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Investing 101
What Your Investment Advisor Doesn't Tell You

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The Stock Market Value of a Company is Wrong
Stock markets are a place where you buy fractional parts of companies called shares or stock. On investment sites you will see the market value of a company = (number of outstanding shares) X (current share price). This is what people who are currently buying and selling the shares have negotiated as the value of the company.

There are many other ways to estimate the value of a company but stock market theory says the stock value (or market value) is the best one. Sooty asserts that the market value is a trailing indicator because it is usually the best estimate for the company as it existed three to six months ago.

What you need is something tell you the value of the company today or better yet: the value three to six months into the future. But more on that later.

All Stocks Go To Zero
Stocks start at near zero, rise to a peak, and then fall back to zero. How quickly they rise, how quickly they fall, and how long it takes to go from birth to zero depends on what business they are in and how smart the company is managed. Some companies complete the round trip in months (like heavily promoted mining stocks) others may take a 100 years to complete the cycle (like Bears Stearns born 1923, RIP 2008).

Of the 500 largest US companies on the S&P 500 in 1957 only 74 survived 40 years later (1997). A tiny number were bought before they actually hit zero but most went out of business and their shareholders were left with nothing. The US stock indexes at the close of 2009 were lower than the close in 1999. A growth investor who was well diversified would have earned nothing over those ten years.

You may be convinced your favorite stock will never go to zero but are you willing to bet your life savings on that? It is best to assume every stock you own will eventually go to zero so you must have an "exit strategy" for each one.

Company Financial Reports are Lies
Okay that is a little harsh but the financial report a company provides is a marketing document that tries to attract new stockholders or keep the existing ones. Like a product brochure they will fudge the truth or try to leave out embarrassing details. There are some pretty harsh laws about out-right lies but like laws on advertising there are ways to suggest the situation is better than the cold hard facts would reveal.

As an investor you need to know where and how information can be hidden. The best place to hide unpleasant things is in the notes. The balance sheet will show a million dollar piece of equipment. There will be a little number next to the amount. Find the number in fine print below the table and you discover that the equipment is actually "stuck in a swamp a thousand miles from any town and cost to recover it has not been determined". I would probably deduct that from the book value of the company.

The other major trick is to push bad news into the next quarter or pull good news in from the next quarter.

AR fudge: recognize payment on a customer's bill in advance when the actual work won't start for six months.

AP Fudge: pay late on a big bill even if it means interest charges or penalties.

GL Fudge: depreciate or write off equipment in the next quarter to avoid the charge against this quarter.

HR Fudge: lay off a bunch of experienced staff and hire much cheaper junior staff to cut labor costs (see Circuit City Overpaid Staff Layoff).

Eventually the company will have to reverse out the fudges but they can temporarily show a financial position that is better that the real situation. These will often show up in Q1 and Q2 reports. By Q3 they will start to worry because by Q4 (year end) they will have to unwind the fudges or attract a tax audit. Now some fudges (like GL and HR) can be floated over a year end but even those have to be corrected within a couple of years.

There are many good companies that report their honest position each quarter but it is hard to tell the honest ones by reading just one quarterly report. The wise investor will read at least 3 years of financial statements and follow "noted" items to see how they are treated. If the company is less than 3 years old do not buy it. If you detect any fudges assume you missed most of them and do not buy the stock. Keep reading the reports for stocks you own looking for any change in management behavior. Despite Sooty's "buy and hold" approach if the management suddenly embraces the dark side it is time to unload the stock.

"Buy Low and Sell High" is Gambling
It is intuitively obvious that if your buy a stock at its low point and sell it at its high point you will make money. Sooty asserts that it is impossible to tell when a stock has hit its high and extremely difficult to tell when a stock is at its bottom.

There are many strategies to figure out the high and low points. Most involve graphing the stock price and watching for it to "break out" from its 50 or 200 day moving averages. There are other patterns that suggest a stock establishes "support levels" and if it crosses these something important is happening. So you sell if it falls through a level or buy when it climbs through a level. This allows you to buy low and sell high with some (Sooty says "illusionary") statistical confidence.

Trying to guess the highs and lows of a stock is much like trying to guess the next lotto ticket number (Jees I haven't seen 17 or 27 show up for a long time - I'll try those). Most rising stock volatility is based on herd mentality (everybody is buying so I better get in before it's too late). Most falling stock volatility is because something bad happened six months ago and stock is heading to zero.

