Companies do not operate in a vacuum. They are in constant competition for consumer and investment dollars. To make the best investment decisions, you need to have a good understanding of the competition facing those companies whose stock you consider buying or selling. In fact, it is always best to analyze stocks in pairs.

When you are evaluating Google’s stock (GOOG), you have to evaluate its performance versus a competitor like Yahoo! (YHOO). If you are studying Google’s PE RatioThe price of a stock divided by the earnings per share. This is a measure of how pricey the stock is and should only be used to evaluate a stock versus its competitors. , Cash Flow per Share Cash flow per share is calculated as the cash flow from operations divided by its total number of shares outstanding. and ROE, you must compare it to the industry averages or its direct competitor’s ratios.

When you are evaluating Boeing (BA) as a company, you must also view its performance versus its head to head competitor like Airbus. When you are evaluating Ford Motor Company (F), you should also me analyzing it against General Motors (GM).

More than financial magic, national or global economic conditions, dedication to Research & Development, or monies spent on marketing and branding, the quality of a company’s competition can affect earnings and cash flow. Avoid making major decisions on purely historical data, as the competition may be about to introduce one or more new products or embark on a massive marketing campaign that could affect another corporation’s earnings and/or cash flow.

Mark's Tip

There are a few companies that operate in industries without competitors. Intuitive Surgical (ISRG) developed the first surgical robot that performs minimally invasive surgery and reduced hospital stays from 4 days to 1 day in some instances. That stock went from $20 to $325 from 2004 to 2007. FedEx (FDX) initially had the monopoly on overnight package delivery—it took UPS and the United Postal Service a few years to catch up. Crocs (CROX) shoes were the craze for at least a year until other shoe companies started copying them.

However, as global business cycles compress and rapid changes occur, particularly in the technology-based industries, the introduction of new products or dramatically upgraded current products are important contributors to both future earnings, cash flow levels, and ultimately—stock price.

Currency speculation and hedging (usually through hedge funds) are similar. You invest in foreign currency believing (sometimes just hoping) that the exchange rate against the dollar becomes more favorable – and profitable over time. As you can imagine, you can make or lose a great deal of money in the arenas of FX (also called FOREX), currency speculation, and hedging.

Consumers also appear to be much less loyal to “tried and true” products than ever before. This behavior is forcing companies, even those with a good existing product mix, to modify some or create new ones to stay competitive. The formerly effective tactic of marketing a product as “new and improved” (Would someone please finally explain how any product could be both at the same time?) seldom works any longer.

Skeptical? Just ask Bill Gates about the Windows Vista operating system. Many customers expressed extreme distaste for the new operating system, often choosing to retain the older Windows XP, which Vista was intended to replace. This hurt Microsoft’s revenues.

Mark's Tip

When you are evaluating a stock, think about the products that the company offers, and ask yourself if they have new products under development that will add to future revenues. Obviously, technology products change so fast that every year products are getting faster, cheaper, and with more memory. Pay attention to who is always the leader and ask the sales reps at Best Buy what company’s products they like best. And remember that things like toilet paper and toothpaste do change. Toilet paper becomes more “green” and earth friendly and toothpaste is now stressing “whitening” more than ever. I travel a lot, and with the “No liquids over 3 ounces allowed” in your carry on bags at airport security, I was amazed at how some companies quickly offered their products in 3 oz travel sizes, while others still haven’t been able to produce a 3 ounce size. Look for signs like these of well managed companies and well managed brands.

History is full of examples of CEOs moving from one company to the next, or retiring, or getting fired. Remember when Steve Jobs retired from Apple? The company and the stock seemed to get lost without any new product development. Shareholders were crying to have Steve Jobs come back, and when he did he led a new era of product development at Apple that included the iPod and the iPhone.

Now that Steve Jobs is battling cancer, what implication does that have for Apple’s stock? Also think about other key leaders…What would happen to Microsoft if Bill Gates quit? What would happen to Google if Sergei resigned?

In more common terms, think about a marketing manager at Company A that decides to eliminate a successful branded character “spokesperson” (like Tony the Tiger or the Cheerios bee) against all wise advice and evidence that the “spokesperson” still works extremely well for the company. Predictably, sales of the product fall off. As long as that marketing manager is in place making unwise decisions, the company’s earnings may be negatively affected. Once he or she is given the boot and the “spokesperson” returns, earnings increase and stabilize.

You need to develop a solid knowledge of a company’s management team to keep track of this information. Mutual fund managers, who are often responsible for investing millions in a single company, will often personally visit with management teams and do extensive research on the background and experiences of a CEOs in order to gauge the quality of a company’s leadership.

You won’t be able to do such extensive management research, but over time, you will start to recognize the names of people who seem to always land in successful companies and help those companies to grow (or fail!).

A company balance sheet has three parts:

• Assets
• Liabilities
• Ownership equity

The main categories of assets are usually listed first, and typically in order of liquidity. Assets are followed by the liabilities. The difference between the assets and the liabilities is known as equity or the net assets or the net worth or capital of the company. According to the accounting equation, net worth must equal assets minus liabilities:

Net Worth = Assets – LiabilitiesAnother way to look at the same equation is that assets equal liabilities plus owner’s equity. Looking at the equation in this way shows how assets were financed: either by borrowing money (liability) or by using the owner’s money (owner’s equity). Balance sheets are usually presented with assets in one section and liabilities and net worth in the other section with the two sections “balancing.”

