Stock Forex

Choosing Stock Wisely

If there is a way to make the selection of a stock and building a portfolio of solid stocks a fun process, we’ll make every attempt to find it. A few assumptions: 1) we want to find stocks at bargain prices, and 2) we surely do not want to overpay for our stocks.

Isn’t that the essence of it all—to find great stocks at bargain prices? Also, we want to buy stock with the highest likelihood of increases in value and the lowest likelihood of losing value. If the stock produces a dividend (income) that would be nice too.

Real Estate: A Foundational Example

Determining value is very perplexing and very diffi­cult. Over the years many ways of determining value have been proposed. Whether we’re buying or selling, we want the best price. The three most common ways to determine real estate value are listed here. After this short exploration we’ll use what’s applicable from this to aid us in choosing stocks.

1)  Cost or Replacement Value

Buildings and land have value based on how it is being used. We’ll explore more of this in the income section, but we’ll cover it briefly here. A building used as a factory will be worth so much: use it for residences and it may go up in value. Turn it into a shopping center and it goes up again. You can’t do this with stock, but what the company does with its assets can change what it’s worth.

With real estate we just figure what it costs to replace the building—including the land—and that’s the replacement cost. Is it this simple? Well—not quite.

2)   Income

The gross and net income and the use of income multipli­ers are the most commonly used basis for the determination of value. You see, the cost of replacing a structure is not adequate to determine the full or accurate value.

What income does a building make? And even if you know that to the penny, other factors enter in:

A.   How long has it been since a rent increase?

B.   How expensive is the debt? And can it be refi­nanced or paid off?

C.   Can other expenses be lowered?

And none of this has to do with the tax deductions. How does it affect our tax bracket? All sorts of other variations occur. If we raise the rents, will the income remain stable? If we “net” more, the value will increase—could it be refi­nanced at a higher price and the new-found money used to buy more properties?

3)  “Comps”

One common way to value real estate is to find properties in the area which have sold recently and determine the value of your property based on an average of several properties— taking into account the differences. This is one of the func­tions of appraisers. Banks use this method extensively so they are not giving mortgages above “what the neighborhood will bear.” Extensive appraisals can be done using all three of these methods. It is wise to use all three with a more nebulous “growth potential” factor thrown in. The potential for growth or increase in value is a reason why many real estate investors invest in the first place, but so many things change, and there are so many chances to be wrong, that hardly anyone uses it as a main factor in determining current value.

I could go on, but since this is a chapter about stocks, let’s just take from real estate the thought behind the process. The example of real estate cannot solve all the problems, or answer all the questions, but it is worthwhile. It’s good to have another point of reference. I’m good at many of my stock decisions because I integrate knowledge I gained in real estate.

The point is not that many companies own real estate, but that the price of the stock, the income, and tax consequences have many similar characteristics.

Here is a micro point on these movements. I think good news plays out in days. However, it can take months for company’s stock prices to recover from bad news.

Now, if you’re playing the stock, either long or short, the length of time is crucial to your profitability. However, if you’re playing stock options, a high point and then small percentage down in the stock, or a bottom and small recovery in the stock ($1 to $5) could produce drastic profits.

Define A Joke

Watching “Data” on Star Trek is a lesson in human behavior. Laughing (getting a joke) is difficult—at least the timing is difficult. Data doesn’t get jokes. He can’t tell one, or understand the punchline. I saw a bad movie (Solo) and the humanoid (machine) questioned why everyone was laughing. “A joke,” he was told. Obviously, he wants to know what a joke is. No good explanation was given. Let me try my hand at it. I’ll then get back to booms and busts. A joke is a story, and at the end a complete surprise occurs, either in the actions of the participants, or a twist in words, with unexpected meaning, hidden meaning, or a nuance to something else. Based on your point of reference, the company you’re in, or the mood you’re in, determines your response—a chuckle, a scoff or a belly laugh, et cetera.

It is the twist, or reversal that interests me. Never has a movie brought tears to my eyes as the end of Steel Magno­lias—then in a half second, everyone is busting a gut laugh­ing. The writer played our emotions like a maestro. The markets also thrive on fear and greed, and unexpected rever­sals.

