Knowledgebase, Newly Revised, Part 2

Some ideas for evaluating a new company.

  1. Go to the company website and find out what they do. To get there, google, for example, “Zillow investor relations” and you’ll get the Zillow investor relations website.

  2. Read the text part, at least, of their last quarterly report. “Analyzing the financials” sounds intimidating, and probably isn’t necessary. They usually tell you what is going on in words.

  3. Read the transcript of the conference call. You should be able to find it on Seeking Alpha “Zillow Q1 2015 Transcript” should get it. (Yep, I put it in on Seeking Alpha and it came right up.)

  4. Go back through at least two years of quarterly reports and pull off at least adjusted earnings and revenue. Make a table for each. Let’s look at stock ABC. Here’s what their Revenues looked like:

2012: 18 24 25 33 = 100
2013: 32 39 51 56 = 178
2014: 56

You see what a good visual image this gives you. You can see both sequential change and year-over-year change at a glance. And that 78% increase in revenue from 2012 to 2013. And other patterns jump out to the eye as well. For example, you notice that earnings don’t rise between the fourth quarter and the first quarter of the next year (it’s called seasonality), and then they do rise in the second and subsequent quarters. When that happens in the future it won’t bother you because you’ll say “Oh yeah, their first quarter’s usually flat with the quarter before.”

Here’s Adjusted Earnings, showing an incredible rate of growth.

2012: 02 04 08 08 = 22
2013: 08 10 22 19 = 59
2014: 19

Then do a running 12-month trailing earnings:

12 2012: 22
03 2013: 28
06 2013: 34
09 2013: 48
12 2013: 59
03 2014: 70

This gives you a picture of where they are going and how fast. You should graph this on a piece of log paper. (On log paper a move from 10 cents to 20 cents is the same length as a move from 50 cents to a dollar (100%)).

For contrast, here’s the earnings for DEF. Regular good growth, but not as fast. Since ABC is growing a lot faster it will probably sell at a higher PE than DEF. There’s a limit how high a PE you should pay for rapid growth though.

2012: 58 64 67 70 = 259
2013: 74 78 85 91 = 326
2014: 100

12 2012: 259
03 2013: 275
06 2013: 289
09 2013: 305
12 2013: 326
03 2014: 352

A quick glance will show you that DEF does not have the same seasonality, but rises a little each quarter.

Here’s another a nice way to evaluate companies for investment.

  • Look at Cash Flow. You want to make sure the company is self-sustaining, producing positive Free Cash Flow, and not eating away at its Cash Balance. You’d also like to see Free Cash Flow grow from year to year.

  • See if Revenue is growing year over year, and whether operating expenses grow at a slower rate so that Operating Margins can increase as revenue expands.

  • Make sure that the share count is not increasing unreasonably fast.

  • Divide the Market Cap by Free Cash Flow to get the P/FCF ratio, an analog of a P/E ratio. It should also be somewhere in the 20’s or so, depending on rate of growth.

  • Check levels of cash and debt.

  • Look at the 10K to evaluate the business, its competitors and its risks.

  • Read the last couple of conference call transcripts to see how management feels about the business and its future prospects.

A COMPANY may do well, but the STOCK may do poorly, if the stock price has too much growth already factored in.

To get an idea how my method of evaluating stocks works, here’s a post I made on the XONE board a few years ago when MF was touting XONE as the next greatest thing and the price was $59.

“Why would a stock with negative earnings, that has never had a profitable year, be selling at such a huge inflated price. Granted, some is about prospects for the future, and some is the 3D printing hype, but some must be hopes of the company being acquired. Look, last year they lost $10.2 million on $28.7 million of revenue. That’s a negative margin of 35.5%. It means they lost 35 cents on every dollar of sales!!! They lost 20 cents this quarter in spite of great revenue. Say that by magic they overcome the loss in the next three quarters and finish the year with 25 cents profit. I’m not rejecting the possibility. With that miraculous result, they’d then be selling at over 200 times earnings. (220 times to be exact)…What can I say? I think the technology and the company may have great futures, but the stock may be miles ahead of itself. Miles and miles and miles. I may be totally wrong, and greatly underestimating, but it’s worth considering those figures.”

