Five year summary of PDCO stock price. From 2012 to 2018

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Noam Ganel is the Managing Director of Pen & Paper, a value-oriented stock research publication. Subscriptions are now available. He also serves as  Vice President in Capital Markets at Silvergate Bank and holds the Chartered Financial Analyst (CFA) credential.

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The hats the investor must wear

Buying Stocks is not Stock Investing

August 10, 2018

Without the appropriate experience and education, no one would dare perform brain surgery. Yet for stock purchases, all that one needs are a few extra dollars and a brokerage account. It is so easy to buy stocks nowadays that it is often forgotten that stock investing requires much more than clicking on a few buttons. In this meditation, I will describe the many hats the investor must wear and some of the tasks associated with these jobs. 

Avoiding certain stocks

The first task is to know which stocks to avoid. Most readers of Berkshire Hathaway’s annual report memorized the term circle of competence. I would also add that you should refrain from buying stocks that do not match with your value system.

For example, I read last week about Signet Jewelers (SIG), a diamond jewelry retailer with a market capitalization of $3.6 billion. At first sight, Signet appeared to have all the ingredients of an undervalued stock: The company showed a high return on capital invested; had increased earnings per share since 2009; and the stock price had recently halved.

While I am fond of such stories, I did not feel comfortable with Signet’s business model. Reading its annual report, I found that the company had financed over sixty cents of every dollar of sales. In other words, Signet not only leverages its balance sheet (for every dollar of tangible assets, Signet had more than 70 cents of liabilities), but also finances its customers to buy the product.

That was against my value system. If a person finances a car acquisition so that he or she can get to work or school, I regard the debt obligation as a proper investment for a better future. But when a company is providing finance so that a young man can impress his young fiance with a wedding ring he cannot truly afford, I think it’s a bad start for a healthy marriage and a bad recipe for our society as a whole. 

Preparing a watch list

Another weekly ritual of the serious stock investor is finding stock candidates and adding them to a watch list. A watch list is composed of several companies that the investor would be interested in purchasing shares in future time, at the right price of course. Often companies on the watch list performed better than their peers; are managed by honest and capable people with a solid track record in business; with a product or service that has a competitive advantage - but with a current stock price that is just too dear.

The Mosaic Company (MOS] is on my watch list for example. Based in Plymouth, Minnesota, Mosaic mines and produces phosphate and potash fertilizers. Consider its stock price. Over the past decade, the stock traded as low as $10 and as high as $89 per share. The 10-year average price range was $58 to $33; the company 10-year average earnings were $3, and 2017 was the first year it reported on a loss in the income statement in over a decade. To me, at a current price of $29, the stock is too high. However, if the stock price will drop to the low $20s level, I will be rushing to buy it.

Portfolio management

Just as a business owner is expected to review the operating financials of a business he or she invested in, the same is expected of the cautious investor. The investor must ask and assess whether management is acting on behalf of shareholders and whether the investor would repeat the stock purchase, if the investor had not already been a shareholder.

One method to monitor and assess management is by watching their acquisition behavior. Some of the questions the investor must ask are: Is management overpaying? Is management financing the acquisition with debt or is it using the company’s stock (and diluting current shareholders)? Because the nature of managing a corporation is that the more assets, the easier it is to justify a higher salary or bonus. Often you will find careless, senseless acquisitions. 

Finding creativity

The investor is expected to think outside the box to find bargain stocks. I know stock investors who refuse to read stock reports written by brokerage companies, as they feel there is too much misaligned of interest. I also know investors who refuse to speak to management because they are concerned that management will influence their decision making process.

I like to find stocks using four main methods. First, I glance each week at a list of stocks that are trading at a 52-week low (I use a free stock screen provided by Guru focus). Second, I read the 13-F filings written by investors such as Guy Spier or Bruce Berkowitz and try to reverse engineer their thought process. Third, I glance at stocks that cut their dividend rate - read Who Cut Dividends in March 2018? as an example. And finally every year I watch for companies that left the S&P 500.

When Patterson Companies (PDCO) announced that it would be leaving the S&P 500 index in March of this year, in a course of one day, its stock fell from $32 to $24, a 22% decline. So I decided the buy the stock and you can read why in The One Advantage of Short Term Thinking? A Cheap Stock Price.    

Selling stocks

While there is no rule or given law to determine when is the right time to sell a stock, there are a few invariable considerations. Taxes are one. If in a certain year the investor is expecting a large taxable income, it may be sensible to sell certain stocks that lost value, to offset the taxable income.

But the main reason to sell a stock is when the investor believes that the sale price aligns with the value of the stock, and ideally, that there are other immediate companies where the investor can allocate the sale proceeds to. When I make a stock purchase, I write down using a pen and paper what would be the price that I would sell the stock. To me, it takes away the emotional aspect of owning a stock and replacing it with meeting an objective I had set for myself.