This past Sunday evening, I went grocery shopping and bought bananas for 39 cents a pound, down from 52 cents ten days earlier. I owe my savings to Gabriel Wisdom's new book,
Wisdom on Value Investing: How to Profit on Fallen Angels,
pictured above. Grocery shopping on Sunday evening, when the store wants to clear the shelves, is just one of the many tips mentioned in his book. You'll find that gem in his discussion
of CATS: Cheap and Timely Securities.
I found the book an easy read, one that does not clutter the prose with mumbo-jumbo or complex formulas. His extensive research will cause you to think, Wow! I didn't know that!
As the title suggests, this book is about value investing, using financial ratios to select stocks and hold them for the long term. It does not pretend to cater to traders, only
investors willing to hold a stock for 3 to 5 years. That amount of time gives the company a chance to fix its problems and be recognized not as a fallen angel but as one in good graces.
Let's start from the beginning and see what the book has to offer. In the first chapter, he opens with ten traits that successful investors possess. Whenever I meet or speak with a
trader or investor, I am on the lookout for new tips that will make my own trading more profitable. Even though I don't hob-knob with the jet set, Gabe has covered many portfolio managers,
traders, and investors on his radio show and picked up a few tips. Here they are.
Think like a contrarian. Buy when others are selling or excessively pessimistic, and sell when they are buying/overly optimistic. This reminds me of the magazine cover theory. When
the stock market makes it on the cover of Forbes or Time magazine, you know the market has peaked.
Use a method to find value. Don't just pick any stock that touches your fancy. Use free cash flow, earnings momentum, price to sales, price to earnings, and so on to find value in a
Don't change methods. A trader emailed me saying that he found a winning strategy of trading ascending triangles. Out of ten trades, nine made money. So what did he do? He threw away
his winning strategy and bought a stock called Bre-X. That company turned into a gold mining fraud and the stock went to zero. He lost all of his money. The moral of this story is, don't
throw away a winning strategy just to experience the adrenaline rush of a new trade. Give your investments time to prove themselves.
Know when to sell. Have a target price or know what the financial ratios have to reach before you sell. Sometimes the financial situation will change within a company and that
becomes the clue to sell. Whatever the mechanism, know when it's time to find another investment.
Diversify. You can make a lot of money by putting all of your cash into one stock but if that stock tumbles, you're cooked. A portfolio of stocks, properly diversified in the
number of stocks held and the number of industries, will help protect you for any one position causing severe damage. Wisdom writes, "With a properly diversified portfolio, a savvy investor can
expect a 70 percent chance, or better, of making a profit." Avoid over-diversification. He recommends holding between 20 and 30 stocks
with not more than 20% coming from any one industry/sector.
Markets Change. Volatility in the stock market changes over time so get accustomed to changing market conditions. Do not sell a holding simply because volatility increases.
Beware risk. Recognize that volatility and risk are different. Keeping a stock whose fundamentals have changed and price is dropping is relying on hope and miracles to
stop the bleeding. A fallen angel is a stock that runs into trouble but can recover. A risky investment is a company that runs into trouble, serious trouble, trouble that increases the likelihood
of bankruptcy or a stock price that remains flat lined for years like a dead animal.
Learn from mistakes. Learn not only from the mistakes you make, but from those of others.
Understand risk. You have to understand risk and know when an investment is a bad idea. Gabe is not fond of momentum
trading, that of buying high and selling higher. He'd rather wait for a stock to sink low enough to be a bargain before he'll buy.
Be ready. I have a watch list that I review daily with price targets listed. When a stock drops into the buy
zone, I pounce. Investing and trading over the decades has taught me patience to wait for the right conditions before buying. Chasing a rising stock often leads to a loss.
Gabe spends time in the book discussing what a fallen angel is and how to separate them from dead animals, those stocks that won't recover. Here's an example of what he looks for
in a fallen angel.
Shareholders return on equity over 15% for 5 years.
Revenue/sales growing at least 10%.
Earnings growing at least 10% or higher during the past 5 years.
Book value is climbing 10% to 15%.
Debt to equity ratio lower than 25% (but he uses 70% for industries with high debt like utilities).
Here's an interesting tip: When hunting for bargains, take the annual earnings per share and divide it by the interest rate on a bank certificate of deposit or
Treasury bond. For example, if a company earned $2 last
year and the CD rate is 5%, then the fair value of the stock is $40 (2/.05). If the stock is trading at 80, it's much too expensive. If it's at 20, then you may have found value.
He makes an interesting claim when he writes "Going back to the 1800s, cyclical highs of the stock and financial markets occurred every nine years," with 2008 being a cyclical low.
That means we are at the beginning of a nice, long bull market.
He documents other cycles, such as an 18 year cycle for housing. The housing market tumbles for 9 years and then rises for 9 years. The cyclical high for real estate was in 2005, so
the bottom won't come until 2014.
I like checklists and so does Gabe. He presents a three-part checklist for investing, discussing each one in detail so you understand his recommendation. Here's a brief summary.
Part 1: Quality
Is return on equity over 15% in each of the past 5 years?
Are net and operating profit margins higher than the industry?
Is the debt to equity ratio below 70% or for highly leveraged industries like utilities, can they repay the debt?
Can free cash flow cover the bills with plenty left over for building the business?
Are sales and earnings growing, over the last several years?
Divide annual earnings by the interest rate a bank certificate of deposit or Treasury bond pays. Is the result above the current stock price (the higher the better)?
Divide free cash flow by the stock's price. The higher the free cash flow yield, the better. Is the result higher than others in the industry?
Is the price to earnings (PE) ratio below its historical average and below industry peers?
Is the price to sales ratio below 2 (the lower the PSR, the better)?
Calculate the PEG ratio by dividing the price to earnings ratio by its earnings growth rate. Is the result below 2 (below 1 is better)?
Is short sale interest below 8%? If shares sold short is high (over 7%), then there is a high probability the stock will drop within 6 to 12 months.
Are the insiders buying and not selling over the past 6 months?
Is the stock trading above the 50- and 200-day moving averages? A good time to buy is when the stock returns to the 50-day moving average.
Once you have bought a portfolio of stocks, when do you sell? Gabe gives three answers.
If the reason you bought the stock has changed, then sell it.
If price hits your target, perhaps sooner than expected, then dump it. Don't give back your profit by waiting too long to sell (never get greedy).
If you find a better stock, then buy it. Good opportunities are rare. Exchange the worst performing stock in your portfolio with a new candidate that has a better prospect.
Review your portfolio monthly to be sure nothing has changed and you are current on developments. At the end of each earnings announcement (that is, quarterly),
Gabe recommends you review the above three criteria to see if any of your stocks need pruning.
The preceding tips are just a few of the ideas Gabriel Wisdom shares in his book. He dedicates a full chapter on selecting real estate as an investment, for example. The
last chapter is one I wish was first. He writes about his career from a disk jockey in San Diego and Los Angeles, to getting a doctorate in Counseling Psychology, and eventually
to stocks, cofounding American Money Management and yet still finding time to talk finance on Business Talk Radio.
If you are looking for a book that explains how to screen stocks for a long-term investment, then start with Wisdom on Value Investing. You'll find it as entertaining as it is
informative. His tips just might make you a bundle of money, or protect you from costly mistakes.