Financial Figuring

So how does one go about picking a good company to invest in? Some people analyze all the numbers (revenue, sales, profits, earnings per share, P/E ratio and on and on). This is called Fundamental Analysis. Other people look only at the price of the stock thinking that anything worth considering is already reflected in the price. These people are using what is called Technical Analysis and are often looking for patterns in the price charts. Both methods have merits and to be perfectly honest I try to use a bit of both before I make any purchases.



I find that fundamental analysis can convince you that you’ve picked an excellent company but you may end up buying at the wrong time. Once you’ve decided upon a company put it on your watch list, which is just a list of companies that you are interested it and are considering for investment. At this point I would open up a chart and examine the price trends. This can help you discover if the timing is right for your purchase. Keep in mind this is really an art, not a science, you are dealing with expected probabilities not hard and fast rules.

I will post more on both Fundamental Analysis and Technical Analysis over the next couple of weeks, but I think that there is a more (pardon me) fundamental question here. Namely, how do you find a company to begin your analysis?

There are as many ways of doing this as there are investors. One of the best is to begin by looking around your home. What do you use all the time and can’t do without? Does your neighbour agree with you? What about your friends? Do they use the product too? Would you still buy it if you lost your job? OK, who makes it? Now you have a company to investigate.

Often this will produce a company that is huge and a proven winner. Like Proctor & Gamble (makers of every day consumer goods) or Apple Computer or even Wal-Mart. No doubt these are good companies to invest in, but they are already pricy. One way to find a smaller company that has a chance to really explode on the scene is to identify a supplier to these companies.

Just like in the Klondike it was the suppliers to the miners – those people and companies that supplied the picks and shovels – that were the biggest winners. Sure a lucky few struck it rich and drew thousands of people to try their luck, and every single one of them bought a shovel and a pick (and a back up in case one broke out in the bush).

Apple Computer and Wal-Mart are two companies that have already “struck gold”. Shares of Apple more than doubled in 2009. They’ve soared more than 1,000% over the past 10 years. Apple produces the iPod and has sold hundreds of millions since their introduction a few years ago. It is one of the greatest business stories – and greatest stock moves – in history. What do you think happened to the stock price of the company that supplied Apple with the little scroll-wheel feature on the iPod? The company is called Synaptics and its stock jumped from $2 to $40 for a nice little gain of 1,840%

Wal-Mart too has a great story of massive growth. A few years ago Wal-Mart announced that it would put a little tiny radio frequency tag on every single product in every single store. This would help out with managing their supply chain and increase their efficiency and therefore positively affect their bottom line. What do you think happened to the company that supplied those millions and millions of RF tags and readers? You guessed it; Intermec went on a $14 to $39 sky-rocket.

The trick of course is finding out who supplies the critical piece of hardware for the latest must have gadget. But you can do this with a little research at Yahoo Finance and Google, by reading news reports and keeping your ear to the ground.

This article is written substantially from material gathered from the great staff at All About Trends and has been reprinted with their permission. Thanks very much for all your help and support.

PULLBACK OFF HIGHS — On the longside it’s the only pattern you’ll ever need to know.

The Pullback Off Highs (POH) pattern is one of the most bullish and constructive long-side set-ups out there. Rather than go straight up, an index or stock will make a move higher, then spend some time consolidating those gains often down to an area of chart support such as its 50-day moving average, before making another move into new high ground.

When a stock clears these consolidation periods, it’s your opportunity to buy them and take advantage of the next run — and the bonus part is when you catch a stock at the beginning of a new uptrend, you’ll often get to trade the stock and lock in profits over and over again. You are buying it at the point where it’s just started a new move and is near support which minimizes your risk. Here’s an example:

ABVT — Abovenet

In the chart above are 3 things you ALWAYS want to be on the lookout for:

1. The stock is in a clearly defined uptrend and above the 50 day average.
2. The stock pulled back to trendline support in green. Trendline support also happens to be the 50 day average.
3. Full stohcastics were in oversold position (Green circle).

Once you see those things there is only one thing you need to know after that. That is to draw a trendline (Pink) off the most recent highs as shown. That is what we commonly refer to as a Pullback Off Highs Line or POH for short. Then it’s all about an upside crossover of that line. That crossover is you’re longside entry.

