Investing in Stocks? You’re Probably Doing it Wrong

I remember when I first started investing. I read a couple of articles (books were TL;DR) and I thought I knew everything. Besides, my idiot friends were investing and made money, so how hard could it be?

I actually did pretty well with my first trades. Of course, none of that had to do with skill. First, I got lucky with many of those picks. Second, I started investing in a bull market, so it actually would have been harder to lose money in that time period.

Now that I’m a much more knowledgeable investor, these are the things that I was doing wrong, and you probably are too.

Dividend Growth

So let me get this straight. You buy a stock and every 3-6 months, they pay you money!? And you get to keep the stock? How amazing is this – sign me up!

When you buy a stock, you own a piece of the company. A dividend is one way for a company to return capital to shareholders. Investors like dividends because, hey who doesn’t like cash? Also, that means that the company is stable enough to offer a dividend. If a company has inconsistent cash flows, it would be difficult for them to offer a consistent payout that is required for a dividend.

So we’ve established that getting cash is good. But if you actually pay attention, you’ll notice that a company’s share price drops on the ex-date (the date when you’re not eligible to receive the dividend for that period). Assuming all else equal, the drop in the share price is equal to the amount of the dividend. So if you have a $25 stock that has a 4% yield ($1 dividend), the share price will drop to $24 on the ex-date.

Another thing to note about dividends is that they’re expected to grow every year. I’ve heard some people get all excited because the dividend went up. It’s SUPPOSED TO. Dividends should be growing with free cash flow because most companies have targeted payout ratios. What really matters is how much the dividend is going up, and if the growth is higher than prior years.

Investing in Total Shareholder Return

Yes, cash is nice, but really the company is forcing you to take a distribution and reducing your capital gains. That’s why I prefer to focus on TSR (Total Shareholder Return). Don’t just pick a stock with a high dividend yield. Focus on picking stocks that give you the highest TSR, which includes capital appreciation AND dividends.

Also, if you really like cash, you can sell stock on a regular basis to make your own dividends. The only difference are trading costs and potential tax implications, since dividends and capital gains may be treated differently.

Merger Arbitrage

One of the first stocks I ever bought was T. This was back when SBC was gobbling up the baby bells to form AT&T again. I can’t remember the exact numbers, so I’m going to make them up for illustrative purposes. SBC was trading at $30/share, and was buying T. In it’s bid, it was offering 0.5 shares of SBC and $10 in cash. So the total offer was $15 in stock (half a share of SBC), and $10 in cash, or $25 in total. Yet T stock was trading at $24.

I thought to myself, this is incredible! I can buy T stock for $24, and I’ll make $1 as soon as the deal closes. Why doesn’t everybody do this? They do, and it’s called merger arbitrage.

When a deal is announced, there’s a risk the deal doesn’t close or it gets blocked. So the target will trade at a discount to the acquisition price. A larger discount means investors believe there’s significant risk a deal won’t close. Conversely, when a target trades above the acquisition price, it means investors believe there’s a chance another buyer will come in with a superior bid.

Picking Up Nickels in Front of a Steamroller

Yes, I did make that $1 by buying T stock and waiting for the deal to close. But no, it wasn’t free money because I was taking on the risk that the deal would get blocked. If SBC was offering a 30% premium for T, the risk reward would have been 4% upside ($1 gain $24), or 30% downside, because the stock would have went back to pre-deal prices if it didn’t close.

That’s why they call merger arbitrage “picking up nickels in front a steamroller”. Most deals will close and you’ll pick up a few percent on each deal. But when you’re wrong, you get run over by the steamroller.

Diversification

I’ve talked about the importance of diversification in the past. Diversification isn’t just about buying a bunch of different stocks. You think need to think about all the factor risk that you’re taking.

For example, some companies have more exposure to the economic growth cycle vs. others. Staffing companies like RHI depend on job growth, and really need a strong or stable economy to do well. Grocery stores, like KR, can actually benefit from a weak economy. Everybody needs to eat, but when money is tight and people lose their jobs, they go out to eat less and stay at home more.

Other factors to consider are geographic exposure, market cap, value vs. growth, and sector exposures. Large cap stocks don’t trade the same as small caps. Generally, small caps outperform during the good times because a rising tide lifts all boats, while large cap stocks do better in periods of weak economic environments because they have the scale and resources to weather the storm. I’ve discussed before how in some periods, value outperforms growth.

No Safe Place to Hide From Diversification

You may think that buying safe, stable names will reduce your need for diversification, but you’d be wrong. Below is a chart of KR’s stock. KR is as stable as they come. People need to eat, and they’ll always need groceries. However, look at that big down move in the middle of June ’17. That’s AMZN announcing the purchase or Whole Foods. Note that AMZN didn’t say anything about going after the other grocers. It was the FEAR that AMZN would make Whole Foods more competitive that spooked investors.

The point of diversification is so that you don’t have too much exposure to unforeseen events like this, unless you believe AMZN is going to take over the world and is going to destroy every company out there. I’m half-jokingly in this camp, and if you are too, then maybe you should just own AMZN.

KR Share Price Chart

KR stock price chart
Source: Google Finance

Consensus Expectations

Consensus expectations is something that took me a long time to understand. If revenue is growing and earnings are growing, then the share price should go up, right?

Not exactly. Yes, earnings growth should lead to price appreciation, but there are investors like me that spend all day trying to understand how fast a company’s top line can grow and how much it can generate in earnings. If I think a company can grow very fast, then I’ll buy that stock and bid it up. Chances are, others will too.

This leads to consensus expectations. What are most investors expecting the stock to do? If a company beats consensus expectations, more investors will buy the stock because it’s doing better than expected. If it misses expectations, the stock will sell off.

What’s the Whisper Number?

To add confusion to all this, there’s something known as the “whisper number”. Since it’s impossible to poll every investor out there, consensus expectations are derived from the sell side analysts that cover that stock. But sell side analysts don’t buy stocks. Buy side investors like me do.

Sell side consensus expectations may be too conservative because either they’re using company guidance, or they’re just low-balling (some sell side analysts love to have low estimates when they like a stock so they can say afterwards, “well, they beat MY numbers!”)

What really matters is what buy side investors are thinking. There’s no published number for buy side estimates, but we all talk to each other. If you talk to enough buy side investors, you’ll get a sense for what the whisper number is.

There’s no way for a retail investor to get the whisper number, but just be aware of it when a stock beats consensus but still goes down.

confused investing
I’m like this way too often when trying to understand stock moves.

Leave a Reply

Your email address will not be published. Required fields are marked *