That post got all of two rec’s! No one listened. XONE’s price as I write is $11.50, less than a fifth its price of $59 when I posted that evaluation. And it was finally sold by MF last August, down 82.9% from the recommendation. Eventually it may turn around and start making money (or be acquired), but there was a lot of opportunity loss for anyone who has held it all this time. Tell me again how it’s always a mistake to sell out of a position. Intelligent stock picking (and selling) does pay off. And buying stock in companies that are losing so much money that they’d have to quintuple their revenue to break even is not a smart move.

Given a choice between a low PE company and a high PE company, growing at comparable rates, I’d go for the low PE company every time. Which is why my big positions all have reasonable PE’s. What’s reasonable? You might say a PE of 15, I guess, if you were talking about conservative, slow growing, Dow-type stocks. Mine are much faster growing. If I can get that rapid growth at a PE of 15 to 25, I consider that cheap.

Why some stocks are priced unreasonably high and others are not.

  • Public Facing: Everyone has heard of Amazon, and most people have bought something from them. It gave the illusion that they were very profitable (they weren’t for a long time). AMZN got a big PE.

  • Boring: Railroads are boring. The MF SA board for WAB has had a total of 174 posts since it was recommended back in 2012. The MF HG board has had 38 posts total since 2012. That’s 38 posts! The fact that the stock wasn’t boring, and almost tripled in price from mid-2012 to mid-2015, didn’t matter.

XONE and WPRT had exciting stories and lots of posts. The trouble was that neither of them had ever made a dime of profits. They crashed.

  • Glamorous: UA has glamor. You see it on TV at all the sporting events. SKX has earnings growth. Who gets the high PE? I’ll leave it to you to guess. At the time I wrote this, UA’s trailing earnings the previous three years were

61 cents
75 cents
95 cents
Did that warrant a PE near 100 times earnings???

SKX’s trailing earnings the previous three years were (they have since split 3 for 1)

Did that warrant a PE of under 25??? But Skechers shoes are comfortable and boring.

And with UA making 95 cents a share and growing slowly, and SKX making $2.99 a share (more than three times as much), and growing rapidly, which had the higher share price? UA! Based on these facts, would you pay more for UA stock, just for the glamor? People did! It’s insane!

Here’s a new metric - The 1YPEG - Normally a PEG ratio is the PE ratio divided by the estimated average earnings growth rate for the next five years. But that’s a total guess! No one knows what a company’s average earnings growth rate will be for five years.

Perhaps a more useful ratio is a one-year PEG looking backward. In other words, the one-year trailing PE divided by the one-year trailing earnings growth rate. It has a major disadvantage or flaw that you are looking backward, but at least you are using a real number, not a guess! Who would have dreamed at the end of 2012 that SKX would have 1500% earnings growth in the next two years? I guarantee you, no one! A five-year estimate is nonsense.

A growth rate the same as the PE gives a PEG of 1.0. A faster growth rate gives a lower PEG. A slower growth rate gives a higher PEG. The examples below are out of date but are presented as examples:

SWKS had a PE of 25 divided by an earnings growth of 64% so its 1YPEG was 35/64 = 0.39

MIDD had a PE of 31 divided by an earnings growth of 24.5% so its 1YPEG was 31/24.5 = 1.26

(SWKS was growing faster than its PE and MIDD was growing slower than its PE).

Please remember that the 1YPEG isn’t a magic formula that replaces everything else. It’s just a screen of how the PE stacks up to the current growth rate. It doesn’t replace evaluating the company, and what it does, reading the conference call transcript, making sure the company isn’t weighted down with debt, and all the other factors I’ve talked about.

