Investing III - Lesson still being learned

In my last post I spent a certain amount of time talking about stock fundamentals, notably Price/Book. I also disclosed that a couple of the stocks I own just now have a P/B of less than 1. Today's follow-up post, then, addresses the question of how it is possible for a stock to have a P/B of less than 1.

It comes down to this: Speculation.

The stock market, at its most fundamental level, is not about assigning value to companies and stocks as they exist today through the invisible hand of the marketplace. If it was then every company would have a P/B of roughly 1.

No, instead the stock market is really about assigning value to companies and stocks as they MIGHT exist TOMORROW through the invisible hand of the marketplace.

When you buy a stock today that you think will be worth more in the future, then your action of buying the stock will probably cause that stock's value to go up, slightly. Especially if a lot of other people come to the same conclusion at the same time and you're all trying to buy the same stock. As you bid against each other the stock rises in price, until you collectively decide what the maximum is that you're willing to pay today for a stock that, hopefully, will still be worth more tomorrow.

It's the same when you sell. If you decide today that a stock you own has reached its maximum value (or its maximum value for the near future, anyway) then you try to sell it. And your action of selling the stock will probably cause that stock's value to go down, slightly. And again, if a lot of other people come to the same conclusion at the same time and you're all trying to sell the same stock, then as you bid against each other the stock lowers in price, until you collectively decide what the minimum is that you're willing to accept today for a stock that may not be worth as much tomorrow.

It's a lot like lemmings, sometimes. The wisdom of crowds can be replaced with the madness of crowds very quickly.

What does this have to do with Price/Book? Again, it's speculation. Basically, there are stocks out there that buyers and sellers speculate will be worth significantly less or significantly more tomorrow than they are today. And when this happens the P/B begins to drift significantly away from 1. Effectively, they're speculating that the Book value is going to change - that the company is going to have a net worth Tomorrow that is greater or less than its net worth today.

It's still odd to see the P/B drift too far away from 1, but it happens.

How often does this happen? Well, it depends on the industry.

Cleantech stocks are all the buzz right now, so it's not uncommon to see them with a P/B of 5 or more. It's the same with internet stocks - last decade's buzz - but to a lesser degree. Still, in both cases investors seem to think the net worth is going to go up. A lot.

What about more mainstream stocks? Well, let's look at Dow Jones.

The Dow Jones Composite Index is comprised of 65 stocks. I've checked the fundamentals of every 5th of those 65 stocks in order to come up with 13 representative (hopefully) P/B ratios. Of those 13 stocks, one of them had a P/B of more than 5. Another had a P/B of less than 1. The other eleven, obviously, each had a P/B between 1 and 5.

Let's break it down further:

P/B between 0 and 1: 1
P/B between 1 and 2: 3
P/B between 2 and 3: 4
P/B between 3 and 4: 2
P/B between 4 and 5: 2
P/B between 5 and 6: 0
P/B between 6 and 7: 1

I think I can safely say in a bell-curve kinda way that stocks with a P/B of less than 1 or more than 5 are outliers.

I'm still trying to figure out how to use this knowledge. As the title suggests, this is a lesson still being learned. In my previous post, though, I've shown one application for this knowledge: Showing when a stock is over-valued.

Can it be used the other way? Can the P/B be used to show when a stock is under-valued?

And if a stock is under-valued, shouldn't one buy it?

Maybe not. I'm in the midst of finding out, though.

Operating on the theory that an under-valued stock is maybe worth buying, I have purchased a few shares in a couple of stocks with P/B ratios of less than 1. One has a P/B of 0.86 and the other has a P/B of 0.21.

If these stocks are simply under-valued then one day - hopefully a day in the near future - their value will rise until their P/B approaches 1. When that happens I will stand to make a profit should I choose to sell.

The problem is this: Maybe they're under-valued for a reason. And if they're under-valued for a reason then they very well may continue to decline in value.

That being said, I'm sticking to my investment rules. I'm not investing money I can't afford to lose, I've looked at the fundamentals (Both of the stocks in question have positive balance sheets and more cash than debt), and I'm reasonably diversified (These aren't the only stocks I own).

If these stocks go the way of the dodo then I'll still have some other investments, and I'll have learned something. The fundamentals seem to indicate that these stocks are not on the brink of extinction, though.

The worry is that the other people trading these stocks know more than I do - which is almost certainly the case. These stocks are under-valued for a reason, probably. They can't have been driven down in price purely by speculation.

The madness of crowds is a strange thing, though. Maybe my stocks have been dragged down when they shouldn't have been.

Whatever the outcome, I'll let you know.

Investing II - Lessons Learned

As I said in yesterday's post, today we'll talk about my limited experience investing in the stock market. Before I do, let me reiterate that the best investments are getting out of debt, starting a savings account, buying a home (and paying that home off as quickly as you comfortably can), and starting a retirement account. They're not as high-return as some stocks, I supppose, and responsible investment of that sort is just kind of boring, really. But these are still the best, most guaranteed long-term investments you can make (even in the midst of the mortgage crisis, which is a topic I'll have to write about one of these days).

