In this month’s column we return to a topic we covered in May:  investing strategies and techniques.  What is behind picking a stock to buy?  What thinking goes into choosing to sell a stock?  

Fundamentals vs. Technical

Stock investors generally fall into one of two categories: 

A Fundamentals trader looks at the qualities of a company.  He researches the company’s qualities and shortcomings.  He evaluates the management team.  He evaluates the company’s products vs. the competition.  He takes note of how innovative the company is.  He decides whether there is a future for the product(s) being sold:  are their products going to continue to be in demand?  Will demand increase?  Can the company use their current products as a springboard to increased sales?  Is the company buying start-up companies which have knowledge that can be used to enhance its products?

In other words, is the stock one that you expect to be good to own for several years or more?

A Technical trader looks at trends – statistical trends, how the market is moving generally, where the general sentiment of the majority of investors is headed.

If the Fundamentals trader sounds like one whose practices are in line with what has been recommended in previous articles, that should be no surprise.  To make intelligent investment decisions requires all the information you can gather.  

Investing techniques often associated with Technical trading include “Timing” and “Day Trader”.  

Timing refers to focusing on the exact instant to buy or sell shares of stock.  

For the Fundamentals trader, timing is less important; the impact for an investment measured in years will be minimal.  For the short-term Technical trader, changes in price are a central part of his concern.

Similarly, a Day Trader tends to buy and sell stocks several times throughout the day, as prices rise and fall, in an attempt to anticipate future changes in stock prices.  

Statistics – the historical record – is an important consideration for all investors.  Those who fail to learn from history are doomed to repeat it.  But trying to use statistics to foretell the future is like trying to drive your car by looking in your review mirror.  

Price/Earnings Ratio

The Price/Earnings ratio  is one of the indicators you should consider when buying a stock.  The P/E ratio usually appears on any list of statistics about a particular stock.  It is calculated by dividing the stock’s price per share by the company’s earnings during the past year.  

Use the P/E to help you decide if the stock is over-valued or under-valued by investors.  If the P/E is high, then even if the company has good fundamentals, it may not be worth the price.  If the P/E is low, then look for reasons why investors are shying away from buying that stock.  

A stock may still be a good investment, but an abnormal P/E should raise a red flag for you.  Find out what is causing the P/E to be so far from the norm.

What is the norm?

Traditionally, a P/E close to 17 was considered normal, and banks’ P/E are even lower.  That is still true for traditional industries:  Norfolk Southern Railway is 23.94; Bank of America is 12.75; Lowes is 21.05.  

But the Tech stocks tend to be higher:  Adobe is at 53.88; Amazon is at 58.04; Microsoft is at 35.39.

“Trendy” stocks can be even higher:  Chipotle’s P/E is 90.56.  That unrealistic P/E ratio indicates that investors believe it is a high-growth company – or perhaps the Technical traders believe that people will continue to blindly buy the stock, driving the price still higher.  

Know the market: 

Restaurants are not typically very profitable.  They are not generally high-growth businesses.  Chipotle is very popular for the moment, but soon another restaurant will become the next nation-wide fad.  The P/E ratio tells the story:  don’t be the last holder of Chipotle stock standing when its price starts to fall.

 Watching the Market As a Whole

The Dow Jones Industrial Average (“DJIA”) is still the most commonly-referenced index of the market as a whole.  The Dow is composed of thirty companies which supposedly provide a representative picture of the Stock Market’s status.

For an investor, however, the Standard and Poor’s 500 (“S&P 500”) is a better gauge of how the market is doing.  The S&P 500 are the 500 biggest companies, by capitalization (i.e., a company’s stock price multiplied by its total number of stock shares).  Since those 500 purchase products of many other companies, their influence on the market is even greater than is obvious.  

It is also true that with 500 companies included in the S&P 500 index calculation, no onecompany can have a disproportionate impact the index (as Apple did some months ago on the Dow Jones Index).

Use the S&P 500 to gauge the direction of the American economy as a whole.  Politics – a new law passed by Congress or an action of the President – can have a very visible impact on the S&P 500, letting you know what will happen to stocks you own.

 A third indicator of the economy in general is the CBOE Volatility Index (“^VIX”).  But note that the VIX goes up on bad news and down on good news.  The VIX also tends to move suddenly and more radically than the Dow or the S&P.  Politics, news from the Fed, violence, the crash of a commercial airplane – all can cause the VIX to jump substantially.  

The VIX is quick to jump, but slow to decline.  It indicates general skittishness and caution by investors.

Pundits

Columnists and writers who focus on issues of interest to investors are generally not to be taken seriously.  Think about what their objectives are:  they have to write a new column every day, and they have to convince readers to read their column every day.  If they fail, editors will stop paying them.  

Sensationalizing some subject is a pundit’s simplest strategy.  Articles with titles like “17 Reasons Why the Market Will Crash Today” are the pundits’ standard fare.  The same company which a pundit noted yesterday as “outperforming competitors” will be noted today for “underperforming competitors”.  

Pundits do not have to be right in their predictions.  Today’s article will be forgotten by tomorrow morning.  Rarely do they have any more insight into the Market than you do.

Next Month:  Investment  Strategies and Techniques Continued.■