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Research:
I always read the company’s financial statement to get an understanding of the profitability, cash flows and the amount of leverage (debt) being used. If there are unusual gains or losses, I’ll strip these results out e.g. if land was sold for a large gain, the EPS will be positively distorted for the one quarter but it’s nothing to get too excited about as the gain won’t be repeated. Equity analyst reports are useful to read as are the credit rating agencies reports (if company has rated) debt and their insight is useful and usually different from the equity analyst. It’s a good idea to read the MD&A section of the financials to get a feel for the company and what management expects in the future. The pending litigation is a worthwhile read as sometimes the company is suing or being sued for a large sum of money.
Diversification:
I don’t believe in diversification just for the sake of diversifying. It takes a lot of effort to be knowledgeable about just one stock, tracking a portfolio of greater than 10 stocks, would require too much time for little if any benefit. The first stock added to a portfolio is the best stock in terms of risk/reward ratio. Each additional stock added after the first pick is going to be marginally worse than the previous, otherwise it would be your first pick. If each additional stock added to a portfolio keeps making the average risk/reward of the portfolio worse, what’s the point of adding the new stock if you’re already sufficiently diversified? Each stock added to a well diversified portfolio simply detracts from the overall portfolio returns. I’m happy with a portfolio of 5-6 stocks.
Stocks:
I like to buy stocks that trade at a low price earnings ratio (i.e. 12 and under) in industries that I like e.g. energy (oil, gas, uranium and coal), base metals, precious metals, fertilizer. I will buy energy stocks that trade at a higher P/E ratio if the company has high reserves of energy. I’ll also buy stocks with a higher P/E ratio if the call options are expensive (see below).
Options:
I like to sell covered calls against the stocks that I buy especially if I can find an option that has a high premium and pays dividends. There are stocks that have call options that can be written/sold that will yield greater than a 50% return if you sell the covered calls 12 times a year. This covered call strategy usually allows you to keep any dividends paid, as the holder of the option is usually reluctant to exercise if there is time left on option. Once the stock trades ex-dividend, the stock price drops by the amount of the dividend making the option that you sold worth less. Since you wrote the covered call, you own the stock and you receive the dividend, but the option that you wrote has a better chance of expiring worthless. For example, you can sell/write a call option on a $17.00 stock and pick up a premium of $1.00 for a 1 month expiry. If you can do this 12 times a year, you will have picked up $12.00 in premiums at a cost of only $17.00 The idea is to find a number of stocks you don’t mind holding for the long term so that if the stock goes down, you’re okay holding the position. If the option gets exercised and becomes too expensive, you write the covered call option against another stock. This strategy is actually considered conservative as you have some downside protection (from the premium received) and have limited upside. When the returns are capable of easily returning 20-30% per year, it doesn’t feel very conservative, but compared to a strategy of just owning the stock, it is relatively conservative.
I like to buy put options on companies that have high P/E (or negative) ratios in troubled US industries e.g. car manufacturers, retailers, hotels, airlines, casinos, housing companies. As the US economy continues to weaken, I suspect that consumers will begin to shop for value causing the Wal-Marts to do well at the expense of their more costly competitors. I’m a little wary of buying more puts on US financial institutions as even though I think there is a lot more pain on the way, a lot of these financials make a lot of money if they weren’t writing down bad assets etc.
