Saving and Investing
Investing is the best way a person has to build their money over the long term. When you look at cash accounts like Savings, Money Markets and Certificates of Deposit, they pay less than 1% interest on average. You might get a few percent out of a CD. If you want to reach your long term financial goals, you will have to use investing where average returns can be between 6% and 10%. You can get more than that, but then you have to take on more risk. Investing requires risk, but without investing, you will never achieve those goals you want for the long term. If you put aside $500 per month for 40 years into a savings account, you might have about $295,000 in cash at 1% interest rates. That is never going to get you to your goals of retirement. If you put that same $500 into a tax free account like an IRA for 40 years at a 6% rate of return from stocks and bonds, you would have over $950,000. That is a massive difference of $650,000 by taking on a bit more risk of investing. The amount of risk you are willing to take will vary from investor to investor.
Asset allocation is about picking the right types of investment to achieve your investment goals. There are a lot of different assets from Stocks, Bonds, Real Estate, Commodities, and Currencies. Each of these assets has a different risk and reward profile. Stocks tend to average about 10% annual over the long term. They can have big swings of upward of 20% in a single year, but the average is about 10% returns per year. The return is 10% and the risk is 20%. Bonds tend to return 5% to 6% on average depending on the bonds. They tend to be less volatile with bonds moving about 10% in the big swings. You have a lower return, but you also have lower risk. Other assets like Real Estate, Commodities and Currencies can be even more rewarding, but they bring with them more risk.
Know Your Goals
The most important thing to consider when you are starting to invest is what your goal is. I see a lot of investors who jump into investing with a get rich quick mentality. They have no plan and they tend to do poorly vs the average returns of the market. The first thing you need to know is what you want to achieve from investing. Most people will find they can reach all their goals with a simple diversified index fund. They don't need to beat the market. They just need to perform inline with the market. That makes long term investing a very simple task for them as they can automate contributions and just track how things are going from time to time. If you are getting started later than other investors, you might have to play catch up. This might be a situation where you might embrace a bit more risk and use less bonds and more risky investments like stocks, real estate and commodities. Your goals will dictate what level of risk you need to take as an investor. You should never take on any more risk than you absolutely have to.
Types of Assets
Bonds are owning debt. It can be debt of the Federal Government like Treasury Bonds, it can be debt of local and state authorities like Municipal Bonds, or it can be the debt of companies like Corporate Bonds. Each level of these bonds has different risks and rewards. The same theory applies. The more risk you assume the more reward you can get with bonds. Government Bonds are considered to be risk free as the government never fails to pay its bills. At least it hasn't for the last 200 years. The returns on the treasury bond are typically the lowest. We often measure this by the 10 year yield for bonds which sits at 3.82%. That means you can already double or triple your return by own Treasury Bonds over a savings account. Municipal Bonds are from local and state governments. They do have risk as there have been some high profile bankruptcies from states and cities. Each of these bonds gets a credit rating from a ratings agency like S&P. You can use those ratings like triple A to find the highest quality Municipal Bonds. Many states allow you to earn income on these bonds tax free if you own Municipal bonds from your home state. The final type of bonds is corporate bonds. They are considered the most risky class of bond. There is a vast difference between corporate bonds with high quality companies like Apple and Junk Bonds. Junk Bonds are what we call the bonds of the below investment grade ranked companies by the S&P ratings. Apple is rated at AA. Any bond over triple B is considered investment grade. Below triple B is considered Junk Bonds.
Stocks are equity ownership in a company. We call them publicly owned companies. These companies are owned by shareholders who own tiny fractions of the overall company. A single share of the company entitles you to a share of the profits or losses of that company. You might not be able to build your own business, but you can own a tiny part of great companies like Apple or Amazon. Stocks are considered a more risky investment than bonds. They tend to average returns of 10% a year, but individual stocks can be very volatile. Apple might move 10% to 20% a year in stock price, but a speculative biotechnology or technology stock might swing 70% in a single year. Stocks are ownership in a company. That means you have the risk of what might happen to that company. Some companies go bankrupt. The best way to own stocks is by owning a large index of stocks to capture the average returns of the market without the individual risk of any one company.
Real Estate is owning property. Many of us already own a home. That is real estate. When it comes to investing, you might go out and buy up property and become a landlord or real estate expert. For the average investor, real estate will come from owning Real Estate Investment Trusts (REITs). These are large investing groups that pool together investor money by selling shares like stocks. They take all that money and they invest it into properties where they hire managers. Real estate tends to do well in inflationary and low interest rate environments as they borrow a lot of money to buy these properties so they have to pay interest on all those mortgages. The returns on real estate can be upward of 12% to 14%, but then they can have higher volatility as they do well in low rates and poorly in high rates environments.
Commodities is another asset class many investors like to own. These tend to act like a hedge since they often do well when investors panic. They tend to protect against inflation and do well as a hedge against the dollar. Many investors will insist on keeping at least 5% to 10% of their investments in commodities like Gold or Silver. You can do this by owning the physical asset like buying gold from a broker and keeping it in a safe at home. Many investors will own commodities like Oil, Gold and Silver through index funds. These are funds that pool together investor money and buy the physical assets and store them somewhere safe. They sell shares in that store of assets like they would a stock. The stock of those assets will fluctuate with the value of the underlying assets. They will buy or sell the assets in the warehouse based on investors buying or selling their stock.
Portfolio Theory and The Efficient Market Theory
Portfolio Theory is a fancy concept by which financial experts will design a portfolio of assets using mathematical formulas to achieve the perfect level of return for the level of risk each investor is comfortable with. Today, this can easily be done by AI and robo advisors. You can punch in your information to a robo advisor so it can determine what your financial goals are and what level of risk you are comfortable with. Then it actually picks a portfolio of assets for you to reach that perfect level of risk and reward.
The other concept is The Efficient Market theory which I subscribe to for the most part. This says that the millions of participants of the market are listening to all the news and taking into account all the facts. The market prices itself efficiently because the millions of participants are taking into account all the foreseen data around the economy and the market. I find this tends to be true for the overall market and it prices in all the news and events. I always say if you think you see something coming for the market, the market has already seen it and priced it into the price of the market. Where I find the market tends to fail to be efficient is in pricing individual companies. The market paints with a broad brush. If it likes oil and hates biotechnology, it will own all oil even the worst companies. It will in the same way dump all biotechnology companies including the best companies. This is where I have spent my 27 years of investing. I look for companies that are mispriced because their sector is currently hated by the market. Then I try to find and own the best companies in that sector as they will be cheap.
If you believe in efficient market theory, then you believe the average investor will never beat the market. The data supports this theory as less than 10% of active investors can actually outperform the market over a 5 year period. It shows about 20% can do it for a single year, but less than 10% can do it consistently. Those statistics are good enough for me. This means all you need to do is weight the market. What does that mean? If you are designing a portfolio which has an asset allocation of 60% stocks, then you just allocate that 60% to a low cost market index fund. This fund will give you the average performance of the market over time. An investor who believes in efficient market theory would just use a low cost index for bonds, stocks and commodities to reach their weighting for each asset. The term weight just means how much of an asset you own. If I own more Apple than I do Ford, then I am weighting Apple more than Ford.