On the longside of the market you now know why they really are the only chart pattern you will ever need to know.

Thanks very much David and I thought that I would include a follow up from the article to see how ABVT did in the following weeks from that upside crossover of the pink line in the first week of December 2009. As you can see, even if you had waited until the day or two after the crossover and bought around $54 you still would have enjoyed a large move all the way to $66 in just three weeks. It doesn’t always work like that, but in this case it did. Usually though you would place your buy order as soon as it crossed over the pink POH line.



Like David at All About Trends says it’s the only long side chart pattern you will ever need to know.

Most people think that winning in the market is about predicting the future. Most people buy some stock and hope the market rises. They have no idea what to do if something unexpected happens. When it does (as it is usually wont to do) they fly by the seat of their pants and end up trading with their emotions. There’s nothing more destructive to building wealth than emotional trading.

Like a professional poker player calculating the odds, the market is all about probabilities. It has nothing to do with predicting the future, and as such money management becomes critical for successful traders. What I mean is, for the successful trader, the stocks they buy are actually less important than the position size they use and the decisions they make after they have initiated the trade.

Trading Rule No. 1: Figure out your total portfolio amount and for each new trade entered risk the same amount on each trade, and keep it small. Most investors put more money into their favorite ideas than they put into their least favorite ideas. They have no plan for figuring out position size.

The best traders know they can’t read the future, so they give every trade the same chance. They make lots of small but profitable trades and accumulate their fortunes slowly but surely. The key is to keep your trades small and constant by putting 2-5% of your total trading capital in each trade.

Trading Rule No. 2: Cut your losses. When you initiate a trade you are trading against professionals, armed with incredible research budgets and advanced supercomputers. This is not a second job or a hobby for these people. These people live, eat, sleep and breathe the market.

The market can be a hostile place for anyone but especially for beginners and those without a plan. To control your losses, use a stop loss. This way you know exactly how much money you stand to lose if your stock falls, before you’ve even entered the trade. The stop loss applies at all times and can never be overridden. Read that last sentence again. Your stop loss can NEVER be overridden. While it is true you may get whipsawed by having your stock briefly trade down and then zoom back up without you, it is far more likely to keep on falling and you do not want to be on that express elevator to the basement.

Trading Rule No. 3: This one is counter-intuitive. If your trade is starting to show a profit, add to your position. If it keeps rising, add more. For example, begin your investment with a purchase of $2,000. Once your stock is up X%, invest another $1,000. Then, once your stock is up Y%, invest another $500, for a total cash investment of $3,250. Decide what X and Y are before you enter the trade and write them down so there’s no confusion. You want to use decreasing amounts of capital on the way up so that your average cost of entry stays low. Also you need a target where you will be happy to close your position, and make sure X and Y are not too close to the target.

I am so often tempted to buy more while the stock price is falling. While this sounds crazy, believe it or not this is perfectly natural. After all you have done your research and identified a great stock. You dig up enough gumption and initiate your trade and now the stock has dropped 10%. Well clearly it is an even better deal, right? Your stock is having a 10% off sale and if you double your position your average cost of entry is great. When it finally takes off you will realize even more profits. The only problem is that if you have identified a great stock and opened your position and the price still went down 10-15% then you did NOT identify the right entry point. GET OUT and try again with anther stock or at least a better entry point.

It is much better to average up than average down. On the way up, your profits increase in capital if not in percentage points. But percentage points can’t be spent at the grocery store and capital is what we are all are looking for. By averaging down you are decreasing your percentage loss, but increasing the actual amount of money flushed down the toilet. Don’t do this.

By sticking to your plan and using these three simple money management rules, that is, keep your positions small and constant, cut your losses and push your profits you can beat the market. You can’t win every trade, but in the long run, you’ll generate a positive return in your trading account.

The other day a good friend of mine told me that he had opened up a TFSA (Tax Free Savings Account) and now he was wondering what to invest in. My friend is very conservative and this was a big move for him – in fact to fund the TFSA he had cashed out a GIC which was paying him about the same as inflation was taking away from his interest. In other words he was just about treading water with the GIC and although the investment was safe he felt he could and should do a bit better. In fact he said he could be happy if he could earn 3% on top of inflation.

