Economy, how do you frighten me? Let me count the ways.
- Despite a recent string of pauses, the Fed has been raising interest rates over the past year, which can be a precursor to a bear market.
- The yield curve is flat, bordering on inverted, which often foreshadows a recession or even a depression.
- There might be a housing bubble (or there might not be, or there might be), and rising interest rates are finally starting to hit that market. Consumer spending has been driven by people cashing in on the cheap equity in their homes. Who knows what will happen if housing prices fall -- reducing homeowners' equity and their ability to use that equity to buy new gadgets from, say, China?
- Consumer debt ratios are already at all-time highs.
- And then there's the dollar. We're running record budget deficits and record trade deficits -- meaning that other countries are lending us money so that we may sustain our lifestyle. If they pull the plug on us, we could face a plummeting dollar -- likely resulting in inflation, stock market troubles, and a real decline in both wealth and income. (Wow, I haven't even mentioned war, terrorism, hurricanes, rogue waves, oil, derivatives, secular bear markets, or Sith Lords.)
Luckily, what's bad for the economy isn't necessarily bad for investors.
Pulling the wool
The media loves to focus 90% of its attention on these issues because they're exciting. But when it comes to investing, they're less than 10% of the story. Ours is arguably the most resilient country on the planet. Last century, we faced World Wars I and II, the Cold War, the Great Depression, the failure of numerous banks, the impeachment of one president, the resignation of another, an oil shock, interest rates rising from 2% to 15%, several stock market crashes, and, of course, disco. We didn't just survive -- we overcame these challenges and prospered (and danced).
These macroeconomic issues are scary. But instead of being overwhelmed by the impossibly complex big picture, narrow your focus to individual companies. The market doesn't dictate your portfolio's performance; that's dictated by the performance of the stocks you own. Even in a bear market, some stocks outperform. Your job -- with our help -- is to find those stocks and snatch them up.
Don't be fooled: There will be risks. Don't let them keep you up at night. Instead, focus your analysis on understanding how economic events can affect the businesses in your portfolio. If you own Wells Fargo (NYSE: WFC ) or the Royal Bank of Canada (NYSE: RY ) , for example, war and hurricanes will likely be less important to you than a potential derivative meltdown. Translation: These two companies are big players in the derivatives markets, so you should focus your efforts on understanding the inherent risks in derivatives.
Beyond these macroeconomic factors lurk two potential mistakes. The bad news is that they can destroy your returns. The good news is that they're completely under your control:
1. Not knowing what you own: The biggest mistake you can make in the stock market is not understanding what you're buying, or what you already own. While the market may seem irrational, over the long term it's supremely logical. Strong companies prosper, while weaker companies die or are devoured by competitors.
So before you invest, make sure you have rational reasons for investing. Don't invest based on tips or stories; invest only in businesses. Make sure you understand how the business makes money and why it will continue to do so in the future. If you don't understand float or a combined ratio, don't invest in St. Paul Travelers (NYSE: STA ) -- even if you heard that it's a top insurer. If you don't know what VoIP stands for, then you probably shouldn't invest in Sprint Nextel (NYSE: S ) or Nortel Networks (NYSE: NT ) -- two companies that will be significantly affected by voice over Internet protocol in very different ways.
At Motley FoolInsideValue, to get up to speed on a company, we begin by picking through its SEC filings, such as its 10-K. These documents provide an overview both of what the company does and its potential risks. Then we sift through articles, conference calls, websites, press releases, and even discussion boards. Finally, we distill that knowledge into an overview that subscribers can use to understand a company's business, competitive position, and risks.
2. Buying above fair value: The second mistake that should frighten your boots off is the possibility of buying stocks above their fair value. Look at the long-term charts for Red Hat (Nasdaq: RHAT ) and Priceline.com (Nasdaq: PCLN ) . Both of these companies correctly identified and exploited major trends in technology -- Red Hat, the move toward Linux as an alternative to Windows; and Priceline, the explosion in e-commerce. Six years ago, investors recognized correctly that these businesses could be two of the most successful new tech companies in the following decade. Yet investors who bought then have lost much of their investment.
The problem? They bought these stocks at prices way above their fair value. Regardless of how successful you are at picking "the next big thing," if you consistently buy businesses at prices well above their fair value, you will underperform. It's simple mathematics -- if you pay $1 for something worth $0.50, you're almost certain to lose money, unless you can find a bigger idiot who's willing to pay even more than you.
This dynamic is reversed when you buy below fair value. If you pay $0.50 for something worth $1, you have a decent chance of later being able to sell at a profit and less chance of losing money. That's what value investing is all about.
If you don't know how to value a stock, we can help with that. One of our Inside Value discussion boards is focused on that topic, and a member of the team has created an online course to teach people how to value a stock. Plus, we have a discounted cash flow calculator that can be used to work out the fair value of any stock. Of course, our stock picks only include stocks that are trading below their fair value, and every recommendation includes an estimate of what that company is worth.
Knowledge is power
The way to deal with potentially terrifying issues is to be in the know -- know the business in which you're investing, and know its fair value. Such knowledge not only reduces macroeconomic nightmares to manageable risks, but also puts you in a profitable position when fears of such risks are overblown.
If you want to get ahead of the pack, Inside Value can help. Our analysis of undervalued stocks will give you a head start in identifying undervalued companies. A 30-day free trial will give you access to all Inside Value content: our top recommendations, our discounted cash flow calculator, five special reports, and our discussion boards. It's free with no obligation, so it's really a no-brainer for anyone interested in value. To give it a try, click here. Don't be scared.
This article was originally published on Jan. 3, 2006. It has been updated.
Fool contributor Richard Gibbons is a member of the Inside Value team, a father, a husband, a chess player, an ultimate player, a juggler, and a geek. Richard has no financial position in any company discussed in this article. Priceline is a Stock Advisor pick. The Motley Fool has adisclosure policy.