And its also important to realize that a low 1YPEG doesn’t protect you from a ridiculously high PE. The low 1YPEG just means that earnings are currently growing even faster than the high PE, but super-rapid growth can’t be maintained for long, and when the growth rate comes down, the PE and stock price have a long way to fall. I have found it also helps to make a guess of what I think the rate of growth of earnings will be for the year to come as well, and compare that to the PE. (That’s only a one-year guess).

I also consider acceleration or deceleration of earnings. They show up nicely on my trailing earnings monthly graphs. I have a very nice visual of an ascending line. This is at about 45 degrees for stock ABC, for instance, showing consistent growth of about 30% per year. Stock DEF goes about straight up (coming off a small base), but because of the law of large numbers it’s starting to slightly flatten from perhaps an 80 degree ascension to a 60 degree one, and I can see that it is starting to slow down. GHI was rising at about a slower 20 degree slope but the last two quarters the slope has changed direction and is angling down, meaning they have had negative comparisons.

I’m not sure I can come up with a single calculation that will give you all the information that goes into my thinking about a stock. Often the CEO’s explanations in the conference calls play a considerable role, along with the rate of growth, the company’s competitive position, the PE, how much is recurring income, and other factors I’ve already discussed.

Looking into the future of a stock: Let’s look at imaginary stock ABC, which has a PE of 45, and a TTM earnings growth of 45% as well. At a PE of 45, their stock price is inherently unstable. By the law of large numbers, that rate of growth is going to come down. For example, say this year their earnings “only” grow 30%, which is certainly not bad. But if their PE stays at 45, with a growth rate of 30% they will appear overpriced. Indeed, they’ll BE overpriced. To get their PE down to 30 their stock price will actually have to grow slower than 30%. It’s a double hit. Here’s the calculation:

Year 1 - Earnings $1.00, stock price $45, PE 45

Year 2 - Earnings $1.30 (up 30%). To get to a PE of 30 we take $1.30 times 30 and we get a stock price of $39!! So the stock price will actually have to fall during the year from $45 to $39 to accommodate the new 30% rate of growth and give a PE of 30! Even though earnings were up 30%!

This is why high PE stocks are dangerous !!! Stocks whose PE’s are actually higher than their rate of growth are even more dangerous. Low PE stocks are much safer.

## Portfolio Management

The number of stocks in my portfolio waxes and wanes according to a number of things, but probably never is less than 10, or more than say 25. Okay, so what makes the difference?

A. If I have stocks that I have strong convictions about I will tend to add additional funds to them instead of looking for new stocks, and I end up with a more concentrated portfolio.

B. If I have less conviction, or if some positions have become too large, I will try out a lot of smaller positions in order to decide which ones I should add to and make into ongoing positions.

C. Consider, for instance, if something were to happen and I were to have to exit my largest position now. That would be a big part of my total portfolio. I wouldn’t put that much into any one or two new stocks, nor would I add that much to existing positions. I’d probably have to reallocate the money to five or six smaller (3% to 4%) positions, and maybe one or two “put it on the radar” (1% to 2%) positions.

D. When the market tanks irrationally, I tend to reduce or eliminate the stalwart stable stocks that haven’t declined much, the WAB’s and CASY’s for instance, and reinvest the money in the great, fast growing stocks, which have declined a bunch with little or no reason except that the market is falling. This also tends to concentrate my portfolio. I might buy some of a new stock that has fallen in one of these panics, but it’s difficult emotionally to put money in an unfamiliar stock when there’s panic all around.

E. When I think my main stocks have gone up irrationally, are over-extended, and the positions have gotten too large, I tend to trim them and put some of the funds back in the stable stalwarts and some in new “try-out” stocks. This increases my number of stocks. (This is similar to B.)

