How to Take Profits, Protect Profits and Avoid Losses
Wednesday, October 3, 2007 | Dylan JovineRating:
I HAVE TO SAY, YOU GUYS REALLY IMPRESSED THE HECK OUT OF ME ON MONDAY.That was the day Wayne Mulligan asked for your help answering three of the investing questions readers sent me two weeks ago.
The questions you answered so brilliantly were:
1. What are the strongest investments in a down market?
2. How do you know when management of a company is good if they are not Warren Buffet or someone well-known? What is it you look for to tell you?
3. Why are a company’s P/E ratio and Return on Capital important factors to look at when making an investment?
For anybody who hasn't seen the answers to these questions yet, I invite you to read the comments posted here:
http://tycoonreport.tycoonresearch.com/articles/761112436/dinner-s-on-us
Not only are the answers solid, but they're also very expansive. It's easy to see how much thought you all put into them.
In addition to sporting a smile that goes from ear to ear, I'm really looking forward to dinner at Peter Luger's with three of you.
(Yes, as soon as the three "winners" are announced, dinner is on me!)
Now I'd like to answer a couple of questions you've submitted. Instead of just running through them with short answers, I'm trying to bring you quality answers, so please be patient as I get through the rest of them.
Mark asks: Is it better to work with or through a broker or to develop the independent mindedness to become one's own broker in the stock world?
Thanks for your question, Mark.
I can't express enough how important I think it is for you to learn how to invest on your own. There are two reasons why you must become independent in your investment operations.
The first reason is because our government has made promises that it will simply be unable to keep. In short, the U.S. government has promised much more than it can afford to pay to its citizens, and something is going to have to give. Either benefits will have to be cut dramatically through lower payments or an increase in the retirement age, or we'll be taxed a heck of a lot more. The bottom line: you'd be better off not expecting anything from plans like Social Security. That means you're going to have to fight on your own to make sure you retire with the degree of comfort that you deserve.
In addition to the Social "InSecurity" problem, there are tremendous changes happening in the world right now due to globalization.
In days past, we were all told that all we needed was an education to get ahead and be protected from job losses. Indeed, during the 1980's alone, everyone with "white-collar" jobs felt protected from the losses hitting the "blue-collar" jobs. Most people felt that they could live with the fact that manufacturing was going overseas. As long as it didn't affect the "white-collar," the elitists in the country felt protected.
"Spend big money on your college education. Spend bigger money on your graduate degree. As long as you have that, you'll be protected." (College marketing campaign)
But I've got news for you, ladies and gentlemen: nobody's job is safe anymore, and you know it. Almost anything you do now can be outsourced overseas to highly competent and lower cost "replacements". Taxes can be done overseas for less money. Software programming can be done overseas for less money. Medical research and imaging and even some medical care can be done overseas for less money. Legal work can be done overseas for less money. Architecture can be done overseas for less money.
I can go on and on here, folks, but I think you get my point: most degrees you are getting today won't be worth as much in five years, 10 years or 20 years as they are today.
But investing is one area that you'll always be able to make money in.
Just think about it: once you learn how to invest properly, you'll always be able to make money in the markets.
As a matter of fact, as the rest of the world becomes capitalist, investing becomes more and more valuable than ever before. Now, instead of just making money in Western markets, you can make money investing almost anywhere in the world.
Look at China. Look at South Korea. Look at India. The list goes on and on, folks, and the point I'm trying to make here is that the trading techniques you learn here will apply to any of those markets and many more that I haven't even mentioned!
That's why, in my opinion, the most important advanced "degree" you can get is a degree that teaches you how to invest properly. Nobody will ever be able to take that away from you - you'll be able to make money at any location around the globe at any time of your choosing.
So for those reasons alone, learning how to invest on your own is critical.
But there's another important reason ... one that I've mentioned too many times to remember ... it's the "two master" problem on Wall Street.
