Top 10 Online Investing Hacks Tips
Pages: 1, 2, 3
5. Buy Low and Sell High
Well, duh! As it turns out, it's tough to hold investments or buy more when prices are plummeting, and equally difficult to wait patiently for lower prices when the stock market is soaring. By assessing the rational price of a stock, you can make the right decisions while others overreact.
For growth companies, the PE ratio gauges whether a stock is over-, under-, or fairly valued. The ratio of price to earnings per share is similar to the price per gallon of gas, except that the PE ratio indicates how much investors are willing to pay for a dollar's worth of a company's earnings.
Because it fluctuates with the price, a PE ratio at any given moment isn't that helpful. However, the average PE ratio for ten years, called the signature PE, is a typical value to which the PE ratio returns from higher or lower levels.
The signature PE represents a reasonable amount to pay for a dollar's worth of earnings, but there are times, sometimes entire years, when investors pay more or less than is reasonable, as illustrated in Figure 1. When the current PE ratio is above the signature PE, the PE ratio eventually declines, most often from a drop in price. If the PE ratio is below the signature PE, the price often increases until the PE ratio is at or above the signature PE.
Figure 1. The PE ratio often reaches significantly above and below the signature PE
How can you put the PE ratio's tendency to return to the signature PE to practical use? When you plan to purchase a stock, compare the current PE ratio to the signature PE. If the current PE ratio is much above the signature PE, the stock is probably too pricey and will likely go down over time. If it's below, you might have a bargain. You can also produce the historical value ratio by dividing the current PE ratio by the signature PE. If the historical value ratio is more than 110 to 150 percent, you should wait for the price to fall into a more reasonable range.
You can also use the historical value ratio to calculate a rational price for a stock. The rational price of a stock is simply the price you would pay if the stock were selling at its signature PE, and is calculated by dividing the current price by the historical value ratio.
6. Spot Hanky Panky with Cash Flow Analysis
Although it's no secret that some companies have cooked their books, you can spot signs of questionable bookkeeping before the results or subpoenas are served. Company books are never cooked evenly -- at least some of the numbers are real. It's more like they've been microwaved on high for a few minutes, rather than baked at 325 degrees until done to perfection. Earnings are the obvious numbers to cook, because that's what the market pays attention to. So a good place to hunt for numbers that don't make sense is the balance sheet. You have a better chance of uncovering the truth about a company's cash flow by comparing successive balance sheets to determine where the money came from and where it went during a particular period.
WorldCom was one company that fudged its financials by capitalizing some costs instead of recording them properly as expenses, which (surprise!) resulted in higher reported earnings. How so? It stems from how capitalization and depreciation affect a company's earnings. When a company spends a big wad of money to purchase equipment or other things that it will use over a long period of time, the big wad of money doesn't show up as an expense on the income statement. If it did, earnings would take a huge hit in the year of the purchase and then would look particularly good for the remaining years when the equipment helps generate income with no expenses to match. Depreciation is an accounting mechanism that, in effect, spreads the cost of a capitalized purchase over the useful life of the asset. The purchase cost appears as a use of cash on the cash flow statement; the value of the asset shows up on the balance sheet; and each year of the equipment's useful life, a depreciation expense appears on the income statement. Let's look at a simple example. If a company has revenues of $100,000 and expenses of $50,000, its net income is $50,000. However, if the company plays games and transforms the $50,000 in expenses into capitalized expenditures, the straight-line depreciation, assuming no salvage value, would be one-fifth of the $50,000 for five years. This ploy increases the net income to $90,000 for the year.
Figure 2 shows a comparison of Worldcom's EPS to free cash flow from September 1998 through September 2000 using Spredgar (http://www.spredgar.com), which shows free cash flow, mostly negative -- and often dramatically less than reported positive earnings.
Figure 2. Worldcom's EPS looks much better than the cash flow it generates
How is this possible? Spredgar's net balance sheet cash flow for the quarter ending December 1998, shown in Figure 3, shows WorldCom's expenses appearing in the Property, plant, and equipment (PP&E) line item (cell D93). During this period, PP&E was more than five times reported net income! This number doesn't represent long-term assets and investments, which are listed on the next line. For eight quarters starting in October 1998, PP&E ranged from 80 to 400 percent of net income. Stuffing expenses into this area enabled Worldcom to report net income as positive, while the correct categorization of expenses resulted in a loss.