Records of the values of each account in the balance sheet are usually maintained using a system of accounting known as the double-entry bookkeeping system.

A business operating entirely in cash can measure its profits by withdrawing the entire bank balance at the end of the period, plus any cash in hand. However, many businesses are not paid immediately; they build up inventories of goods and they acquire buildings and equipment. In other words: businesses have assets and so they can not, even if they want to, immediately turn these into cash at the end of each period. Often, these businesses owe money to suppliers and to tax authorities, and the proprietors do not withdraw all their original capital and profits at the end of each period. In other words businesses also have liabilities.

The company’s revenue and earnings estimates that you see published by the company, and the many Wall Street analysts that follow that company, should be an important element of your buy/sell decision. However, don’t merely read these projections and accept them as fact.

Learn what criteria and assumptions helped create these estimates. What is your opinion on the company’s outlook? What is your understanding and expectation of the economy and the business cycle? Are we slipping into a recession? Does this company truly have a product that everyone in the world wants to buy? You should try to read some expert opinions that comment on the validity of a company’s projections. Sometimes you will learn of well-constructed, thoughtful, fact-based assumptions that create solid revenue and earnings estimates. You’ll also probably find some projections that are little more than a “wish list” created by a company’s management that make a few too many assumptions for you to believe.

As you follow the news for a particular company, you will notice how Earnings Estimates will change frequently over time as business conditions change or as the economy shifts. This is normal and goes to show how these are only estimates about an uncertain future. Never should you invest strictly on an earnings estimate or a recent change in an earnings projection.

If Stock A and Stock B are in the exact same industry, have the exact same revenues, costs, EBITDA and net income, which one is the better buy? We still can’t answer that question until we know two more pieces of data—the number of shares outstanding and the share price.

If Stock A and Stock B both had $5,000 of Net Income, but Stock A had 1,000 shares outstanding and Stock B had 100 shares outstanding, then Stock A is earning $5 per share ($5,000/1,000 shares) and Stock B is earning $50 per share ($5,000/100 shares). This is how Earnings per Share (EPS Earnings per share is calculated as the net income of a company divided by its total number of shares outstanding. ) is calculated—the Net Income divided by the number of shares outstanding.

Now we are finally getting to a point where we can start forming some expectation about a fair share price. Since Stock A has 10x as many shares issued, then it would follow that we would expect Stock A’s price to be 1/10 the price of Stock B.

Fortunately, there is a common metric called the PE RatioThe price of a stock divided by the earnings per share. This is a measure of how pricey the stock is and should only be used to evaluate a stock versus its competitors. , or Price to Earnings Ratio, that takes all of this into account. (We are just about done with all of these computations, but don’t worry, most financial websites do the math for you.) So, if Stock A is trading at $100 per share and we know it is earning $5 per share, then its PE is 20; if Stock B is trading at $750 per share and we know it is earning $50 per share, then its PE is 15. Finally, we can say that given these companies are in the same industry and all things being equal, Stock A is overpriced and Stock B is underpriced.

Mark's Tip

Never, ever, ever judge a company based on its stock price alone. Yahoo! and Google are both in the online search engine business and Yahoo! (YHOO) trades at $20 a share and Google (GOOG) trades at $500 a share. Does that mean YHOO is cheap and is the better buy? Absolutely NOT! You must look at the PE ratios of the 2 companies to put their share price into perspective of earnings and shares outstanding. If you still don’t get it, please re-read this chapter!

Assuming you understand the EPS calculation, the next obvious calculation after EPS (Earnings per Share) is Cash Flow per Share Cash flow per share is calculated as the cash flow from operations divided by its total number of shares outstanding. . This is simply the cash flow from operations that you see on the Cash Flow Statement divided by the number of shares outstanding. As you learned the differences between Net Income and Cash Flow, the Cash Flow per Share calculation eliminates the non-cash items that sometimes clutter the Income Statement that don’t represent real cash outlays by the company. Many Wall Street analysts feel Cash Flow per Share is the best way to truly value a company and therefore its stock.

Return on Equity

Return on Equity (ROE) is one more fundamental metric that must be mentioned as we try to evaluate a company’s performance. ROE is a measure of how much profit a company is able to generate from the money invested by its shareholders.

Think of it this way: if your teenager asked to borrow $1,000 to start-up a small business then chances are you would comply. When he came back in a few months to ask for $10,000, you would examine how well his company performed with the initial $1,000 before making the next loan. It makes such good sense that you might wonder why more people don’t use this handy little measure before pouring massive sums into a money pit masking as a company.

To calculate ROE, divide the profit by the initial investment. Using this example, if your teenager was able to make a $250 profit on the initial $1,000 investment, the ROE would be 25% ($250 / $1,000) which would be a very good ROE for most companies on Wall Street today.

Before we discuss how to analyze a company on a cash flow basis, let’s be clear that we understand the difference between net income and cash flow.

