I recently had the pleasure of speaking with an investment club and was able to offer some thoughts in response to some of the members' questions about investing. Their queries are ones I often hear from investors (those in clubs or investing on their own), so I thought I'd recap their thoughts and my responses for you today.
"We often research very promising companies, only to find that they're trading at prices too steep for us. We're despairing -- it's so hard to find good companies at compelling prices."
First off, I was impressed that they're not only researching companies enough to determine if the firms are top-notch, but are also paying attention to the price and are unwilling to pay too much. Two critical questions when evaluating a company are:
- Is this a high-quality firm? For example, it might have strong growth prospects, competitive advantages, lots of cash, little debt, high profit margins, etc.
- Is the price right? This is generally much harder to determine. The club, like many clubs and individuals, follows the systems of the National Association of Investors Corp. (NAIC), which recommends using its Stock Selection Guide (SSG), a worksheet that helps you determine whether and when to buy or sell.
But back to their question. I recommended that they keep a "watch list," filling it with any impressive companies that they run across. Over time, they'll likely end up with a bunch of promising candidates, and the list will help remind them to check on these firms' status periodically. I suggested this because inevitably, over a period of time, one or more of the firms will see its stock head south, creating a possible buying opportunity for investors paying attention.
If a stock on your watch list drops sharply in value, don't just automatically buy it, though, resting on the research you did a while ago. First find out why it dropped and determine whether it's a short-term, solvable issue, such as was the case with Johnson & Johnson (NYSE:JNJ) during the Tylenol crisis of the '80s, or whether the firm has developed long-term problems that make its future prospects less certain.
Finally, consider setting up your watch list as an online portfolio (such as "My Portfolio" offered here at Fool.com), where you pretend you've bought the firms, perhaps at the price at which you first found them, or at what you think is a fair value for the stock. That way, with a few clicks of your mouse, you can see which stocks have fallen and by how much.
"How should we be thinking about a company's industry?"
I suggested that since there are so many companies and industries out there, and our portfolios can only hold so many, that we'd be smart to focus on studying and investing in only those industries we understand fairly well and enjoy keeping up with. For this reason, I generally avoid biotech companies, since I feel hopelessly uninformed about the massive amount of science behind each one. But I confessed to having been invested in Cisco Systems (NASDAQ:CSCO) in the past and Sun Microsystems (NASDAQ:SUNW) in the present, without really understanding very well exactly what the firms do, how they do it, and therefore what their competitive advantages and future prospects are.
Keep a company's industry in mind when looking at its price-to-earnings (P/E) ratio. Some industries, such as the car and truck industry, generally sport low P/Es, sometimes in the single digits. Meanwhile, other industries, such as software firms, often have high P/E ratios. For example, last time I checked, General Motors (NYSE:GM) had a P/E of 8, while Intuit (NASDAQ:INTU), maker of financial software, had a P/E of 32. Other types of companies with frequently (but not always!) high P/Es include popular blue chips and companies with high growth rates.
I also pointed out that profit margins vary by industry, too. Wal-Mart (NYSE:WMT), for example, like most retailers, has fairly low net profit margins, in the 3% range. That might look inferior to a firm such as Starbucks (NASDAQ:SBUX), with its 9% margins, but Wal-Mart remains a compelling powerhouse due to its volume. It pushes enough products off its shelves and into our shopping carts to make blockbuster total profits.
Paying attention to a company's competitors is very useful. Ideally, study them closely, as one or more of them might turn out to be even more promising than the firm you initially began investigating. But don't just look for the competitor with the lowest P/E ratio, as that firm might have a low price for a reason. Sometimes companies with somewhat higher P/E ratios have the brightest futures -- which is why investors have bid up their prices.
"One of our problems is knowing when to sell. What do you recommend?"
We've addressed this critical topic in many places in Fooldom, such as
- Jeff Fischer on when to sell
- Bill Mann on when to sell
- Our "How to Know When to Buy and Sell" How-To Guide
"We have some stinkers in our portfolio, but we're waiting for them to recover a bit, so we can get our money back before selling."
I had an epiphany a few years ago. I, too, often tried to get my money back in a stock. But then I realized that my money is probably best served if it's invested in only my best ideas.
Let's say that I'm underwater by $800 in Home Surgery Kits (fake ticker: OWWWW). Let's also say that out of all the firms I've looked at and studied, I have a list of 12 that I think have the best potential to appreciate. If I sell my Home Surgery shares for a loss and move what's left into one of those 12 companies, I'm more likely to earn that $800 back -- and more. Why try to earn a certain amount in a stock you've lost faith in when you can more reliably earn it elsewhere?
Note, though, that hanging on to the stinker shares might be the right thing to do if the company is merely experiencing a temporary blip and your research suggests that it still has strong prospects. But if it just stinks, and nothing more, then selling is probably best, whether for a gain or loss.
Think about clubs
If you're not in an investment club, think about joining -- or better yet, forming -- one. They're terrific for beginning investors but can also serve seasoned investors very well, as a dozen brains can research more companies than one brain can.
Learn more in our Investment Club area and on our Investment Clubs discussion board. The NAIC also has a lot of guidance for clubs, as does the Women's Institute for Financial Education, with its new Money Clubs.
And for ideas of companies to consider investing in, check out our suite of Fool stock newsletters, which deliver promising investments each month.
Selena Maranjian 's parents love their investment clubs. Selena owns shares of Johnson & Johnson and Sun Microsystems. For more about Selena, view her bio and her profile . You might also be interested in these books she has written or co-written: The Motley Fool Money Guide and The Motley Fool Investment Guide for Teens . The Motley Fool is Fools writing for Fools.