So what is asset allocation? This is determining how much of each asset you are going to own in your portfolio. The classic portfolio of my childhood was you weighted bonds to the same as your age then you filled the rest of your portfolio with stocks. If you are 25 and just getting started, you would own 25% bonds and 75% stocks. As you get older, you slowly shift the balance from the more risky, higher return stocks and toward the lower risk, lower return bonds. This ensures capital preservation as you approach retirement. This is an important term to understand in investing. When we invest money, there is a risk we can lose some or all of that initial investment. Companies default on bonds and go bankrupt. There is no risk free investment. Capital preservation is about reducing risk so you don't lose your input invested cash. As you get closer and closer to retirement, the desire to protect your money increases. The last thing you want is to reach a year from retirement and see all your stocks collapse 30% right before you plan to retire. You might be forced to delay retirement.
Portfolio Theory now embraces all asset classes. There is a point where taking on some additional risk can help returns with very minimal impact to the risk profile while helping improve returns. Even adding a little bit of some super risky assets can add a bit of performance to a well allocated portfolio without ratcheting up the risk a whole lot. I have seen portfolio designs which showed adding a super speculative asset like crypto made for an efficient portfolio. When it comes to portfolio theory, you will see the term efficiency frontier. This is a curve that shows various combinations of assets in various amounts and how they affect the risk and return of that portfolio.
Risk vs Reward
When it comes to investing, I find too many investors only focus on the rewards and dismiss the risk. They take way too much risk and end up underperforming the market. They would actually do better just owning the market using a low cost index fund. So what is this index fund I keep talking about? Index funds take money and they use it to buy stock, bonds, real estate or commodities using the same weightings as their respective market. A stock index would own all stocks and weigh them in that index based on the market size of each company. A mega company like Apple would be a large part of every index fund while a tiny company would have very little weight in that index. There are two types of index funds with mutual funds and Exchange Traded Funds (ETF). The mutual fund will buy assets in weights equal to the market then they will sell shares in their fund to investors. These are called mutual funds. Some of them have high fees and many have time requirements for ownership. The ETF takes the same approach where they sell shares in their fund and use that money to buy assets in equal weights to all the stocks in the market. They act very much like a stock of a company except you own all the companies in the market and not just one company. ETFs are an excellent way to own an asset like stocks, bonds, real estate or commodities. Some of them are managed and they require more expenses which come out of the fund itself and lower returns. Others are designed to be low cost with minimal management as they just weigh an asset equal to the overall market. Some examples of good ETFs are like the SPY for the S&P 500. There is the VTI which mimics the overall market. There are bond ETFs like BND or HYG that own bonds. You can even own an EFT for Oil, Gold and Silver with USO, GLD or SLV.
If you come up with an asset allocation of 60% stocks and 40% bonds, you can do this by picking a low cost index fund or ETF that is offered in your 401k, IRA or self directed investment account. You can have an IRA with your broker and do asset allocation of 60% VIT for stocks and 40% TLT for bonds. I have gone over 401k and IRA investments with many people. Every one of these company plans will have at least one low cost fund that will give you the exposure to the asset you want to meet your allocation to that asset.
When in doubt, you should seek the advice of a professional. They go to school to learn how to efficiently build portfolios for each client based on their goals and risk appetite. You can do it yourself, but you might not have the most efficient portfolio you can have. Picking individual stocks I do not believe should be for most investors. I believe 90% of investors would do best to contribute every payday to your employer's tax free investment account they offer you. You should allocate that money to funds that are low cost for the assets you chose to own. Stock picking is fun and it can be very enjoyable for many investors. I think it should be done in moderation especially for new investors.
Now we are going to start to look at strategies to build a portfolio of investments. This will be about picking individual stocks, bonds, REITs or commodity indexes to reach our investment goals. If you have 60% of your assets in stocks, you may choose to pick individual companies. In that case, you will need additional strategies to help protect you from the risks and maximize the return. This can be things like using diversification to spread out risk over many companies. It can be using sector allocations to take advantage of some sectors doing well during good periods of the economy and other sectors doing well in weaker periods of the economy. It can use strategies like weighting some companies more than others as they are safer or provide a desired return. There is a lot of planning that can go into building a portfolio that performs to the return you like for a level of risk you are comfortable with.
Active vs Passive Investing
Up till now we talked about passive investing and how to allocate capital using investments that mimic the overall market or the asset class they are designed to track. Passive investing works for millions of investors who want to invest to meet their long term goals. Active investing appeals to a lot of investors who want to pick stocks. There is something fun and exciting about picking stocks for yourself. The truth is most active investors never beat the market. If you are going to pick stocks yourself, you should accept the fact you might underperform the overall market. I think active investing for a small part of a bigger asset allocation might be best for many investors. This gives you a small portfolio to dabble while keeping the vast majority of your investment in assets that will perform as expected. I have a few portfolios that I have developed for active investing that I call discretionary portfolios. They are built from funds I do not need or would not matter if they are lost. They don't count for my retirement. That is often the best way to start with active investing.
Trading vs Investing
I would bet that the vast majority of the market today is short term trading. Most investing funds and active investors today do trading based on technical indicators of some kind. This involves charts and other indicators such as trend or volume. I have never gotten into trading, but the statistics suggest the vast majority of traders do not outperform the market. When everyone is looking at the same charts and the same patterns, trading often becomes a game of the herd chasing the same trade. I call it the momentum trade. Everyone buys as long as the chart is strong and everyone sells as long as the chart is weak.
Investing is about finding great companies with strong fundamentals and buying their stock for the long term. It is about ownership in a company and its products or services. Investing doesn't have much concern with the short term moves of the market or the economy. For an investor, weakness in the economy or the market overall is an opportunity to buy more stock at a cheaper price. From here on out, we will solely focus on strategies for investors with few exceptions. I tend to be a long term investor, but I like to trade around my positions from time to time to take profits and buy back cheaper.
Diversification is the first tool and most powerful tool of the investor. It is about spreading around your money so that any one company does not make up too much of your portfolio. I have seen a lot of investors go all in on one company. Sometimes it is a successful company and they do very well. This is an extremely dangerous way to invest. All you have to do is ask the investors who bet everything on companies like Enron or Theranos. Diversification is the most powerful tool an investor has against risk of single company ownership. In the same way we would own different assets to help protect against market risk, diversification helps protect against single company risk.
There are different levels of diversification. Some people will tell you it is fine to own just a handful of stocks with a larger percentage of your money in each stock. Others will say you should own a bunch of companies to spread out the risk. I think that depends on each person. The more companies you own, the more work you will have to do to keep up with them all. The more companies you own the more work you have to put into investing. Time is a resource that will be important in determining how diversified you can be. The type of companies you own will matter. If you are picking large companies that are stable like Apple or Amazon, you could have few companies with bigger positions. If you are picking a lot of small companies with a high level of risk, then maybe you want to spread out your investments across many more companies.
I tend to dabble in the most risky parts of the market like small cap technology, small cap biotechnology and crypto. This means I like to really spread things out as the risk of failure is also high. I used to do at least 10 companies and around 10% in each company. That worked fine, but losing 10% when a company goes bad was more than I was happy with losing. Over time I added more companies until I reached around 20. That gives me 5% or less in each company. That is a very acceptable level of loss should something go wrong. That is what I am comfortable with. You will have to decide for yourself based on what kind of companies you own, how much time you have and what level of risk you are comfortable with.
Sector allocation is another important part of diversification. Not every sector does well at the same time during any economy. Some sectors hold up well during bad times and might even do better in a weak economy. We call them the consumer staples. They are the things people can not live without regardless of how the economy is doing. They are things like food and drug stocks along with utilities. They have stable earnings no matter what economy we are in. They tend to do well in a weak economy and poorly when the economy is strong.
