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How Many Different Stock Sectors to Have in Your Portfolio

I got a great question over email about over-diversification and wondering how many different stock sectors one should own. Here it is:

Thanks for all the great information. I look forward to your emails every week. The one thing I struggle with when it comes to investing is the variety of stocks I think I should own. I want to be diverse but not diluted. I know it is impossible to have every base covered. However, do I balance cyclical with non-cyclical stocks, medical with consumer discretionary balanced with consumer staples. When and where do I stop buying new stocks and simply grow the ones I already have? I am not afraid of research but I don’t want spend all my free time researching new companies. Thanks.

I agree that it is impossible to have every base covered. In fact, you don’t want to be too diversified because at a point you are minimizing the benefits. I talked about this in-depth with David Thomas from Shares and Stock Markets, and in the video we share that the positive benefits of diversification really diminish after 20-25 stocks.

If you use a diversification like that, then you are only exposing your portfolio to 4-5% on each position, which is ideal. You’ll find that 5% number as a popular metric for a lot of technical traders, who often trade much more frequently and pride themselves in risk management.

stock sectors

Those of you familiar with the CNBC tv show Mad Money know about the segment where Jim Cramer looks at a portfolio of 5 stocks and decides if it is diversified enough. I really believe that 5 stocks aren’t enough.

Think about it. A portfolio with only 5 stocks means a 20% exposure with any one position. If a position goes south 50%, which isn’t impossible in the slightest, you’re talking about a wipeout of 10% of your portfolio. Even with experience under my belt in the stock market, I still wouldn’t be comfortable to put that much risk on any one stock pick.

You have to think about the worst case scenario. Nobody is that good at investing that they can disregard that fact. We are all subject to the same market insensibilities.

So I strive for a portfolio of 20-25 stocks.

When to Stop Buying Stocks

This leads to another part of the question which is when to stop adding to positions. My answer is never.

As I talked about in my 7 Steps to Understanding the Stock Market, the best tip I can give anyone is to dollar cost average. This means you set aside the same amount to invest every single month. No matter if the market is going up, down, or sideways, you will make money in the long term if you are consistently adding to your positions.

So how to do this while also avoiding over-diversification?

Simple. Just buy more of what you already have. Let’s say you have a healthy, balanced portfolio of 25 stocks spread out between many stock sectors. Instead of buying more stocks or more stock sectors, add to the positions you already have. Find the companies that are still undervalued, and add to your positions.

If you had enough confidence in the beginning to put your money into that position, then you should still be willing to buy more.. assuming that the price hasn’t run up since. If the value is there, then as Cramer says buy, buy, buy.

Different Stock Sectors

As a part of your diversification, you’ll also want to make sure that you are exposed to a wide variety of stock sectors. Having both cyclical and non-cyclical stocks in your portfolio is very important.  [click to continue…]

How to Read Annual Reports for Beginners

The first step to doing your own fundamental analysis on stocks is being able to read annual reports. In this post, I’ll show you why you need to learn how to read annual reports, as well as some tips and tricks and complete breakdowns.

annual reports

Why is it Important?

If you want a fighting chance at picking individual stocks, you must know how to read annual reports. The ability to read annual reports is the bedrock foundation of fundamental analysis.

The fact that public companies are forced by law to submit annual reports, also known as 10-k’s, is the big reason why they are so crucial when you are deciding on and researching stocks. This one commonality between all of the stocks listed on any index gives you a level playing field and a chance to be able to discern winners from losers.

You must be objective with your investments. If you don’t have an objective way to measure success, how can you ever hope to find it?

For example, take the hypothetical worker at a Fortune 500 firm. That worker could possibly have contacts in the company, and access to management unlike access available to the general public. On the surface you might think this gives the worker an advantage with investments. If they can only get some inside information, you think, then they could know when to invest.

On the contrary, this is the absolute worst way to evaluate stocks. There is not a single person on this planet, not even an investing great like Warren Buffett, who has the time and the access to be able to converse with management over whether their company is a good investment. Besides that, I’m sure there isn’t a management who doesn’t think they are doing even a satisfactory job, which we know can’t be the case. Bankruptcies will continue to happen like they always have, and by definition every management can’t be doing average or better than average. So the deduction you might get from a conversation with management might be skewed.

Investors’ only chance at outperforming the stock market come in leaning more on objective rather than subjective measures.

The only reason that the numbers system works is because it is an objective system. No matter if the sun is out or if it’s raining, the number 2 will always be the number 2. It doesn’t matter if you’re having a horrible day or a great one, 21 always means 21. Numbers are the ultimate form of objectivity.

