Learning to Invest the Intelligible Way: Part 1 (What does the company actually do?)

It has been a busy start to 2010, and this is my first chance to sit down and jot down some thoughts. The state of capital markets and how these affect the public continue to be at the forefront of my mind, so I will stick with this subject for the time being. In the previous note, I commented on the illogical analysis provided on CNBC and why the investing public would be wise to avoid the network altogether. Today will be the first of many notes to come where I will reflect on some of my lessons learned as an investor.

But before I begin, I'll start by saying that anyone deciding to invest in the stock market should first pay off all credit card and high interest debts. A return on a stock investment MAY award you with a 10% return on a good year; the interest rates from credit cards are GUARANTEED to eat up a significant portion of personal savings every year good or bad. Secondly, once credit cards are paid off, determine if the stock market is the right place for your money. The stock market has advantages as an investment vehicle as it is highly liquid with very low transactional costs (what I mean by this is, is that through a discount broker like TDAmeritrade it is very easy to put money into a ROTH IRA, for example, and buy XYZ stock instantaneously at a very low fee).

This ease of use, however, comes at the significant price of major risk. Because of corporate law (with Delaware law leading as the dominant model), common shareholders (average folks like you and I) are legally assured of getting the short end of the stick. Never forget that the system is rigged for insiders (key executive officers) and investment banks to win and to win big; it offers no guarantee for the average investor of even a nominal return. In fact, a common shareholder's investment can be wiped out entirely, and it frequently is. Think of the stock market as the largest casino in the world with lots of glitz and pizzaz, and... inherently dangerous. This doesn't mean you cannot come out a winner, just as you may at a casino in Las Vegas (or soon to come to Ohio?!?). If you approach the market with respect, discipline, and an intelligible strategy, you can increase your odds substantially to come out on the winning side.

So short-term debts are paid off and you have decided that the stock market is the place you want to put at least a portion of your long-term savings... Where do you begin to look for stock ideas? I recommend starting up a profile on Motley Fool CAPS (Fool.com), where you can begin reading what other investors have to say about specific stocks. Use the CAPS system to make some mock picks of your own so you can get a real sense about how good you are (or, are not) at randomly picking stocks and doing so without actually costing your hard earned money. By making some mock picks at the beginning (let's say over a 3 month period), you will have a better sense of where you need to improve as a stock picker. But by far, the biggest advantage of Motley Fool CAPS for me is the stock screener it provides. Input some data for the type of stocks you are looking for, and seconds later you have a list of stocks to choose from. For the stock screener alone, it is worth starting up a free profile on Motley Fool CAPS.

From a stock screener list, the real research begins. There are several steps that I go through to narrow down the list to the stock I decide to put money in. Rather than listing them all now, I will go through each step one-by-one so I can offer a better explanation for each step. The very first process I engage in is determining whether I understand the company's business model. It does me little good in putting money into a company when I am clueless as to what the company actually does and how it actually makes a profit. If someone asks you, "So tell me, what does Company ABC do?" and if you are unable to explain it in simple and understandable terms, I would caution you against putting your money in the company. There are thousands of companies out there that offer a fairly simple and straight-forward business model that requires little expertise to understand, and from which to choose as potential investments.

Because of this first step, I tend to avoid industries like biotechnology and banking. If I were asked to explain how a certain biotech company makes money, I don't feel I could do that confidently. Nor can I adequately explain what a certain bank does, as a bank's (particularly investment banks) reported data is frequently shadowy in order to protect their business strategies from competitors. For example, Bank of America's stock (BAC) traded above $50 per share in 2007. Do you think the millions of Bank of America investors truly understood the bank's business model? Of course not. If they had, they wouldn't have invested in the bank in 2007 with the knowledge of the extreme risk it possessed and which was realized by a collapsing stock falling into single digits in 2009; Bank of America required the federal government to pump $45 billion into it through the TARP program with additional guarantees of $118 billion -- these were done to save the bank from collapse in 2008 and 2009.

Stick to companies you can comprehend at some reasonable level. Pull up the company's latest annual report (10-K filing) on SEC.gov. Included in a 10-K report is a detailed description of a company's business model. Read it carefully. Does it make sense to you? Go to a company's website. Read about the company and its products or services. Are you able to make sense of it? If so, then the company passes your first step as a potential investment. If not, toss it in the trash and go to the next stock on your list.

Peace

JMac