To invest in stocks coming from that kind of background is a major change and I felt that I should really do some research before making any kind of recommendation to him. Needless to say he is the sort of investor who is ‘buy and hold’ or ‘set it and forget it’. For those strategies to work you really need to try to identify long term trends in the market and invest in those areas. Also you need to find companies that are world beaters.

Dan Ferris wrote an article on how to value what he calls ‘world dominators’ for MoneyWeek Magazine In this article he compares three large takeovers from a few years ago. Specifically the purchase of Gillette by P&G, the buyout of Wrigley gum by Mars and the takeover of Anheuser-Busch by InterBrew. All of these took place before the meltdown of the financial crisis at the end of 2008.

Still it is useful to examine what these excellent companies where bought for. Dan states that each purchase price can be calculated by looking at ‘free cash flow’. “This free cash flow is the money left over after paying all the bills, taxes, and interest payments.” And the multiple that was used in each of these purchases was 30 times free cash flow.

Why 30 times free cash flow? Why such a high price?
The answer is simple. These businesses aren’t likely to look very different a decade or two from now, because they dominate their markets. And though they’re very large businesses, the chances are excellent they’ll deliver enough growth to make the seemingly exorbitant price of 30 times free cash flow worth paying. If you can pay just 15-20 times free cash flow for these businesses, you’re setting yourself up for years of incredible returns.

Let’s take those numbers forward to today and look at some potential world beaters and hopefully we can identify some great companies that also have a large margin of safety (a la Phil Town and nicely described by Trent at The Simple Dollar here)

XOM Exxon-Mobile - Free Cash Flow $47.25 Billion.
30 times FCF = $1417.5 Billion.  Market Cap $328 Billion. — BUY
WU Western Union - Free Cash Flow $0.95 Billion.
30 times FCF = $28.5 Billion. Market Cap $13.5 Billion. — BUY
PFE Pfizer - Free Cash Flow $11.5 Billion.
30 times FCF = $345 Billion. Market Cap $157 Billion. — BUY
INTC Intel - Free Cash Flow $8.3 Billion.
30 times FCF = $249 Billion. Market Cap $115 Billion. — BUY
HD Home Depot - Free Cash Flow $4 Billion.
30 times FCF = $120 Billion. Market Cap $49 Billion. — BUY
UTX United Tech. – Free Cash Flow $4.9 Billion.
30 times FCF = $147 Billion. Market Cap $67.5 Billion. — BUY
VZ Verizon Comm. – Free Cash Flow $7.2 Billion.
30 times FCF = $216 Billion. Market Cap $87 Billion. — BUY
MCD McDonalds - Free Cash Flow $3 Billion.
30 times FCF = $90 Billion. Market Cap $67.2 Billion. — Maybe
UPS United Parcel Service - Free Cash Flow $3.1 Billion.
30 times FCF = $93 Billion. Market Cap $61.5 Billion. — Maybe
JNJ Johnson & Johnson - Free Cash Flow $8.8 Billion.
30 times FCF = $264 Billion. Market Cap $178 Billion. — Maybe
MO Altria - Free Cash Flow $2.5 Billion.
30 times FCF = $75 Billion. Market Cap $42 Billion. — Maybe
DIS Walt Disney Co. – Free Cash Flow $3.4 Billion.
30 times FCF = $102 Billion. Market Cap $57 Billion. — Maybe
IBM Intl Business Machines - Free Cash Flow $9 Billion.
30 times FCF = $270 Billion. Market Cap $173 Billion. — Maybe
MMM 3M Corp. – Free Cash Flow $3.5 Billion.
30 times FCF = $105 Billion. Market Cap $59 Billion. — Maybe
MSFT MicroSoft - Free Cash Flow $17.5 Billion.
30 times FCF = $525 Billion. Market Cap $274 Billion. — Maybe
WMT Wal-Mart - Free Cash Flow $7.13 Billion.
30 times FCF = $214 Billion. Market Cap $205 Billion. — Hold
CSCO Cisco Systems - Free Cash Flow $4.7 Billion.
30 times FCF = $141 Billion. Market Cap $140 Billion. — Hold
DD DuPont - Free Cash Flow $1.36 Billion.
30 times FCF = $41 Billion. Market Cap $31 Billion. — Hold
KFT Kraft Foods - Free Cash Flow $1.7 Billion.
30 times FCF = $51 Billion. Market Cap $44 Billion. — Hold
KO Coca Cola - Free Cash Flow $4.36 Billion.
30 times FCF = $130 Billion. Market Cap $130 Billion. — Hold
PG Proctor & Gamble - Free Cash Flow $5.78 Billion.
30 times FCF = $173 Billion. Market Cap $178 Billion. — Hold
BUD AnheuserBusch InBev - Free Cash Flow $1.8 Billion.
30 times FCF = $54 Billion. Market Cap $81 Billion. — Sell
BA Boeing Co. – Free Cash Flow $-1.5 Billion.
30 times FCF = $0 Billion. Market Cap $42.5 Billion. — Sell
CAT Catepillar - Free Cash Flow $-3 Billion.
30 times FCF = $0 Billion. Market Cap $37.5 Billion. — Sell
GE General Electric - Free Cash Flow $-81 Billion.
30 times FCF = $0 Billion. Market Cap $175 Billion. — SELL

