Tim's Rules

So the New Year is upon us at last. I have thrown out a few ideas and predictions for the stock market in the year ahead. Hopefully these cheap stocks will allow us to make some money over the next year or two. Before we move deeper into the year  I would like to share some thoughts and ideas that might be even more helpful in approaching the markets than a handful of stock ideas.

These market maxims just might help you keep you approach to investing businesslike as Ben Graham suggested many years ago. Hopefully they give you the thought processes needed to stay calm and buy fear and sell greed. None of them are entirely original and have been stolen part and parcel form some of the greatest investors in history. They have served me well for a long time now and I hope they work for you as well.

First and foremost is book value matters. It is the single most important variable in stock selection in my opinion. You can keep the entire income statement and just give me the balance sheet. Form the absolute level of the book value and its growth rate I can determine pretty much everything I need to know about a company. Everyone else focuses on earnings and that is exactly the wrong approach.

When approaching the stock market, react do not predict. Hearing all the stories of people that successfully predicted some extreme market movement and mad a fortune make for good reading. It is usually luck far more than skilled. If you read about all the amounts of money lost trying to predict market moves you would find yourself working through a library of losses. The stock market will from time to time create an enormous amount of opportunities when fear holds investors in its chilly grip and selling is wanton. Be a buyer. When the champagne is flowing and everyone is bragging about all the money they made in the stock markets new world order it is best to be a seller.

Do not do what everyone else is doing. I talk to traders all the time about this. I patiently explain that by trading the same stuff everyone else does, they pretty much guarantee lackluster results. I suggest they focus on stocks where CEO and CFOs are buying as an example. 75% of the 350+ stocks that qualified this year went higher and the average gain on all positions was 33%. Why not concentrate on those? There is some good deal of evidence that traders would do well to culling the herd of falling knives to find those with technical or statistical tendencies to rise in the near term.

After agreeing with me that this makes sense they go on to point out that Apple’s  (AAPL)store in Billings had long lines last weekend the squiggle line is close to crossing the choppy line in an ascending diamond reverse mountain pattern and they need to jump on that sucker before it breaks out. Do not be that guy.  Look for niches and situations that give you an edge and concentrate on those situations. If you want to play around, head to Vegas for a weekend.

Investors should buy businesses, not electronic tickers. Think long term and ignore that quarterly short term focus of Wall Street. A penny or two variation in quarterly earnings is pretty much meaningless in determining what the hotels in Sunstone Hotel Investors (SHO) will be worth in five years.  Think like a private equity investor and buy unlived assets no else wants and own them for a long time. When everyone else in the market loves them and the assets sell at a premium go ahead and sell them to the clamoring public.

Scale in and out of stocks. You will never sell an exact top or buy an exact bottom. Move slow and stay small. Buy down days and sell stocks when they are overvalued a little at a time. Stocks that become overvalued are often rising in popularity and could go higher as momentum folks get involved. The opposite is true on the way down. Cheap stocks are unloved and usually being sold by the public as well as the funds. Make volatility work for you over time.

To thrive as a long term investor you must first survive.  When approaching a stock the two most important questions you must ask yourself are is it cheap and can the company survive? If the answer to both questions is yes you usually have a stock that has a margin of safety and over time the upside should take care of itself. Margin of safety first, upside second.

When selling options be aware that valuation is first and foremost as a consideration. Only sell puts on stocks you want to own and calls on stocks you wish to sell.  Sell puts as the market is declining and calls after a rise in share values. Most do the opposite but the idea here is to buy the stock below the market as it is falling and sell after a rise in prices capturing premium on both sides. Do not use margin unless you are hyper aggressive. Even then post 75% equity minimum on put sales. Most of us should post the full cost at the strike price. Sell only as many calls as you own shares of the underlying stock. The idea is to add premiums to your investment returns not make wild ass speculations on price direction.

Read everything you can. Know what’s going on in the world, in politics and in the markets.  A working knowledge of social and demographic trends and events will help you understand why a particular stock is cheap and its prospects for survival. Make it a point to read those that disagree with you and approach markets differently that you do.  Be open minded and only be dogmatic about book value.

Younger or more aggressive investors should devote a part of their portfolio to long shots. Use Value Line and S&P star ratings to find fallen angels, turnarounds and undiscovered growth stocks. Own several of them and keep the positions sizes relatively small. Ask yourself if the company can survive and why business will get better. If you are right 50% of the time you will rack up impressive long term returns on this portion of your portfolio.

 The hardest thing you will ever do is buy at the point of maximum pessimism. Buying coal stocks right now is as difficult as buying European banks was last year.  When no likes a company, sector or asset and they are selling as fast as they can it is time to evaluate the situation as a buyer. The best investments you will ever make are when you are something of a buyer of last resort in a panic.

Asset based value investing. It requires research, discipline and patience. It does work very well however and given most peoples short term focus and need for constant action it is not a very crowded field and I doubt it ever will be.

Good luck to us all in 2013.