Friday, February 01, 2008

Rule #3: Do your homework.

The importance of this rule cannot be stressed enough. Do not buy a company because its recommended by your friend or relative. Do you own homework on the company before pulling the trigger. This may include reading all available articles and press releases by the company. Reading the quarterly and annual reports and SEC filings. And even reading any analyst reports on the stock to get an idea of what others are thinking.

Ideally your homework should cover the following points.

  • What does this company do? What business is it in? How big is this company?
  • Has the company had a consistent past record of sale, revenue and earnings growth? Or is the company headed for a turn around?
  • The most important part of your homework, the investment thesis. What makes this a good investment? Is the company offering any product or services that is revolutionary or just executing better than others? Does it have a strong brand name? Or is the company just plain undervalued? Are there any business or economic trends taking place that could make this company valuable in the future?
  • Equally as important, what is the time frame for this investment? What do you estimate the company/stock to be worth by that time frame?
  • What are the risks associated with the thesis?
  • What is the exit strategy?

I have made this mistake many a time of buying companies without doing due diligence. For example, I bought this company Insteel Industries (IIIN) because I read an article at The Motley Fools about how this company has a great future. This company made steel reinforcing products, and we were at that time in a commodity bull market (and still are). The company was down from its highs, and I thought this would be a good time to open a position. After I bought it, it went down further, and I continued adding to my position, until I realized this company is going no where and sold it for a 30% loss.

Another mistake was buying the drug/biotech company called Dendreon Corp. (DNDN) because I heard a called in Jim Cramer's Mad Money show say there is a good chance that its provenge drug has shown excellent results in studies and would be announced at a medical conference. As expected, the study results were not that great, and the stock moved lower from where I purchased. But since this was strictly a trade, I cut my losses quickly.

Never buy a stock based on tip, rumor or speculation. It will more often than not leave you in a world of pain.

Thursday, January 31, 2008

Rule #2: Invest in companies with good management.

Good management is equally as important as a good product, maybe even more important. Contrary to what people think that a good product sells itself irrespective of the management, a bad management can turn a company with a good product into bankruptcy. The golden example of this rule is Krispy Kreme. This company probably makes the best doughnuts out there, but bad management has led this company to the brink of bankruptcy.

Another example of this rule is a company I invested early on called DHB Industries. This company made protective vests for army and police departments throughout the country. And various studies had showed that the product of this company was superior to its competitor. Unfortunately for the shareholders of this company, the owner/chairman/CEO was not exactly shareholder friendly. In a matter of 10-12 months, he did everything possible to erode the companies value while paying himself. In 2005 alone, he paid himself close to $100 million, threw a huge birthday party with company money (rumored to have cost $70 million), awarded himself more options vesting at below $1 when the share was dropping in value every day. Within 8 months of me purchasing this stock, its share price dropped from $12 all the way to $3. It continued to go lower, and was delisted from the NYSE and currently trades in pink slip. I even made the mistake of doubling down on this stock as it kept losing value.

Moral of the story, do not invest in company who's management's interest is not aligned with the shareholders. This most definitely results in the company value eroding. If you do want to make money off of this situation, SHORT the stock.

Rule #1: Invest in companies you know and use.

This is my first rule of investing because its a easy way to find good investments. This philosophy is something that was made popular by one of the great investors Peter Lynch. This does not mean to immediately buy every company whose product you use, but use that as a starting point to do your research.

Now when starting out to invest money, it can be difficult to trust your own instincts, especially if they are contrary to the so called market experts. I myself have fallen prey to this and lost many a good investment opportunities.

For example, when I started investing in early 2005, I was a subscriber of Netflix Inc. I loved their service, and I was so impressed that I even tried to get my friends on it instead of blockbuster. So naturally, this was one company I wanted to buy. The stock at that time was trading below $10. But this was also a stock that had dropped in value form $35 just an year ago. The reason was that Amazon was going to enter the online movie rental business, and video on demand would kill Netflix. I did do my homework and still believed in the Netflix story as they had a strong brand and good financials. But I was afraid of being a novice and not knowing what I was doing. So I just decided to follow the market experts and not buy the company. As you guessed it, within 6 months, the stock had $30. A 3-bagger in just 6 months that I missed.

I was also using XM satellite radio at that time, and did like their service. But this was a business that had never made a profit, and was eating through their cash reserves at an alarming rate. But this was a stock that was very popular with the experts, and so I decided to buy it. And the stock promptly started its decline form the high 20's to the low teens.

There are many other examples of missed opportunities with companies I loved. Chipotle Mexican Grill and Google are two of them that immediately comes to my mind. At one point in time, I used to eat from Chipotle every day as I loved their grilled chicken burrito. But when the stock became public in the mid 40's, I thought it was very pricey. I wanted it to come to the 30's before buying it. But that never happened. The stock currently is trading way over the 100 mark these days, and I missed another 3-4 bagger.

And finally Google Inc. Now this is a search engine I had used since the late 90's back in India when no one else knew what Google was. Once I found out about Google, there was no other search engine I used. But when the company when public in 2004 around $85, I didnt buy i t. My reason was that I could not understand the business. In all the years I had used Google search, I had used the sponsored links just a handful of times. And I could not understand how they could make so much money from advertising. In 2005 when I started investing, few of my colleagues had bought the stock in the $130 range. I still didnt pull the trigger. We all now know the Google story. Within a matter of 3 years, the stock touched almost $750, an easy 6-bagger that I missed.

So moral of the story is, if you like a company, and have done enough research on it, then go ahead and buy it if you like it, no matter what the expert opinion o it is. More often than not, you will come o ut ahead of the market.

Wednesday, January 30, 2008

Investment Goals

I am just listing my investment goals. These will continue to be added or modified upon in a regular basis.

  1. Average around 15% annual gains.
  2. Beat the S & P 500 by 3-5 percentage points a year.
  3. Keep learning & do my own homework.
  4. Keep number of open positions small & manageable.
  5. Try to find atleast one great investment idea every year.
  6. Pick stocks with a 3-5 year time horizon.
  7. Know in detail about every pick. Have specific price targets and stop loss points.
  8. Don't be greedy. Take profits regularly.
  9. Contribute atleast 10% of my income to my investment portfolio annually.

What I plan to do with this blog.

I have been investing in the markets since 2005, and in those years, i have made a few good investments as well as bad ones. But I never really took the time to analyze what went right or wrong in each of those investments. So I going to use this blog as an investment journal to explain my picks, my thoughts on the market as well as the do's and don't that I have learnt so far.

The first set of posts are going to focus on my investment mistakes and missed opportunities and analyze them a little bit. They will then be followed by the successful investments I have made and what went right in those.