Sorry, but it’s time for an accounting lesson! When we set up a lemonade stand as a child, we would go to the store and buy $20 worth of lemons, cups, and ice. We would then stand on the street and try to sell 50 cups for a $1 each. That $50 in revenue and $20 worth of expenses provided us a net income of $30 and a cash flow of $30.

But the reality was that we borrowed mom and dad’s table to make our lemonade stand and we didn’t pay them anything for borrowing that table. If we wanted to expand our lemonade business by opening another stand at another street corner, we would have to buy a new table—which might cost us $75. So, on the second day of our 2-lemonade stand business, we would spend $40 on lemons and $75 on a table and sell $100 worth of lemonade. That’s now $100 in revenue, $40 in lemons, and $75 for a table. So that means we end the day with $15 cash less than we started with.

On the third day, we don’t need to buy another table. So on the third day we have another $100 in revenue and $40 in costs and a positive cash flow of $60.

The cash flow is easy to see each day, but what was our net income each day? The answer is that it depends on how many days we will use our table. If we think the $75 table will last for 75 days, then didn’t that table really cost us $1 a day to use? Accountants at publicly traded companies must do this type of math and allocate the costs of these “fixed assets” over the expected life of the asset. This process of expensing the table at $1 a day is called amortization (or depreciation). The purchase of fixed assets and their depreciation is one of the differences between net income and cash flow.

Now suppose in day 2 of our lemonade business, a customer took lemonade from us and then realized he didn’t have the $1 to pay for it, but promised to come back the next day to pay. On day 2 we would have only received $99 in cash from our $100 in sales, but on day three we would have received $101 in cash on $100 in sales. The sale really occurred on day 2, it’s just that we didn’t get paid until day 3.

Similarly, on day 2 in our trip to the grocery store in the morning we might have forgotten to take our wallet, but the grocery store manager gave us credit as long as we promised to pay the next day. Suddenly you can see how net income and our cash flow can really get out of alignment with the purchasing and payment for our inventory, the collection of cash from our sales, and the purchases of fixed assets that have expected useful lives of 3, 5 or even 30 years.

Now consider this: A company with excellent profitability may experience serious problems if its sales are concentrated in a very small customer base, if all products are sold on company credit resulting in massive accounts receivable, or if the company is slow to develop new or improved products in a fast moving industry. Much needed cash flow – to fund operating expenses, R&D, debt service, and marketing – may be missing and the company’s long-term ability to operate profitably – or simply operate at all – may be in danger.

Another company, working on small profit margins, however, may have excellent cash flow and inventory turnover. They enjoy sufficient cash to meet all operating, marketing, and debt service obligations and have funds leftover for future projects. As an example, consider successful supermarket chains that often work with profit margins as low as 5%. However, their consistent profit, combined with excellent cash flow (and few accounts receivable), typically keeps supermarkets viable and a very stable investment.

The Cash Flow Statement that you will find in a company’s financial statement should help you narrow down the true cash flow generated from operations. Don’t be afraid to look at these statements! You will find out how the company manages its business, how it manages its cash flow, and might reveal unexpected changes that can give you clues about future performance.

Now take a look at Apple’s Cash Flow Statement. Notice how they started the 3 months with $11,875 million, generated $3,938 from operating activities, invested $8,639 million, received $62 million from other investing activities, and that resulted in them having $7,236 million at the end of the quarter. That is quite a company!

Fortunately, the financial statements have tried to simplify some of these accounting issues with the use of a few key terms that everyone reviewing a company should be interested in.

The following section is an explanation of some of the primary sources of earnings and cash flow information with which you should become familiar. They help you analyze potential investments that may fit your strategy and eliminate others that might not match your preferences.

The Income Statement from the 10-Ks The annual SEC filing by public companies that includes their audited Income Statement, Balance Sheet, Cash Flow Statement and other detailed notes about the companies financial and operating conditions. and 10-QS The quarterly SEC filing by public companies that include abbreviated, unaudited financial statements. is the first place to start. Take a look at Apple’s Income statement from a recent 10-Q and you will see their Operating Income, Income before taxes, and then Net Income:

Make sure you look at the Net Income line with caution as it might not necessarily be showing you the number you are expecting to see. It is important that the Net Income line be showing a profit, but sometimes there are extraordinary or non-recurring items that impact the Net Income that will muddy the picture. A company may lay off 10% of its work force and have a one-time expense of its severance package, or it may sell-off a business for a one-time profit that shows up on its Income Statement. These non-recurring items can make the Net Income line meaningless and misleading.

It is more important that the company is actually making a profit from its normal business operations and not from picking up one of these one-time events. The Income Statement should contain data showing that a company is actually “earning” a profit. Learn to separate operating results from overall results.

For example, suppose Company A showed a substantial Net Income during the most recent annual period that was well ahead of last year’s performance. However, upon close inspection, you discover that much of this profit was generated from a sale of assets, accounting entries, or other extraordinary (as in “extra ordinary”) events. When you eliminate all of the non-recurring line items on the Income Statement, you might discover that Company A only earned very modest net income from operations. This should raise a red “caution flag” to challenge you to investigate further and read the reports closer.

