Thursday, July 26, 2007

I'm a kid. What stocks do you recommend I buy? (Momentum and Recovery Picks)

Reader's Question: I am a kid who wants to buy stock with the $8,000 I have in the bank. Will you give me some suggestions on what to buy?

First of all, congratulations on being fortunate enough to have a such a sizeable chunk of cash to invest at such a early age! Please do all that you can to learn how to invest it wisely and make it grow. Sustained success in investing your own capital can set you up for a more comfortable and fulfilling life in your many decades of adulthood ahead.

I will assume that you are investing to maximize your total return over at least the next five or ten years before you head off to college, and that your parents are providing you with food, clothing and shelter, so that you really do not have a need to generate much investment income. I think you are right in choosing to deploy virtually all of your investment capital into equities, since, as Wharton finance professor, Jeremy Siegel, is quick to point out, stocks have a robust track record of outperforming bonds and cash over the long haul.

I am going to suggest ten investment ideas and leave it up to you to “drill down” and do more research to decide which particular stocks to buy. Most of my selections are well-known brand names that you undoubtedly have heard of before. All of the names on my list are companies that I expect to grow substantially over the next decade. Half of the stocks (momentum plays) are currently trading at or near their 52-week highs, while the other half (recovery plays) are trading at large discounts to their prior peak prices. While I can not predict with any certainty whether the momentum plays or recovery plays will perform better over the next few years, I do expect that at least a few of the stocks on the list will very handily outperform market averages--your job is to make sure you pick the winners!

Rather than spreading your money thinly across many different stocks, I recommend that you establish a concentrated portfolio with no more than five positions. By owning only a few stocks, you will be more likely to find time between school and play to follow all of the relevant news about your stocks, read quarterly and annual financial reports, and listen to conference calls. Learning enough to develop a feel for what makes companies and products succeed and fail, and what drives stock prices higher and lower, will be a valuable hands-on educational experience that should serve you well throughout your life.

(Click on chart below to enlarge for easier viewing.)

Momentum Plays

Apple (AAPL): After Macintosh computers came the iPod and iTunes and now the iPhone. Apple has even dropped “Computer” from its corporate name to reflect the company’s success across a broader scope of consumer electronics. A visit to your local Apple store should reveal how the company’s attractively designed products are capturing increasing mind share and market share. Under founder Steve Jobs' leadership, this innovative company is still solidly in growth mode.

Google (GOOG): Google continues to thrive as the global leader of Internet search, despite ongoing efforts by Yahoo and others to capture eyeballs and search-related advertising revenue. Triple-digit year-on-year growth has slowed as Google has grown into its current $150 billion market capitalization, but the stock’s PEG ratio of 1.0 at today's price level is attractive. Expect Google to remain the search engine of choice in the U.S. and most countries for the foreseeable future.

Boeing (BA): The 787 Dreamliner is the first commercial airplane to be manufactured “in pieces” by an international consortium of partners, with final stage assembly at the Boeing factory outside of Seattle. As Dreamliner sales continue to ramp up, Boeing should reap the benefits of global collaboration and realize higher efficiency and profits for many years, likely outselling competitor Airbus in the process.

Toyota (TM): As the maker of reliable, high-quality cars and the popular, fuel-efficient, hybrid-engine Prius, Toyota has overtaken Ford (F) and is poised to edge past General Motors (GM) to capture the top spot in the ranking of automakers by number of vehicles sold worldwide. Innovative design, perfection of their just-in-time manufacturing process and the superb maintenance record of their cars will keep Toyota in the lead. At a forward P/E of 12 and a 14% discount from its 52-week high, Toyota’s shares are a relatively attractive buy at current price levels.

Chinese Stocks: China is the world’s most populous country (over 1.3 billion people vs. a U.S. population of 300 million) and has a booming economy expanding at the remarkable clip of 10% per year. A good way to achieve exposure to the Chinese stock market is through an index fund such as the iShares FTSE/Xinhua China 25 Index (FXI). The most heavily weighted companies in this index are mobile phone giant, China Mobile (CHL); oil and gas producer, Petrochina (PTR); and leading life insurer, China Life (LFC). For more adventurous investors, an interesting smaller company with current market capitalization just under $1 billion is Home Inns (HMIN), which currently has about 150 hotel properties under management and is still in the early stages of building out a major chain of economy hotels across China.

