Lessons From “Beating the Street” Continued and Five ETF Mistakes to Avoid

A man of character finds a special attractiveness in difficulty, since it is only by coming to grips with difficulty that he can realize his potentialities.

– Charles de Gaulle

Constant dripping hollows out a stone.

– Lucretius

Today continues taking in the wisdom from Peter Lynch’s book, Beating the Street.

You can catch up on Part I here.

One of my favorite quotes from yesterday was:

The smallest investor can follow the Rule of Five and limit the portfolio to five issues. If just one of those is a 10-bagger and the other four combined go nowhere, you’ve still tripled your money.

This applies to someone who is not a full-time investor. Meaning they have nine-to-five job doing something else.

There’s just no reason for the small investor or part-time investor to follow a bunch of stocks. They’ll never be able to spend the proper amount time studying the businesses.

By narrowing down the list to five, it’s easier to learn the business and keep up with the news on the company. There’s less quarterly and annual reports to read.

It’s easier to understand when the stock is trading at cheap prices and at dear prices. Because the investor will have become familiar with how the stock performs across multiple business and economic cycles.

So, keep this in mind. Pick five stocks in industries that you understand. Maybe it’s the industry you work in. Now, there probably aren’t five great businesses in one industry.

So, maybe you look at the supply chain within the industry you work in and look at those stocks too. Or, if you have a hobby you enjoy, then look there. Or, maybe the industry your significant other works in.

The point is to choose businesses that are easy to understand for you. As you follow these stocks over the years, you’ll see which companies survive the market crashes and global chaos that happens from time to time.

You’ll be well on your way to becoming a financial winner.

OK…

Here are more of my favorite quotes from Beating the Street

Beating the Street Continued…

It’s usually a good thing when a company buys back its shares, as long as it can afford to do so. Conversely, it’s a bad thing when a company increases the number of shares. This has the same result as a government printing more money: it cheapens the currency.

If it continues to buy back shares… someday they (the shares) will be very scarce and very valuable. With fewer shares outstanding, the earnings per share will increase even when business is flat. When business is good, the share price can skyrocket.

Corporate managers often pay lip service to “enhancing shareholder value” and then go out and squander the money on fanciful acquisitions, ignoring the simplest and most direct way to reward shareholders – buying back shares.

The popular prescription “Buy at the sound of cannons, sell at the sound of trumpets” can be misguided advice. Buying on the bad news can be a very costly strategy, especially since bad news has a habit of getting worse.

Buying on the good news is healthier in the long run, and you improve your odds considerably by waiting for the proof.

This is a useful year-end review for any stock picker: go over your portfolio company by company and try to find a reason that the next year will be better than the last. If you can’t find such a reason, the next question is: why do I own this stock?

A healthy free cash flow gives a company the flexibility to change course in good and bad times.

In these last four paragraphs, he’s talking about cyclical stocks…

With most stocks, a low price/earnings ratio is regarded as a good thing, but not with the cyclicals. When the p/e ratios of cyclical companies are very low, it’s usually a sign that they are at the end of a prosperous interlude. When a large crowd begins to sell a stock, the price can only go in one direction. When the price drops, the p/e ratio also drops, which to the uninitiated makes a cyclical look more attractive than before.

This can be a misconception. Soon the economy will falter, and the earnings of the cyclical will decline in breathtaking speed. As more investors head for the exits, the stock price will plummet. Buying a cyclical after several years of record earnings and the when the p/e ratio has hit a low point is a proven method for losing half your money in a short period of time.

Conversely, a high p/e ratio, which with most stocks its regarded as a bad thing, may be good news for a cyclical. Often it means that a company is passing through the worst of the doldrums, and soon its business will improve, the earnings will exceed the analysts’ expectations, and fund managers will start buying the stock in earnest. Thus, the stock price will go up.

It’s perilous to invest in a cyclical without having a working knowledge of the industry (copper, aluminum, steel, autos, paper, whatever) and its rhythms. The most important question to ask about a cyclical is whether the company’s balance sheet is strong enough to survive the next downturn.

Five ETF Mistakes to Avoid

ETFs can be confusing. You need to study them just like any other investment.

Or, you’ll end up losing a lot of money.

Fidelity Investments just put out a list of the five mistakes investors make when buying ETFs.

A lot of it is common sense. Here they are…

Buying the hot new thing.

Many new ETFS are chasing trends. New ETFs come out mainly because there has been huge run up in the market and the issuers launching them are trying to take advantage of it.

But by then, it’s already too late. It’s likely you’ll be buying at the top of the market.

Buying something you don’t understand.

With ETFs, you have access to a lot of strategies that big money uses. Futures, interest rates, leveraged strategies etc. You name it. There’s an ETF for that.

Some of these strategies are tactical or short-term plays. An investor who holds these over the long-term could slowly lose money. They generally have higher expense ratios too.

Thinking all ETFs are created equal.

Fidelity uses an example of ETFs focused on China. In 2014, there were 13 different ones for an investor to choose from.

In one example they used, one ETF was down 7% and another was up 51% over the same time-period.

The ETF that was up 51% had a much larger exposure to Chinese consumer stocks. The bottom line… You need to look at what’s inside the ETF.

Just because there’s several ETFs covering China, Russia, technology, or whatever, doesn’t mean that each ETF has the same exposure.

See what companies it holds. See if it’s exposed more heavily to a certain industry or a single company.

Ask yourself how those things will do given the current economic environment or given the current stage of the business cycle.

Trading just because you can.

ETFs are easy to trade in and out of just like a stock. Investors can make the same mistakes as they do trading stocks too.

They’ll buy the ETF at the wrong time and sell at the wrong time. They’ll panic when everyone else panics.

Investors will still come up against their number one enemy… Themselves.

Know why you’re buying it. Know why you’re selling it. It can’t be “just because.”

Only using market orders.

You should always buy shares using limit orders. Even more so with ETFs.

A market order tells the broker to buy at the best possible price right now. Many ETFs don’t have a lot of liquidity.

Meaning it’s a lot harder to match buyers with sellers. The difference between the bid and ask prices can be big.

Buying using a market order could mean paying a price you didn’t want to pay. A limit order gives the investor control over the prices their willing to pay.

For example, let’s say the bid is $35 and the ask is $40. You can use a limit order for the number of shares you want to buy, and place it at $35.

When the stock comes down to your price, the order will go through.

Again, these are common sense. The same principles apply to buying shares of companies.

But given the ETF boom, it’s worth thinking about these things.

Consider them the next time you’re thinking about buying one.