"

"I like to say that if you can't explain why you want to own the stock in three bullet points, you shouldn’t buy it," Mr. Cramer writes. "Not only will doing so help you better understand the story, but in doing so you will better discover if there is something you missed. Ideally you will even find someone with the opposite view of your own and have a good old fashion bull-bear debate."

His investment guide includes a list of eight questions his ex-wife would ask "over and over again whenever he wanted to put on a new position":
  1. What's going to make this stock go up?
  2. Why is it going to go up when you think it is?
  3. Is this really the best time to buy it?
  4. Haven't we already missed a lot of the move?
  5. Shouldn't we wait until it comes down a little more?
  6. What do you know about this stock that others don't?
  7. What's your edge?
  8. Do you like this stock any more than any of the others you own and why?
"That last one was especially important because she never liked to add another stock without taking one off. After all, how many good ideas can a person have at once? Moreover, sticking to that rule will help you abide by rule 11 and keep up with your homework."

Aaron's Rule: Do Your Homework

Most publicly-traded U.S. corporations are required to file a Form 10-K with the U.S. Securities and Exchange Commission (SEC). The document gives a comprehensive summary of a company's financial performance during the company's most recent fiscal year. I read the 10-K of each corporation that is in my investment portfolio. And I often read the 10-Ks of corporations that are competitors or partners of the corporation I hold stock in.

While the SEC provides a useful guide on how to read a 10-K, there are certain parts of the 10-K that I pay close attention to. Item 1 - "Business" is where the corporation provides a detailed description of its business including its main products and services, what subsidiaries it owns, and what markets it operates in. This section may also include information about recent events, competition the company faces, regulations that apply to it, labor issues, special operating costs, or seasonal factors. This is a good place to start to understand how the company operates.

I strongly recommend learning about the risks that may have a material effect on the company's operations or financial performance. Item 1A - "Risk Factors" includes information about the most significant risks that apply to the company or to its securities. Companies generally list the risk factors in order of their importance. In practice, this section focuses on the risks themselves, not how the company addresses those risks. Some risks may be true for the entire economy, some may apply only to the company's industry sector or geographic region, and some may be unique to the company.

Understanding the management's perspective on the business results of the past financial year is crucial to helping me evaluate the worthiness of owning the company's stock. Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operations" gives the company's perspective on the business results of the past financial year. This section, known as the MD&A for short, allows company management to tell its story in its own words. The MD&A presents:
The company's operations and financial results, including information about the company's liquidity and capital resources and any known trends or uncertainties that could materially affect the company’s results. This section may also discuss management’s views of key business risks and what it is doing to address them.
Material changes in the company's results compared to the prior period, as well as off-balance sheet arrangements and the company’s contractual obligations.
Critical accounting judgments, such as estimates and assumptions. These accounting judgments – and any changes from previous years – can have a significant impact on the numbers in the financial statements, such as assets, costs, and net income. 
Source: U.S. Securities and Exchange Commission
I also read the quarterly earnings report, known as Form 10-Q, and listen to the earnings report which generally include statements by the corporation's chief executive and chief financial officers. Shareholders often have the opportunity to pose questions to the corporate executives. The SEC reports and information about the quarterly earnings calls are often found on the company's website under "Investor Relations."

Building a valuable investment portfolio is not difficult, but it does require time to learn about the company's business, financial performance, and risks that may adversely impact both. What resources do you use to evaluate the investment worthiness of a corporation?

Aaron Rose is a board member, corporate advisor, and co-founder of great companies. He also serves as the editor of GT Perspectives, an online forum focused on turning perspective into opportunity.