For now, though, let's talk stocks.

I'm a complete amateur investor, and it shows. I doubled my money on some lucky hunches, then lost over 75% of what I had. Starting over with the remaining 40% or so of what I started with I've then doubled that again. For those of you following at home that means that right now I have about 80% of what I started with. Overall, then, the stock market has been a losing proposition for me, but I've learned a thing or two in the process, and I haven't lost everything.

What have I learned? I've learned not to put all of my eggs in one basket, and I've learned to look at the Fundamentals.

Eggs

When I started out I put all of my eggs in one basket, largely because I just didn't have that many eggs. And I did okay. I chose a stock that (A) I believed in and (B) fluctuated a lot within a certain range. I used all the money I had and bought when it was at the low end of the range, sold when it was at the high end. I did that a couple times, and I had doubled my money! Yay!

So I bought again when it was at the low end of its typical range of motion, expecting to make a nice profit when it went up again.

It didn't go up again. In fact, it discovered a new low end to its range of motion.

And there it languished. For years. I stopped paying attention after a while.

Then I started hearing about Green Investing. I want to be rich, sure, but I want to get rich while making the world a better place in the process. Green Investing sounded like the thing for me.

So I sold the stock I had at a loss. I'd heard about a few other stocks that looked interesting to me, and I tried again. I found a penny stock I liked, and I did the same trick as before. I looked at its range of motion. I bought low and sold high. And then I diversified.

Which is good, because when I tried that trick again with the penny stock in question, I lost my shirt. As of this writing I've lost over 98% of what I currently have invested in that particular penny stock. I'm holding onto the stock because it would cost more to sell than the stock itself is worth.

But having diversified, I've survived. In fact, I've made enough from my other investments to set off my losses. And I've learned a valuable lesson about penny stocks: Look at the fundamentals.

Fundamentals

Penny stocks are very tempting, because they don't cost a lot to invest in, and they sometimes take off and have a huge rate of return.

But sometimes - a lot of the time (really, the vast majority of the time) - they don't. They stay penny stocks forever. They lose value. They eventually wink out of existence like the barely burning kindling they always were.

How can you tell if a given stock is a barely burning piece of kindling being kept alive purely by someone blowing on it all the time, or if it's a piece of kindling strategically laid at the base of a well-laid bonfire waiting to happen?

There is a LOT of information in the statistics of a given stock. That being said, I really look at only 3 things:

• Assets and Cash
• Liabilities and Debt
• Price per Book (P/B)

The first two items are what you really need to look at on a penny stock. If it has more Cash and Assets than it has Debt and Liabilites then the management of that company has some wood to throw on the fire. If the opposite is true then you know they're out of wood and the fire is about to go out.

The reason my favored penny stock has succumbed to a dull red ember is because they're out of wood. They've got a great product. They've got contracts to provide that product to buyers. But they don't have adequate capital to actually produce and deliver the product.

So that turned out to be money spent on learning to look at the Fundamentals.

I'm now dabbling in stocks whose balance sheets are positive. That doesn't make them guaranteed to go up, but it does significantly reduce the likelihood of them winking completely out of existence.

Okay, so what about the other fundamental statistic I look at when choosing stock? What about Price per Book? What is it and why do I look at it?

Well, the Price is the price itself of the company's stock. And the Book is the book value of the assets of the company, like the blue book value of your car. Price per Book, then is the total value of the stock divided by the total value of the company.

Simple. Okay, how do we use this?

Here's an example. Syntroleum. Ticker symbol SYNM. This is a company that, among other things, has a joint deal with Tyson Foods to produce "clean renewable synthetic diesel and jet fuel using low grade fats and greases as feedstock".

They make diesel fuel from Tyson's waste. How cool is that?

And they have a positive balance sheet! They have no debt and millions of dollars in the bank! Clearly, we should all go and invest in this stock, right?

Not necessarily.

Why not? Because a lot of other people already have. We may have missed the boat on this one.

SYNM's P/B is 26.23 as of this writing. That means that the stock is worth over 26 times more than the assets of the company. And the stock is selling at $1.79 per share. That means the assets of the company are worth a little over $0.07 per share.

Now, a P/B of 1 to 5 is pretty reasonable, and a P/B of up to 10 is probably pretty acceptable, but a little more risky. Anything with a P/B over 10 and I'm very skeptical.

If SYNM ever comes down to $0.70 or so, I'm all over it. It will still have a P/B of 10 or so, but that's at least entering the realm of the less ridiculous.

What am I currently invested in, you ask? Well, for liability reasons I'm not going to tell you. If I ever find myself writing about a stock I actually own then I'll disclose that fact, of course.

I will tell you that all of my stocks are generally in the realm of Cleantech / Green Investing, and that none of them have a P/B of more than 3.

And a couple of them have a P/B of less than 1.

How is that possible? Well, that's a topic for my next post on investing, I suppose.