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Passive approach

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Active approach

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The small investor vs the market

Active approach

Introduction

A portfolio reflects its owner's position and attitudes. While the passive approach is to do as little as possible, the active approach is to put maximum effort into gaining the best return. That does not mean to trade a lot, because that may in the end be counterproductive, but it means maximum effort in researching stocks before you pick them. Of course, that means investing time as well, and time is money, plus you have to be willing and able to take risk.

Strategy

Do what is unpopular on Wall Street. Popularity is a very important factor in market behavior. A business can be unpopular on Wall Street but do perfectly fine judged by the balance sheet. If you can buy a stock of a company that is simply doing well and your estimate of the real value of that company (and with that, the stock) are higher than the current market price, then you have more reason to buy it because you will have more of the thing that you think is worth a lot. In other words, you'll get the stock cheaply. So you have to look for good quality, but unpopular businesses. Unpopular on Wall Street that is, because of course the company has to sell stuff and make a profit.

Buying after bad news can be a good idea, because the market tends to overreact (see http://papers.ssrn.com/sol3/papers.cfm?abstract_id=7224). Company should be large (able to withstand setbacks), relatively stable, and selling below the past average price. Track which companies have recently hit new lows.

In 2002, Johnson & Johnson admitted that there was an investigation into possible false record keeping in one of the factories. The stock price fell, but of course it came back up. Isolated bad news events influence market sentiment, but do not necessarily mean that the company is unhealthy.

Look up what percentage of a company's shares are owned by institutions (internet). Over 60% means there is not much to discover, and it also means that if those institutions sell, the stock price will collapse.

Check comparables. Look at business segments footnote or management discussion and analysis, in annual report, typically lists revenues and earnings of each segment. Then search databases such as Factiva, ProQuest or LexisNexis for examples of other firms in similar industries that have recently been acquired. Using EDGAR you could locate their past annual reports and determine the ratio purchase price / earnings for those companies. Based on that ratio you estimate how much a corporate acquirer would pay for a similar division in the company under investigation. You may discover that the sum of all the parts is worth more than the current stock price suggests.

If the current market situation is bad, near-term prospects are poor, and the price of stocks reflects the current pessimism, buy an important cyclical enterprise, such as steel shares.

Special situations

- Arbitrages: Purchase of a security and simultaneous sale of one or more other securities into which it was to be exchanged as part of are organization, merger etc.

- Liquidations: Purchase of shares which where to receive one or more cash payments in liquidation of the company's assets.

Stock selection

Criteria for the active approach are roughly the same as for the passive approach, except that the size criterion is dropped. You could add that the stock has to have a high S&P ranking.

1. Strong financial condition. Current assets should be at least 2x current liabilities. Long term debt should not exceed net current assets.

2. Uninterrupted dividend payments for at least 20 years. It is nice if the dividend yield (ratio dividend/ share-price) is close to the yield on high-grade bonds.

3. Consistent earnings, meaning some earnings in each of the past 10 years.

4. Earnings growth. An average annual earnings increase of 3-4 % / year measured over 10 years. There should be some growth, but growth is not the main thing. More on growth stocks.

5. Moderate P/E ratio < One should adjust the criterion value based on the average of the particular industry. Selecting stocks below a PE of 15 gets you a list of banks, insurance and steel companies, all industries in which a PE that low is nothing unusual, and therefore not a good criterion level to go by. Find the PE for most industries here: http://biz.yahoo.com/p/industries.html

Management

- Are the financial statements understandable?
- Are nonrecurring and extraordinary charges really rare, or rather common?
- Are managers talking about the business or about the stock price?
- Stock options should not be more than 3 % of shares outstanding
- Back page of annual report lists heads of operating divisions. If many names change during the first one or two years of a new CEO, that is fine. If it continues, it means things are not going well.

Warren Buffett's approach

Look for companies with strong consumer brands, easily understandable businesses, robust financial health, near monopolies. Buy when there is ascandal, big loss, or bad news. He likes managers who set realistic goals and do not take a mega salary. He wants steady and sustainable growth. Buffett's annual reports can be found at www.berkshirehathaway.com. worth reading.

Practice before going out there

Practice picking stocks for a year or so (Patricia Dreyfus, Investment analysis in two easy lessons (interview with Graham) Money, July 1976 p.36). Nowadays, this is easy, using free online portfolio trackers on http://www.morningstar.com, http://finance.yahoo.com, http://money.cnn.com/services/portfolio. By practicing without real money, you can make mistakes, develop discipline, compare your approach to leading money managers, and learn what works for you.

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