Change Is Inevitable

When stocks move up or down—either unexpectedly or in reaction to news, especially if they move quickly, there is a high incidence of a major divergence. A favorite play is to buy a call on the low-side turnaround, and buy a put on the top­side turnaround.

A perception of the facts (right or wrong), starts the move­ment. Activity breeds activity and more investors rush in. They listen to current events and future predictions and that subse­quently affects the price. Their purchasing/selling is integral to the process. New information—either right or wrong tests the strength or weakness of the previous assumption/activity, and the price is sustained or divergence occurs. A short term profit can be made. It’s quick and semi-predictable. Get in and out before anyone ever sees (or reacts to) the trend.

Now, use your profits to increase your holdings in great companies. It is the very boom and bust cycle (volatility) which gets me excited. Most investors run from the boom and bust scenario, however, some of us profit big time from this technique.

Markets rise and fall on a perception of what will happen in the future. I have two problems with this.

1.    No one knows what will happen. Too many other things change. What seems logical turns illogical.

2.    We still must take into account our biases—how we as individuals and groups view such things. Life is too fluid to predict.

Most of the future’s news is discounted long before it happens. Look at the last example! We want to discern things, to have peace of mind, to have things fit—to make sense. What twisted logical path did the market (the invisible “they”) walk down to come to a conclusion that a stock’s price will fall in nine to eighteen months, and then have the price fall now? With this type of logic at work and the crazy reaction to it, what are we to do? More importantly, what plays can we make to build up our income?

I’ll give specifics in a few moments, but first, my list of important observations:

A.  Individual Investors

1.    There is in each of us (even at the corporate level) a desire to grow, to build, to achieve.

2.    We all, even companies, have a desperate need to not only survive, but to thrive.

B.   Market Movement

1.    The market has a mind of its own and will usually do that which it must do to make fools out of a majority of investors.

2.    The market is not right. It just isn’t. It’s fluid, it moves unexpectedly.

3.    There are short term plays and long term plays—you decide the length of time.

4.    There are opportunities everywhere.

5.    Investors’ actions shape future events, not predict them. They cause change, not re­flect it.

6.    Investor bias rationalizes (and hence changes) the facts.

7.    You can profit going both ways—up prices, down prices.

8.    The “herd” mentality takes over and when it’s played out (the boom), then prices start down as they bottom out (the bust), then the cycle starts over.

9.   It is at this precise moment when you capital­ize on profits.

That took a lot to get to these points, so let’s keep rolling. Let’s use a stock moving up for whatever reason as our example. We own a stock or have an option on it. The stock moves with a mind of its own. It’s reflective of news—good earnings, higher dividend paid out, prospects for the next few years. Everyone wants in. The price goes up and up. However, it will turn around to some degree. The sentiment will change.

The time comes when the momentum will turn. Perhaps the turn will come when an analyst at a major firm, a person who has loved this stock (to death!), now thinks it shouldn’t be an “aggressive buy,” but a “buy,” or a “hold.” A small downgrade. If you are into buying puts or going short on the stock, wouldn’t it be great to sell at the peak, or buy the puts just as it’s about to fall?

This is it. Playing this high point and the corresponding reverse (bottom) is point for action. And, it’s just not that tough to make money this way. We’ll call this point a “crossover,” or a conver­gence. Crossovers occur at both peaks and valleys.

We’ll explore this premise after we look at a scenario. This scenario conforms to this strategy. Not all scenarios do, but the ones which do, allow us to get in, then get out with a lot of cash. This scenario plays out frequently, I’m not investing in “the market” but in certain stocks and options within the general market. And if you think the market has a mind of its own, go with the trend. Don’t try to “catch a falling piano.” But only go so far.

Five Sections (Stages) Of A Crossover (The Boom/Bust Scenario)

First: the price movement is unnoticeable. The trend starts, the price rises or falls inordinately quickly, compared to its historical moves. Volume increases as stock momentum builds. Look at the following:

Speedway Motorsports (TRK)

December 1995, stock had been trading between $25 and $30 for the last four months with no big trend. Volume (interest)

in TRK increased in December of 1995 and January of 1996 and the stock started to climb. The stock split in mid March and has been trading be­tween $25 and $30 for the last six months.

