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Know Your Stock Before You Invest

Had you bought and held onto Iomega in 1999/2000 thinking that it was a great turn-around case?
Did you buy eToys at 7$ thinking that it can't-go-any-lower, and then had to see its stock price touching zero?
Did you buy US Steel Group USX, a commodity steel producer sometime in 1991 around 23 and watched it touch 40 plus twice in 1993 and 1998, and today again around 15 dollars?
Have you watched the rise and fall of Yahoo, CMGI, Amazon which had lot of glamour and fancy in Internet/Tech boom period?
If you are one of those mentioned above, I am sure the following thoughts will help you reach to your investment goals to some extent.

When you consider any stock for investment, the first thing you should know is what kind of stock it is. Investing is like a journey. You can take a car to go up to a couple of hundred miles, or ride on a plane and go thousands of miles. If you ride on a rocket, you may even go to moon or in outer space. However, if you are riding a camel-cart, you should know its limitations. Same analogy can be applied to investments we make. Depending on our destination (investment goal) we should select a right type of vehicle(stock).
It is easy to say, but it is more of an art than science to know the stock that we are buying. Stocks can be classified on using various parameters and in many different ways. It is a subjective process. However if I had to, here is how I would classify stocks. Feel free to customize this list for your own use.

  1. Commodity stock: Stock of a company whose products are largely subject to market forces, say steel, aluminum, automobiles, chemicals, oil, and now PCs, etc. Many of these products are often traded in futures market or have very large consumer/industrial markets, and their producers have almost no influence on price, demand or overall supply. They can't decide price at which to sell their goods. They are price takers and have to take price that is prevailing in the industry or market. They are at the mercy of market forces.
    * Commodity stocks usually have lower volatility (beta) than that of market. This means they move slower than the benchmark index. If index goes up or down by say 10%, they usually move less than 10%. So they are not good for traders most of the time.
    * They aren't good for very long term investors as well. They hardly make you fortunes like Dell or Microsoft did over a longer period.
    * If you buy a commodity stock when its products are selling at cyclical bottoms, you can usually double your investment in 2/3 years. But if you hold on to them too long, your overall returns will hardly be attractive. You would have good years and bad years that on longer term would result in average raturn.
    * When to buy a commodity stock? Some excellent buy signals are: when products have low demand and hence low prices which in turn gets relfected in lower stock price, profits are bad, if not worst, and EPS is maybe negative or P/E is very high (mostly because denominator/EPS is very low). During such cyclical low times, you would have hard time justifying your purchase of such stocks.
    * When to sell? Sell them when the company reports massive profits, impressive financials and high EPS that causes P/E to be lower. At such times, there would be good deal of news about such companies and their products. When things seem rosy and you find most of the investors and press considering their stocks cheap and 'good buy', it is time for you to say good bye.
    * Important thing to keep in mind: Please don't confuse dying products from cyclical products. Cyclical products have significant economic value and they are likely to be in consumption for next many years.

    Good example: During 1999, when I was talking to an oil industry expert, oil was trading around $14. He was very pessimist at that time--. Now today (2005), Oil is trading at historical high price and everyone is getting on oil/energy stocks
    . Do you think oil will hold on to this $60 plus level for long time? I doubt-- it is a commodity and I will not be surprised to see oil trade at $20 level in 2008/2010!!! The world of commodities is very cyclical.
    (Commodity stock of 2006? Jetblue JBLU closed today at 10.20 (May 30, 3006). Due to lot of competition in airline industry and high oil prices, Airlines stocks are doing pretty bad and this is the time I think is to go long with such stocks. IMHO.)

  2. Growth Stock: Revenues are growing at at least 10% rate. Better if margins are also improving. Their products have most likely good consumer loyalty and brand values. The market for such products seem to be growing or the company seems to be increasing its market share. Such companies have some, if not significant, ability to set prices for their products.
    * They have average or somewhat higher beta/volatility. If you expect market index (like Nasdaq) to go up by 10%, such stocks usually go up from 10-15% or even more...
    * Such stocks are ideal for long term holding. Don't be over occupied by their price level or P/Es as they always seem to be on higher side. Concentrate more on the denominator of the P/E ratio, I mean, earnings instead of price. Even with high P/E ratio, it not unusual to see the stock doubling every few years.
    * What makes them great? Products, Management team and industry dynamics.
    * Don't look at ticker everyday nor search yahoo for news related to such stocks. They might have bad news now and then. It takes dedication, loyalty and patience to profit from growth stocks. If you are with them early on, you can make good deal of money.
    * When to sell them? It is hard to figure it out. One good indication is when everybody starts liking them, it is on everybody's portfolio or buy-list and when valuations have gone crazy (???).

    This are the stocks for long term holding and to multiply our money.

  3. Turnaround Stock: They are real treasures for minting money; but also like a treasure, they are very hard to find.
    * Before you invest, doubt them thoroughly. Avoid if you get too excited by its story (Believe me more money is lost in potential turnarounds than in other categories of stocks. Maybe 90% of them never turn around!)
    * Certain things that make them a good bet: new CEO or senior management, new products announcements or in pipeline, new investment by private or reputed investors, sale or restructuring of unprofitable business units, increase in revenue or profit margin, etc.
    * Don't classify a stock as a turn around case by reading a press note or an article. Research the company thoroughly. You must be proficient in reading financial statements, accounting practices and disclosures/footnotes. Better if you also have good understanding of company's products and the markets they are sold in.
    * These are the stocks usually quoted under 5$ and are lying there for quite sometime. Initially they seem to be isolated from market movement and don't move with overall market's movement. It may seem that they have their own pace and they are unrelated by major market sentiment. When the turnaround is really happening, their beta/volatility may seem 2 to 5 times of the market. This is the phase the turnaround investor would be enjoying the most.
    * The process to turn around a company sometimes takes years. So some familiarity with technical analysis of stocks may prove beneficial. Before totally committing yourself, watch their price fluctuation and charts for confirmation. If they are making new tops and higher bottoms in stock prices, accumulate or average up with progressive stop-loss.