Let me explain:
It's impossible to convince me that you can trust Wall Street. Now, I'm not saying that everyone who works on Wall Street has bad intentions - not at all. But I am saying that trusting the wrong person just one time can be devastating. For example, former Merrill Lynch analyst Henry Blodget publicly rated the stock of ExciteAtHome a “buy,” while suggesting in private communication (an email no less) that it was “...a piece of crap.”
Now this is just one example, granted. But remember something: Wall Street has two main sets of clients - institutional investors (big investors, corporations, hedge-funds, private equity firms, governments) and individual investors (you). And no matter how much regulation people put into place, there will always be the inherent conflict that comes with serving two masters - especially when one master pays so much more than you do.
And if you were the person three years away from retirement, and you owned a lot of Enron stock (after all the firms on Wall Street recommended it), you'd be working again. That would be painful indeed. Or if you thought you were safe with bonds just recently and trusted both Moody's and S&P's recommendations to purchase subprime bonds for extra income, you'd be feeling the pain right now.
That's the "two masters" problem, and no matter how much regulation is ever passed, that will never change, period.
(Now there are plenty of good brokers out there. Here at Tycoon Publishing, we use Scott Teich, who helped us set up our company-wide 401k plan. But the only way you'll even have a chance of finding a good one is to be knowledgeable enough to know which questions to ask in the first place.)
Ken asks: I've noticed several people have asked questions related to trade management, specifically how to take profits, how to protect profits, and how to avoid losses. Some have been more specific, asking about stop percentages. These things need to be addressed in more detail.
Thanks for your question, Ken.
Since I am not a trader, I can only speak to how I manage trades myself. And that is really summed up in one word: VALUATION.
Before I buy a stock, I have a good idea of what the business is worth. For example, last year I recommended Radio Shack in the $16 range. Based upon my own earnings estimates, I believed the stock to be worth $25 to $35 per share. Therefore, I knew my ideal sell price BEFORE I purchased the stock. Thus, when the stock shot into the $29 range I was prepared to sell it already.
When you have strong estimates of what a business is worth, it also helps eliminate the need for stop-losses, another favorite tool of traders. You see, most traders look at stocks as intangible pieces of paper that float up and down independent of the underlying business. That's why they incorporate such tools as stop loss orders. And that's fine. But it is a fundamentally different approach to what I do each and every day.
You see, from my vantage point, a stock is not just an intangible piece of paper. It represents a piece of a business. Specifically, it represents a claim on the future free cash flows that the business is going to throw off. Therefore, the business is an asset just like your home is an asset or an apartment building is an asset. (If you don’t believe so, just ask somebody who owns a private business to sell it to you for half of its worth on a day the market crashes.)
Now, many traders would say it would be too risky to buy a stock if the price were declining. But would it have been too risky to buy shares of Radio Shack if the price had declined to $10 a share if the company was worth $30?
At that point you could have sold the assets to any one of five private equity firms or private buyers for no less than $20 per share or 15 times earnings. Remember, the company is one the largest electronics retailers in the country and had a 50-year history of building a solid brand name and earning rates of return on capital in excess of 25% (well above the average of 12% for American companies).
In addition, you could have polled ten Wall Street analysts who all believed the company would earn close to $325 million dollars the following year just by incorporating some of the easier changes new management would recommend. The same exact company traded as high as $35 per share, so an investor who would have purchased it at $16 and then at $12 and finally at $10 per share would NOT have been taking much risk - unless they were traders. Then it would have been very risky.
Now, if Radio Shack stock had declined even further to $5 per share because the market was afraid of who-knows-what high, it would have looked almost suicidal to most traders. But to me it would have been heaven: buying a $30 stock for $5 per share seems less risky to me than buying it for $20 per share.
If I took the approach most traders took and looked at assets as intangible pieces of paper instead of for their cash producing ability, I would jump for joy if a car I wanted to buy rose in price. Or a home. Or a new stereo system.
Have a great week.
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Dylan Jovine
Contributing Editor
The Tycoon Report