K-Mart(KM)

K - M a r t showed a build­ing trend in Sep­tember and Oc-

tober of 1995, with a big trend up in early 1996. K-Mart then showed trend reversal from December of 1995 to February of 1996. As the stock was falling, so was the volume. The stock changed trend in March, volume increased and so did the stock price.

Second: activity reinforces more activity. Recommenda­tions (from the professionals) fly. Everyone wants in. Major purchases oc­cur.

Third:   the strength (or weakness) is tested. Doubts occur in the wis­dom of the rec­ommendation.

New recommendations appear, after all the facts are used, distorted and abused to prove points.

Fourth: the main point, or question, is simple—is the price sustainable?

1.    Where is the market headed?

2.    Check other news.

3.    How was the news received?

4.    How much buying has been going on?

5.    How many institutions jumped in?

6.    When the high and low was tested, did the price return to the previous support level or did it break support?

Fifth: divergence. If there is no compelling reason for it to stay high, it will decline. BUT IF

THERE IS NO COMPELLING REASON FOR A FALL, it may fluctuate, but the stock might establish a new range. The price will be tested repeatedly. The opposite is true for a falling stock, once it hits bottom. The bottom support level will be tested repeatedly.

A Perspective

Go with the “herd” until the time is right. Buck the trend at that time. I have seen very rapid movements up and down. I hope after this next sentence or two, my strategy will make sense. So much doesn’t make sense, but this does. The stock price will change.

If I own a stock at $80 and it gets trendy—caught in an updraft, I’d rather sell at $110—even if it goes to $120, because in two hours it could fall to $90, or a $50 stock could fall to $35 (IOM). A good time to get out would be when you wouldn’t get in.

If you think the stock market is logical, or that a certain move in a particular stock price is logical, then I will show you dozens of illogical moves! Can you predict a price change— 100% of the time? No. Can you do your best to make a calculated risk? Yes.

Try this one on for size. When a stock price starts to rise, it creates excitement. The higher it goes (or the faster the rise) the more investors want in on the action. It rises more. More investors buy in. It rises and rises, sometimes 10 to 20% in a few days. Then … it stops! Does it just stay there? Or does it swing back down? Usually it falls, as investors’ sentiment takes it the other way.

I’ll give a 5-step process in a while, but first, what is happening here? Which price was right—the price two weeks ago at $80 a share, or the price now at $120. And three weeks from now, what will be right? The $90 price which the stock has fallen back to, or the $80 or high of $120?

What did supply and demand have to do with this? What about the market always being right, or a search for equilib­rium, or any other high-falutin’ theory exposed by a guru of Wall Street? Maybe, just maybe, this $30 run up was because a competitor’s Indonesia mining operation turned sour. But look what the “herd” did!

Here’s another one. Throughout this past year employ­ment reports have been good—more people employed. To me this should be good news. It means more people working, paying taxes, and not living off the government. It means more savings, more spending and all the other great things that help make a bigger American pie.

But, no. The stock market (DJIA) falls 80 points. Why? Because, as those wonderful things happen, inflation will go up, then the Feds, in nine months or a year, will edge up interest rates; corporate profits will decline slightly in 12 to 18 months, so the stocks price will fall. But they fall now in anticipation of this chain of events—which no one can predict anyway.

I rest my case for craziness. However, this last point does make a nice segue to a discussion of future events.

I also like to share in the profits of the company. I take all the dividends I can take, but for the most part I’d rather the company keep the profits and expand the business.

These dividends include regular dividends, irregular divi­dends (which I look for all the time), a cash distribution (which may not be taxable, but which reduces the price of the stock which could be sold for a loss), and MIPS, or Monthly Income Preferred Securities—large companies which pay out monthly checks.

One of my strategies is to own the stock long enough (sometimes as little as one day) to capture the dividend. Wait until it increases in value, then sell it. I do this every quarter with certain stocks.

Options

Buying stock options gives the investor a chance to control large amounts of stocks with a small amount of money. An option gives you the right (not the obligation) to buy or sell a stock. Because options end—they expire—they are very risky.

If you learn how to play them well, the profits can be phenomenal. I’ve written extensively on many forms of options investing elsewhere, so only a brief synopsis is here.