Other sectors tend to be very strong when the economy is roaring. They tend to be the companies that make more money when people have more money to spend like retail, industrials and consumer discretionary sectors. We call these sectors of the economy the cyclical sectors as they will do well at one part of the economic cycle and poorly at another part of the economic cycle. There are some sectors we call secular sectors. They don't move with the economy, but tend to have their own cycles where there is a boom and bust. Things like telecom and technology tend to have their own cycles depending on rollouts of new technology in development.
Spreading your money across multiple sectors allows you to ensure you have at least something that is doing well no matter what part of the economic cycle we are in. When I was a young investor, I had a set of sectors that I would always own because they gave me broad coverage of the economic cycle. I always had an Oil company, Bank, Industrial, Telecom and a Utility at the least. If we were in the upcycle, I would add more of the sectors like retail and consumer discretionary. In the down part of the cycle, I would add more of the steady dividend stocks like food and drug stocks.
This is about how much of a stock you own. We call it the weighting of the stock in the portfolio. Some investors will weigh every company equally. This is how I do it on my cost basis. I will buy up to an equal weight of a stock based on what I pay for it. I own about the same amount for each company. Some I will own more as I like them more while others I will own less as I don't have as much conviction in them. My max weight for a company is around 5% of my portfolio. Some of them are a bit more and several of them have less than that amount.
Some investors will weigh their companies by the level of conviction they have in them. They will have larger amounts of the companies they love and less of the companies they don't have as much conviction in. They might own 10% or 20% in one company they believe in the most and a few others they only own a few percent in like 5% in a few other companies they think might be great in that space. I think this is a good strategy when the big weighted companies are big cap safer companies. Sometimes investors will have a large weighting in a company that is very speculative which then makes this strategy more risky. Regardless of which strategy you use, you will have to consider how much weight you will give each company in your portfolio.
Value vs Growth
Value investing is about finding companies that look cheap based on their assets or cash flows. It has metrics like a price to earning ratio, margins, cash flows and assets. I spent many years as a value investor looking for companies that were beaten down and trading at a discount to their intrinsic value. The value investor is looking for companies that are trading at a discount to their intrinsic value based on some macroeconomic forces or because the company might be facing some challenges. Many large companies in the market will fall into the value category. Most of them have low growth rates and are fully mature companies. The key to the value investor is about finding the companies which are trading as a discount and holding them until the market values them correctly.
Growth investing is all about the future. Many growth companies are in their early years of startup and many are not even profitable yet. They receive revenues, but they don't have any profits as they spend more than they make to drive growth. For the growth investor, it is all about what the company will become in the future. This makes growth investing very risky as some of these companies will not be successful.
I find that investors will typically be drawn to one type of these investments or the other. I rarely find an investor which will do both value and growth investing. Most investors will end up falling in love with one type or other. Some will love the treasure hunt of investing in growth companies while others will find value metrics to be more their thing. It is my belief that owning value is the same as owning the market and I would just use an index. I am a growth investor. I only like to pick individual companies that I think will become a huge success someday. That means I take on a lot of risk, but I only do so in my discretionary portfolios where I can afford the losses. I use a ton of risk mitigation strategies to ensure I don't lose a lot of money. That probably costs me something on the big winners when I hit on them, but it is worth the trade off as the failure rate in early stage companies is very high.
My Portfolio Building Strategy
I started in 1996 and have been actively investing for 27 years. I have been retired since 2000 and doing investing as a hobby. I have a small biotech portfolio I started back in 2011 that I use for playing biotech stocks. I typically have between 10 and 20 companies in my portfolio. Right now, I think it is well over 30. That is because the market has been in such a huge bear market for biotech that I have been buying everything I can. I don't like to put too much stock in any one company as biotech is very speculative, and the statistics show that 90% of these early stage companies fail. I usually don't put more than 3% to 5% in any single company. At least not early on.
I like to play baskets of companies based on key science concepts. I start with concepts like Techbio, CRISPR, Synthetic Biology and iPSC. Then I assess every company in that space until I find all the top companies I like. I will build a basket of those companies. I typically have 3 to 5 science themes and each theme has a max cap of 20% of my portfolio. I will usually have 3 to 5 companies in each theme. Less than 2 companies and it is not a theme. More than 5 has to be narrowed down to the best of the best.
I never risk more than 3% to 5% of my money in any single company. That means I will only exceed that limit if I have enough capital gains to reduce my cost basis. For example, if I had gains that equal 2% of total portfolio in a company, I would be willing to own up to 7% of my total in that company because only 5% of that would be my money. The rest is already paid for. Most of the time, I am cutting companies out that did not live up to expectations while building positions into new companies into market corrections.
I never buy all my stock in a company at one time. I tend to like to nibble away at it as it comes down in price. With today's free trading at most brokers, there is no reason to buy a ton of stock at one time unless you think you can predict the market. Once I have built my position in a company, I tend to trade around that position taking profits when the markets are up and buying some back when the markets are down. I tend to use 20% as a rule for buying or selling on stock moves, but not always. I like to watch the market sentiment to see when things are over loved or over hated. I never sell my core shares in a company unless I think it has become fundamentally broken. I try to keep half of my position as my core position and use half for trading around my position into the market swings.
I find this strategy works best for me as it gives me the best of long term investing and the best of short term trading. It keeps me active enough that I don't get bored and quit, but also focused on the long term so I don't miss the bigger picture. This is just my strategy.
Now I am going to share with you how I do my due diligence for companies. This is just my method. I am sure everyone else has their own. I tend to spend a lot of time getting to know a company very well. I like to follow them and get a good feel for the company and the management team. I am never in a hurry when shopping for a new company. I make sure I take my time and do all the work before I start to buy. Then I start by buying a tiny position to get started. I will nibble away at the position over time as I get more and more familiar with the company and confident in my investment. If at any time I start to doubt, I stop buying so that my position doesn't get bigger. This often stops me from taking a full position in a company that I will end up selling later once my concern comes about.
Macro is a Backdrop
When it comes to picking a good long term investment, I find too many investors get distracted by the macroeconomic backdrop. They let a down market dissuade them from buying a great long term investment. The negative sentiment causes them to not buy when the price is actually at its cheapest. The economy has its boom and its bust periods. The good news is the bust periods typically last one to two years. The booms can last for many years or even a decade. Taking advantage of a weak market or economic backdrop is actually the best asset of a long term investor. There should be no reason a recession today or next year would stop you from owning a company you think could be worth 10 times this value in another 10 or 20 years. Yet, no matter how many times I try to teach investors this concept, they still get hung up in the panic and fear of a down market.
Know Thy Companies
If you really love investing and picking companies, then you should desire to know everything you can about them. No one should know more about your companies than you. Obviously, the management and insiders will always be privy to information no one else has. No other investor should know something that is publicly available information and you do not know it. This means you have to spend a lot of time digging through financial reports, presentations, publications and listening to webcasts. The only competitive advantage vs other investors you have is knowledge. You should know every partnership, every lawsuit, every data read out and the amount of sales each company has. Here I am going to share with you my system for doing research on companies before I ever make a purchase.
Key SEC Filing
The first thing I will do for a company that is new to me is look over their science. I know the science and I know what looks like it could work and what looks like it could have problems. I really need to see how the science works and what the data looks like before I decide if it can be a huge winner or a struggling science concept. If the company has recently gone public, they will have a recently published S-1 which is put out ahead of the IPO. These usually go very in depth into the science of the company. If the company is within a few years of the IPO, I will go back and find the S-1 and go through the science to see if it has any issues or problems. Any company that is at least a year old will have published an annual report 10K. This is a very in depth document like the S-1 and gets published each year. I am going to read that and make sure I am up to date on any data that might have come out since the S-1. Then I check the quarterly report 10Q to ensure I have the latest data possible.