Annual reports are naturally objective, which should be music to your ears. The fact that there are GAAP audited standards means that every stock is subjected to the same qualifications. No matter how many great writers or infographers a company has on staff to flower up the annual report, the company can’t hide from the audited and consolidated numbers. Which brings me to my next point.

Learning What to Read

When I say learn how to read an annual report, I really mean that you have to learn how to find and interpret the important numbers in there. I can assure you that over 95% of an annual report is useless to you. A lot of times companies will add stuff in there that is unnecessary, with unnecessary graphs and numbers to make things look better than they are. I see it all the time.

You must learn to separate the useful wheat from the chaff. Oftentimes this is a task quite difficult for the novice beginner, and so they give up before they start.

Don’t give up. The power behind this skill set is both rare and substantial. Combine it with a great strategy and you can make some serious money for yourself and your family.

The first thing you’ll notice about an annual report is that it’s often over 100 pages long. The meaty part that you want to concentrate on are the “Consolidated Financial Statements”, usually broken up into:

1. Consolidated Statement of Income
2. Consolidated Balance Sheet
3. Consolidated Statement of Cash Flow

The numbers in these sections are the only ones that matter. Numbers that you pull from any other part of the annual report are not guaranteed to be audited, in fact you can probably guess that they are likely prettied up by some accountant engineering.

A mistake I see investors make is that the gloss over the importance of consolidated numbers, and just rely on financial website quotes instead. The problems can arise twofold. [click to continue…]

Line-by-Line Cash Flow Statement Example

In the previous post I shared with you simple cash flow analysis with 3 of the most common ways to interpret the cash flow statement. Now I’m going to show you a line-by-line cash flow statement example of Johnson and Johnson (Ticker: JNJ).

cash flow statement exampleRight away, we can observe that there are 3 major categories for the statement. They are:

1. Cash flows from operating activities
2. Cash flows from investing activities
3. Cash flows from financing activities

Each are pretty self-explanatory, but I’ll go through them real quick just in case.

Operating activities have to do with the day-to-day operations of the business. Usually these take up the brunt majority of cash flow, as it is the centerpiece of the business. If the net cash numbers for operating activities are negative, it is not a good sign.

Next is investing activities. Yes, if you didn’t know already, companies invest in stocks and bonds just like individual investors do. It’s one of the reasons why we see so many people get affected by a stock market crash. The net cash numbers for investing activities can be negative or positive depending on the company, and transactions concerning the balance sheet are usually found here.

Finally you have financing activities. Again, this number can be positive or negative depending on how management is utilizing their capital. Here you will see transactions relating to debt, both the paying off of and acquiring, as well as other expenses such as dividends and share repurchases.

I’ll include pictures of the Johnson and Johnson annual report so that you can follow along. [click to continue…]

Simple Cash Flow Statement Analysis for Stocks

In each of the previous parts of this series, I’ve been showing you how to break down and understand the annual report for a company. Last but not least, here’s how to do cash flow statement analysis.

cash flow statement analysis

Cash flow statement analysis is important for several of the following reasons. For one, it can signal potential value that the income statement has not uncovered yet. On the flip side, it can also warn of a company whose earnings look good on the surface but actually these earnings are in jeopardy.

The cash flow statement is a much better representation for how much cash they actually have in the “bank”. Think of it like the way you do your personal finances. The cash flow statement would be like your bank account statement, while the income statement is more like your monthly budget. The balance sheet, as I’ve shared before, is like your net worth.

Remember that the name of the game is earnings… because that turns into cash, which gets paid to the shareholder. So while earnings seems to be the sole focus on Wall Street, there are still some steps to take before those earnings become usable cash.

In fact, the cash flow statement is often an early indicator for future earnings. The reason for this is that higher cash flow numbers lead to more earnings, and thus share price appreciation, because more available cash allows management to throw more money into growing the business.

The share price can also appreciate from higher cash flow numbers being used to pay more dividends, as shareholders love special dividends and dividend increases and will tend to buy more when management is showing this. Earnings and the income statement alone won’t be able to tell you this, which is why the cash flow statement is so important.

Cash Flow Statement Analaysis

There’s 3 major ways to do cash flow statement analysis. I only use one of these ways, but it’s important for me to show you all 3. Examine them and use the one that makes most sense for you.

