Tuesday, January 1, 2008

Wise Stock Investing is about Much More than Being "Right"

The title may sound strange to some investors or traders, especially to those that are new to the subject. Some people are convinced that this is the single most important thing for success in the stock market. But the truth is; when it comes to being a successful investor, how much money you make when you're right really isn't all that counts. The simple fact is you won't always be right. Oops. Bad news, right. It's not something you like to hear, but it's true. Isn't it? Even though it's possible that some of you may have met someone, at one time or another, that claimed to be right almost 100% of the time. And if you haven't met that person yet, you might run into him or her somewhere in the future. When you do, be careful. When someone tells you he or she is always right, in general, three scenario's are possible:

- You're talking to the world's best investor / trader
- You're talking to a textbook example of beginners luck
- You're talking to a liar

Let's take a quick look at all these possibilities. The first scenario is of course highly unlikely. Fortunately it's easy to find out if this is the case. Just take a look at the person's track record. People that like to brag about being right all the time, usually enjoy making their point. So they would love to prove their track record to you. If they fail to cough one up, they're probably not telling you the truth.

The second scenario is a lot more likely. Only a couple of years ago, when every idiot could make a profit because share prices were continuously on the rise, it seemed like these people grew on trees. In todays market you won't find a lot of those people hanging around. Most of them got more than they could handle when the bubble burst. And many of them never had the courage, or the financial means, to return to the game of investing.

Then of course we have the third and most likely scenario. In this case, you would take the same approach as you did with the super investor. You ask them to show you their track record. The liar of course will never give you this. Instead they will try to convince you with wonderful stories. All of which are probably fascinating. Some would be interesting enough to serve as a plot for a Hollywood blockbuster on Wallstreet. However, none of these stories will do you any good when it comes to making it in the stock market.

The plain and simple truth is that nobody can invest for any period of time and be right each and every time. It simply is not possible. Now that doesn't mean that anyone telling you they never lose is lying. It depends on what they're really saying. They are not saying that they never lose on a trade or on a specific investment. What they may be saying is that they never close out a year with a loss at the end. So how come they can make money every year even when they lose on some trades just like everybody else? The answer is simple; they are right more often then they are wrong. And more importantly, when they are wrong they limit their losses.

To illustrate this, let's compare the stock market to a game of roulette. Some people could easily substitute one for the other. They live under the assumption that both are simply games of chance. Others may find this comparison ridiculous because the two are so vastly different. The two camps would probably never agree, so let's not go into that discussion here. However there is something very important we can learn from roulette.

In a game of roulette the odds are actually divided in a reasonably fair way. If you were to continue playing by constantly just betting a small amount, say $10.00. And you would consistently play the same color, say black. You would be right 18 out of 37 times on average. Of course you would also be wrong 18 times. If you would consistently play the game this way, you would probably never win much, but you couldn't lose much either. As a matter of fact if you would just continue playing long enough, you would eventually lose on 1/37th of all your bets.

Unfortunately the same can not be said for the stock market. The odds are quite different there. Yes, the market can go up and down, and there is no zero, but there are many more factors to be taken into account than in a game of roulette. The same strategy that was described in the roulette example could work quite well in the stock market, but it could also cost you everything you've got. One part about being a successful trader is to be right as often as possible. And even though you cannot predict the market, at least not perfectly. You can do your homework by studying the technical analysis charts and doing some fundamental analysis into the company. If you know what to look for, this will greatly increase your chances of being right.

However, you still will not be right all the time. And that is where both the lesson from the roulette example and the title of this article come in. First of all, you have to place your 'bets' evenly. Stick to the $10.00 example. Don't be persuaded to invest a significantly large part of your investment capital into any one trade just because you're so sure this time. This may work out fine many times, but sooner or later it will hurt you, and it will hurt bad. You see it is not how much you make when you're right that counts. It is what you keep yourself from losing when you're wrong that really matters in the long run. You can be right 90% of the time and make some pretty good money. But it won't do you any good if you lose it all on the 10% of your trades when you're wrong. Of course diversification and proper asset allocation can help protect you, but that simply isn't enough. You have to know when to get out.

So next time when you're about to make a trade, ask yourself: "What if I'm wrong". And then determine a price level at which you will take your loss and get out. Once you've determined this simple rule, just stick to it. It may cause you to lose a little money every once and a while. Even on trades that may bounce back just one day later. But in the long run that will hurt far less than the losing trade you so desperately hang on to, hoping it will recover. Only to find out that it won't.

Earnings Per Share May Be Dangerous To Your Financial Health

There's a serious and completely preventable problem occurring in the financial investing arena these days.

This threat to one's financial well-being comes from the sole focus on "earnings per share" triumphantly trumpeted by companies in their quarterly financial press releases. And the financial media doesn't help any with their superficial thirty second blurbs informing the investing public of the same thing. Even more alarming is that this novice mistake is frequently made by "expert" and "veteran" investors, as well.

The unfortunate truth is, failure to address this common oversight can cause painful repercussions to your investing portfolio. And also hinder you from identifying companies worthy of your long-term financial best interests.

What is this critical investing component? It's the Cash Flow Statement, kin to the more popular balance sheet and income statement. How does the free cash flow statement help you with your investing oversight? A company's free cash flow helps to answer three very fundamental questions - When to buy? When to sell? And at what prices?

The fact is, free cash flow is what should be monitored first and foremost as a shareholder in any business. Most everyone knows that "cash is king". Free cash flow is the lifeblood of any company.

The problem when paying sole attention to "earnings per share" is that it is formulated using "generally accepted accounting principles". Commonly known as "GAAP", this accounting methodology is a flexible representation of the company's revenues and expenses, mainly formulated for tax reporting purposes. The sticking point is that "GAAP" consists of many non-cash items - sometimes considered as "accounting fictions". And because of the permissible leeway in how GAAP can be implemented, it's subject to manipulation.

In contrast, the cash flow statement is less prone to being manipulated than the other two financial statements. That's because it mainly boils down to what money came in and what money went out. Not unlike an individual's monthly budget.

When analyzing a company it's critical to understand how much cash flow it is earning from its operations. This amount represents the excess cash that can be taken out of the company to be used for dividend payments, share buy-backs, new investments and acquisitions; all activities geared to the benefit of shareholders.

With GAAP earnings on the other hand, companies often take significant "one-time" charges against current earnings, usually after some adverse event, like a company acquisition gone bad. As a result, future earnings are then susceptible to being inflated artificially.
The income statement also includes many non-cash allocations and accounting conventions that don't reflect a company's true cash position.

A further example of an ongoing non-cash "cost" is depreciation and amortization, which can add up to significant amounts. In reality, the cash has already been spent for these assets. GAAP adjusts these one-time payments over a period of years to smooth out the companies earnings over time so they don't appear too lumpy or erratic.

Another flaw might be using the balance sheet for liquidity analysis because the data represents only a specific period in time. By contrast, liquidity analysis derived from the cash flow statement can be used to provide a more dynamic picture of what cash resources are available, and can be evaluated over a chosen period.

One can also see whether cash spend is at levels that the company is going have to incur debt, slow its spending rate, or both. This is especially important for new companies that are not generating profits yet. Do they have enough cash to remain in business?

Changes in cash flow can be reveal much about a company's accounting practices, too. Cases where cash flow is not rising, or declining, as fast as earnings may warn of possible accounting shenanigans.

These are just a few of the many insights and potential advantages that analyzing the cash flow statement will bring forth. And it's freely accessible at the Security and Exchange Commission's EDGAR financial statements web site.