    If you have correctly figured a turn around, it can earn you tons of money and fame. The feeling that comes with finding a turnaround stock at very early stage is as fulfilling as finding a growth stock very early in its life-cycle.

  4. Fancy stocks: These stocks have lot of glamour around them in markets. Owning them during their prime time brings you more pride or even envy in your friends' eyes. Do you remember Yahoo, Amazon, CMGI etc in 1998-2000 period?
    * They have high beta ranging from 1.5 to .... If market is up by 20%, such stock may be up by even 100% or more. Same thing when markets are down. If benchmark index is down by 10%, such stocks may have lost 20-75% during that time period!
    * They seem to have revolutionary products and tremendous upward potential for growth.
    * They often have bad financials and little or no profits. It is not surprising to see as much net loss as the revenue they have. Revenue seems to be growing at a great rates in percentage terms though the absolute level may not even justify their current market capitalization.
    * They are considered to be smart dogs, and it seems that they are out to revolutionize their markets or industry.
    * Find conflicting product reviews and try to understand the product and its market. Ask yourself: Is the company really great? How much is the potential for this stock? The sooner you realize the potential the better. Such stocks often multiply many times during a period of one to two years.
    * I strongly advise that you keep a progressive stop-loss on your positions in such stocks.
    * When to sell? When they start fluctuating a lot each day, be cautious. It is hard to say, but I would give two tips (i) Ask 10 of your friends randomly for their opinion about that stock and when 8 to 10 of them advise you not to sell, consider selling it. If 4 to 7 are worried about its high valuations and are even courageous to think about going short on it, just hold onto your position, or even double it; the stock is on its way to make new highs. (ii) If you find media with lot of positive things to say about the company, be extremely cautious.
    * Watch them carefully. If you miss to sell fancy stocks at right time, you will have great memories, but little money from them.

  5. Value Stocks: Most of our purchases would fit here.
    * Value stock is a stock which you believe is worth more than what the market and millions of other investor's on aggregate basis think. When you find an undervalued stock, buy it and wait until it gets properly valued.
    * Value is very subjective and it forms the very base on which all markets are created. For a trade to take place, you need a seller (who wants to sell the stock mostly because he thinks it to be overvalued) and a buyer (who considers it undervalued). If we all don't have different valuation approaches, JDSU would not trade between 150 and 5 dollars over a few months period.
    I consider any stock price to be composed of two components: Real Value -Business Value (of course as per my valuation approach!) and the emotional value. Real value component, mostly valued based on economic context or based on parameters like profit, P/E ratio, etc., does not change as frequently as the stock price fluctuates but the emotional or the psychological component, formed of what most investors think in emotional/expectational context, is what causes the most fluctuations in a stock's price. At the top of a bull trend you may see emotional component to be as high as 95% of the price for some stocks and at the bottom of the bear market, the emotional component may even turn negative causing the stock price to go under its 'true' business or economical value and make it very attractive from value perspective.
    * Define your exit strategy with three parameters: target price or fair value, stop-loss and time horizon. A stock may seem undervalued at 20 dollars but still it can go down as low as 1$ as the market may never judge the stock based on your valuation model. Also, a stock may stay undervalued for years if the valuation strategy you are using never gets accepted by other investors. So when you buy a stock ABC at say 20$, decide that its fair value as on today is say 30$ and you would hold on to it with a stop loss at say 15$ or for say 6 months at most.
    * Most of the valuation models are quantitative and backward looking and hence when you find a stock undervalued, it may actually be facing bad circumstances currently or is expected to do bad in near future. So do your home work before you jump on.
    * I guess as much money can be made in Value stocks as in growth or other category of stocks. So try to master the art of valuation.

  6. Can't-go-any-lower stock (or can't-go-any-higher stock when you are shorting):
    The biggest reason to buy a stock, mostly in a down market, and also the biggest trap for most of us.
    * We are watching CMGI going down from 160 to 120$. Then on one fine morning, we come to know that CMGI is currently traded at 110 because they had some (minor) bad news, and someone from inside us starts shouting- it can't-go-any-lower than this rate! Our heart starts pumping excited and we put an order to buy at 110 dollars and we actually get the stock at say 109$ or so. We feel great may be more than what Columbus felt when he found America!
    * Buy a stock for most of other reasons but never buy a stock thinking that it can't-go-any-lower than this.
    * Do you ever go short on stocks? If you have lost money on a short sell, what was the reason behind your going short? I am sure in most cases it would be 'can't-go-any-higher than this' attitude!!!
    * Sometimes as any strategy in the market, this one works too. So please don't shout at me when you have a can't-go-any-lower winner.
    * Two pieces of advise: think of booking a small profit in most cases (provided the major reason you bought or shorted the stock was can't-go-any-....) and do keep a stop-loss (just to accept the reality that "Oh god! It can actually go lower than I thought! What a stupid I was!!!')

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