The numbers used to generate the table above come from Yahoo Finance and you just need to enter in the ticker symbol and then scroll down and click on the Key Statistics to bring up a page like this where you will find the market cap and the free cash flow. Keep in mind however that free cash flow is calculated using the most recent numbers available and market cap is calculated daily.

What jumps off the page and hits me in the face are two things. First is what a great value Exxon Mobile is at only 7 times free cash flow. Secondly how terrible is General Electric with an $81 Billion dollar negative cash flow. That’s nearly half its market cap no company, even the mighty GE can keep this up for long.

This is a great place to start your research into long term world beater type companies. I would definitely take a closer look at Exxon Mobile, Pfizer, Intel, Home Depot, United Technologies, Verizon Communications and Western Union all of which have more than our 50% margin of safety of what we think the company is worth. Additionally, I would be looking to sell General Electric right away and also consider Caterpillar and Boeing to short sell. In fact a short sell of GE might be a big winner, however my friend would never go for something as risky as short selling, it’s just not the conservative sort of play. However it certainly opened my eyes to the possibility. For the seven companies in green I would also like to see how they react to some long term trends that we identified in another post (Long Term Investing Trends) and discover how much profit is generated from outside the USA and if any are related to healthcare.

One long term trend (i.e. over the next 5 years) is going to be US inflation. With the truly astonishing amount of debt the US is trying to support (something like 12.5 Trillion – no that is not a misprint – and that doesn’t include state and municipal debt or even federal obligations like future Medicare, prescription drug liability and social security which would really shoot the moon in some estimates the US Federal Reserve has doubled the money supply in the last 6 months of 2009. Looking way back to a 1st year economics course the law of supply and demand must tell you that if you double the supply of something (US dollars) each of those dollars must command less demand (in other words be worth less). This of course leads to inflation. While it won’t come to issuing a Trillion dollar bill like they had to recently in Zimbabwe to help pay for a loaf of bread, inflation will eat into your savings and investments.

So what can we do? At first glace a couple of things seem obvious. Namely that if the US dollar is going to fall then almost certainly gold will go up. The US dollar is the reserve currency of the world and if every one’s reserves are going to be falling in value that will spur governments to trade their reserves for something that will hold its value, namely gold. Not just governments either, institutions and individual investors will also do the same, which will really put some upwards pressure on the price of gold. Especially if gold is priced in those same US dollars.

The easiest way to buy gold is through the SPDR Gold Trust (ticker symbol GLD). The trust buys and holds physical gold and is the sixth largest holder of gold in the world, each share of the trust represents a portion of those gold holdings. This way you don’t have to actually take delivery and arrange security of the shiny yellow metal. The expense ratio is 0.4% and the trust has more than $42.5 Billion in assets.

The other side of this trade (long gold) is of course to bet on the fall of the US dollar – which can be done with an ETF like the Power Shares ETF Trust US Dollar Bear (ticker symbol UDN). This ETF holds short futures contracts so as to capitalize on the US dollar’s fall against the Canadian Dollar, Euro, Japanese Yen, British Pound, Swedish Krona and Swiss Franc.

Another major trend has to do with demographics; specifically I’m talking about the aging population. As the baby boomers retire there will be more people all over the Western world over the age of 65 than ever before. So how can we capitalize on this trend?