Conversely, suppose Company B showed a net loss on its Income Statement in its most recent accounting period. However, upon further investigation, you learn that the reason for this loss was because the company took a “one time charge against earnings” because it closed a non-profitable business, terminated 1,000 employees, and paid them all a severance package. When you review the company’s income from operations, you see the excellent earnings data that the company exhibited in prior years. Company B may be the better longer-term investment even though it is showing a net loss for the current year.

EBITDA

An easy way to see the performance of a company is through a metric called EBITDA Earnings before interest, taxes, depreciation, and amortization. . It is a complicated looking, but very useful bunch of letters. It stands for “Earnings Before Interest, Taxes, Depreciation and Amortization.” This line item on the Income Statement throws out all the extraneous activity in a company and reduces the core business operations into the number that is most used to evaluate the operating performance of a company.

An Income Statement follows this format:

• Revenue/Sales – The “top line” number on an Income Statement is usually the revenue/sales number that indicates the total sales of the company. This is the total cash register receipts of all of the stores if it is a retail business.
• Cost of Goods Sold – The Cost of Goods Sold is the direct costs of the product that was sold. By “direct costs” we mean the actual cost of making the product and getting it on the store shelves. If we buy shoes from China for $45 and pay a freight company an average of $2 a shoe to get them from China to our store, then our Cost of Goods Sold is $47.
• Gross Profit – The Gross Profit is how much money we make from the sale and is simply the difference between the Sales and the Costs of Goods Sold. If those shoes sold for $100 then our Gross Profit is $53.
• Selling, General, and Administrative Expenses – Often called SGA Expenses, this line includes all of the other indirect costs of doing business (except for interest charges and taxes). So this includes marketing and advertising costs, salaries, rent, electricity, accounting, legal, and all of the other costs involved in running a business
• Operating Income – The Net Income is simply Gross Profit less SGA Expenses. If the number is positive, then the company is profitable. If it is negative, then the company is losing money.
• Interest and Taxes – Usually you will see interest expense and corporate taxes as a separate line item.
• Net Income – A simple calculation of Operating Income less Interest and Taxes shows you how much, at the end of the year or quarter, a company believes they have made (assuming all of their accounting is correct)!

Just to clarify, many people use the words “revenue” and “earnings,” and “revenue” and “income” interchangeably. Yes, earnings and income are interchangeable, but revenue and income are not. When reading Income Statements, revenue is the “top line” of the Income Statements and earnings/income is the “bottom line.”

In previous chapters we talked about IPOs and what it takes to be a public company in the U.S. To remain a public company in good standing with the Securities and Exchange Commission (SEC), after its IPO a company must “file” certain information on a quarterly and annual basis. The SEC then makes this information available to the public so that all investors have a level playing field and have access to the same information at the same time.

Here are the 3 most frequently filed documents with the SEC:

• 10-K The annual SEC filing by public companies that includes their audited Income Statement, Balance Sheet, Cash Flow Statement and other detailed notes about the companies financial and operating conditions. – this is the annual report that is filed by a public company with the SEC. This is an extremely in-depth document that contains lots of information including a description of the business, audited financial statements for the company’s most recent fiscal year (income statement, balance sheet, cash flow statements, and a statement of shareholder equity), executive compensation, a description of the company’s option plan, future commitments for leases, a review of any legal issues pending, and much more. An independent accounting firm confirms that the information presented is accurate by auditing the financial statements. A 10-K must be filed within 75 days of the company’s fiscal year end.
• 10-Q The quarterly SEC filing by public companies that include abbreviated, unaudited financial statements. – this is a company’s quarterly report that is filed with the SEC. The 10-Q is less detailed than the 10-K, but it gives you a snapshot of its financial statements so you can see how the company has performed in the most recent 90-day period. These financial statements are generally unaudited. Companies are required to file their 10-Q within 45 days of the end of their quarter.
• 8-K – this form informs company shareholders of “unscheduled material events that are important to shareholders”. This would include the resignation of an officer of the company, a major purchase or business deal the company has made, and even bad news like an SEC investigation into the company’s business practices. These are all material events that would require an 8-K to be filed. The 8-K is extremely common, and many companies will file a number of 8-K’s throughout the year.

When you start reading a company’s SEC filings, you will notice that they are boring, dry and full of legalese. But they are supposed to be that way because they are full of objective FACTS about the company, and FACTS are what you need to evaluate a company’s prospect for success. The SEC filings deliver the pure information about a company, unblemished by brokerage analysis.

Mark's Tip

I always like to read the latest 10-K report first to see how the company has performed over its latest fiscal year, and more importantly, how that performance compared to their previous 12 months. Then I look for the most recent 10-Qs and compare the sales growth, profit margin percentage, and net income. I hope to see trends established in the 10-K continuing in the 10-Qs.

You can find out almost everything that you ever wanted to know about a company just by skimming through the pages of their quarterly or annual reports. Are their sales increasing or decreasing? Is their profit margin growing or shrinking? How much cash do they have on hand? How much debt do they have? How are their European operations progressing? What kind of compensation package does the CEO of the company have? Who are the officers and VPs of the company? What is the company’s dividend policy? It’s all in there.