The next thing I really want to look at for a company is the Indications and how big they are. Small indications make small profits while big indications make big profits. This is important to the long term success of the company. I want to know if there are any partners and how they take off the sales of any product. I want to really know the financial terms. There is no point to owning a company if you don't know what it could be worth in 10 years. The only way to do that is to look at its pipeline and figure out what it can earn in revenues and then figure out what those revenues can be worth.
You might say, what about management? What about them? The only way to really know a management team is to follow them over time and see how well they do. This is the hardest part of any investment as management can make or break the best companies. It is never something you are going to read in a 500 page document. It can only be determined by watching how a management team handles its affairs for presentations, financial management, navigating the regulatory process and building the company.
I like to go through the press releases of the company. If it is a younger company, I tend to start at the very first press release and go through them in chronological order. This gives me a very good feel of the news and events in actual time. I can see what decisions the company has made for its programs and finances and build a picture of how well they are developing the company over time. I tend to go through at least 3 years of press releases, but I will often start at the beginning and skim through them all for a company that is new to me.
When it comes to getting to know management, nothing helps better than listening to them present and speak. You can get a good feel for how they handle themselves. You can tell if they make hyped up claims to pump the company. This is distasteful as many of the management teams that resort to hype do so as they lack real sustenance. I can tell if a CEO delegates by allowing his other team members to take charge of their respective fields like finance or science. A CEO that dominates and doesn't delegate worries me. I can tell if the CEO knows science or is a finance professional. Both can do well, but they need to know both skills or be willing to delegate those areas to someone who does. A business person CEO teamed with a great science CSO often does really well. You can get to know a management team and how proficient at their job they are by just listening to how they present over time. I will often go through at least a year's worth of webcasts if they are available. That gets me a few earnings calls and several science conferences if I am lucky. If a company doesn't have those webcasts then I will follow them in real time until I hear enough to feel comfortable with the management team. It just takes longer.
Posters and Presentations
I like to go through the posters, publications and presentations. Not every company will have a page of their website where they put publications, but I find I am more confident in the companies that share this data. The publications are data that is published in various journals or at science meetings. I will also go through the slide decks from the company. Some companies will put out a slide deck every month. These can often give very useful data about the indications, their size, the competition and potential.
Staying up to Date
Once I have done all my initial due diligence, I don't just stop there. I keep up with all these events. I usually pick one weekend a month where I will go through all the press releases, events, slide decks and SEC filings for each company I own. It has been so important to me, that I put all these links on every company's profile on this website. This saves me a huge amount of time trying to go to the website of each company one at a time and find the information. You should get to know the company's website. It will be your top source of information for each company you own. I even have a bookmark folder for each company I own.
Here I am going to share with you the top things I look for in any company I invest in. There are a lot of things that go into building a great company, but I tend to focus on fundamentals and valuation. They seem to influence the company's chance of success with the greatest impact. Fundamentals are about the quality of the company. Fundamentals tell me which companies I should buy. I also focus on the value of the company. Value tells me when I should buy a company. When it comes to fundamentals, I tend to focus on two key aspects of companies that I feel are the magic formula to success. They are Management and Science. Then I look at the financial potential of the company and its current valuation. Lastly, I look at the risks of the company.
Great management can turn even average science into a successful company. Bad management can wreck even the best science. I would never own a company with what I perceive to be weak management. When I look at a company's management, I really look at the CEO. They are the captain of the ship and ultimately all decisions go through them. I like to evaluate a company's management over time. It really takes time to figure out if management knows what they are talking about, and if they are living up to their promises.
I like to go over at least a year's worth of conferences, webcasts and earnings calls. I take notes on what was promised, like drug development timelines, and then I check off the promises delivered and circle those that are not. If they miss a deadline, and they provide a good reason for it, I will let it go. I know Covid has delayed many company's deadlines. I don't expect perfection. I expect consistency. As long as there is not a habit of dropping the ball. I like to follow a company for a few months and listen to conferences in real time before I make any commitment to buy. Then I start slowly with a small position and only add when I think the company is impressing me with the results like data or events. It is like any other relationship. I have to take the time to get to know the company and trust the management before I commit my hard earned money to them.
A great CEO will be honest and have integrity. They are straight shooters. They are going to tell you what they expect and admit when the results don't match up to it. A weak CEO will try to explain away bad data or try to spin bad data as if it were good data. Those are the ones you have to be aware of. A great CEO just lets the data speak for itself, and tells the truth. A great CEO is also a great communicator. They go to various conferences and love to talk about their company. They also have to be able to communicate well. You want to see the CEO be able to handle the tough questions with grace and ease. What I don't want to see is a CEO who is hyping or pumping up the science or company. They tend to be the worst with throwing around flashy buzz words just to crush investors when it all fails.
A great CEO must be a good financial manager. Managing cash balance is key in the biotech market where a stock can go through long periods of "out of favor". I like to see at least 2 years of cash on the balance sheet to get through the lean times. It is also important for a CEO to time the secondaries when they will be best received. I like to see them take advantage of investor optimism and sell into the big rallies based on good data or just market excitement. Another major aspect of good financial management is not recklessly spending money. I see some companies that have just so much going on that they burn huge amounts of cash. They become giant money pits.
A great CEO needs to navigate the regulatory process very well. I see it too often where an inexperienced CEO makes tons of blunders with trial design, regulatory submission, manufacturing inspections and communicating with the FDA. This leads to delays in timing of trials, clinical holds, Complete Response Letters (CRL's) or even bad trial outcomes. It can be hard to know if a CEO is one of these rookies, but it usually shows up quickly in the data.
The last and most important attribute of a CEO for me is visionary. A great CEO has to make great decisions around company development. They have a vision about their company and where they want it to go. They make great decisions to develop the long term story. They make good partnerships where needed. They make good decisions about which indications to pursue first. Some CEO's lack decision making and spend a huge amount of money trying to chase everything at once. A good leader will pick a few key programs and pursue them to commercial before spending more money. A good leader won't always be perfect so I don't sell on just one bad event like a trial failure or a delay with a trial. If it becomes a habit by happening more than once, then that is an alarm the CEO might not be up to the task. I personally think that management makes up about 70% of the value of a company.
The quality of the science is the other part of the magic formula for a winning company. I look for a technology platform that can yield many new drugs. I also like companies focused on mastering one science. Some companies look like a swap meet of different technologies. They tend to be a Jack of all Trades, but a master of none. Here are some attributes that I look for in a company's science and pipeline.
When it comes to science, there is never a lack of great companies out there who are innovating. That means great companies have more than one drug in the pipeline. I don't want any one-hit wonders. They tend to be too volatile and way too binary. They are either huge wins or massive losses. They can be gut wrenching. I want a technology platform that can yield many successful drugs. Those are the big winners when their technology works out. They can keep following up one success after another.
I like to look for companies that have science that separates them from the rest of the pack. You want a competitive advantage in any business and game changing science is one such method. I want superior science compared to peers, or I want a company with no competition in a new area of science. I tend to focus on picking areas of science that are leading the technology in the industry. This means I am betting on my ability to pick out innovative new science. I have to assume I will be wrong on a lot of these companies as they are so speculative and early stage. I manage this using strategy. I pick a basket of companies in a new innovative space and place small bets on each. Then I monitor them as they advance the science. I use the data to weed out the weak companies and buy more of the winners. I reward success and don't reward failure.