Figure 3. Worldcom's cash flow shows results not often seen in legitimate businesses
Because of Worldcom's capitalization games, depreciation (cell D104) is higher than net income for the period. If you're capitalizing expenses, you must depreciate and amortize them, which results in high depreciation and amortization expenses. This is not likely to happen to a legitimate business, because it implies purchases of assets that don't produce sufficient income. However, for the next seven quarters, Worldcom's depreciation and amortization ran between 30 and 100 percent of net income. You can compare financial measures for a company to the industry average to look for numbers that are out of whack, as described in Tip #3.
7. Low-Expense Mutual Funds Perform Better Over the Long Term
Some funds are simply dogs, but in a lot of cases, below-par returns result from excessive fund expenses. Fund shareholders pay the costs of operating a mutual fund through fees and the annual expense ratio. Fund expenses are deducted from your investment in a fund so they reduce the return that you earn. The commissions that funds pay to brokers for trades further reduce returns by one to two percent a year, but this reduction doesn't show up in the fund performance figures that funds publish. The returns you receive from your fund investment will be lower than the published performance figures.
The returns for funds with similar portfolios and investment philosophy can vary significantly simply due to a difference in expenses. To get an idea how much fund expenses impact performance, compare a mutual fund's performance to the performance of its peer group or to a corresponding benchmark index. For example, every fund in Table 1 achieves the same nine percent return as the index, but expenses gnaw away at the returns you receive.
Table 1. Mutual fund expenses reduce investment returns.| Fund | Expense ratio | Front-end load | Effective annual return | Value after ten years for $10,000 investment | Ten-year expense costs |
|---|---|---|---|---|---|
| Index | 0% | 0% | 9.00% | $23,673.64 | None |
| Fund A | .5% | 0% | 8.46% | $22,516.23 | $806.79 |
| Fund B | .5% | 5.75% | 7.81% | $21,221.55 | $1,335.40 |
| Fund C | 1.0% | 0% | 7.91% | $21,410.01 | $1,572.31 |
A one-percent increase in fund expenses doesn't guarantee a better-performing fund, nor does it reduce your investment risk, but it does cost you over $1,500 dollars over ten years. Fund B with the hefty front- end load in Table 1 surrenders .65 percent of annual return because of the money paid up front in commission. Managers with higher expenses have to perform better just to stay even with their low-cost cousins. The problem is that very few managers do that over long periods of time. Sales charges or loads are fees that investors pay to purchase fund shares through a broker or financial planner -- for so-called financial advice. These charges cut into your investment above and beyond regular fund expenses, so they increase the damage to your investment returns.
Expense ratios range from as low as 0.18 percent of invested assets to as high as three percent, depending on the type of fund, the frugality of the fund family, and individual fund characteristics. Use the following guidelines to quickly assess a fund's expense ratio:
- Domestic stock and bond funds generally carry lower expense ratios than foreign stock and bond funds, because it's cheaper to research and buy U.S. stock and bonds.
- Look for large-cap stock and bond funds with expense ratios at or below one percent.
- Look for small-cap, mid-cap, and foreign funds with expense ratios at or below 1.5 percent.
Only the administrative expenses, management costs and marketing, and distribution fees are incorporated into a fund's published expense ratio. Marketing fees (called 12b-1 fees) are identified separately, whereas the costs of brokerage commissions are typically hard to find. Morningstar's web site provides basic expense information for a fund in the Key Stats section. Look for below average values in the Expense Ratio % field. Ideally, the word None should appear under Front Load % and Deferred Load %. Don't stop there. You can gain some insight into the commissions being paid behind the scene by looking at the turnover ratio further down on the Snapshot page. The higher the turnover ratio, the more commissions paid to trade, and the more taxes you'll owe if you hold the fund in a taxable account. Then, click the Fees & Expenses tab to see whether a fund also charges a redemption fee or 12b-1 fees.