I really like it better when I have fewer, but high conviction stocks. I’m more comfortable, and I can probably make more percentage gain for my portfolio with 12 positions than with 24. Fewer are easier to follow, and the chances of finding 12 that will average 25% gain (if you can find them), is MUCH better than the chances of finding 24 that will average 25% gain, and HUGELY better than your chances of finding 100 that will average 25% gain.

When do I sell?
I tend to sell a piece if my position has gotten too big for me to be comfortable with. However, I have let rare positions get very big if I was in love with the company.

I tend to sell a piece if I feel the price has shot up wildly. On the other hand, a stock might go up steadily, but if my position isn’t too big, the rise isn’t too fast, if their revenue and earnings are moving up nicely, and if the PE is still under 25, I may add multiple times along the way instead of selling. In other words I don’t sell just because something is going up.

I tend to sell a piece if I feel the story has changed. I had IPGP for a long time but when they seemed to be turning into a slow grower, I reduced to a half position, and then sold out. I sold out of ISRG because of all the bad publicity with the head of the GYN Association saying it was overused and of no additional benefit. While they will continue to do well I figured that hospital boards would hesitate longer before buying a new machine, and with a high PE, a slow down would drop the price. Well, they pre-announced a slowdown in revenue and they went down $90 in a day. Many RB’ers were still in it, but it seemed to me that the handwriting was on the wall.

There really are some times when it makes sense to sell a stock. Saying that “it would be better if I held” because at some time in the future the price may go back up up is not valid (it’s silly, even). Just think of a stock that you sold at $200. It dropped to $50. It gradually came back and now, 5 years later, it’s at $220. Would you say it would have been better to have held because it’s now up 10% in 5 years!!! That really is silly. You could have thrown the money at a dartboard of MF recommendations and beat that result by 500%. And could have done lots better than that by intelligent picking.

There’s a big opportunity cost to leaving your money in a stock which keeps going down, and then stays down, as well as whatever paper loss you have.

Here was another post where I described what I do when I need cash for an attractive opportunity:

(1) sell a little of stable, slower-moving companies that I have confidence in, but which haven’t fallen hardly at all and which aren’t going to run away from me when the growth stocks start back up.

(2) sell high flying stocks with earnings growth that doesn’t warrant their high PE, and which therefore seem vulnerable.

(3) sell my little experimental positions in stocks which may turn out well in the future, but where I have surer places to put my money.

(4) sell stocks which may not be losing money, but where earnings are disappointing (even if they may have good excuses).

Since I’m almost always nearly 100% invested unless I’ve recently sold out of a big position, I often don’t have the money to take a full position all at once. If it’s something I absolutely fall in love with, I’ll jump into it right away with whatever money I have available, and will likely trim some other large positions to fill out a full position. If I’m not sure, I’ll take a small position to put it on my radar. I then may start adding more as money becomes available, often building to a “full” position, which for me is an average-sized position, not an oversize position. I may do this fairly rapidly, or if I’m building two or three new positions I may have to split available funds between them. Or as I get more familiar with the stock that I’ve taken a starter position in, I may say to myself, “This is stupid, it’s not my kind of stock”, and sell out of my starter position. That does happen.

I usually keep enough for several months worth of living expenses in my checking account that I have withdrawn from my brokerage account. I don’t count this as part of my portfolio.

We all tend to get worried or elated over moves of our stocks with no news attached. This is usually random noise. For a trivial example, say your stock dropped from $58.70 to $58.30 from Thursday to Friday. Did anything happen that caused it to be worth 40 cents less on Friday? Of course not. The message in all this is to keep your eye on the company, and how it’s doing, and not as much on the stock price.

## Adjusted (Non-GAAP) vs. GAAP Earnings

I use adjusted results because they tell you what the real company is doing. I pay no attention to GAAP earnings and only look at non-GAAP or adjusted earnings. I know this bothers some people, but it’s what I do. I feel that GAAP earnings ridiculously distort the picture. (Consider company X that has a big tax benefit this quarter and reports huge GAAP earnings, and then next year they pay normal taxes and looking at GAAP it appears as if their earnings have tanked, just for a trivial example. Or company Y that has outstanding warrants. If their stock price goes down, GAAP rules makes their apparent GAAP earnings go up due to repricing of warrants. Just nonsense. I especially remove stock-based compensation as an expense).