When evaluating companies as the data comes in, I don't dump a company if they have a failure early on. Too many times, I have seen a company fail once just to make a massive comeback. Failure is part of the game for early stage biotech. What I don't want to see is a pattern of failure. If I have a company that has a big clinical setback, I put them on probation until they get another data readout. Good data forgives the older failure, but another failure confirms it.
The final aspect is I focus on key areas of science. Biotech is a big space. There is a lot of science across so many areas of disease. I find I do better when I pick a few key areas to focus on. Sure, I might miss a great company that develops a good new Alzheimer's drug. That is fine because my focus allows me to be an expert in the areas I focus on. I have more success when I focus. I used to cover anything in biotech, but I found that I was hindered by areas of science where I did not have the expertise to keep up. That is when I switched to focus on key science themes for me. I focus on Genetics, Immunology, Hematology and Oncology. They are all extremely complementary to each other. Oncology actually requires a mastery of Genetics and Immunology.
When we are investing, we only have a limited amount of capital. That means you want to get the best possible return for the amount of money you invest. I have a saying that goes, “I love big indications and I can not lie”. If I am looking at two companies that have great science, which one has the biggest potential? One might have an innovative drug, but it only applies to a few hundred patients. The other might be just as innovative but help millions of patients. When investing in companies, I want to pick those who have innovation, but also the largest potential.
When it comes to returns in an investment, sales drive profits which drive returns. That means I want to pick companies that have the biggest potential market size. I can see a company with 18 indications, but they are all very small indications. Another company might have a handful of indications, but one or two of them could be multi billion dollar opportunities. I see too many investors get hung up on the science and forget all about what it might actually mean in sales. After all, we are investors and we are here to make money in our investments. I love to see good science helping sick people, but I always want to see how much money it will make me.
Understanding partnerships for companies is important to understanding the potential of the company. If they only get 20% of the revenues on a product, it offers less potential than another product that might get 50%. The use of partnerships is a double edge sword for young companies. Having a partner can help spread out the risk for an early stage biotech. It can help provide cash in the form of upfront payments and milestones. It can even bring in important expertise to a young company to help them grow, learn and develop. A partnership sells out a chunk of the future potential for something right now like desperately needed cash. It is important to understand the financial term of partnerships and how they impact the long term potential of the company.
Investors see partnerships as a stamp of validation for the company's science. I agree that it can be nice to have a bigger company partner with one of my companies as it does say they see something in the science. The issue with that belief is many big cap companies will make many partnerships with smaller companies, and they don't expect them to always work out. They often abandon partnerships with smaller companies when they change their plans. I like it when a company uses partnerships wisely and sparingly, but doesn't over use them. I am not a fan of companies that excessively use partners as it gives away too much potential.
Valuation is what the company is currently worth. The market itself works like a popularity contest as investors go from euphoria to panic and back to euphoria again. That means companies will be very expensive at times and very cheap at other times. The real value lies somewhere in between. As companies progress and develop, their value will grow. We can calculate the value of a company at any point in its development. Then we can wait for the stock valuation to get below the intrinsic value we calculate. That makes value a measure of when we can buy a company. I will spend an entire section on valuation.
The last part of evaluating the fundamentals of any company is to look at the risks. All biotech has many of the same risks. Early stage companies are more risky than later stage or commercial companies. When I look at a company, I am looking for risks that go beyond the normal biotech risks. This can be a part of the science that seems like it hasn't been figured out yet. It might be a weakness in management. When it comes to investing, we want to make the best investments that require the lowest risk for the returns we seek. If I am looking at two companies with both being phase 1 with similar science and similar potential, I want the company that has the lowest risk.
I have been valuing companies for about 27 years now. I was fascinated as a new investor on what made companies worth what they were worth. My first exploration into valuation was the classic Benjamin Graham with his book the Intelligent Investor. The is the man whom Warren Buffet studied under. It was all about paying for earnings. Most investors today would tell you that the valuation of the company is linked to the cash flows it produces. Many analysts now use a complex and very biased Discounted Cash Flow (DCF) model. But what about companies that are not profitable yet? After all, many of the best investments are early stage companies that are spending more than they make to drive growth. What are they really worth? Are they only worth the physical assets? Is there no value for technology and intellectual property? Here is a look at my evolution of looking at valuation over my 27 years as I went from a value investor to a growth investor with an eye for value.
Price to Earnings Ratio
When I first got started into the valuation game, I read the book "The Intelligent Investor" by Benjamin Graham. This book is the Bible of valuation. It was written in a time before the internet and the hyper growth companies. When doing valuation, it all comes down to what we will pay for earnings of a company. In a bull market, investors will often over pay for earnings. In a bear market, investors won't pay as much for those same earnings. We call the amount we pay for earnings the multiple. The multiple is based on earnings and it expands and compresses with the economy. Everyone has heard of the Price to Earnings multiple (P/E). That is the multiple we are talking about here. To give an example, I am going to use Apple. We have the Price of the stock at around $153. It has earned $5.89 in trailing 12 months earnings. Once we have the Price and the Earnings, the P/E is simple math. It is the Price divided by the Earnings. In this case it's $153/$5.89. That comes out to 25.97. That is how they calculate Price to Earnings multiple.
The average P/E is considered 15 from the classical Ben Graham valuation days, but they never had hyper growth companies back then. Some of these companies can have 50% to 150% growth when they go public. In that case, how do we know if we are expensive on this P/E? When it comes to Apple, some people might think a 26 P/E isn't all that bad for such a great company. Others might find it extremely expensive when it's historically traded at 15 P/E. The rule is, The higher the level of growth, the more investors will pay for those earnings. Often, I will do a P/E for the current year and then for next year. That will give you an idea of how expensive the company is on forward earnings. This helps compensate for growth. The future earnings for Apple are $6.58. That makes the forward P/E of $153/$6.58 equals 23.25. The growth rate is the difference between the current earnings of $5.89 and $6.58 which is 11.7%. Paying a 23 P/E for a company growing at 11% growth seems very expensive to me.
That is where we can adjust the P/E by the growth rate using another metric called Price to Earnings Growth (PEG) ratio. This takes the normal P/E and divides it further by the growth rate. We just calculated a forward P/E or 23 and growth rate of 11%. This is where we take the P/E and divide it by the growth rate or (23/11). That gives us a PEG ratio. In this case it is 2.09. The understanding for PEG ratio is that any company trading at less than 1 PEG ratio is very cheap. It's my experience that when a company has very high growth and the PEG is low, it is because investors do not trust the growth. When the PEG ratio is higher than 2, it is considered way too expensive. This can happen if the company has a very attractive dividend. Many companies like Apple here in our example are very expensive because they also have a dividend which gives them value above the level of growth in earnings. Many dividend companies will often trade at high PEG ratios as they have yield that supports the value where growth no longer exists. This is an example of classical Graham valuation, but what do you do when there is no earnings?
