Investing can be complicated, but I believe it can be simplified so the everyday person can use investing as a tool to build wealth. The goal of this post is to simplify the investing process by guiding you through 5 steps that describe my personal investment making decision process. This process has produced some fantastic results for me over the past 10 years, and I hope you will consider some or all of them before investing.
Step 1: Big Picture – State of the Global Economy and Geopolitics
Step 2: General – Sector and Industry Focus
Step 3: Specific Company
Step 4: Invest
Step 5: Re-evaluate Your Investment Every Quarter
Step 1: Big Picture – State of the Global Economy and Geopolitics. Identifying if the world or country is in a state of growth is relatively simple on the surface. Our first step is to look at the gross domestic product (“GDP”) of the world or a specific country. This is one of the most commonly used economic indicators of growth. GDP is the total value of goods and services produced by a country in one year or a specific time period. But to determine if a country is growing, we need to be able to pinpoint where in the economic cycle the country is currently. So what is an economic cycle?
According to Investopedia, “the economic cycle is the natural fluctuation of the economy between periods of expansion (growth) and contraction (recession). Factors such as gross domestic product (“GDP”), interest rates, levels of employment and consumer spending help to determine the current stage of the economic cycle.” An economic cycle is broken down into four distinct stages; expansion, peak, contraction, and trough. “During the expansion phase, the economy experiences relatively rapid growth, interest rates tend to be low, production increases and inflationary pressures build. The peak of a cycle is reached when growth hits its maximum output. Peak growth typically creates some imbalances in the economy that need to be corrected. This correction occurs through a period of contraction when growth slows, employment falls, and prices stagnate. The trough of the cycle is reached when the economy hits a low point in growth from which recovery can begin.” So where and how do we invest based on an economic cycle? Well, it really depends on the type of investor you choose to become. You can trade based on short-term (1-30 days), medium-term (2-12 months), or on a long-term (1-30 years) basis. Throughout Brett’s Napkin, I generally advocate for a long-term investment strategy. Research has proven if you stay invested throughout many economic cycles, instead of choosing to buy and sell based on current economic conditions, you will have a higher return on your investment. Now they're exceptions to this, but all of us have a life outside of investing and are only using investing as a tool to generate growth. We want to stay humble, smart and try not to outsmart the market, because in the end, no one is smarter than the market itself.
Some of the critical indicators described above are GDP, interest rates, unemployment rate, wage growth, and consumer confidence. These statistics for the United States can be found on the Bureau of Labor Statistics (https://www.bls.gov/home.htm), and the Federal Reserve Bank of St. Louis (https://fred.stlouisfed.org/). These two sites are an excellent starting point to learn more about the current health of the U.S. economy by analyzing statistics. As you are conducting your research look at the last several years of each indicator and try to create the current economic cycle. This will enable you to pinpoint where in the cycle an economy currently is.
Thanks to technological advancements and an opening of the global economy, you can invest in virtually any market across the globe. So how do we learn about which countries are growing and which are not? Take a look at the Wall Street Journal and the Economist. Both are excellent sources of useful information so you can stay up to date on current events and learn about new investment opportunities. Another great source of information is Citi GPS. Citi GPS produces excellent content on the global economy’s most demanding challenges, identifies future themes and trends, and help’s you invest in a fast-changing and interconnected world. And best of all it is free to the public.
Once you determine which country or region of the world you want to invest in, you need to review the current political environment. We are now in a world where a single “tweet” can shave 10% or more off a company’s stock price in a single trading session. Generally speaking, investing in a county with a democratic system of government and one that advocates for open markets, and has strong and stable democratic institutions, like the ones of the United States, United Kingdom, France, Japan, and Australia, to name a few, are called advanced economies (“AE”). Where those of China, India, Brazil, and Nigeria are called Developing Economics (“DE”). Napkin Note: AE's are ones who have stable political systems, advanced manufacturing capabilities and a high standard of living. Generally speaking, these economies are less risky to invest in and thus will have a lower growth rate on your investment. Whereas DE's are in the growth stages of development and there is greater potential for rapid growth and thus higher investment returns. Portfolios containing both AE and DE investments are all part of creating a well-balanced, diversified portfolio.
Step 2: General – Sector and Industry Focus. At this point, you have determined the countries and or regions you want to invest in. You now need to narrow down your search down to the sector and the industry you want to invest in. The main difference between a sector and industry is a sector refers to a large segment of an economy, while the industry is specific to a group of companies. After reading the WSJ, Economist, and Citi GPS for a few weeks, you will begin to see opportunities in specific sectors and industries. Below I have identified 11 sectors and 68 industries, which apply to the U.S. Economy. Fidelity does a great job explaining each one of these sectors and industries and then allows you to use a Stock/ETF/Mutual Fund Screener to find specific investments within each sector and industry. I encourage to read more about sectors and industries through your brokerages’ education center. By using comparison tools, you will learn which areas are growing and why.