I ignore the stock-based compensation because it is already accounted for in diluted shares. More shares reduces earnings per share. Taking it also as a non-cash expense double counts it, which is why almost every company that I know of subtracts out the stock based compensation non-cash expense when they figure adjusted earnings or “real earnings.”

I don’t like excessive stock compensation either, but you have to remember that at most small technology companies, that is most of executive compensation, as the companies don’t have much money. It also allies the insider’s interests with ours if they have options that are only valuable if the price goes up.

In the earnings press releases, management almost always gives a reconciliation between adjusted and GAAP figures. You can see exactly what they leave in and take out so you aren’t taking it on blind trust. If I have confidence in management, I just use the adjusted earnings they give. If I start messing around and adding and subtracting things I won’t remember next time what I did and why, and also the earnings won’t be comparable with past and future earnings. On the rare occasions that I do eliminate something (a big swing due to foreign exchange gains or losses, for instance), I make a big note in red in my notes so I’ll remember to eliminate the same thing next time. This perhaps sounds overly trusting, but what I’m aiming for is seeing how the company has been functioning over time, and accepting management’s adjusted earnings usually works for me. After all, they are trying to evaluate the same thing.

It’s important that you realize just how insane some GAAP rules are. Let’s consider company ABC, which makes engines, and has some outstanding warrants. What would happen if some terrible news came out during the next quarter? For example, if a big new engine had a bunch of defects, or a new competing product showed up which was taking lots of their customers. Their revenue would drop like a rock, and their stock price would crash (for good reason!).

GAAP rules for repricing the warrants would mean that because the stock price plummeted, the company would show huge (imaginary) INCREASES in GAAP earnings for the quarter!!! And this is from a system that is supposed to be giving the public a clearer idea about what is really happening at the company!

(For those who wonder what their rational is, it’s: stock price down = obligation from warrants reduced = more GAAP “profit”)

By the way, analyst earning estimates are almost always adjusted earnings too, as far as I can tell. Also the companies’ disclaimers almost always specify that they use adjusted earnings for their own internal evaluations of how the company is doing. They often give GAAP results as a formality, and then base their entire discussion of results on adjusted results.

For those who think that GAAP are the only valid earnings, and that Non-GAAP are just “cheating,” these were the latest PSIX results, at the time I wrote this:

GAAP earnings: 68 cents
Adjusted earnings: 39 cents

WHOA! Adjusted just about half of GAAP? It’s supposed to be the other way around! How can that be? Because, as usual, GAAP has a lot of nonsense in it:

  1. GAAP was up because the stock price was down so they had to reevaluate the “liability” of the warrants downward due to the lower stock price. This gave more GAAP “earnings”. (Note that if the stock price had been up, repricing of the warrants for more liability would give lower earnings. If you think that makes sense, well…)

  2. In addition, GAAP income included a non-cash gain resulting from a decrease in the estimated fair value of the “contingent consideration liability” recorded in connection with an acquisition. This also gave more GAAP earnings.

Now if you think GAAP gives a better idea of how the actual business did in the quarter, be my guest. As I said, it’s nonsense to me.

[The following entry was from a great post by ptheland]

At its core, accounting is an attempt to present the financial performance of a business so that management and investors can make intelligent and informed decisions about the business. Income is reported when earned, expenses reported when incurred, assets and liabilities of the business fully disclosed.

However management always has more information about the business than investors… so management can mislead investors about the finances of a business. Many of our current accounting rules are nothing more than a reaction to a problem (usually a fraud by management) that has arisen at some company. If you follow all of the big frauds over the years, you’ll usually find some new accounting rule following the fraud that is an attempt to keep that fraud from happening again.

