How not to invest and NSL

There is this notion that you have to make mistakes in order to learn. I do not know whether I generally believe in this but I truly hope to have learnt something out of my huge trading mistakes with Netflix. Then something good might actually emerge from me losing money. As I already indicated since I purchased Netflix in early December 2015 the stock lost 25% of its value. Today (27.01.2016) I finally and way too late sold my shares in this company. What had happened?

Well, first of all it has to be mentioned that I did not have any strong reason buying the stock in the first place. As the ignorant beginner I am, I did not analyze financial statements, the earnings prospects or any other indicator of the companies performance. I only knew that Netflix is a strong brand among people and especially the young (Netflix and chill?). The second thing I did was looking at the chart, seeing the incredible growth the stock has had in the last few years and then getting greedy and thinking that the past would equal the future. The rule I set myself was to sell if the stock lost 5% or more – well apparently that did not happen, did it? This is the thing that I hope I could learn with this trade – cutting my losses. Lets see whether that will work out better in the future.

From how not to invest to hopefully how to invest. In the following I´ll explain N, S, and L of the CANSLIM method.

Something New

In order for stocks to increase there should be something new. Something new could be a new product, new (preferably competent) management or new highs in the stock. Yes you heard right. O´Neil actually says that new highs are a good thing. He claims that between 1953 and 1993 95% of the best performing stocks belonged to companies linked to new products, new management, change in the industry or new price hights. When should a stock be bought then? Prior to buying the price should be at a new high or just coming out of a price consolidation. The paradox is that what seems too high often goes higher and what seems to low often goes lower.

Shares Outstanding

Shares outstanding is of great importance because of the supply and demand aspect. The stock prices of companies with many shares outstanding seem to be harder to move and do not tend to advance as much as smaller capitalized stocks. 95% of the winning stocks analyzed by O´Neil had fewer than 25 million shares outstanding with an average of 11.8 million shares outstanding. Due to the this stock splits should be avoided. A positive indicator however seems to be the company buying back its shares from the public. This reduces shares outstanding and in this way increases earnings per share. The importance of this measure already has been emphasized in the last blog entry. Related to the supply and demand aspect is the trading volume of a stock. Trading volume should dry up during corrections and considerably increase on rallies (50%-100%).

Leader or Laggard

Laggard stocks and purchases out of sympathy should be avoided at all times. Rather leaders instead of laggards should be bought. For this relative price strength can be observed. This measure compares the price development over a specific period (6 or 12 months) relative to the overall market. The relative strength should be at least in the 70th percentile. The 500 best performing stocks of O´Neil´s analysis averaged a relative strength of the 87th percentile just before their major price moves. If the relative price strength has been deteriorating for at least seven month or there has been a sharp decline for four months attention should be paid. The stock may be of questionable performance in the future.

Next, Institutional Sponsorship (I) and Market (M) will be elaborated on.

Best,

Nils

Selecting the right stocks

After a little bit of my background and what I believe in it seems to be time for actual content and knowledge. The first book I want to write about is “How to make money in stocks” by William O´Neil. The first time I read about the author of this book was in Jack D. Schwager´s “The Market Wizards” where O´Neil was interviewed and explained the possibility to pick the right stocks at the right time. With an annual average profit in excess of 40% O´Neil seems to be an authority that can be relied on. He is of the strong conviction that everyone should own stocks and that this investment method is in the long-run a safe way to prosperity.

O´Neils approach to pick the winners and short the losers is based on the CANSLIM framework which he developed. This framework is based on the conviction that by analyzing past winning stocks patterns can be observed and then applied to the stock selection process. CANSLIM in this respect refers to seven defining characteristics that are incorporated by the winning stocks. The acronym consists of:

  1. Current Quarterly Earnings Per Share
  2. Annual Earnings Per Share
  3. Something New
  4. Shares Outstanding
  5. Leader or Laggard
  6. Institutional Sponsorship
  7. Market

In this entry I will elaborate on the meaning of the first two criteria – Current Quarterly Earnings Per Share and Annual Earnings Per Share. The remaining five categories will be dealt with later on.

Current Quarterly Earnings Per Share

The first claim O´Neil makes is that current quarterly earnings per share should be up substantially compared to the prior year´s same quarter. Substantially is to say 20%-50%. According to his analysis 75% of the best performing stocks of 1953 through 1993 showed average earnings increases of 70% before their major price advances. This point is highly interesting to me since I did not pay a lot of attention to the change in quarterly earnings per share in my prior stock purchases. Actually, buying Netflix I strongly disregarded the quarterly earnings per share, which were down compared to the year before. Needless to say that my current Netflix investment is down 22% (That´s right, the stock decreased by one fifth in value since I purchased it!!). While a required increase in the quarterly earnings per share of 20%-50% seems exaggerated you do want to purchase the exceptional stocks. Current Quarterly Earnings Per Share filters out a lot of the stocks not worth investing in.