Most companies will also prepare an “Annual Report” and distribute it to their shareholders. It is this Annual Report which often contains the “glitz” and positive “spins” on the company’s performance. While smartly constructed and well-written, you should learn to separate the prose in the Annual Report from the true financial and operational performance as exhibited in their 10-Q and 10-K SEC filings.

Money Watch SEC Filings

Mark's Tip

Notice that I said the company prepares an Annual Report and distributes it directly to the shareholders. The Annual Report is NOT filed with the SEC and therefore has less objective information. While the Annual Report is usually attractive and enjoyable to read, there will be little valuable information in the Annual Report that is NOT in the SEC filings.

Exit Strategies Are Designed to Protect Your Value

Rule #7 – Have an Exit Plan and Target for Every Stock

Few experienced traders ever invest in any stock without having an exit strategy. In its simplest form, an exit strategy is a plan to get you out of something you’re in. In the investment universe, it means you should have an exit plan for each investment, before you enter into that investment. Understand what you’re trying to accomplish, set limits on market values to define your accomplishments (on both the upside and the downside), and have an action plan that allows you to exit successfully.

Three primary considerations typically dictate your exit strategy development:

• 1. How long do you plan to own the security? You should have an idea of the time period you want to own the investment. It matters little whether you favor a short- or long-term duration. The choice is yours. Also, should circumstances change during your hold period, you can always modify your original plan and shorter/lengthen the ownership target period.
• 2. What level of risk do you plan to endure? Zero risk would be wonderful, but that’s impossible. Decide how much risk you feel comfortable to take with a stock. This can appear to be a moving target, but you’ll feel more comfortable in setting a risk parameter. Even if you’re wrong, addressing this issue will help your eventual success rate. How much are you “willing” to lose on this investment? That is your risk level.
• 3. At what price do you want to exit? This component is both the easiest and, sometimes, the most troubling component of your exit strategy. You’ll invariably find that you ask yourself:

“Should I wait until the price goes higher than my original exit target?”

“Maybe I should hold the stock a bit longer, even though it’s decreased to my exit target, to give it a chance to recover?”

In most cases, if you’ve developed a thoughtful, fact-based exit strategy, you should resist the temptation to change your plan. Of course, if factual events occur that indicate a strategy change, make it to protect your portfolio.

Protecting your values should be at the top of your exit strategy checklist. A good exit strategy is faithful to Rule #1: Ride your winners and cut your losers. Here are a couple of popular options to achieve these goals:

• Stop-Loss Orders (Stops) (S/L): These are common components of many exit strategies. Stops encompass orders you can give your broker that direct him/her to sell a security at a pre-determined price. When your price point is reached, your stop becomes a market order to be executed right away.Stop-Loss Orders are an excellent tool to protect your values. By setting high and low price points, you are “programming” your profit and capping your losses.
• Trailing Stop (T/S) Orders: A modification of an S/L is the Trailing Stop Order. You set a “distance” between the market price and your Stop Order. While you don’t want this order to move downward on the loss side (you could only increase your losses), it can be useful on the upside. For example, assume you place a Stop-Loss Order on a stock that you bought for $85 for when it reaches $135. But, suppose it projects to go even higher? You might lose further profits. You decide to issue a Trailing Stop stating that your S/L should be $20 below current market price.As long as the price of your security keeps moving upward, your T/S will trail (follow) its rise in value. Once your stock begins to fall, your T/S Order will become a market order to sell when the stock’s market price falls $20 below its peak. Once again, you have protected your values quite effectively.

Summary

You’ve made your first purchases and now you have some idea what to do with them. While you’re not yet an expert, you should now have enough information to create a basic holding strategy and an exit plan. You understand that you should ride your winners and dump your losers. Having a sensible exit strategy helps you maximize your profits and minimize your investment losses. You’re ready to get into the game. Play well.

• Cutting Your Losses
• Stop Loss Orders
• Stock Exit Strategies: Knowing When to Sell is Important
• Stock Volatility Information
• When to Sell Stocks
• Limit and Stop Orders Video Tutorial

Further Reading
Exercise 1. Create target selling prices for each stock you hold in your virtual account. Use your order history to record your exit strategy and target price.

2. Create Stop Loss orders for each stock you hold in your virtual account.

Identify Market Tops to Maximize Profits

Market tops are subjective opinions that often quickly become fact, for better or worse. How can you possibly identify a market top? Here are some suggestions that many experts believe will help you identify market tops.

• Closely watch the Dow Jones Industrial Average, NASDAQ Composite, and S&P 500. Pay particular attention to the relationship between volume and the index. At some point in a bull market, the volume will fade as the index continues to be strong—this is a bad sign that there aren’t any more buyers.
• Also watch the relationship between volume and your stock’s prices. Low volume doesn’t tell us much, but large volume helps support price movements.
• Track the above noted activity over a four or five day period. This trend often precedes an overall market downturn. Feeding upon itself, as an almost a self-fulfilling prophecy, the “mood” of the market also tends to change, becoming a bit of a bear rather quickly.

Rule #6 – Sell into rallies that have fading volume.

Try not to miss these market top indicators. You may lose profits you’ve already achieved. If you have been on a good streak, you don’t want to quickly change from offense to defense if you can avoid doing so. Identifying market tops can be a profitable component to your market strategy in both the short and long term.