In any case if you bet on an outcome without having any real knowledge about the underlying process you are by definition gambling. Most gamblers understand that only the casino makes money in the long run. In the stock market only the brokerage houses make money because win or lose they always get their trading fees.

Pay Me Rent
While Sooty believes in 'buy low and never sell' he still wants to get his money out of a stock before it hits zero. If the stock returns a monthly or quarterly dividend the amount invested in the stock drops over time. Stock volatility is less important because even the stock lows are higher than the net amount invested. The risk to the investor drops to zero as the accumulated income approaches the original purchase price.

Sooty does not have millions to invest (you probably don't either) so he must select stocks that pay the highest rents and that means higher risk. This requires more research but it means the net investment (the money at risk) drops faster. Sooty takes risks but is not a gambler (more later).

Buy Low, Pay Me Rent, then Sell At Zero
Sooty's strategy for investing uses all the points you have seen so far. If you have read the financial statement you have a pretty good idea what a company is actually worth. This is hard to do and takes a lot of reading but you can develop a reasonable estimate. If the stock is trading below this estimate it is a "bargain" and a good candidate for purchase. Find 3 or 4 candidates you like, watch their stock prices to get a feel for the mood of the herd and buy the best bargain price. This is the "buy low" part of the process.

Pick stocks that pay reasonable dividends for their sector. For banks it is about 5%, for income trusts and utilities it is about 9%, and for very risky investments (like shippers) it can be as high as 15%. Since you are buying at a "bargain" the rate you actually get should be higher. Based on the price you paid and the amount of dividends calculate how long it will take to get all you money back, that is, how long before your ACB (Adjusted Cost Base) goes to zero. If you are getting 12% this would be 8 years. This is the "pay me rent" part of the process.

When your ACB goes to zero you own a "zero risk stock". You can hold that stock forever while it keeps paying out dividends. At some time the company will collapse and your dividends will stop. As long as your ACB goes to zero before the stock value goes to zero you come out ahead. In effect this means you expect to sell your stock at zero. This is the "sell at zero" part of the process.

Now this ignores a bunch of complexities such as; trading costs, a non-zero ACBs because of company buyouts, the opportunity costs based on the prime interest rate, the inflation rate, or the dividend rates of competing investments. As you develop your portfolio models you can certainly add these complexities. You will quickly discover that they often affect all of your stock picks equally and rarely help you decide what to buy.

Diversity Reduces Risk
If put your entire life savings in one stock and it does well; you do well but if it fails you are wiped out. This is a very high risk strategy. It is best to assume one of your investments will fail and the others will do as well as you expect. If your portfolio is paying an average of 10% then you better hold at least 11 stocks so you can lose one a year and still break even.

Oddly enough the lower your return the more different stocks you need to hold in the portfolio to avoid a loss. At 5% you need at least 21 stocks to break even if you lose one of them each year. If you hold 21 different stocks paying 20% and you could lose three of them a year and still make money.

As a rule of thumb you should probably plan on having at least a dozen stocks in your portfolio. If you are concentrating on a sector (like REITs) then you should have no more that 25% in that sector and at least a dozen stocks in each sector portfolio.

Sooty's strategy is to have one cash portfolio (like GICs), one diversified portfolio (like income trusts) then build sector portfolios (like shippers or utilities). Once a sector portfolio is complete; pick a new sector, become an expert in the stocks in that sector, and build a portfolio of at least a dozen stocks from the income generated by your other portfolios.

Do Not "Dividend Reinvest"
Dividend Reinvestment Plans (DRIPs) allow you to have your income stream converted to stock so you increase your holdings. Companies often provide discounts on the stock price (up to 20%) and charge no brokerage fees.

This is a really bad idea. You have just converted your income stock to a "growth stock" and as I said all stocks go to zero. If you start with 10,000 shares paying a great dividend and after ten years DRIP your investment into 30,000 shares only to watch the stock go to zero you still lost your entire investment. Take your income stream and buy a different investment. Building diversity out of income reduces your risk. Adding to your position in a single stock (even "averaging down" which Sooty is ashamed to say he has done) increases your risk.