Step 3: Specific Company. Over the last ten plus years, if I can share one tip about investing it would be to leave your ego and emotions at the door. If you choose not to, then please don’t invest and head to Las Vegas, because investing is all about calculated risk-taking, following a specific set of rules, and not bringing your emotions into the room. Thus creating rules and sticking to them is the best strategy for success. William O’Neil is a brilliant investor and the founder of Investor’s Business Daily (“IBD”). IBD is a weekly paper, providing news and analysis on investment opportunities. They specifically focus on "stock-picking," and is a great tool to find new investments for your portfolio. In addition, William O’Neil created 20 investment rules for success, which I highly recommend you follow. I have listed these rules below. Some of these rules make references to the IDB paper, which you would need to purchase in order to follow the individual rule. For now, you can substitute these rules with one of mine which I have listed below the IDB Rules.
Consider buying stocks with each of the last three years’ earnings up 25%+, return on equity of 17%+ and recent earnings and sales accelerating.
Recent quarterly earnings and sales should be up 25%, preferably 40% or more.
Avoid lower-quality stocks. Buy stocks selling for $15 to $100 or higher.
Get and use charts to spot sound chart bases and exact buy points. Confine your buys to proper points as stocks emerge on big volume increases.
Cut every loss when it’s 8% below your cost. Make no exceptions so you’ll avoid any possible huge, damaging losses. Never average down in price.
Follow selling rules on when to sell and take your profit on the way up.
Buy when market indexes are in an uptrend. Reduce investments and raise some cash if general market indexes show six days of increased volume distribution.
Read IBD’s Investor Corner and Big Picture columns to learn how to recognize major tops and bottoms in market indexes. You can learn to do this.
Buy stocks with a Composite Rating of 90 or more and a Relative Price Strength Rating of 85 of higher in the IBD SmartSelect Ratings. Run a checklilst on the top stocks on the IBD 50.
Pick companies in which management owns stock.
Consider boldface stocks on IBD’s New Highs List and Nasdaq Stocks On The Move.
Select stocks with increasing institutional sponsorship in recent quarters.
Current quarterly after-tax profit margins should be improving, near their peak and among the best in the stock’s industry.
Don’t buy due to dividends or P-E ratios. Buy the No. 1 stock in an industry in earnings and sales growth, ROE, profit margins and product quality.
Pick companies with a unique, superior new product or service that leads its industry.
Invest in entrepreneurial New American companies. Pay close attention to those with IPOs in the past fifteen years.
Check out companies buying back 5% to 10% of their stock and those with new management.
Don’t try to bottom guess or buy on the way down. Never argue with the market. Forget your pride and ego.
Find out if the market currently favors big-cap, mid-cap or small-cap stocks.
Do a post-analysis of all your buys and sells. Post on charts where you bought and sold. Evaluate and develop rules to correct your major mistakes.
3 Additional Rules (Some of Brett’s Napkin Investing Rules)
Never invest more than 10% of your total portfolio value in one stock. Diversification is key to building a stable well-balanced portfolio.
Never follow the crowd. Conduct your own research and take the time to discover new investment opportunities.
Follow the flippin Rules. It’s critical you follow the rules no matter what.
Step 4: Invest. Okay, you made it! I understand you may be confused right now because I gave you a bunch of information to digest, so take a deep breath and if necessary re-read steps 1 – 3 as many times as you need.
Before you invest, something to keep in mind is diversification. Just because you spent countless hours researching a stock, doesn’t mean you can’t lose money. As a general rule of thumb do not invest more than 10% of the total value of your portfolio in any one stock. Please stick with this rule even if you only have $100 in your brokerage account. Because over time your account will grow and you will have gained discipline. Also, try to create a well-balanced portfolio of small-cap, mid-cap, and large-cap companies as well as investing in different sectors and industries and across different economics. Consider investing in fixed income securities, like corporate, U.S. Treasury, and or municipal bonds. We will review how to create a well-balanced portfolio in a later post.
Now go ahead and press trade, because you are ready to buy stock.
Step 5: Re-evaluate Your Investment Every Quarter. In my opinion, this is a critical step. Documentation of not only what we are invested in and how your investment went is essential, but our emotions and thought-process is crucial to developing into a stronger investor. I found this to be incredibly useful for me. Learning from my mistakes made me into a smarter more rational investor.
Another Thought. Thanks to new financial products like ETFs, you may find you want to invest in a specific country after researching Step 1, or even a particular sector like in Step 2, and now you can. You can use the ETF screener from your brokerage account, to find county and sector-specific ETFs. We will review the benefits to choosing an ETF over an individual stock in a later post.
(I have not been paid to endorse any of the following resources; WSJ, The Economist, Citi GPS, and Investors Business Daily)