What happens if Quarterly EPS actually decrease? According to O´Neil two consecutive quarters of deteriorating EPS imply trouble for the prospects of a firm. While the best company periodically can face difficulties attention should be paid in the case of more frequent decreases.

As a last note it is mentioned that at least one other company in the same industry should yield strong results in this category. If not at least one other company in the industry can be found that hast strongly increased EPS the industry as a whole might be vulnerable.

Annual Earnings Per Share

Besides required increases in the EPS compared to the prior year there should be a steady increase in the annual EPS as well. As a rule of thumb for five consecutive years annual earnings per share should have increased over the prior year´s level. As for the quarterly EPS O´Neil expects considerably high growth rates. The annual average growth should be at least 25% and as much as 100% in the best cases.

The consistency and general trend of the growth is of great interest as well. Since less cyclical companies tend to produce more steady earnings O´Neil advocates for a measure of the stability of the past five year earnings. The growth rates of the past five years are plotted and a trend line is added. The more the data points deviate from the general trend the more cyclical and less attractive the company is expected to be.

Incorporating both the quarterly and annual earnings per share trend seems to allow for a good analysis of the strength of a company and are the cornerstones of the CANSLIM method.

In the next entry N,S, and L will be the topic of discussion.

Nils

What I believe in…

When I was a little kid I used to pray to god often. I´d pray so he´d help my family my friends and the world in general. I´d pray so he´d make everyone healthy, wealthy, loved and happy. And additionally I prayed so he´d fix everything that was not perfect with my life… When something with my social life would be out of order after the normal prayers I´d pray “and please god make that everything with my social life is gonna become good”. When I had confidence issues and was not very outgoing but rather introverted after the normal prayers I´d pray “and please god make me more confident and outgoing”. This routine would be the same for pretty much every challenge that I´d face – actually I did not face these challenges but rather hoped that my problems would just solve themselves.

How is this relevant for a blog that is about my journey of learning about investing and trading. Especially now, with highly volatile markets since this year has started, there would be a lot for me to write about . So why this post? Well, I think that my worldview has changed dramatically in the last four years and I think that I have changed a lot as a person as a result. Most importantly, I would like to remind myself of and commit to this worldview of responsibility.

As I already indicated I never really felt responsible for my problems. I did not even think about the possibility that me being totally dependent on my parents might influence my lack of confidence or that I´d need to go to talk to people in order to increase my social circle. The first time that I became aware of this worldview was when my grandfather gave me the book “How to rationalize yourself” by Gustav Großman.

Ordinary people always blame circumstances for the bad things in their life. If they succeed, it was their skills and decisions that made them succeed. If they lose however, it was the circumstances and bad luck that made them lose.

This assertion struck with me and changed me as a person and to the present day I think changing this worldview is the most important in order to become more independent, self-reliant, successful and even happy – because deep down in yourself you know the truth.

While I do acknowledge that there is something like luck and bad luck out there I am convinced that it plays a minor role in the life of 97% of our western population. If you don´t not achieve your goals it is because of your decisions and actions that have brought you to where you are today. Pretty much 100% of the time there is someone who has been in a more unfortunate situation than yourself and who has succeeded despite all the obstacles. IF YOU DO NOT SUCCEED THIS FAILURE IS ONLY SUBJECT TO YOURSELF.

So, how does this relate to learning investing and trading. That´s pretty easy. I am convinced that I can learn what it takes to be great in trading and investing. I have to put my 10000 hours into this topic and then something good will result in the end. Of course, I have to be willing to pay the price for success and if I am I will  find out in the next years.

The start of the journey

So is it possible to beat the market me?

I don´t know. Probably not. Definitely not with my current knowledge and skills. But why not give it a shot? I probably will get wiped out. But at least I get wiped out doing something very interesting and maybe in the end I will even learn something. At the moment I have no clue about investing and trading and this will not change by reading a few books but there always is a start.

My glorious history of investing so far contains the purchase of two stocks so far. The first one is Berkshire Hathaway which I bought after reading the “Intelligent Investor” by Benjamin Graham for the first time and falling in love with Warren Buffett. The second one is Netflix which I like because of the strong brand but at the same time it seems incredibly overvalued. Why did I buy these stocks? I kind of just liked them and had a “good feeling” about their prospects. No analysis whatsoever!

This is something I want to change. I want to learn how value companies and trade the markets – or at least I want to give my best in trying to.

This blog  first of all is created in order for me to put a structure into my learning experience and write down what I think that is relevant. However, if someone miraculously stumbles over this blog and has something to add, correct me (that very likely will be necessary in the next few years), or give me some general tips – you´re very welcome to do so.

So lets start this journey and see what it may bring along!

Best,

Nils