Monday, July 18, 2011

Take Some Time to Read This Book on Investing

If you're fairly new to investing and you have not yet read Peter Lynch's One Up on Wall Street, put it on your summer reading list.
It's a story that instills confidence that you don't need to be a professional to make money in stocks. In fact, as the title suggests, Lynch shows that you actually face some advantages over those stock-picking pros.
It's a good guidebook to avoiding pitfalls and capitalizing on opportunities, written by one of the most successful investors of our time.
But one of the book's most valuable lessons for new investors lies in how Lynch simply and smartly outlines six different categories of stocks:
  • Slow growers
  • Stalwarts
  • Fast growers
  • Cyclicals 
  • Turnarounds
  • Asset plays
When we look at a stock, we should be figuring out where the company falls on that spectrum.
When we do so, it helps us to start putting numbers into context.

Comparing apples to oranges
Just this week, I came upon two fellow stock investors gazing at a computer monitor, shaking their heads. They were pointing at Netflix' price-to-earnings ratio of 82 and wondering why anyone in his right mind would buy a stock with a P/E that high.
Pfizer was selling at 20. Netflix, 82. Pfizer appeared the better bargain, by a long shot.
Problem is, you're not comparing apples to apples. In Lynch's language, you'd be comparing a fast grower (Netflix) to a stalwart (Pfizer).
If Pfizer, with slow and steady growth, were priced at an 82 P/E, it would be insanely expensive.
And if Netflix, with its rocket-fast growth, were priced at 20, it would be like discovering a box of your favorite candy bar mistakenly priced at a nickel apiece.
Another new investor told me Apple's price-to-book ratio scared him off. He was worried the company was terribly overvalued.
This was a case of an investor trying to evaluate a fast-growing tech stock as if it were a stagnating asset play.You buy Apple for its fast, consistently growing earnings.  It's not going to go out of business soon. Nor is it getting eyed up as a cheap buyout. Its book value is less important.

Pick your play
While some investors may choose to stock their portfolio with only old, reliable stalwarts, or only fast growers, I like to pick from across the categories.
I think doing so offers another level of diversification on top of diversifying across different industries.
I also think that evaluating stocks across these different categories is fun and rewarding.
Think about picking stocks the way a football team's offensive leader picks plays. He assesses the situation, considers the options, and he calls a play he thinks is appropriate.
Sometimes, it's a handoff to a back for a few yards.
Sometimes, it's a quick pass 7 yards ahead.
And once in a while, it's a long rainbow toss down the field.
A good team has to keep all of those plays in its portfolio, and all require different skills.
It's much the same for an investor.
A slow grower with a low P/E takes a clean exchange to a running back who can get you three yards in a cloud of dust.
A stalwart takes an accurate throw to a receiver who can cut sharply back for a first down.
A fast grower requires the ability to throw long and go long. Not only that, it takes the skill to throw not to where a receiver is, but where that receiver is going to be when your pass gets there.
And that's exactly what investors in Netflix are trying to do.
That 82 P/E is the quarterback's best guess as to how far down field his speedy receiver can get. If he doesn't overshoot, there's a good bet he may have a touchdown on the play.
With that in mind, Netflix may still look pricey.
But sometimes, you've got to take a shot down field.

No comments:

Post a Comment