Price to Sales Ratio
Next I am going to look at a value metric for those kinds of companies. When a company has no Earnings, most investors will come up with all kinds of metrics to attempt to value them. I find the best metric is just Price to Sales. What is the Price to Sales ratio? This takes the Market Cap of the company and divides it by the total Revenues or Sales. In the Case of Apple it has a 2,400 billion market cap and 394 billion in sales. That makes the Price to Sales (2,400/394) or 6.09. I use P/S all the time in companies that don't have any earnings. You can even adjust this for growth like with the PEG ratio. Then I compare this with other companies in the sector and for the sector in general. There are sources on the internet where you can find the average Price to Sales ratio by industry. If your company is growing faster than the average company in the sector, then it's safe to assume it should have a higher Price to Sales ratio. The other thing to consider is profit margins. If 2 companies have the same sales, the one with a higher profit margin would get a higher valuation. I have seen this in healthy eating stocks in the past. When I had 2 companies with different Price to Sales ratio, the ones with higher growth and higher profit margins had a premium.
My system for valuing biotech is something I developed over the years. I built this system to be an easy way to get a general ballpark valuation for a company so I can tell if it is overvalued or undervalued. I built it from years of watching how company's stocks respond to clinical data. The value a company loses or gains on a clinical data read out informs us to what the value was attributed to that program in the value of the stock. Then I have to assume 2 variables in this value. The first is the valuation takes into account the potential of the program. A program that could do $1 billion in sales would be worth more than one that could do $250 million in sales. The second assumption is the valuation takes in consideration the level of validation of the program. A phase 3 program is more validated than one in phase 1. It would have a bigger impact on valuation than a program in phase 1. If both these assumptions are true, then we can use the move in a company's stock price based on a clinical failure or success to inform us of the value.
My model is a sum of the parts model. I take each drug in the pipeline and figure out what it could earn in revenues at peak sales. Then I adjust that value based on the level of validation of that drug. That gives me the value for that single drug. Then I add up all the value for all the programs and add in the cash. If I have a drug worth $500 million value, a second worth $250 million, and the company has $500 million cash, my valuation would be $500 million + $250 million + $500 million = $1.25 billion value.
The key values here are estimating peak sales and adjusting those sales based on the level of clinical validation. You can often get estimates for sales from analysts or even the company. The harder way is more accurate, but takes more time. If you follow your companies, they will often define for you the size of the patient population in their presentations. Then all you need to do is find prices of comparable drugs, and you can calculate peak sales. The only change would be to adjust for potential market share for competition. The level of validation for the drug would simply be the level of clinical success it has achieved. I take the peak sales and adjust them for the phase of development using .1x for preclinical, 1x for phase 1 data, 2x for phase 2 data, 3x for phase 3 data and 5x sales for a mature biotech valuation.
Once you have the value for each drug in the pipeline, you just add them up and add in the cash on the balance sheet. This will give you a total valuation for the company. You can compare the market cap you calculated to the current market cap to see if it is too expensive or too cheap. You can even adjust your valuation based on the outstanding shares and get a stock price for that valuation. Every time a company reports they will issue a 10Q or 10K. The very first page will list the number of outstanding shares at the time of reporting. You can divide your valuation by the shares outstanding and get a price target.
Risk is the possibility of losing money in an investment. We can manage risk in our investments once we understand what it is and what kinds of risk there is around investing. Often just understanding the risks helps people better understand how they want to invest. I always use the expression of, “Manage the risks, and the rewards will take care of themselves”. I think I adapted this from something Warren Buffet once said. No truer words have been spoken. You can't make money unless you understand all the risks and how to mitigate them. You can't make money if you lose everything in one very speculative investment that fails.
How much risk you are willing to take comes down to two factors. The first is your personal tolerance for risk. Some people, like me, can put all their money in a bunch of risky speculative biotech companies and sleep like a baby. Other people get all nervous and can't sleep a wink if their portfolio goes even slightly into the red. I know a lot of people who say they can tolerate a ton of risk, but they freak out whenever something goes wrong with any of their companies. You have to honestly know how much risk you are comfortable with.
You should never take any more risk than is necessary to achieve your long term goals. The market averages 8% a year over the long term. If you need more than that to reach your retirement goals, then you might need more risk. If you don't, then you can safely put your money into a low cost index fund and kick back. The amount of risk you want to assume depends on how much risk you can tolerate and how much risk you need to assume to meet your goals. I honestly believe that 90% of investors could contribute to a low cost index fund each pay day using a tax free account and do well over the long term.
The further you go out the risk spectrum while investing the bigger the reward, but so is the bigger risk of losing all your money. I see so many investors focus only on the rewards and never the risks. Each asset class has a different risk and reward level. Bonds typically have lower return rates around 5% to 6% while having a lower risk. They will rarely move more than 10% in a year from highs to lows. Stocks will average 8% to 10% on average, but can swing more than 20% up or down in a single year. Asset allocation is a key principle of designing a portfolio to meet the highest possible return for the lowest possible risk an individual investor wants to assume.
There are different kinds of risks an investor will face while investing. Market risk always exists. This is the risk of the overall market having a crash or correction. Corrections and crashes happen all the time in the market. They can come from economic forces like a recession or geopolitical forces like an earthquake, pandemic or war. You can't control the events that cause market risk, and you don't know when they are going to strike. In the market we call them the Black Swan events. There are two main ways to protect yourself from the overall market risk. The first is you can hedge yourself. I have friends that sell covered calls or other options strategies to protect their investment in stocks from market risk. They earn extra money selling these calls when stocks are flat to going lower as the calls never get triggered. They take their own risk as a spike in the stock or market could end up with you getting “called” out of your stock, limiting your upside. The other is just to raise cash into big rallies for the market and buy back positions into the big crash or correction. That is my strategy. I tend to fade the rallies slowly as the stocks move higher. Then I slowly buy back my positions into a sell-off. I never go below a minimum position and never over a maximum position.
The other major risk is company specific risks. Anyone who has been in biotech for 5 seconds knows these all too well. They often come in the form of clinical failures, but there are many types of company risks. The biggest one is the risk of a poor management team. A poor management team can turn your investment life into a humbling experience. Taking a discovery stage biotech from start to commercial takes many important skills for a management team. Many of them are not up to that task. There are risks of patents, competition, obsolescence, failure to find funding, manufacturing and so many more.
The first thing new investors in biotech should figure out is what you are willing to lose. With a sector where 90% of the science fails, you have to have a high pain tolerance or a very good strategy. We will go with strategy because no one wants to endure a lot of pain. When it comes to science, we go through a lot of failures before we find great success. Hopefully, most of that is done in the early discovery phase before it comes into the clinical stage. Even so, many drugs still fail to ever reach commercial sales. We will look at strategies to limit the damage any single company can do while maximizing the returns each company can give us. For me, that level is 5%. I will risk up to 5% of my money on a speculative company. If I take that kind of loss, I know I can make up for it.
Diversification is the best strategy for protecting yourself from single company risk. If you are diversified enough, it can also protect yourself from overall market risk as assets like bonds do well in bad markets while stocks do well in good markets and real estate does well with inflation. Spreading out your money is the best lesson any successful investor learns. Nothing is worse than going all in on a single company or asset and it fails miserably. You will always hear about that one guy who got rich going all in on a company, and it was a huge winner. What you never hear about is the 100 other people who go bankrupt from going all in on a company that fails. People who had all their money in companies like Enron and Worldcom know this lesson all too well. The first thing I recommend for new investors is figure out how much they can afford to lose in a single company. That becomes the limit they should use to put into any one company. I usually will go between 10 and 20 companies depending on how much I want to risk in each. If you have 10 companies, that would limit each one to 10%. At 20 companies, that would limit each to 5%. How much money you concentrate in each company depends on how risky it is and how much risk tolerance you have.