You simply can’t write rules that cause people to behave morally … Laws and rules simply define behaviors that will be punished in some way. Investors are entirely reliant on management for their financial information… Dishonest management will create dishonest reports. Honest management will create honest reports.

What does this say about GAAP vs. Adjusted Earnings? It says we need to look at management first. Financial reports that follow GAAP don’t necessarily give a good picture of a business, they simply follow the rules laid down by GAAP. Adjusted earnings can be a good thing when honest management is attempting to give investors a more complete picture of the business than can be conveyed in GAAP financial statements. But adjusted earnings can be used by dishonest management to cover up problems.

So I’d say the first step in evaluating a business is to look at their management. Honest management will give honest financial statements. Dishonest management will give dishonest financial statements - even if those statements follow GAAP.

So, do I choose GAAP or Adjusted? Bring on the Adjusted! But it is up to me to do my due diligence and evaluate management.

What if a company only provides GAAP earnings in their press release? It’s usually pretty quick and easy to make your own approximate adjustments. Someone mentioned that IPGP, for example, only gave GAAP earnings. I went to their press release. I scrolled down past the text and I came to the first table called Consolidated Statement of Income (that’s the usual one where they give revenue, expenses, net income taxes and earnings per share) and just below that was Supplemental Table of Stock-Based Compensation. Couldn’t be more convenient. I decided to see how long it would take to get their adjusted earnings.

On the first table:

Income before taxes $89.7

Taxes $26.9

I divided 26.9 by 89.7 and discovered they are paying a 30% tax rate.

On the second table:

Total Stock-based Compensation $3.5

Adding Income before taxes (89.7) and St-B Comp (3.5) and I get $93.2 as new Net Income before taxes.

Now 70% of that (or 65.2) will be net income after taxes.

Divided by number of diluted shares or 53.4 gives me $1.22 per share (up from $1.18 GAAP).

That took me two and a half minutes with my little pocket calculator. Note I rounded everything off for simplicity. It took me a lot longer than that to write it up for you afterward.

Note that the table under that shows Acquisition Related Costs and has Amortization of Intangible Assets. They put that little table there because people usually add Amortization of Intangible Assets back in, as well, in figuring adjusted earnings. I didn’t bother with it though since in this case the amount was trivial and only would change things by a half a penny, and I was trying to keep the calculation simple. But that gives you an idea.

Note that you can’t always find Stock Based Compensation in the press release. Unfortunately, sometimes you have to track it down in the SEC filing. The good news is that most companies give you adjusted or Non-GAAP earnings straight out in the press release and you don’t have to do any of the calculations yourself.

## What is my Buying Policy?

What is my buying policy? I actually don’t have a fixed buying policy. That means you can rule out cost-averaging over a predetermined time. I never do that.

You can also rule out: “I am tempted to just start waiting a bit longer until the right opportunity arrives.” If I like a stock enough to take a position, I will always take at least a starter position, and figure on adding later. I never wait for the “right opportunity” to take a starting position. I do add to a stock when it goes down for no reason on an opportunistic basis, but you can’t take that as a rule, as some of my most profitable deals ever I kept adding on the way up, instead of on the way down. (If I start buying at $25, adding at $28 or $31 might seem expensive, but when it gets to $75 or $120 the difference between $25 and $28 will seem negligible. Also if it’s at $25 and I wait for $22, to buy at a “cheaper price,” I’ll really kick myself when it’s at $120 and I never got in because of waiting for a cheaper price.)

As you can see, there’s no clear rule, but I was able to rule out two approaches (buying thirds at predetermined times and waiting for a cheaper price to add).

Remember you’re not locked in. Not infrequently I decide my initial purchase was a mistake, I don’t really have faith in this stock, and I sell out at a small profit or loss.

