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It has been a crazy couple of weeks in the stock market. If you haven’t watched the investment news for awhile, you missed a wild ride in a few heavily shorted companies. Gamestop is one of those companies, and in the chart above you can see that its price was in the $11 range for several months then rose to the mid-upper-teens for a period of time before being pushed up to nearly $500 in a short squeeze before backing down to the $50 level. This is the essence of volatility and one of the things that you see when stock markets are nearing a top – people forget about basic risk management and turn investing into gambling.
If you are wondering how this sort of thing happens, here is a short explanation in bullet point format:
· Gamestop as a business historically sold video games in cartridge format
· Most video games are now downloaded directly over the internet, leading to a significant decrease in revenue over time and a subsequent drop in its stock price
· Gamestop acquired a new major investor that recently sold their own internet driven business for more than a billion dollars who has said he plans to help Gamestop transition to a new internet-based business model
· Many large hedge funds were short the stock of Gamestock, which is bet against the company in the belief that it would go down even further in price
· However, small investors were discussing this change on internet discussion boards and as a group decided to try to drive the stock price higher with buying, forcing the hedge funds to cover their shorts by buying stock, starting a process that feeds upon itself: buying begets more buying
· Once the ball got rolling, and the stock price started to move, the discussion boards detailed how the small investors could buy calls on Gamestop which ultimately would move the stock higher because the brokers would have to buy the stock of Gamestock as a risk management measure which put more pressure on the hedge funds to buy as the stock price moved up
· Here is an Article Posted On Reddit re: Gamestop Investing that helped to fuel the fire, and which the hedge funds missed – there is another Reddit post out there (I can’t find it now to provide you the link) that told people to sell when the stock reached $480…guess what the high was on that chart: $483
· A lot of people who bought at the beginning of this frenzy made good money, but it was still a bet that that the Reddit community could drive the stock to a level where the hedge funds would be forced to buy stock to cover their short position
· However, many more people lost money because they were a buyer at prices above $50 and didn’t sell into the frenzy – and the hedge funds who were forced to buy at $483 or some other price significantly above today’s $62 price have lots hundreds of millions of dollars, putting two major hedge funds on the brink of bankruptcy
· This frenzy also forced a number of brokers to halt trading in Gamestop shares, causing a number of investors to lose money, either actually or from an opportunity cost standpoint, and the class action lawsuits against them are starting to come forward
Let me make it clear, what the small investors did was not illegal, but it is not investing.
What is investing? Let me walk you through a process that I use that entails a significant amount of due diligence. Due diligence is a process used to find the stock of a company that has the opportunity to outperform the rest of the stock market. If you invest your own money, I hope you are engaging in a similar process – if not, I would be happy to manager your nest egg so that it follow process.
Due diligence involves research into companies to determine whether they would make a good fit as part of an overall portfolio designed to achieve an objective. I won’t discuss in this post how you design and develop a portfolio nor how to position a portfolio to achieve an objective, but those will make interesting posts for the future. However let’s take a look at buying one stock so you get a feel for the process.
Step #1: you determine that you need to buy a stock – there are many reasons for this, like you have some cash to invest or you want to swap a current stock in which you have lost faith into one that you believe will outperform the market.
Step #2: you decide on a stock you want to research – there are a number of ways to determine your research candidate, like you hear about it on investment television, from a neighbor, or perhaps you are a fan of their products, to name a few.