"16% Income is Unsustainable" - Not Always True
The Dutch East India Company founded in 1602 paid over 16% dividend every year for 200 years (until the stock went to zero). There are lots of great companies that pay high dividends long after your ACB has gone to zero. Even Bernie Madoff's Ponzi scheme (not an example of a great company) paid 11% for nearly 40 years so if you bought his shares (once) and took your dividend every year (did not DRIP) even his scam would be a "Sooty safe" investment after 9 years. If a Ponzi can be made risk free then investing real companies is a much safer gamble.

To repeat: the calculation is "how many years before my ACB = zero" (stock price/dividend) and "how long before this stock price goes to zero". If (by calculation) the ACB = 0 in 10 years and (by guessing) the company will still be making widgets and paying a dividends in 15 years you are "safe". Five years later your ACB life is 5 years and you expect the company will still be paying a dividend in 15 years you are "safer". After 10 years you move the stock to the "zero risk" spreadsheet and forget it.

Notice none of this analysis involved stock price. If the company doubles the dividend the stock price will often double. You only recalculate the ACB based on the new dividend. There are only two stock prices that concern you. If it hits 0 remove it from your spreadsheet. It the company is bought or is taken private you have cash to make other investments.

If I hear you say the words "take a little off the table" I will reach through this web page and slap you.

Financial Escape Velocity
Most financial planners assume you want to run out of money a few days after you die (your last cheque bounces). This means you save more than you earn early in your career then spend more than you earn after you retire. The problem is that medical research advances could cause you to outlive your retirement savings and end up at the mercy of your government pension plan. Living longer than you expect could mean living many years on a diet of Mac'n'Cheese and cat food.

To ensure you don't outlive your retirement savings you should plan to live forever (Sooty suggests you might actually have to deal with living forever. Read about it here). This introduces the concept of a "financial escape velocity" an income level from your investments that will always exceed your standard of living. The worst case is that you die early and your greedy relatives and your ungrateful children spend years in court trying to get their hands on your estate.

Your escape velocity is different from mine. If you live a simple life in a rented one bedroom walkup in a small South American town your escape velocity could be $5K per year. If you live in a New York penthouse and insist on a new SUV each year you might find you would have to watch your budget on $500K per year. So your first task is to figure out your personal financial escape velocity.

You next task is getting off the launch pad. For that you have to live below your income and invest every spare dollar. Compound interest will increase your income and after some years you will get to your escape velocity. How quickly you reach escape velocity depends on how much income you can spare and how good you are as an investor. You should be able to easily sustain 5% per year on your investments (banks and other very safe investments) but 8% compounded is a reasonable goal for a dividend investor.

Get an Excel spreadsheet plug in your starting cash position. Compound it at 5% per year and plot your annual investment income. When that crosses your escape velocity income get the number of frugal years. You will be very disappointed at first because it will almost certainly take more money than you can spare for investing and it will take many, many years. From this you will learn two things; "I need more money for investing" and "I need to spend less on stuff".

When you reach your escape velocity you have a couple of choices. You could maintain you income level but move to safer (lower return - less work) investments. You could increase your appetite for stuff to match your increasing income. You could take the excess funds and play with very risk investments like some kind of video game.

In any case reaching your escape velocity gives you the most precious thing in your life: choices.

Still interested?
Given you understand Sooty's investment principles you can move on to specific investments. Sooty now has many portfolios: Industrials (very good), Income Trusts (very good), REITS (very good), Banks (good) and Shippers (a complete disaster).

If you are starting out you should read the Income Trusts section first (it also applies to REITs) and construct your "base portfolio" of diversified income stocks. Once you have your base completed you can pick a sector for your first "sector portfolio".

Currently the Income Trusts section is dated. It is unchanged from when Sooty was first building the portfolio. (This note will be removed after the section is rewritten.)

Currently the Shippers section is very dated. It was an interesting experiment but shipping company stocks are full of unpleasant surprises and not a beginners portfolio.

If you want to build your base portfolio from American (NASDAQ or NYSE) based stocks go to the US Stocks page.

The Banks section is a great place to start if you have lots of time (you are age 30) or you want a very safe start.

We are now finishing the first decade of the Great Recession. It looks like there is no end in sight for the low grow, low interest rate investment environment. In this environment investing in a "sector" is not a great strategy because a portfolio of all the stocks from a specific sector will underperform. The market is swamped by ETFs that flatten the returns.

In the current environment choosing the right company is more important that choosing the right sector.

It is possible there is no end to Great Recession and it is the "new normal". Read Investing Like Darcy in a Piketty World Economy to see why Sooty believes the Great Recession will persist for decades to come.