On the other hand, if I’m really excited about a stock I’ll take a substantial position right from the start. I’m more likely to do that with a MF recommendation (because there’s a board with other people following it that I can use for a resource) than with a little stock I found myself. But I occasionally change my mind on those too.

Since I’m almost always nearly 100% invested, I often don’t have the money to take a full position all at once. If it’s something I absolutely fall in love with, I’ll jump into it with whatever money I have available, and will likely trim some large positions for more cash. If I’m not sure, I’ll take a small position to put it on my radar. I then may add more as money becomes available, often building to a “full” position, which is an average-size position, not an oversize position (which stocks have to grow into). I may do this fairly rapidly, or if I’m building two or three new positions I may have to split available funds between them. Or as I get more familiar with the stock that I’ve taken a starter position in, I may say to myself, “This is stupid, it’s not my kind of stock”, and sell out of my starter position. That does happen.

Never miss getting into a stock because you are waiting to buy it cheaper. The decision is whether you want to invest in it or not. Once you decide, take a starter position, at least. Don’t wait around for a slightly better price.

Price anchoring is a BIG mistake. Treat a company as if you had just encountered it, and then decide, based on its current earnings growth, PE ratio, prospects, price, etc, whether you want to buy it now. Where the stock price was in the past is irrelevant. You can’t go back and buy it at that cheaper price where it was two months ago.

When the whole market is falling, putting more money into your favorites usually works out very well in the end. On the other hand, when one stock is falling off a cliff in a rising market, it usually means that something is very wrong. Putting more and more money into it on the way down is usually very dangerous, and a way to lose a lot of money.

If the stock is going up, it generally means the hypothesis upon which you bought the stock is working out the way you hoped. The business is doing well, revenue, earnings, cash flow, and all the rest are going up. I’m glad to add to an idea that is working out. If it’s going up wildly on just hype I won’t add.

There are others who like to “average down,” which sounds good, but it often means buying an idea that isn’t working out (watering the weeds, making excuses for bad news). Oh, sure, if my original purchase was at $73, and a week later it’s at $71 because the market is down a little, I might add a little. That’s just random noise. But if they come out with really bad news or a bad report and the price is dropping like a rock, I’m not one to say, “Oh, they’ll get it figured out. I’ll buy at this cheaper value.”

I saw the following question on a MF board and thought it typified what I wouldn’t do. Here’s the question: “With the disappointing XYZ results, is XYZ a buying opportunity?”

I didn’t know anything about XYZ, nor did I read their results, but the general idea of buying more of a company because it had bad results and the price fell, and thinking you are getting a bargain seems foolish to me.

There are exceptions: If a stock, after reporting excellent earnings, falls off a cliff because it didn’t meet estimates, or some such nonsense, but I know what the news was, I read the conference call, and I know there is nothing wrong, at least that I could see, I don’t hesitate to add. (Maybe some hedge fund got a margin call on another stock and had to raise cash in a hurry and so had to liquidate my stock at whatever price they could get. Who knows? Irrational things happen.)

You can’t buy all the great stocks! (unless you run a big index fund yourself). Some stocks you pass on will go up. It’s guaranteed! Personally I don’t even think about them. I just care about how the ones I bought are doing. (THIS IS A KEY POINT, READ IT CAREFULLY!)

Where do I get my stock ideas? Many of my stocks were MF picks (mostly RB, actually), although I had invested in several of them before they were picked by MF. As I indicated above, I really prefer to invest in MF picks because the discussion boards and continuing coverage is incredibly important to me.

People on our board have introduced me to a number of stocks with their posts (INBK, CRTO, INFN, EPAM, PN, MITK, just to mention a few).

I got SBNY from a newsletter published by Ophir Gottlieb at Capital Market Laboratories.

I’ve gotten some stocks from random Seeking Alpha articles.

I got a couple of stocks over the years from a newsletter called Stock of the Month, published by Street Authority. Note that these newsletters have no discussion boards and no real ongoing support, such as you find on MF.