Rule #5 – Know When to Hold’em, Know When to Fold’em

Avoid falling in love with any one particular stock as the market can turn on it very quickly. While you may love a particular stock, millions of others may develop a dislike on a moment’s notice. You must be prepared to cut ties with an investment when as this condition starts to emerge. This brings us to the only exception to Rule #1.

• Exception – Market Tops: As you become more experienced, you’ll get a “feel” for those times when one of your winners is at a “market top.” As you watch stocks day after day and month after month, you will get the feel that a stock has gone too far too fast and it just has to come back down a bit. This is the time to consider just selling your winners (or tightening up your stop-loss order to 4%) so you can increase your cash holdings so that you can find another stock that’s on the way up.

As you can see, your possible first reaction (sell the winner and keep the loser), for reasons that have been proven over time, is typically the wrong one. Remember, your winners deliver profit “on paper,” but your losers involve real money you’ve already invested. It’s critical that you cut (minimize) your losses to safeguard your overall portfolio value. For this reason, you should develop effective exit strategies.

Rule #4 – Diversify, diversify, and diversify

Reminder: Always diversify your portfolio into at least 10 different stocks. It doesn’t matter if you are starting with $10,000 or $100,000–you’ll have more success if you think big and proceed as though you were a major-league investor. Diversification is important because while one sector of the economy might be falling 10%, rarely does the whole market sell off 10% in the same time period. So, with a properly diversified portfolio, you may get stopped out on one or two stocks, but hopefully you will have gains in others.

Mark's Tip

Some of the great investors and portfolio managers over the last 30 years (Peter Lynch, Warren Buffet) talk about having the “ten-bagger” in their portfolio. Sure, it’s nice to pick a stock that gains 10 or 20 percent a year, but what really drives a portfolio higher is a stock or two that tenfolds, or earns a 1,000% return. Over the years, Apple Computer (APPL), The Gap (GPS),Coca-Cola (KO), are some of the few that fall into this category.

Rule #3 – Never, ever, ever lose more than 10% on any single trade.

Traders, finance professors, and common sense all say that you should never let one sour apple ruin all of the other apples in your basket! Picking 9 stocks that gain 10% will be a waste of time if your 10th stock loses 100%, so DON’T LET THIS HAPPEN TO YOU! Having 9 stocks that gain 10% and one stock that loses 100% still results in a net LOSS of 1%!

The easiest way to follow this rule is to place a stop-loss order on your stocks as soon as you buy them. If you buy IBM at $100 a share, then immediately place a stop loss order at $90. This way you will be able to sleep at night and not have to worry about a market crash erasing more than 10% of your portfolio value in any given day, week or year.

Mark's Tip

Placing a stop loss order or a trailing stop at 8 to 10% below your purchase price is a routine you must practice religiously. William O’Neill, the father of technical analysis and the founder of Investor’s Business Daily recommends the 8% point, but others say 10%. Yes, you will get burned at times. If the stock falls 10%, you get stopped out, and the stock may recover. But more often then not, a stock that falls 10% will continue to decline even further. Sure, it’s OK to buy the stock back later at the cheaper price, but don’t buy it on the way down, wait until it has bottomed, formed a base pattern on the chart, and then shows signs of life again.

Rule #2 – Don’t fall in love with your stock purchases – winners OR losers (particularly losers).

Remember, you are not a welfare agency, rehab specialist, or air/sea rescue professional. If an investment is going south, sell it – without remorse and move on. Don’t forget, investing is a business, not a hobby or a charity.

Mark's Tip

Remember, stock trading is a zero sum game. If you are not the winner then you are the loser. If you bought a stock and it went down, then you made the seller of that stock happy because they were able to pass that loss on to you. If you bought a stock and it went up, then you made the seller of the stock very sad.

Admitting that you were wrong to buy a stock is the most difficult fact to accept in investing. It makes every investor feel bad when they see their portfolios losing money, which makes it even more difficult to sell. The reason why most investors fail is due to their feelings about the stocks they buy and sell. Don’t let your ego get in the way of making money, or in the case of a losing trade, from stopping the bleeding. If you can master your ego and your emotions, you will have more profits on your winning trades and smaller losses on your losing trades – guaranteed.

This lesson will teach you some generally accepted trading rules. But unfortunately, trading is an art — not a science — so don’t be shy. Create your own investing strategies as you grow and learn.

When you are learning a new skill, it always seems as though there are a few general rules of thumb that you must know in order to get started in the right direction. In golf you must “keep your left arm straight” (if you’re a righty) and in blackjack you must “assume the dealer has a 10.” In stock trading the first rule is:

Rule #1: Ride your Winners and Cut your Losers.

This rules looks simple and seems obvious, however, it is the opposite of what most people do when they start trading stocks.

There is a common affliction that hits most new investors that causes them to do the exact opposite—they can’t admit that they were wrong. This condition is best shown by example. Assume you invest $1,000 in two companies as your first two trades. After the first month, Stock A’s market value has increased to $1,200 while Stock B’s market value has decreased to $800. What is your first reaction? Is your first thought to sell your winner (Stock A) and take your profit, and wait until your loser (Stock B) regains its value? This is the LOSER’S mentality! Yet, this game plan is usually the first one followed by newer investors.