Step #3: examine the macro issues impacting the stock:
· is the stock market itself in a bull phase or a bear phase;
· do you believe from a timing standpoint that now is a good time to buy ANY stock;
· is the industry within which the company operates in a bull or bear phase:
· are there forces that are acting as catalysts to push the stock price higher or are there headwinds that will exert downward pressure on the stock price (e.g., an example catalyst for an electric vehicle company is the government doing something to cause the price of oil to go higher; an example of a headwind for a retail store is consumers choosing to shop online instead of going to the mall)
Once you determine that the overall market is at a place where buying stock makes sense and that the industry for your company is not facing significant headwinds, then we turn to examining the company itself
Step #4: examine the fundamentals – this involves math, so be prepared to do it or trust the wall street analysts numbers (I don’t trust them since they are predominantly bullish and will sometimes use unconventional methods to justify a future stock price target higher than today’s price)
· you need to determine an intrinsic value for the company’s stock (this is different than a price target that analysts publish) and compare it to today’s stock price since you want to buy the stock near or hopefully below that intrinsic value – this is complicated
· an intrinsic value involves examining the company’s cash flows an discounting them so you determine what they are worth today
· if the stock market is in a bull phase, it can be difficult to find a stock trading below its intrinsic value – so you will have to decide it buying above intrinsic value makes sense or whether it would be better to buy it once the price moves closer to intrinsic value
· you need to determine if the company’s ongoing operations will support a move higher in stock price
· you need to examine a company’s earnings growth (historic and projected) and its return on equity (historic and projected) to see if they meet you desired levels
· there are two ways a stock’s price will move higher or lower: (1) rising or falling earnings; and (2) how much investors value those earnings – a high level of earnings growth and return on equity will help you make sure you are meeting (1) above
· you need to examine a company’s financial strength to make sure they will be around for the long term and can withstand a recession when it happens
· debt levels, cash on hand, owners equity levels, and free cash flow generation are critical
Step #5: you need to look at a company’s valuation to determine if it is an acceptable time to buy or whether you should wait until the stock price comes down to acceptable valuation multiples – see (2) above
· price to earnings multiples, prices to sales multiples, price to book multiples, price to earnings growth multiples, price to intrinsic value multiples all need to be examined at a minimum to see if the stock is trading at an acceptable valuation level to buy it
· studies show that more money is lost in the stock market buying a company that is over-valued than lost based upon buying those with bad fundamentals
Step #6: you need to look at a chart to see if technically it is time to buy or not
· a stock chart is just a visual representation of the collective investor view on this company
· sentiment and momentum play a big part in the short term outlook for a stock’s price
· buying a stock when it is near the bottom of its short-term trading range can produce significantly higher long-term returns than buying a stock near the top of its short-term trading range
· this helps you determine what price you want to pay for the stock and what price you will accept paying for the stock if it never gets to the price you want (if your analysis supports buying it at the higher price
Step #7: buy that bad boy!
· if everything aligns and you are satisfied you have a company that you want to own with good fundamentals at an acceptable valuation and current stock price, then buy it
Step #8: determine what price you want to sell the stock
· set an upper price target for the stocks – this doesn’t need to be a hard sell target, it might be the price where you want to rerun the steps above to make sure owning the stock makes sense (e.g., an example of this is buying a cyclical stock tied to the ups and downs of the economy – you want to buy it when the economy is a catalyst for the stock price to go higher but you want to sell it before a downturn in the economy becomes a headwind; setting a price target will force you to re-examine your reasons for owning the stock and will tell you whether to continue to hold it or whether to sell it – just remember to set a new target price if you continue to hold it)
· set a price below your purchase price where you draw the line on losses – a common one is 9% so that you avoid any double digit losses on an investment
· this can be tricky because many times you hit your loss limit and sell the stock only to see it recover and excel to the price target you set – but it is more important that you maintain standard practices because over the long-term you will be more successful than if you are haphazard in your actions
· sometimes something can happen and a stock will plummet below your loss limit price (it’s just the way the market works and is typically news related relative to some non-public negative information becoming public) – you have to decide whether to cut your losses and sell at this lower price or you determine that this is an over-reaction by the market and it has provided you an opportunity to buy more shares at this cheaper price
Step #8: document your analysis and your reason for buying the stock and for ultimately selling the stock
· one of the major benefits of documentation is so that in the future you know why you bought a company and so that if you sell it you have done a significant portion of your due diligence in case you want to buy it back
Investing is not gambling – due diligence ensures that your stock portfolio will not go to zero and that you will have the best chance possible to meet your objectives
· yes, some non-public information can become public and drive the price of one stock to zero or close to it, but that is why you build a portfolio and diversify that single company risk away
· you can also have publicly available information drive a stock’s price to zero or close to it, but that is why we have this due diligence process that forces you to periodically review the company you bought and to sell it if something changes or your analysis was wrong (hey, it can happen, it does to professional investment managers all the time for many different reasons: if your projections of future earnings and returns do not pan out, if investor sentiment changes, if your view of an acceptable valuation level to buy that stock is wrong, or any of countless other things happen)
Over the years, I have developed spread sheets that automate a significant portion of this due diligence process. They help guide me to determine if what I want to buy will outperform the overall market and they help guide me to determine if I want to sell it. However, if you are managing your personal portfolio, it is important for you to follow this process or another one that you develop on your own. Sticking to a process will help keep you out of trouble, will help you achieve your objectives, and will make the weight of these critical decisions a bit lighter.