CALL OPTIONS: a right to buy stock. You buy these when you think the stock is going up. This could be on a SLAM (serious down movement), a roll, (when the stock is at the bottom of the roll range), or a stock with good news, et cetera. In short, when you think the stock has pressure to move up, buy a call, ride it up, and sell.

PUT OPTIONS: a right to sell stock. You build value in your put option as the stock decreases. Buy puts when the stock hits a high, or is at the top of its roll range, in short, when you think the high price can’t be sustained.

ROLLING OPTIONS: buying calls or selling puts when a stock is at its low range and then buying a put, or selling a call, when it peaks out and starts back down. Look at the following:

This gives you a way to make money on both sides of the movement.

SELL CALLS—COVERED: writing covered calls is perhaps my favorite way to generate consistent cash flow. Yes, there are other ways I make more money, but not as consistently. This method lets you generate income (in one day) by selling a call option on stock you already own or stock you’ve purchased for just this purpose.

The rules include:

1.    Buying stock on margin—this allows you to double your rate of return.

2.    Volatility—almost like a rolling stock so we can take advantage of the swings.

3.    Keeping within the $5 to $25 price range for maxi­mum returns with a small amount of cash tied up.

There are many variations, techniques, and examples found in my other books.

As the stock moves down, the price of the options moves down also. In writing covered calls, we either sell the call (uncovered—if we don’t own the stock) or buy the stock (hopefully at the low) and wait to sell the call as the stock increases. We want maximum cash flow so we sell at the “maximum” time.

We bought the stock at $4 and sold the $5 call (about 35 days away—the next month) for $1.25 when the stock was $4.87. At the time we bought the stock, the $5 call was 12.5c We take advantage of the stock movement, hence compounding the option rate of return.

UNCOVERED CALLS: many of you won’t be able to do this until you have more experience or more cash in your account. This is called “going naked,” in that you don’t own the stock. You use this strategy when the stock is at the high part of its range. You sell the call—generating pure cash. You wait. As the stock moves down, your obligation to deliver (sell) the stock goes down and eventually disappears as the time expires. You made money with no investment. The risk is that if the stock goes up, you’ll have to buy it at a higher price (offset by the cash you made for selling the call). Don’t sell calls on stocks you think are going up; either buy the stock low (covered) and wait to sell the call—get­ting a higher premium for the options and eventually sell­ing (getting called out) at a higher price, or sell the call when the stock is high—wait for a dip and then:

a.    buy the stock or

b.   buy back the option or

c.    just let the option expire and keep the cash!

SELLING PUTS: this is a great way to make money. You sell a put, generating income. You are selling the right for someone to put (sell) the stock to you at a fixed price. You use this strategy when the stock is low and heading up. The income (premium) you received is yours to keep. As the stock rises, the put option you sold goes down in value. You could either buy back the option at a lower price and keep the difference, or let it lapse on the expiration date. If the stock has risen above the strike price, no one will put it to you. If you do have to buy the stock, the cost is offset by the premium received—like buying wholesale.

TANDEM PLAYS: there are many combinations, but my favorite is a combination of buying/selling calls and buying/ selling puts. Here is how it works (see the chapter: “Tandem Plays” for more on this).

When the stock is low, sell a put and buy a call—both strategies gain advantage with an increase in the stock price. You make money now selling the put and you make more later selling the call option you purchased.

When the stock is high, sell a call and buy a put. You make money on each as the stock moves down. This gives you four plays on a rolling stock with options.

SHORT SELLING: short selling allows you to borrow stock, sell it and generate income. As the stock moves down, you purchase it, pay off the loan (borrowed stock) and pocket the difference. Its easier said than done, but in my case, I’d rather buy puts if I think the stock is going down. I use short selling when I’ve sold a na­ked call and have to per­form. I’ll bor­row stock to cover my posi­tion and hope it turns down.

BLUE CHIPS: there are so many definitions of blue chips that you need to make up your own definition.

These are the stocks you want to own for a long time. They could be brand name stocks, large companies that have fallen out of favor, even regional companies you can identify with.

Cash Flow

Use your profits from selling stocks/options for investing in real estate or other investments like businesses or put your money into good, solid, Blue Chips. The name of the game is to get your stock market profit buying your “hold” invest­ments.

You choose the percentages of your money that work best for you. This is a good solid growth.