At first glance, it may appear to make sense. You sell your winner and take your profit and then you get emotional about Stock B and think “it will come back soon and I will sell it when I can get all of my money back.” Don’t do this! Many, many, many experienced investors would disagree with your plan – strongly disagree. See Rule #1—Ride your winners and cut your losers! This cuts your losses (and you WILL have some losses as everyone does). If your winner is “hot,” it’s likely that its market value will increase further. Similarly, if your “problem child’s” price is declining, the declines will probably continue, causing you to suffer further losses.

Mark's Tip

Gordon Gecko, the main character in the 1987 movie Wall Street, said it best when he said “don’t get emotional about stocks, it clouds your judgment.” You should only buy a stock after researching it and having a strong conviction as to why you want to own that stock—but if you are wrong, admit it and move on to your plan B.

This concept can be understood better when looking at what it takes to re-coop your losses. This is NOT intuitive. You see, due to the way percentages work, it takes a much larger percentage gain to recover your losses. For example, for a stock that has lost 15% of its value will require a run-up of 18% just for you to break even.

These calculations get worse the more your stock goes down. Take a look:

My Stock Loss	Gain Required to Break Even
20 percent	25 percent
30 percent	43 percent
50 percent	100 percent

For example, if you buy Stock XYZ at $10 a share and it drops to $5 then you have lost 50% of your investment. Now for you to recoup your investment, the stock must now double just to get back to $10 a share. No one wants to be in the situation of having to pray for a stock to double, just so that they can break even. In fact, that’s a nightmare. It is much better for you to cut your losses early, at 8-12% rather than get into this predicament.

The law of percentages seen above also works in reverse (and in your favor) when you hold on to your winners. The longer you hold onto a winner, the less a stock needs to move in order for you to rack up really exciting gains. Let’s take a look at the table as stocks rise:

My Stock Gains	Gain Required to Double Original Investment
20 percent	66 percent
30 percent	54 percent
50 percent	33 percent
75 percent	14 percent

The gains get even better when your stock has doubled or tripled already. For example, let’s say you bought Google (GOOG) in 2004 at $100 per share. If the stock is trading now at $400/share, every 1 percent rise in the stock produces for you a 4 percent gain. Not bad, eh? That’s how you get rich: finding winners and sticking with them as long as they keep rising consistently.

Summary

It’s time to decide on how you’d like to construct your portfolio. Whether you decide to invest virtual money or real funds, you should now have a basis to create your own thoughtful plan and strategy. Using your virtual portfolio and trading ability, you can test your strategy and “tweak” it, if necessary, to achieve profitable results in both the virtual and real world.

Glossary

Diversification:

A way of reducing the risk and variances in your portfolio returns by buying a variety of stocks across different industries, market caps, etc.

Peter Lynch:

Past portfolio manager of Fidelity Magellan, which became the largest mutual fund in the 1990s.

Risk:

The expected variance of the returns of your investments.

Sharpe Ratio:

A measure of the success of your portfolio by considering its return and its variance.

Warren Buffet:

Chairman and CEO of Berkshire Hathaway, and generally regarded as the greatest buy and hold investor of the last 30 years.

Further Reading

• Diversify to Reduce Risk
• What’s The Risk? Learning about the Various Risks of Investing
• Market Risk or Systemic Risk
• Bond Basics | What are Bonds?
• What is Market Capitalization?
• CD Basics (Certificates of Deposit)
• What is Inflation?
• Investing in Real Estate through REITs
• What is Hyperinflation?
• Small Cap Stock Investing Can Lead to Big Score
• Dollar Cost Averaging
• Sharpe Ratio Explained
• Buy and Hold Strategy
• Buy What You Know
• Hedge Fund Definition

Exercise

Make a list of stocks that you are interested in. Identify their industry, market cap, and dividend yields. Now build a balanced, diversified portfolio of at least 10 stocks on your virtual account. Make sure you have with a selection of stocks from different industries, market caps, dividends, and countries.

Thanks to the Internet and the wonderful amount of information you have at your fingertips, you can quickly scan 20,000 stocks in a matter of seconds if you know what you are looking for. Stock screeners can save you time by finding stocks in that meet certain financial or analytical measures you are looking for. Although some have more variables than others, all stock screeners work just about the same.

You decide on a mix of financial and investment preferences and parameters. You can then input this data and allow the stock screening software to locate securities that “fit” your perceived descriptions. With some freely available and others offered on a subscription basis, stock screeners are easy and convenient helpers.

While stock screeners operate with the same goal – finding stocks that match your wishes – you can choose different formats for results. Some will generate results on expected returns, riskThe expected variance of the returns of your investments., and projected yields, while others can offer stock suggestions based on growth, effective strategies, and other parameters.