You can use either:

  • Price to Cash ratio
  • Discounted Cash Flow Model (DCF)
  • Free Cash Flow ratio (FCF)

No matter which one you choose, you must be consistent. It could cripple your strategy if you are using DCF one year and then FCF the next. It’s not so important which method you choose, but more that you stick to one method. Any investing strategy will have overperformance and underperformance, but a strategy that always changes will always underperform. [click to continue…]

Pt. 2: Income Statement Ratios and Breakdown

Last week’s post had a simple explanation about the income statement and why it is important for investors. This part 2 is intended to expand on that, to explain more about the helpful income statement ratios and provide a line-by-line breakdown of this financial statement.

income statement ratios

Like I said before, the income statement is one of 3 important financial documents that each publicly traded company is required to file. These are:

1. Income Statement
2. Balance Sheet
3. Cash Flow Statement

What’s important to realize is that the balance sheet makes for a great LONG TERM indicator of company health, while the income statement publicizes the SHORT TERM health of a business. Ideally, I only invest in stocks with great financials in both of these. Finally, the cash flow statement explains what happens to excess cash that was made in the short term and where it exactly goes.

Income Statement Breakdown

Let’s now look at an example income statement from a real company, and I’ll go through a detailed line-by-line analysis. After reading this you should be able to take any income statement from a company’s 10-k and understand what the numbers are saying. [click to continue…]

Debt to Equity Ratio Example: RadioShack’s Demise

The situation with RadioShack is the perfect lesson about debt to equity ratio. I think they will be bankrupt soon. Don’t take my word for it though, here’s why I think RadioShack is the perfect debt to equity ratio example of how not to run a company.

debt to equity ratio example

The debt to equity ratio is a quite simple formula. It’s a great indicator for how risky a stock is, and I’ve written in length about this subject. For those of you who are unaware, here’s the formula:

Debt to Equity = Total Liabilities / Shareholder’s Equity

In the above equation, shareholder’s equity is also calculated in a very simple way. You can look it up in the official annual report, or you can just take a company’s total assets and subtract their liabilities. It’s just a measure of how much assets a company has compared to their liabilities.

As a shareholder, you most certainly want to see equity. You can even argue that a company without equity is useless. I mean, sure it might produce profits, but obviously they haven’t made much progress yet towards building a solid financial foundation. If you want to speculate on these kind of companies be my guest, but I’d prefer to invest in the stock with a fortress of a balance sheet.

Debt to Equity Ratio Example: RSH

All of this explanation leads us to today’s troubled stock: RadioShack (RSH). I’ll show you exactly how dire their situation is right now, and it’s a big part due to their debt to equity.

As you’ll soon see, this company’s equity has quickly eroded at a sickening and destructive pace. This destruction of equity in turn causes their debt to equity ratio to skyrocket, but it doesn’t stop there. [click to continue…]

Simple Income Statement Analysis for Stocks

Last week I taught you about the importance of balance sheets, and now it’s time to shift gears into income statement analysis. The income statement is also called the “consolidated statements of operations” or “consolidated statements of income” in the official annual report. It’s also loosely referred to as the P&L in the corporate world, or the “profit and loss” sheet.

The income statement is a crucial part of analyzing a stock. Even if a company has a solid balance sheet doesn’t mean you can automatically invest and figure to be successful. The company must also be currently profitable if you want a good chance at continued success. Just look at any stock that used to be strong and then went bankrupt, it happens all the time when a company’s main product becomes obsolete. What you’ll see is that the lack of sales will affect the income statement first, and then eventually carry over to the balance sheet. You don’t want to wait around and have to endure the damage.

income statement analysis

Now there are just two crucial numbers that we must take a look at for income statement analysis: net sales (also called revenue) and net earnings (also called net profit). Both tell us a story about how the company is doing.

Net earnings is #1. This is what makes Wall Street go ‘round. Don’t let anybody tell you otherwise, but at the end of the day net earnings determines success or failure. Sure there are times when the market becomes irrational and puts less emphasis on earnings, and this is usually a good indicator that the market is about to crash.

Net earnings are so important because without them, companies couldn’t pay shareholders. Sure they could issue some short term debt, but they wouldn’t be able to pay shareholders consistently without net earnings. Companies wouldn’t be able to reinvest in their own businesses without net earnings (again, in a sustainable way). Without payments to shareholders, shareholders have little incentive to take on so much risk. Thus, the whole concept of the stock market would collapse if companies didn’t have positive net earnings.

