September 14, 1998

[Ed. Note: The following Fool on the Hill column was originally published on Nov. 12, 1997.]

An Investment Opinion
by Randy Befumo

When NOT to Invest

Unfortunately, many investors who are seduced by the lure of easy money try to become "active" investors before they have the skills, the resources, or the appropriate intellectual framework to do so. This is not to say that investing in stocks is extraordinarily difficult -- it is not. However, beating the market on a regular basis is far from easy and requires that an investor bring to the investing process a singular discipline, knowledge, or passion that will allow him to rise above the herd. Like any other competition, not everyone can win. In fact, net of new cash in-flows into the market, for every dollar that outperforms a market index, somebody else's dollar is not doing quite so well.

How can you tell if you are ready to become an "active" investor? Not an investor who buys and sells stocks on a regular basis, but active in the way the academics mean it -- someone who selects his own stocks. It is not like there is a licensing process or anything. In fact, there is not even a formal course of instruction. Much like parenting, you tend to find out if you are really cut out to be an investor only after you have made a pretty substantial commitment. Today, I want to give some pointers based on some recent e-mail I have received in an attempt to give some guidance as to when you should start buying your own stocks.

In my opinion, you should NOT be investing in stocks...

...if you need the money within two to three years at the least, five years as an intermediate time, and ten years if you are really risk averse.

...if you don't like to do math.

...if you use the word "play," "gamble," "flyer," or any similar speculation-oriented word when you describe your investments.

...if you think indexes matter more than what companies you own.

...if you are unprepared for volatility. A lot of people look at the returns for the stock market only to turn pale at the first loss. If you cannot stand to lose money, you should not own stocks. Period.

...if you think you will only ever buy stocks that go up. News flash -- you are not perfect. No system is perfect. No provider of advice is perfect. You can -- and will -- lose money at some point during your investment career. You can minimize this loss if you do your homework and are careful about valuation, but money lost is money lost.

...if you believe that the share price alone or share price movements alone tell you anything about the underlying quality of the company or its business. All too often people buy low-priced shares with the idea that they are cheap, only to find out that they are low-priced because the underlying business sucks.

...if you couldn't write down a list of why you bought and what might make you sell. If you don't know why you bought a stock in the first place, how can you know when to sell it? Bad scene. Avoid it.

...if you cannot tell the difference between a balance sheet and an income statement. Especially if you don't even know where to find a copy of either.

...if you don't know how to get the phone number for Investor Relations at the company in case you have question.

...if you cannot make a rudimentary assessment of the underlying quality of a company.

...if you cannot define any of the following words: gross margin, operating margin, profit margin, earnings per share, costs of goods sold, dilution, share buyback, revenues, receivables, inventories, cash flow, estimates, depreciation, amortization, capital expenditure, GAAP, market capitalization or valuation, shareholder's equity, assets, liabilities, return on equity.

...if you only have one source of information about the company. I don't care whether it is your best friend, a message board, or some content provider. If you cannot independently verify the facts, you are bound to get unintentionally bamboozled. No one likes to admit he is wrong. If you depend on one source of information, odds are when it finally coughs up the conclusion that it made a bad call it will be too late.

...if you cannot name the major products a company makes or the company's major competitors.

...if you only use one technique to value a company. That is like using one tool to build a house. The house will look like crap and be unlivable. Sales, earnings, cash flow, assets, historical returns, management, underlying quality... are just a few of the ways you can value a company. Don't use only one tool.

...if you don't understand that the earnings estimates you get lag real time. Someone recently wrote to FoolNews commenting that a disk drive-related company looked cheap at five times expected earnings. Unfortunately for that investor, in the past week the earnings estimate had dropped by more than 50%. As estimates are only published once a week for individual investors, if something suddenly changes, the estimates can be very "stale." If that investor had not been following news in the drive industry, he might have made a potentially disastrous investment.

...if you don't follow up on a company at least four times a year. Preferably once a month. These are big investments you are making relative to your savings... put some sweat equity into them.

...if you don't use the Internet. Seriously folks, come on. Almost all of the disadvantage of being an individual investor from the information side was erased by the Internet. If you aren't on it, you are at a major disadvantage to all of the other players. It is like trying to wrestle with no limbs.

...if you buy a stock simply to sell options. Although some might try to convince you this is a conservative, income-oriented approach, the reality is that if you are getting decent premiums for selling the options, you are taking on a lot of risk owning the equity.

...if you refer to management by their first name. This may seem churlish, but nine times out of ten when management is known by their first names the investor has lost all objectivity about the investment.