Don’t buy junk

crap

On average, women outperform men in stock market investments.  The reason for this is quite simple: women tend to buy and hold whereas men trade stocks more often.  The average investor (probably 90% or more of small investors) sell when the market is down and buy when the market is up.  I remember in 2008 as most of my colleagues freaked out and bailed out of the market.  Most women held their stocks through the market sell-off and continued to dollar cost average through 401(k) investments and had positive returns by 2010.  Many of the men who tried to “market time” the market sold at the bottom and then returned to buy at the top.

I count myself among the “guilty” when it came to second guessing the market – and eventually missing great market gains and suffering stock market drops after buying too high.  I’ve sought knowledge, read and studied and only in the last few years have I begun to enjoy strong market gains, whether the market advances or declines.

In this article we will cover the first of the big mistakes that investors make.  If you avoid these pitfalls, you will GREATLY improve the returns on your investments.

1.  Don’t buy junk.  This sounds obvious, but the vast majority of stock investors own “junk” investments.  I’m not talking about junk bonds, those can have a place in a well diversified investment portfolio, I’m talking about bad investments.  Before you know what a “bad” investment is, you need to know first what a good investment is.

To understand what a good stock investment is, you need to stop thinking about investments as buying stocks.  Instead, you need to focus on buying businesses.  Imagine for a moment that you just won the lottery for $8 million dollars.  After taxes you take home $5 million.  You decide that you want to buy some businesses in town.  Let’s say that the “average” business in your town sells for a million dollars.  Let’s say that you decide to buy 1 bar, 1 retail store, 1 restaurant, 1 auto repair garage, and an apartment building.

We will start with the restaurant: you have a choice of a “popular” bar that has a flamboyant owner who is often in the news.  He regularly drives around in his convertible and has several girlfriends.  This guy is well known in town and very popular.  His bar is “the place to be” on Friday nights and often has a line formed up outside on weekend evenings.  Everyone wants to get into this bar on the weekends, it is popular and there is a lot of “buzz” about this place.  Most investors would love to be a part of this business; it is exciting, it is sexy.

And so, you begin to look at the books of this business.  You see that it has a strong cash flow on the weekends but during the week, it draws significantly less in revenue.  You see that the rent on the building is VERY high, the wages paid to the staff are quite expensive and the liability insurance for this “popular” watering hole eat up most of the profits.  Despite the “colorful” lifestyle of the owner, you see that he barely turns a profit.  Moreover, because of several fights at the bar in past weekends, some lawsuits are pending.  This business “looks good” from the outside, but in reality, it does not return much money to the owner.

Take a look at many stocks that are “popular.”  Many pay low dividends, have weak earnings and are priced very high.  I am regularly astounded that stocks with no earnings and high P/E (price to earnings ratios) sell at such high premiums.  And why?  Because  idiots like “Kramer” on CNBC and silly online companies like Motley Fool recommend them.  As I talk to more and more small investors I find that most people are buying stocks based on what’s in trend, what’s en vogue and what is “popular” on CNBC.  Over time, these investments return very little to the owner.

We look at another bar.  The local Irish pub.  It has a steady and loyal customer base, it is “busy” 7 days a week, has low overhead and expenses and returns a cash flow to the owner.  The current owner (who is now retiring) draws $8,000 per month in owners’ equity (salary) and leaves several thousand in the bar for improvements and to grow equity.  You realize that if you draw $8,000 per month, each year you will “take out” $96,000 per year.  In about 11 years you will return your initial $1,000,000 investment.  Starting in year 12, you have a “free bar” and the income that comes in is all profit.  Imagine now that the intrinsic value of the bar has grown in these last 12 years so that now you can sell it for $1.5 million.  Now, not only have you taken all of your money back, but you’ve made a 50% return on your basic capital.  Meanwhile, the “popular” bar had its business slow and after a year or two, it went out of business.

I ask people, “Why did you buy that stock.”  What I hear astounds me.  They ALWAYS have a “story.”  Something someone told them, something their broker told them, something they saw on CNBC or read in Fortune Magazine.  I ask them about the stock’s earnings or its dividend and they have a blank stare on their face.  These people – and I might be talking about you – aren’t investing, they’re gambling.

When you buy a stock you should look for a company with strong earnings, little competition, a strong return of capital (strong dividend) and good future business prospects.  I’ve had this conversation at work a dozen times and every time, I’m asked the question, “Well then, what stocks fit this description?”  And when I answer, I see eyes roll over, sighs of sarcasm and chuckles as though I don’t know what I’m talking about.  To most investors, these investments are “boring” and they don’t have the patience for them.  But good stocks are considered by most to be boring.

Let’s take a look at some “good stocks.”  These are stocks that pay ever increasing dividends, have little competition and increase owner equity through the practice of paying a strong dividend and share buy-backs:

Walmart

Coca Cola

McDonalds

Microsoft

Hershey’s

Sysco

Procter & Gamble

I’m sure you get the idea – fat companies with thick profit margins.  If you buy the stock of one of these companies and reinvest the dividends into more shares, you’ll average about 15% return.  And considering that much of the gains will be long-term capital gains, you’ll never pay tax on the growth of the price of the shares until you sell.  Warren Buffet bought 5 or 6% of Coke back in the 80’s and has reinvested his dividends ever since.  His dividends now pay back the entire cost of his investment EVERY SIX MONTHS!  Think about that for a minute, lets say he invested $10 million, he’s getting back $20 million every year just in dividends!  That initial Coke purchase paid for itself and now pays dividends year after year while the base value of the stock continues to grow.

And yet, I hear of other “investors” buying this or that stock because of some crazy idea they heard on TV.  Example, one of my clients bought Remington (the firearms manufacturer) because Obama’s plans for more gun controls = increased sales.  Maybe.  But does Remington have the fat profit margins and increasing dividends each year like McDonalds has?  No.  Not even close.  When I suggested that he sell his Remington and buy Coke or Walmart or McDonalds, he looked at me as if I had a bullet hole in my forehead.  Again and again, I share the “logic” of buying good companies and people nod in agreement and then tell me how they’re buying Ford or GM because, once upon a time, it traded for 3x what it trades for today.  How silly.  You want a company that pays you to own it, not the company that is popular or has a good story.

The BULK of your portfolio should be boring Blue Chip stocks that are fat with profits, insurance companies, oil & energy transport and some real estate investments that pay you regular rents.  The way to win in the market is slow and steady gains without taking massive losses.  If you can earn 12% year in and year out, you’ll beat all of your co-workers who are chasing Apple to $600 a share.

More on this idea later – but if you own a bunch of junk – stocks that don’t earn (and pay) rich profits, you should consider shifting the bulk of your portfolio to some boring stocks that pay you and pay you year after year.

Good luck.  Good investing!

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