How the Statements Fit

If you look at the 3 financial statements (income, balance sheet, cash flow) and understand their relationships, you’ll better get how it all fits in. First is the P&L (income statement). Sales go in, expenses go out, and the remainder is the profit. The profit then shows up in the cash flow statement. It’s cash we have on hand. If that cash goes back to shareholders, or is used in any other way than buying assets, it gets deducted here. Finally, some of that cash is used to buy assets, reinvesting in the business and helping it grow. That’s when you’ll see it show up in the balance sheet. The balance sheet also accounts for any debts we’ve accrued as well.

So that’s how the 3 statements are all related. The P&L shows us how the company is doing RIGHT NOW, the balance sheet shows us the scorecard of the company LONG TERM, and the cash flow statement details where all the excess cash and profits are going.

The second crucial number of the income statement is net sales. While earnings are crucial, they can be unreliable from year to year. The truth is, you can manipulate earnings from a perfectly legal point of view just based on when you decide to account for certain expenses or revenues or other events. Sometimes these things fall in between years, and so earnings can be jumpy from year to year. Revenue numbers, on the other hand, are harder to manipulate are usually grow at a much steadier pace than earnings. Look at any income statement from several companies and you’ll see that this is the case. Another way of saying that is this: long term success will not happen to a company without a good long term trend of revenue growth.

You need to measure sales as much as you do earnings. Just like all things in investing, you can’t just rely on just one metric. Like with the balance sheet, the most important metrics are those that every single company shares and is required to submit into their annual reports by the SEC, and for the income statement that’s revenue and net earnings.

Now that we know the two most important numbers of the income statement, we must also learn the two important ratios that are drawn from these numbers. Any research with a sliver of credibility will at least consider the following: P/E ratio and P/S ratio. [click to continue…]

Pt. 2: Balance Sheet Equation and Ratios

The last post showed you how simple balance sheets can be. Now we are going to examine a bit further into another important balance sheet equation, as well as a couple of examples to see if we can understand every last detail. If you haven’t seen part 1 of this post, be sure you check it out.

balance sheet equation

So the first thing to understand is that balance sheets will differ from industry to industry. The balance sheet of an insurance company, for example, will vary in the line items from one of a retailer. Their business models are just so different.

But there are 3 important line items that every single balance sheet shares. It’s really the only 3 categories I’ll look at when I am analyzing and comparing stocks. Those 3 are:

1. Total Assets
2. Total Liabilities
3. Shareholder’s Equity

If you were paying attention, these are the same 3 I talked about in Part 1: Simple Balance Sheet Analysis. So of course, we have to know about them because they add up all of the other rows of the balance sheet.

Assets are pretty self explanatory. They are anything that the company owns that has value, and that can be sold for cash. Think of things like inventory, real estate, and even just straight up cash. Yes cash is an asset.

Liabilities are anything that the company owes. Whether that’s short term or long term debt, or accounts payable. Anything that a company is financially responsible for goes in the liabilities section.

Finally we have shareholder’s equity. It’s called shareholder’s equity for a reason, because it is the equity that shareholders are entitled to. Like I mentioned in part 1, this is one of our golden eggs. It’s a very tangible way to see how much value we are getting in a stock.

Balance Sheet Equation

Now I already explained how we can use the P/B (or price-to-book) ratio to find value in the balance sheet with the part 1 post. But there’s another helpful balance sheet equation that we can use to evaluate companies.

This ratio helps us minimize risk. Period. Companies with more debt are more risky, it’s so simple yet so many people forget it. But it’s not just total debt numbers. Instead, it’s all about how much debt does a company have compared to its assets and equity? If we had a way to find this out, we could avoid the riskier companies. [I talk about this in my 7 Steps to Understanding the Stock Market guide].

Debt to Equity ratio tells us exactly this. There’s several ways to calculate Debt to Equity ratio, but I like to use the simplest version. It’s the most useful because it covers our backside in case of strange accounting gimmicks. I use this balance sheet equation:

Debt to Equity = (Total Liabilities) / (Shareholder’s Equity)

Some people just use short term debt to calculate this value, but why do that? Don’t we want to know all of a company’s debt? What if they are just stacking all their debt short term, or long term?

A simplified equation like this one prevents us from getting blindsided by an accounting trick. And it lets us see the whole picture, and get a consistent ratio throughout all companies (this is because the GAAP accounting rules of the U.S. require every company to submit total assets, liabilities, and shareholder’s equity numbers).

As a general rule of thumb we always want a company that has a Debt to Equity of less than 1. Why? It makes sense when you think about… any company with a debt to equity over 1 has more debt than their equity. So if all their debt was called tomorrow, they’d be bankrupt. Is that a situation you want to get in to?