I got a number of stocks from Zack’s Home Run Investor. The author of the newsletter often seems only to know that analysts are raising estimates (which is Zack’s thing). Most of the companies don’t interest me at all, and you really need to research them yourself, but there’s an occasional pearl.

I’ve also gotten ideas from news articles and from random posts on all the MF boards where people mention some company they are interested in.

## What is my Selling Policy?

I tend to sell a piece if my position has gotten too big for me to be comfortable with. Usually, that means more than 12% to 15% of my portfolio. However, sometimes I have let rare positions get to 20% if I was madly in love with the company.

I tend to sell a piece if I feel the price has shot up wildly.

When I’m thinking of selling I seem to sell a little first while I’m evaluating, then decide for sure what to do. I might even decide to buy back the little piece I’ve sold if I reconsider.

One problem investors have is getting attached to their previous decisions and not willing to consider that they may have made a mistake. Not accepting that an investment could be a mistake is a dangerous error. I try to always reevaluate my investments and get out if I’ve made a mistake, or if information changes. Which is why I don’t hold stocks generally for 5 or 10 years.

I always buy with the idea of holding indefinitely, never with the idea of a short holding period, but in practice I guess my average holding period is six months to three years.

As far as holding “until you are convinced something significant has changed,” I sometimes define “something significant has changed” as the price and PE ratio getting wildly high, at which point I will at least reduce my position. If a stock seems overly extended, I usually won’t sell out completely, but I’ll trim my position a little. Then if it goes up even further, I’ll trim a little more. If it drops back substantially, I might buy back some or all of what I’ve trimmed. I usually won’t sell totally out of a position I’m very happy with though, just on the basis of valuation. I definitely don’t sell winners that have had a run-up as a policy. I only sell if I have a specific reason.

We all often worry when stocks we have sold go up. I try to ignore them and figure that once they are sold they don’t matter any more. Here’s a great quote from Huddaman: “I don’t really need to be right for the stocks I sell, I just need to right about the stocks I own.” Boy! Doesn’t that really say it all! It simply doesn’t matter what happens to a stock after you sell it.

You can’t hold all the stocks in the market. Some stocks you don’t hold are going to go up. A lot! So what!!! The only thing that matters is what the stocks you are holding do!

Selling out at the bottom, when everyone is panicking, is not a good outcome. The time to have gotten conservative, and sell the wildly over-extended stocks, was when everything was booming.

On the other hand, when the market is down, selling low-beta stocks that haven’t fallen much, and thus have less to rebound, can be a good source of cash to buy stuff that has fallen a lot.

There’s no such thing as “I was so far down I couldn’t sell”. The stock price has no memory of the price you bought it at. It’s at the price it’s at. That’s the reality of now. The question about any stock is “Where is it going from here? What decision should I make about it now, at its current price and its current prospects?” Not: “What price did I pay for it?” unless you are planning for tax losses or gains.

Again, you don’t have to be right about the stocks you sell, just those you hold in your portfolio.

Do I wait for long-term capital gains? My results are for my entire portfolio, which includes various accounts, some taxable, some not.

Most positions I’d exit short-term would be losses or small gains. If a stock was really doing well I’d be more likely to add to it. If, for some reason, like a major change in the fortunes of a company, I had to get out of a position with a significant gain, I would do it in all my accounts, taxable or not.

Normally, to get to be a big gain it would mean I’ve held it for a year at least. It would be rare that I would be selling out of a stock with a significant short-term gain. So let’s say I do sell $120 worth of stock on which I have a $20 short-term profit. The key is that the tax is not on the whole $120, it’s just on the $20 profit. The difference in the short-term tax on that $20 profit and the long-term tax might be about $4.00. Should I risk the entire $120, keeping it in a stock I’m worried about, because I’m worried about $4 in taxes? When the stock could easily drop more than that $4 in a few days? When I could redeploy the money in something I prefer? I don’t think so.