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2 Ways to Get to the 'Truth' of Investing

2 Ways to Get to the 'Truth' of Investing

 (DreamsTime)

By    |   Thursday, 09 February 2017 05:29 PM

When it comes down to it, investing is about determining the truth. It’s about sorting through the hopes and dreams and fears of the moment now and determining what will happen in the future.

Maybe right now the market is pricing a company for bankruptcy.

What if that isn’t the case? What if the truth is that a company might be facing some short-term problems but is fundamentally sound for the long haul? Then it would pay off well to invest now.

Likewise, many companies today are trading at historically high valuations. That’s not a problem if companies can grow earnings at a higher rate than their multiple. If that’s the case, today’s valuations are justified. The problem is, on the whole, corporate America’s earnings have flattened out over the past two years.

What’s driven share prices to new highs? Financial engineering. That’s Wall Street speak for policies like large share buybacks, especially those undertaken after taking out large amounts of corporate debt.

I’m not saying it’s time to cash out of stocks. Far from it. We aren’t quite at a level in the market associated with a bubble. And the bubble has to form before it can burst. But today’s over-optimism needs to be tempered with caution. That’s why my focus is usually on two areas.

The first area is staying hedged. That doesn’t necessarily mean anything complex. Just protecting what you already have and trying to improve your returns without taking on too much extra risk.

For most stocks, I use a strategy of covered call writing. It’s a great way to use options to protect your existing portfolio. I know, I write about it a lot—but it’s something that’s moved the needle on my investment returns without taking on higher risk.

For instance, I’ve been a longtime shareholder of McDonald’s (MCD). I don’t want to sell my shares per se, but they’re a bit pricy. At today’s price, they trade around 23 times earnings. That’s a bit expensive for a steady-state company whose fast growth days are behind it. I’m happy with the dividend payment. While only 3.3 percent at today’s prices, based on what I paid for shares initially, I’m getting nearly 7 percent of my original stake back every year.

But with covered call writing, I can get the equivalent of another three or four quarters worth of dividends out of the stock within the space of a year. If I’m doubling my dividend, I’m suddenly getting closer to a 15 percent return of my original capital—a fantastic return compared to the market’s historic average closer to 8 percent per year.

For a company like McDonald’s, whose share price tends to move sideways for long periods of time, selling covered calls is a no-brainer. Most portfolios are filled with companies like this—they don’t make big moves often, so it’s easy to grab some extra income out of them.

My second strategy is simple. When markets are pricy, I start to look for what isn’t too expensive.

In today’s markets, there are a few opportunities. I’ve mentioned the retail stocks in recent weeks—that’s an area that still looks interesting, and likely will for a few more months. Last year, high-yielding stocks and energy names got incredibly cheap and then strongly rallied.

These opportunities will appear and persist for months. There’s no need to rush into a trade like this. But I get it—it’s uncomfortable. That’s the great irony of investing. It’s the only time in life where people are willing to pay up for something because the price has been doing up.

It’s the opposite of how our brains are usually wired. If you go clothes shopping and you see a $100 shirt for 75 percent off, you might see a good deal. That’s because your brain is anchored to the higher price. It doesn’t matter if the shirt would have retailed for $25 anyway and only cost $5 to make. You still think you got a good deal.

Yet people do the opposite with stocks. They see a stock shoot from $10 to $20, and then decide they don’t want to miss the next move. But that presents a few problems.

First, it puts a focus entirely on the price, and not what the underlying company does or is worth. It’s difficult to consistently make money chasing stocks higher—eventually shares will run out of buyers and the price will head back down for a bit.

Second, it means following others into a market. Maybe some of the other folks making the trade have a strong rationale for buying. Maybe they don’t. There are plenty of other investors who will always have more specific knowledge about a company than you will. But if you’re following someone else, they’ve already made their bet, and they’re probably already on their way to better returns as a result.

That’s why I prefer to think of investing as going to the grocery store. Only instead of buying food, we’re buying future returns. Isn’t it better to buy steak when it’s on sale? And if it isn’t on sale, don’t you buy more of something that is, say, chicken? Of course you do!

Take that same thought and apply it to your investments. Think about what’s on sale and why. Find the truth. That’s where great returns come from.

The market is pricing a lot of hope into bigger profits going forward. Maybe that will happen, maybe it won’t. That uncertainty should be keeping stocks from going higher, but that doesn’t seem to be the case.

But by focusing on how to get the best returns out of existing trades and finding new trades at more aggregable prices, you can avoid the high valuation problem that currently plagues the broad market. That also means you’ll stay invested rather than cash out, only to miss the next move higher. It’s also the difference between investing and speculating in today’s market.

 

Andrew Packer is a Senior Financial Editor with Newsmax Media. He currently writes the Insider Hotline investment advisory, serves as investment director for the Financial Braintrust, and writes the monthly newsletter Crisis Point Investor.

© 2021 Newsmax Finance. All rights reserved.


   
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AndrewPacker
When it comes down to it, investing is about determining the truth. It's about sorting through the hopes and dreams and fears of the moment now and determining what will happen in the future.
truth, investing, market, stocks
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2017-29-09
Thursday, 09 February 2017 05:29 PM
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