Category Archives: Rules

Rules for investing that you should read before hitting the bid.

Growth Rate Applied to the Mutiple: Whutup?

Rule:

Never pay more than twice the growth rate (converted to P/E) for a stock.

Most institutional investors, (the big guys behind the oak desks that move the markets) have a rule not to pay twice the growth rate for a stock…it is too expensive.

To determine the growth rate, we use FUTURE Earnings Per Share (EPS) estimates. Stocks trade six, nine, even sometimes twelve to eighteen months in the future and if you use the current or the past EPS numbers, most stocks will look overvalued when they could be actually quite cheap and you may miss the opportunity.

For example:

The company: Vandalay Industries (NYSE: GLC) trades at a P/E of 100 has the following EPS over the last few years:

2012: 1.00
2013: 1.20
2014: 1.40

These numbers show that from 2012 to 2013, GLC had 20% EPS Growth. A pretty respectable rate for the Latex Sales biz. With this rule, we would then expect to pay no more than a P/E of 40. [20% * 2 = Max P/E (Multiple)]. However, from 2013 to 2014, the growth rate slowed to 14.3%, which should cause a contraction to the multiple if we compared it to the year prior. We would now expect to pay no more than a P/E of 28.

Obviously we should sell it if we have it, or not even buy it (maybe even short it?) because it’s over valued. Right?

Wrong. We looked at the future predictions for EPS based on the management numbers and we noted the incredible demand for latex in several industry journals. The predicted EPS from 2014 to 2015 is 2.10, a 50% growth rate from 2014 to 2015 and the if the outlying years are even better, a P/E of 100 is not out of the question and maybe a reasonable valuation.

Additional comments:

1) Expect to pay a higher multiple (than the peers) for the best-of-breed stock. The top dog in the business deserves a bit more…you pay for quality.

2) Expect to pay a higher multiple if the company consistently  beats and raises earnings estimates at the quarterly conference call. We like managers that under promise but over deliver.

 

 

 

 

 

 

Timing is Everything

Timing is everything: Here are a few timing stats.

1) If you wait until 11am-12pm on the first Friday of the month (nonfarm payroll numbers are issued) to buy a stock, you will often score a better deal than you would at the open.

2) When institutions dump a stock or liquidate positions, they typically do it from 1:30pm-2:30pm EST on the trading day. If they can’t liquidate what they need to dump, the “Firm Reload” resumes the next trading day.

3) THE DATE to buy a stock with a dividend is, at the latest, the day before the X-Date.

4) You don’t typically want to buy an IPO before the lockup period expires. Wait to see the waist after the insiders sell.

5) Don’t take a position during earnings season, unless you absolutely have to. The unofficial kickoff to earnings season is the release of earnings by Alcoa (NYSE: AA).

6) If you see your stock in the New York Times, Businessweek or Forbes…the smart money has been already made. Don’t be a piker.

Trades vs Investments

Rule:

Never change a trade into an investment and never change an investment into a trade.

A trade is short term where you are looking for a specific catalyst. A trade should be where you are betting on a buyout, a new product that you think the market will like but you also think it is just a flash in the pan idea (Crocs), or maybe you are betting on an activist investor, like Carl Icahn, to unlock some needed value and lay waist to sloppy management.¬† A trade is short term, usually less than six months, and when the trade is done, it is time to sell. Don’t make excuses to keep it. Remember, when the money is made, it is time to go.

Example of a trade: YELP: We are waiting for GOOG, MSFT, FB or YHOO to snap them up, YELP owns the yellow pages, they can’t stay independent for too long.

An investment is usually greater than six months. Sure, you may still be still waiting for a catalyst, but this stock has some mojo; maybe a good CEO, a first to the market product or no competition (we like a monopoly). When you make some money, you must let your winner run, just like in horse racing. Obviously, if there is a change to the fundamentals, it is time to sell, but you are in it for the long haul and if you keep reading the quarterlies and the news, you won’t be surprised to the downside.

Example of an investment: SBUX: They are run by a top CEO, no competition (no, Dunkin is NOT competition, they are being dragged by the ice cream biz.) and they are the masters of mobile payment that is going to double SBUX over time when they license the tech.

Limit Orders

Rule:

Always use Limit Orders when buying or selling stocks. Hitting the buy and sell button is asking for trouble.

If you are a small trader, like most of us, you may see wild swings in your buy or sell prices when compared to the market price if you don’t use the limit option. Brokerages may fix you up with a buyer or seller with an unfavorable price if you aren’t careful.

A Limit Order should only be used while you are in the market during the trading day. If you let the order stand indefinitely or for mutiple days to try to catch some upside or protect your downside, you may regret it the next time a Flash Crash occurs. You should read up on the Flash Crash, you WILL see them again and using the Limit Order, for a short duration, is your only protection.

More info on the Flash Crash can be found here.

Hated Stocks

Rule:

Stocks under $10 are usually considered hated stocks. They are hated, or rather, ignored by the large investment firms. Large investment firms have some very specific rules about what stocks they can invest in. One of the big rules for these firms is not to invest in stocks with purchase prices under $10.

Who cares, right? You should. When these large investment firms take a position in a stock, they are buying tens of thousands or even hundreds of thousands of shares. It can take several days for these firms to take their desired position and this can drive the price higher and higher*.¬† A small, or broken company with a price of under $10 won’t typically move unless there is a catalyst of some kind**.

Try to buy stocks that are over $10 in price to take advantage of the upside that a purchase from a large buyer would deliver.

* Conversely, it is good to know that it can take several days for a large firm to liquidate a position when there is signs of trouble, allowing you to beat them out of the position.

** One way around this is for the company to do a reverse stock split. Watch out for these companies and most of the time, it is good to stay away.

Are you in a Secular Decline?

Rule:

If the S&P 500 rallies for multiple days and your stocks do nothing. You might be witnessing a secular decline. Half of a stocks performance can be attributed to the sector that it belongs to. The rest of a stock’s performance is based on earnings of your particular company.

However, if the market rallies over multiple days and your stock remains stagnate, you had better sell (Channel your inner Bill Engvall: Here’s your sign!). This is a red flag that your stock has little support when the market decides to correct. Even if you believe the stock is undervalued already or that there is a catalyst on the horizon, get out and come back later when the sector is back in favor.