Some investors tend to put more into the companies that have big gains while limiting the newer companies that lack any real gains. Spreading out your money into more companies is the best way to protect it if one of those companies turns out to be the next Theranos. By setting a max limit on each company, it will protect you in case something goes wrong. I always tell myself, “If I am right about this company, it will come back”. Never throw good money after bad into an investment that isn't doing well. A max limit position prevents the desire to double down on bad companies. It is natural for an investor to dig in and insist they are right about a company. They will continue to throw good money after bad into a company as the stock goes lower. All they end up doing is amplifying the losses on a bad investment. Do not ever get into the habit of selling the winners to fund the losers. You end up with a portfolio full of tragedy. Setting a maximum limit on any position should be done even before you make the first buy. Once you have done all your research, you know how risky it is and how it fits into your overall strategy. Set those limits right away and stick to them.
Another good rule is don't buy all of your position at one time. In this day and age, you can trade for free at most brokers. There is no reason to be a hero and go all in with your max position right away. I usually make one buy early with a small position to get me in on the story. Then I wait for a correction in the stock to build up my position. If you love the company now, you will really love it at a much cheaper price. Too many people go all in for their position right away. That is a very risky strategy as we often let emotion control our buying. We tend to chase stocks as they go higher because we want to get rich quick, and we panic sell them as they go lower because we can't stand the pain. Emotion is the challenge of a good investor. By nibbling away at a position over time, you can eliminate the emotions and make it a process.
The best investment in the world is the risk free investment. This comes by taking enough profits in a company to take out your costs. Then you can keep it forever if you want. I call this playing with the house's money. I get that question the most of any question I get from investors. It goes like this, “I bought XYZ company and it's up 300%, should I keep it or sell it?” My answer is always the same. I tell them to sell at least enough to take out their costs. Then they can let the rest run as long as they like the company. This allows us to take out our cost when things are bubbly so we don't lose money during the bust period. The one thing you can count on in biotech is there will be setbacks and struggles for every early stage company. Taking out your cost reduces your risk to zero. I tend to use a system of trading around my position to pay off my cost a little at a time. Once I reduce my cost basis to zero from capital gains, I can hold my shares at no risk to me. The biggest risk I have ever found in the markets is emotion. Things like fear and greed compel investors to do all the wrong things for all the wrong reasons and at the very worst time. Things like buying an exciting new biotech at the peak of euphoria right before it crashes back to reality. Fear will compel investors to sell a great company just because the stock is going lower right before a big buyout. The first thing a successful investor learns to do is to control their emotions with strategy and discipline.
When it comes to long term investing and planning, it is important to keep up with your portfolio periodically. If you are doing passive investing, you might just look at your investments annually to ensure they are keeping track with your long term goal. You can use an online investment calculator to figure out where you should be in your investment journey. If you are 5 years into saving for retirement, you can calculate where you should be to reach your final number for retirement. If you are falling behind or ahead, you can make adjustments. If I were ahead of the game, I would not adjust because if you reach your goal early, you can retire early. I would only take action if I were falling behind. This can happen because you chose a return of 10%, but you are only getting 8% in actuality. That is where managing your portfolio is important to making sure you are on track to reach your financial goals.
Rebalancing is a useful tool to maintain your investments. If you are using a good asset allocation, you will probably have periods where one investment is doing very well and another might not be doing so well. Typically, bonds do well when the economy is bad and the Fed is buying bonds. Stocks tend to do well when the market is booming. This can cause your asset allocation to shift. You have started with 30% bonds and 70% stock but now you are 27% bonds and 73% stocks. This is a good opportunity to rebalance by selling a bit of the stocks back down to 70% and buying some bonds back up to 30%. This can help you take profits in the assets that are doing well and add to assets that are cheap. I have looked at a few studies of rebalancing portfolios. It seemed the data showed that rebalancing too often caused underperformance while rebalancing once a year worked best. I think looking at your investments at least once a year and making sure you are on track for retirement and rebalancing if necessary is a good idea.
Dollar Cost Averaging
I think Dollar Cost Averaging is one of the best tools an active investor has at their disposal. In this day and age, we can trade stocks for free. Most brokers have completely eliminated trading fees. Back when I first started, you could expect to pay upward of $20 for a single trade. You were forced to buy as many shares as you could to spread the cost across as many shares as you could. Otherwise the fees alone would wipe out your gains, but that isn't a problem anymore. I still think some investors are stuck in that habit though. Today, we can buy just one share at a time if we wish. The only fees left are the few cents you pay for the SEC fee when you sell shares. The market is dominated with emotions. We as humans are ruled by our emotional behavior. We get excited when stocks are going up and we get scared when stocks are going down. Human behavior makes us want to buy at the worst time and sell at the worst time. By nibbling a specific amount of shares toward your position at intervals can take the emotion out of the equation. You might decide, I am going to buy $500 worth of shares of the VTI every month when I make my contribution to my IRA. That means you will buy the same dollar amount worth of shares every single month. You buy when the market is up and you buy when the market is down. This averages out your cost basis for your investment.
I like to use a different method of Dollar Cost Averaging. If I love a company, I will buy a small percentage of my position just to get into the company. Then I add a little to my position each time the stock pulls back at least 10% from my last purchase. For very volatile stocks like biotech, I would even use 20% for a gap in price between purchases. The goal is to try to get a cheaper price each time you buy. This ensures you are not chasing the euphoria of the market and only buying into the panic sell offs of the market. This can be a very difficult thing to do as every fiber of your being will scream for you to sell when you should be buying. I tend to automate the process. Most brokers will allow you to set Go to Canceled orders that will stay open for as long as you desire. If I start a position in a stock at $50, I might set up GTC orders for $45, $40, $35, $30, and $25 to reach my full position. Each one of these orders would trigger automatically when the price is reached. If the price isn't reached, then you don't worry about it. The biggest risk to this method is you want to pay attention to your companies. There is a risk that some really bad news happens and the stock crashes. You would end up with multiple bids triggering at the worst possible time. I don't mind buying a good company that gets taken down by the overall market, but I don't want to be buying a company that has failed in a massive way.
Trading Around a Core Position
Another method I use in combination with dollar cost averaging is trading around my core position. I make sure I keep at least 50% of my position for the long term investing. The other 50% I will use to trade around that core position. As the stock is pulling back, I will nibble some each time it reaches 10% or 20% down from my last purchase. When the stock returns to its old highs, I will begin to fade the trading shares down to my 50% core position taking profits each 20% the stock goes beyond the old high. Once I am down to my core position, I stop selling and wait for the next big correction or crash in the market to buy back my trading shares. This method allows me to take advantage of the bubble and bust mentality of the market to make more money and improve my returns. Any profits I take in capital gains, I use to lower my cost basis. My goal is to pay off my entire core position with the profits I make from trading. This lowers my cost basis to $0 and makes my investment on the house's money. That is the ultimate goal as you can own your investment at no cost to you.
Ranking companies is a principle of investing. It is an exercise I like to do with my companies from time to time by ranking them. I will go over each company and assess what I honestly think it has achieved compared to what I expected from that company. This is a fundamental evaluation of the company and how it has lived up to expectations. Often, I will find that some company has really disappointed me. Maybe management just didn't live up to expectations. Maybe the market wasn't as big as I thought. Maybe the data just didn't live up to expectations. No matter what went wrong, it is time to do an honest assessment of each company. I rank them into three groups of Buy, Hold and Sell. That means the companies I want to buy are the strongest companies, and I want more of them on any good sell off. The companies I rank as a hold have neither impressed or disappointed me. I am waiting for more development of those companies. I would be willing to buy more of them at the right price, but I would dedicate my cash to the buy stocks first. The sell ranked companies are those I would look to exit at the next available opportunity. There is no rush to sell those disappointing companies into a weak market. When the market comes back, so will the stock prices of the companies. That will allow you to sell them at a higher price when it's more to your advantage. I try to do this assessment at least once a year. I probably do it after each earnings season.
