The Fribble: Making Money on the Market, Part 1, by MF Runkle

Making Money on the Market, Part 1
or
You Only Need to be Right a Few Times

by MF Runkle

I've written I don't know how many Fribbles on how I've lost money in the market, probably because losing money is easy. It's also funnier to write about stupid things. This time I'm going to write about how I've actually made money in the stock market. I know my Fribbles don't indicate it, but I've actually gained more than I've lost, and in spite of stupid mistakes, I've beaten the averages.

I don't "do" short-term trading. Rather than wade into that controversy about long-term investing vs. short-term trading, I'll just say it isn't appropriate for me. At my level of investment, the commissions would kill me. Not only that, I can't spend the day on the phone to my broker doing trades. I've followed Warren Buffett's strategy, and invested in businesses I understand. I also value the company using standard valuation tools.

While buying stock in a company which has products you like is a good strategy, there's more work needed. For example, I use AutoCAD at work, and love the software. All of my people are trained on it, and we all find it easy to use. Our consultants use it too; it is an accepted standard for CAD drawings. Do I own the stock? No. Check out the earnings estimates of the company. They stink. Ooops, they did stink. Checking out Autodesk, Inc., earnings are expected to grow 55% in FY 97, after years of negative earnings growth. Hmmm... I'll have to look into that further.

Autodesk may be starting to go through a turn around, but are the analysts right? I'm not even going to consider it until I check out its 10Q and 10K on the EDGAR Database; it's free from Uncle Sam. Let's look a little through the 10Q, which is a quarterly report of how they've done (required by the SEC). You can click on it with me if you like. Here it is: 0000929624-96-000309.txt at www.sec.gov.

Now, things don't look so hot. I always look at the Consolidated Statement of Cash Flows. This tells you how much cash the company is bringing in, as opposed to earnings, which may include money that hasn't come in yet. A company can be making a lot of money, but if nobody pays his bill, it doesn't count. Autodesk doesn't look good. Cash flow from operating activities (which is what it brings in from sales, or whatever business it is in) has dropped a lot. For this period, the cash from operating activity in this 9-month period has dropped from 82,049 to 72,274 (thousands) a year earlier. Cash on hand at the end of the period is also down. This company also has a history of negative earnings. Forget it. It's not worth the risk.

I have come to the theory to let others bet on turnarounds. I don't have enough in my portfolio to risk it. Benjamin Graham recommends in The Intelligent Investor some earnings in the common stock for the past 10 years. Of course, this would knock out Intel, which has had a blow out in stock price appreciation. I've gone with a few years of earnings growth, allowing no fluctuations. I don't use a specific formula; each company is different. It's not like designing a concrete beam, where a couple of mathematical formulas work. Another reason for knowing the companies.

Now, lets say we've got a company that has a record of earnings growth, positive cash flow, and you know the business and it's good. Stock prices aren't based on the past; they are based on what investors think they will do. You need to value the company. Look at the earnings estimates from First Call or Zacks, and check out the Fool's School's area on How to Value Stocks. This is my final stage. If the stock looks overvalued, which many of the popular stocks are, forget it. It's very easy to buy at a top (DRiP investing is an exception, another Fribble).

After all this work, my wife and I hold the stock. It may take a while for the price to come up to what we believe is its value. Microsoft was delayed in releasing Windows 95 after we bought it, and the price dropped like a rock -- temporarily. However, the reason we bought it didn't change. Windows 95 was released, and the price... well you know what happened. Here's the key. Often a stock price goes up or down with little relation to its worth. Sometimes a news release causes excitement, and investors and traders pile on. Often, some negative news very distantly related to the company causes people to dump shares. There also is just plain random price movements. If the reason you buy the stock didn't change, don't sell.

There are times it is necessary to realize an investment was bad. Maybe you didn't do your homework, or the company has hit hard times. Sometimes the company is recording lower-than-expected earnings. Also, business changes. If any of these things happens, it's best to cut your losses and sell the stock. It's not worth holding a stock forever if it doesn't make you money.

So, to wrap up, there is a simple way to make money on the stock market. Buy companies in businesses you understand. Research the company as much as possible, until you feel you understand it inside and out. Check out the finances in years past, and check the expected earnings. Analyze the company using methods in the Fool's School, and hold the stock. If the company changes, or you made a mistake, sell. Otherwise, save those commissions and hold. This way, you only need to be right a little, and you can make a lot.