Well, not to put too fine a point on it, but older people are big consumers of health services. This means hospitals and clinics, doctors and nurses, pharmaceuticals, and many other services in this field. Investments in this area should do well.

These are just two possible long term trends that I see happening in the next several years and undoubtedly there are others. If you wanted to combine these two trends I would say look for large healthcare companies that earn a large portion of their profits from outside the USA, yet still report their financials in US dollars. You might also want to see my post on World Beater Stocks.

PS. An alternative to the gold play mentioned above (or in addition to) is to purchase silver. Paper money is a substitute for gold and silver, but silver also has many industrial uses as well. The most common play on silver is to purchase shares of the iShares Silver Trust (ticker symbol SLV). Just because GLD and SLV are the most common play does not mean they are the best. As a Canadian investor it would be wise to look at some Canadian $ denominated funds as well. I am more familiar with Horizons but iShares Canadian ETFs also has a good name.

CANSLIM and Phil Town’s Rule #1 are excellent places to start your investing (see my book review catagory) but I do have some problems with them.  Namely finding enough (any) stocks that would satisfy Phil’s criteria and for O’Neil he advocates buying stocks once they hit a new high.

I understand the reasoning behind ‘buying a new high’ – namely that it can and often does keep right on climbing.  But somehow this always seems to me the wrong place to buy.  It seems that you’ve missed it now that it has broken new high ground.  I prefer alternative entry points to O’Neil.

For example in his famous ‘cup and handle’ chart pattern – I feel that it is much better to make your purchase as price action is coming up the right hand side of the cup, rather than wait for the new breakout after the handle has formed.  You capture more of the move this way and have a higher margin of safety.

I much prefer (and more often follow) his ‘trend lines’ pattern.  Here you draw both upper and lower trend lines and watch daily price activity.  When the stock falls to support (the lower trend line) you buy.  When the stock approaches (or better still peaks above) the upper trend line you sell, only to repurchase when the stock hits support again.

Volume is very important for the price activity as well as 50 day MA for price.  I use the 50 day MA to confirm if stock price is in an up or down trend, and so long as the overall market is doing the same thing I open new positions.  Similiar to O’Neil don’t fight the market.  If the market is moving up and your stock is too and it is also near support it is a good time to buy.

Reading the market moves is akin to an art-form and less of a science than I would like and the only way around this is to gain some experience actually trading stocks, reading charts and getting a feel for what you are doing.  I would recommend concentrating on only a few stocks to watch closely at first so you can see how they behave over time.  Concentrate on the market indexes and the market leaders and of course your few chosen companies.

Mutual Funds are a waste of money!  There, I’ve said it out loud.  Coming from a background in the financial services industry this is pretty much heresay. I’ve heard it said that 75-80% of all mutual funds do not do as well as the market, despite the fact that all mutual funds state that their goal is to do just that.

This failing of course can be explained many ways, but chief among them is the service fees that the mutual funds charge eat into their performance.  These service fees can be as high as 4% and if in a typical year the market returns 8% then you can see that a mutual fund would have to do 50% better than the market just to match the markets performance.

Now ETF (Exchange Traded Funds) on the other hand seem to have a place.  With their expense ratios in the neighbourhood of 0.5% and even less sometimes they allow an investor to put money into specific market segments such as metals, financials, emerging markets, commodities and hundreds of others.  Thereby allowing the investor to bet on a market sector rather than a specific company.  This gives one the feeling of security that diversification brings.

There are lots of great ETFs out there and while you will never hit the mythical “ten-bagger” with an ETF you can invest very successfully by understanding overall market trends. For example if you believe that the US dollar is bound to fall due to massive governmental debt loads, then you would want to look at an HDD.TO. This is a Canadian dollar denominated, US dollar bear plus (or ultra short) which uses leverage to achieve a result that rises twice the percentage that the US dollar falls.

You may also want to consider HBU.TO which is a Canadian dollar denominated, gold bear plus (or ultra long) which uses leverage to achieve a result that rises twice the percentage that gold rises. To be specific it aims to double the performance of the current months gold futures contract. Unlike GLD (or IAU) which is US dollar denominated and is based upon the value of gold bullion.

Do some research however as these bear and bull plus funds that use leverage aim to double the result of the underlying index on a daily basis. Over time these funds stray from their stated goals and combined with expenses do not match 200% of the performance of the index they follow.