Selling Losers to Fund Winners
One of the worst habits I see investors fall into is selling their winners to buy more of their losers. This often stems from the inability to admit they got it wrong. The worst thing an investor can do is to sell companies that are doing well to buy more of those that are doing poorly. Yet, I would bet the vast majority of investors are doing this. They refuse to take losses or they refuse to admit they were wrong. They begin to sell the companies that are profitable to buy those that keep going down. Eventually, they end up with an entire portfolio of really bad companies. If you want to be a successful investor, you can't be afraid of taking a loss when it is necessary, and you can't dig in your heels and refuse to admit you might have gotten it wrong. I go into every investment assuming I could be completely wrong. When it comes to managing your investments, develop the healthy habit of selling your worst company to buy more of your best companies. I typically like to do this selling when the market is up so I can get a better price. This allows me to raise some cash. Then on the next big sell off, I can commit that capital into my buy ranked companies.
Wash Sale Rule
The wash sale rule states that, if you sell a stock for a loss, you can't buy back that stock for 30 days or you wash that sale. That term wash means you can't claim it on your taxes. If I sold a stock and took a $5,000 loss, I can claim the loss on my taxes which helps me reduce my income for the year and lowers my tax burden. For example, If I make $100,000 a year, I have to pay taxes on that $100,000, but if I have a $5,000 loss from a stock, now I am only getting taxed as if I earned $95,000. Some people will actively do tax loss harvesting each year to sell their losers and use those losses to offset or reduce the tax burden they might have for their winners. The sale rule applies only if you plan to buy back that same company. Maybe you have a loss in Beam Therapeutics. In November, you decide to sell it and take the loss. Then you wait 30 days for the wash sale rule. You buy back the stock in January for a cheaper price. You used that loss to reduce your tax burned for the prior year. People who trade a lot really need to pay attention to the wash sale rule as they can end up buying back a stock before the wash sale rule has expired. If you are selling to get out and never return, then it is of no concern for you.
Managing taxes is one of the most important parts of investing. There are a lot of taxes that can be applied to capital gains on stocks. Short term gains of less than one year are considered earned income. They get taxed at your normal income tax bracket the same as if you earned them working. If you make $100,000 per year, your gains on stocks for short term capital gains will get taxed based on your tax bracket for $100,000 in income. Any long term capital gains are taxed in a lower tax bracket like dividends. In our example, you would pay a 22% tax rate on short term capital gains and 15% taxes on long term capital gains. That is a 7% difference just by holding for the long term. Understanding your tax bracket for both long and short term capital gains is important. The difference between long vs short term can be as high as 15% difference as the highest tax bracket is 37% and the highest long term cap gain tax is 22%.
The best way to avoid taxes is to use a tax free account like a 401k or an IRA. These are a must for the retirement accounts. They allow you to compound your returns tax free for many years. You only pay taxes when you take the money out of these plans. Some of these plans allow you to pay taxes before so you don't have to pay them later like a Roth version of these accounts. The traditional 401k or IRA account means you put the money in before taxes and pay the taxes when you take it out in retirement. A Roth version of the 401k and IRA allows you to put the money in after you pay taxes so you don't have to pay taxes when you take it out in retirement. These are important points you have to evaluate when you are planning retirement. The drawback to these plans is you can't get the money out before you reach a certain age for retirement.
If you are planning to invest money for something like a new house in 10 years, you don't want that in a retirement account which requires you to be age 65 to withdraw the money. You will have to use a taxable account for that kind of short term goal investing. There are some plans that allow you to take loans against your 401k or IRA so you can buy a house and things like that. These work great as you are not paying interest to a bank. You are paying it to your retirement as you pay back the loan. You are literally borrowing from yourself. This can be very useful.
Picking to go with a taxable vs a tax free account is one of the most important decisions you will make. You may end up using a combination of both for each of your short term and long term goals. Retirement should always be in a tax free account. Some of the short term goals may require a taxable account. There are two special types of short term tax free accounts with the 529 saving plan and a Health Savings Account (HSA). They allow you to put money into them after taxes and you don't pay taxes on withdrawals for qualified expenses. The 529 savings plan is for saving for a kids college and accumulates tax free and is tax free for qualified expenses like tuition and books. The HSA is for health care costs and allows you to put in money after taxes. It can accumulate tax free and cost no taxes for qualified health care expenses. They might be something of interest to you if they help fill one of your shorter term goals.
Speculation is about investing in companies with high risk levels because they have very big potential. It can be an early stage technology company building electric cars or it could be an early stage biotech company working on gene editing. The thing that draws people to the market is that desire to pick a big winner that makes them rich. Speculation embraces that desire. It is the spice of investing. In moderation, it can make investing more exciting. When it is overused, it can be a recipe for disaster. I embrace speculation in moderation. It makes investing fun and keeps you engaged. I think it is appropriate to do it in a taxable account with a small part of your investment money. We would call these discretionary portfolios. That is money we do not need for our long term goals, and it would not hurt us if we lost it all. My speculative portfolio is about 10% of what my retirement is. That might seem like a lot, but I am already retired and I don't need the money for anything important. I have been able to use that to compound gains in these speculative portfolios over the long term.
When it comes to speculation, I love to use baskets. A basket is a group of speculative stocks. It is basically a mini portfolio within your larger portfolio. The stocks in the basket can all have the same theme or the stocks could come from any sector or place. Let us assume I want to build a basket of CRISPR stocks. I decide I want to own 2% in 5 companies for 10% of my portfolio as my basket. I would pick 5 companies, and I would own 2% of my total portfolio in each of them to make up my basket. When it comes to using a basket you are playing the odds. The odds are the vast majority of the companies will fail, but one or a few of them might be successful and one of them might even become a really big winner. Let us use an example. You picked 5 companies and put $1,000 in each. The first 3 companies fail and go bankrupt so you lose -$3,000. The 4th company doubled so you made $1,0000 profit. The last company goes up 10 fold so you make $9,000 profit. You have -$3000 + $2,000 + $10,000 as your final results. That comes out to $9,000 total of which you input $5,000 for the cost. That is $4,000 more than you initially invested or an 80% gain. That is the basic concept of basket investing to speculate. The goal is to have that 1 winner be a really huge winner. Maybe instead of doing 10x gain, it does a 1,000x gain like an Amazon. That is the whole principle of basket investing.
I use what I call the basket of baskets speculation system for my speculative investing. I do it in all my speculative portfolios with Technology, Biotechnology and Cryptocurrencies. In biotech, I pick key science themes I think will define the next decade of the sector. Then I find all the companies in that science field like CRISPR or TechBio. I will do my extensive due diligence on them and pick the top 4 or 5 companies. Then I build my basket using those top 4 or 5 companies I could find. I do the same thing in technology picking themes like Fintech and Electric Vehicles. Every basket I build in speculation has a key theme around some kind of technology I think could be a huge space in the future.
* I am not a Financial Advisor. This is just My Strategy. Please refer to your financial advisor before making any investing decisions.