Of course, we are talking about extreme and worst case scenarios, but who really would’ve thought that a big bank like Lehman Brothers would’ve failed? I’d prefer to be safe rather than sorry, and I think you should be too.

Now the one caveat to the debt to equity rule is that many financial companies keep their debt to equity ratios around 10. So they are about 10 times more leveraged than the average company (with a debt to equity around 1). Financial companies are banks and insurance companies.

But just because all the cool kids are doing it, doesn’t mean we should just blindly follow the blind. For example in the insurance industry, I’ve found several companies with much lower debt to equity ratios than 10. All trading in the S&P 500. Don’t be afraid to turn over more rocks.

Proof about Debt to Equity

I realize I can tell you on and on about how good debt to equity ratio is. But it’s better to just show you. So here you go.

Check it out, the debt to equity for several recent big name bankruptcies: [click to continue…]

Simple Balance Sheet Analysis for Stocks

The other day I was talking with a friend about balance sheets. We both work corporate jobs, and he has a degree in finance. There was some confusion about how the money gets accounted for, and it’s a common trip up for people just starting out. We were able to hash it out and he gets it now… if you’re confused about balance sheets then this is the post for you.

balance sheet analysis

If you open any Accounting 101 textbook, you’ll see the same simple equation when balance sheets are explained:

Assets = Liabilities + Equity

My wife took a course on accounting, and seriously half of the questions they would ask you about on the homework and tests just used this one equation. It can get confusing though, because the way that money flows inside a company is not as simple as your personal finances.

For example, if you get paid $2,000… everybody can agree that you now have $2,000 more in your checking account. Maybe you had a garage sale, this still becomes $400 into your checking account. It’s easy to track because it’s all in one place, and your income streams are usually limited in number.

Take a multimillion dollar corporation however, and one single checking account can’t ever be enough. There needs to be payroll accounts, expense accounts, accounts for inventory, accounts for revenue, accounts for profits, accounts to pay shareholders… you get the picture.

So when a company makes a big financial decision, the impact of this decision will depend on several factors such as which financial statement is impacted. Again take a basic example where a company is raising cash by selling some of their real estate. Simple minded individuals like ourselves might look at the situation like we do our checking accounts… “well surely the company must have more money to spend now.”

This isn’t the case though. There are 3 major financial statements that every public company is required to submit. This requirement makes it easier for us to understand how any extra money can be used.

The 3 statements are:
1. Income Statement
2. Balance Sheet
3. Cash Flow Statement

Creating cash by selling real estate doesn’t mean the company can suddenly hire 10,000 more people. An asset like real estate belongs in the balance sheet, but the extra cash from this sale will show up positive on the cash flow statement. You see, the cash can only show up on one statement at a time.

Where does the Money Go?

It’s simple when you realize this. The balance sheet has assets and liabilities. When you sell an asset, you lose it off the balance sheet. So your “assets” total on the balance sheet goes down.

But the cash you generated goes somewhere too. It doesn’t go in the income statement (also known as a P/L or Profit and Loss), because it wasn’t generated from your company’s sales. An increase of 50,000 sales and $250,000 more in profits goes in the income statement, but not cash from the selling of an asset.

So you see, the cash from a sold piece of real estate shows up in the cash flow statement. Now we can start to understand why a company can’t just go on a hiring spree now.

It’s because of this: hiring more workers is an expense. It goes in the income statement. When this example company sold its real estate, their income statement didn’t get affected. So if they just decided to hire like crazy, the income statement would be affected and profits would plummet. This would scare the heck out of investors, and just cause panic in general.

Understanding this helps us see why CEOs oftentimes have harder decisions than how it seems on the surface. (Like why did Microsoft just cut 18,000 jobs? They are oozing in cash… it’s not that simple)

If you can understand the 3 financial statements you can give yourself a fighting chance in the stock market. Let’s start with the balance sheet because it is the simplest to learn. [click to continue…]

July 2014 Monthly Report

Just a quick post for today. These past months have been crazy busy, and I’ve been doing some exciting things behind the scenes. For one, I’m working on a podcast with 3 other financial experts that is scheduled to be released September 1st. We have already recorded 3 episodes and will record the 4th tomorrow. Also released a special product to my email subscribers.

Keep checking in for more great things happening with this brand.

Andrew Sather’s Model Portfolio

Screen Shot 2014-08-13 at 11.02.17 PM

Today’s stock pick: BRCD
Value Trap Indicator: 128.41

As always, keep patient and continue collecting dividends. The longer you invest, the greater your chances of success.