Among his many accolades, Lynch is noted for an important and simple theory: Invest in what you know. In one of his books, he talks about Saturday as his day with his daughters. Every Saturday, his daughters said “Daddy, take us to The Gap (GPS) so we can buy some clothes.” Reluctantly, he went for several Saturdays in a row, gave his daughters $100 and sat out in the mall waiting for them. After a few weekends of this routine, his eyes lit up! He started noticing all of the teenage children dragging their parents to the store. He sat outside for an hour and counted the number of people going thru the cash register lines and estimating the average ticket price to come up with a rough estimate of sales. Suddenly, he started liking The Gap and he had his staff research the company the next Monday. Soon it was in his portfolio and it soon become one of his best buys ever, returning over 25,000% from the mid-1980s to its peak in 1999 (that run was from $0.20 to $50.00!).

This is an excellent starting strategy, and possibly enduring strategy for all investors. Instead of spending valuable time becoming an expert on complex investing strategies, expand your “local knowledge” and use your personal industry expertise to purchase securities of companies and industries you know personally.

Think about stating your goal as building a portfolio of “non-losers” as opposed to a group of “winners.” A strategy of finding “non-losers” combined with investing in companies and securities you know often leads to locating under-valued stocks and true bargains that maximize your investment dollars.

You may also find one or more “ten-baggers,” a world-famous Lynch-ism. In baseball, “bags” are a popular term for the “bases.” Finding a ten-bagger (hitting two home runs and a double) means you’ve found a stock that returns ten times your original purchase price. Even finding a group of two- or four-baggers should make your portfolio and bank account quite happy!!!

Mark's Tip

You don’t have to find the next Gap stock or stand in lines at the new restaurants to look for your next 10-bagger! Look for the negative side of things too. Are you getting lousy service at your favorite restaurant? Are you shopping at a store and you look up and notice you are the only one there? Does the tough economy mean that you are not stopping at Starbucks (SBUX) twice a day? Is nobody buying Crocs (CROX) plastic shoes anymore? Don’t forget that you can short these stocks that your experience tells you are losers!

As an example, the legendary investor Warren BuffetChairman and CEO of Berkshire Hathaway, and generally regarded as the greatest buy and hold investor of the last 30 years. has amassed his fortune without using a wide variety of exotic strategies. Buffet is the Chairman and CEO of Berkshire Hathaway (BRK.A) which has a stock price of $99,000 as of December 2009. His company owns large positions in companies like Coca-Cola (KO), American Express (AXP), Wells Fargo (WFC), Proctor and Gamble (PG), Burlington Northern (BNI), and GEICO.

You can check out his holdings, which shows the percentage of each company’s outstanding shares that are held by Berkshire Hathaway, Warren Buffet’s investment holding company.

All holdings are as of  September 30, 2009 as reported in Berkshire Hathaway’s 13F, except for Moody’s, which is as of December 8, 2009.

He is a classic “buy-and-hold” investor. He purchases securities the “old fashioned way.” Buffet studies companies and determines their core values based on the products they make and/or sell, profitability, management quality, and their future growth and sustainability projections.

He never acts on rumors or pure market price indicators. Incredibly, although recognized as one of the preeminent investment gurus on our planet, Buffet seldom sells items in his portfolio. He prefers to use his income stream to keep increasing his portfolio.

Warren Buffet Documentary

https://www.youtube.com/watch?v=RYHPlLsdW0A

Often, a “KISS” approach (keep it simple stupid!) is the best place to start. It can work for you better than many of the other so-called “experts” and sources of information out there. Ask yourself “what field am I an expert in?”

Are you a doctor and do you know what the hot new drug or pharmaceutical company is? Are you a school teacher and do you know what the latest gadget or software program is that your school is buying? Do you work at a grocery store and suddenly everyone is asking for XYZ product and you can’t keep in on the shelves? Are you a mother and suddenly all of the kids are asking for a certain brand of plastic shoes or a new iPod?

Mark's Tip

Each of us knows more than we think we know because everyday we contribute to the profits (or losses) of the stocks that we are choosing in the marketplace. We choose to go to Starbucks (SBUX) for coffee and skip our morning Diet Coke (KO). We eat lunch at McDonald’s (MCD) and not at Taco Bell (YUM). We buy our kids clothes at The Gap (GPS) instead of Limited (LTD). Why do we make these decisions? Because there is something about one product or the way one company is run that makes us want to go there versus its competitor. Do you ever walk into a store or restaurant and say “Wow! This place is packed all of the time?” If so, don’t walk out mad. Instead, find out more about that company and see if they are publicly traded. When my wife comes home from shopping, the first question I ask is “Where did you go?”, then “How much did you spend?”, and then “Was it crowded?” I am not just making idle conversation with my wife, I am researching stocks!

Which portfolio would you rather have? The 2nd portfolio would be great if you sold out on March 1st and locked in your 20% return, but it sure didn’t hold that value for long. What if you had to sell out on April 1st and lost 5%?

To measure this relationship between a portfolio’s variance and its return, Wall Street has developed several ratios or indices. The most popular is also the simplest. It is called the Sharpe RatioA measure of the success of your portfolio by considering its return and its variance.. Nobel prize winner, William Sharpe, created this formula over 40 years ago. The Sharpe Ratio informs you whether the higher returns you receive from certain securities are the product of your wonderful investing strategy or higher riskThe expected variance of the returns of your investments. and volatility. This Ratio provides important feedback and helps you select the right stocks for you and your plan.