Recovery Plays

Yahoo (YHOO): As indicated by its depressed share price, Yahoo has in recent years performed poorly in search, social networking and other areas, behaving like a lumbering dinosaur around more nimble players including Google, MySpace and YouTube. On the other hand, despite its many missteps, Yahoo remains the world’s most trafficked website and the Internet game is still very much Yahoo’s to lose. Similar to how Amazon’s (AMZN) share price came roaring back from a 52-week low of $30 to a recent high of $89 following a series of unexpectedly strong earnings reports, Yahoo certainly has the potential to surprise on the upside over the months ahead.

Starbucks (SBUX): Starbucks’ 12,000 locations may seem like a lot but, if the Seattle area is an indication of the density of coffee shops this popular brand can support, plenty of expansion potential remains both in the U.S. and internationally. The recently announced deal with Hershey (HSY) to produce a Starbucks-branded premium chocolate should add incrementally to growth. Incidentally, speaking of partnering, Starbucks is no longer selling bottles of Jones Soda (JSDA) in their stores; however, this quirky Seattle soda maker may also be a good recovery play on the back of broader distribution of their unusually flavored sodas through big-name retailers including Wal-Mart (WMT), Target (TGT) and Safeway (SWY).

Whole Foods (WFMI): Whole Foods has led the organic food movement for years, contributing profoundly to the growing awareness across America of what a more healthful diet means. More recently, however, Wal-Mart, Safeway and other supermarket chains have jumped aboard the organic foods bandwagon, putting pressure on Whole Foods’ margins and threatening its leading position in organic food sales. Despite new competition, expect growth to continue as Whole Foods builds out more stores, including establishment of a new presence in the U.K. and Europe. More healthful eating is a long-term trend that won’t go away and, with Whole Foods trading at a forward P/E of 24, now may also be a good time to start nibbling on a few shares.

Homebuilders: A glance at headlines and price charts of major homebuilders--D H Horton (DHI), Pulte Homes (PHM), Lennar (LEN), Centex (CTX)--reveals just how much their stock prices have sagged since nationwide home prices and new construction peaked about a year and a half ago. It is important to note, however, that homebuilding is a cyclical industry and the bottom has to be somewhere, perhaps nearby. Patient investors willing to buy homebuilder stocks at today's prices and hold on over the years to come ought to realize substantial profits once the next real estate cycle gets underway.

HRPT Properties (HRP): Following the flurry of private-equity buyouts of REITs over the past year, culminating with Blackstone’s purchase of Equity Office Properties in February, REITs have generally fallen 20% to 30%. One of the office REITs, HRPT Properties, now trades well below book value (P/B = 0.86) and at a forward price-to-FFO ratio of just 8.1. This REIT is the cheapest way that I am aware of to buy real estate in today’s market. HRPT also offers a very attractive 8.5% dividend yield, which trounces current bank CD rates averaging around 5%.

(Disclosure: The author of this article has no current position in any of the stocks mentioned. However, if one of his sons decided to buy any of the stocks on the list, he would not raise a serious objection.)

Tuesday, July 10, 2007

How do I get the money to invest?

Reader's Question: How do I get the money to invest? I read a book recently by Robert Kiyosaki, who wrote the bestseller, Rich Dad, Poor Dad. He teaches the advantages of borrowing money to invest, such as getting a mortgage loan, rather than using your own money. Bad debt makes you poor, but good debt is leverage that makes you rich, because it allows you to invest sooner. He swears by it. Any thoughts?

As you indicate, there are two basic sources of money for investing--your own money and other people's money (so-called OPM). Your own money can come from sources as diverse as cumulative life savings, your most recent paycheck, and dividends and profits from your own investing. Common examples of OPM, used for both investing and consuming, are credit card debt, car loans, real estate mortgages and loans or investment capital that can come from family, friends and others in partnerships.

Getting Started With Your Own Money

Often in life, what's most important is getting started on the right foot. In the case of investing, this means putting some money aside, however small, and setting up a suitable investment program for yourself.

To extract "seed capital" for investing, the place to start is with your own personal income statement. You need to arrange your personal finances, so that your income from all sources exceeds your total expenditures. Practically speaking, this usually entails a combination of elements such as:

  • Income Side: Finding a job that pays better, asking your boss for a raise, saving the incremental pay you receive from your next raise, taking a side job to earn extra income, saving any money gifts and cash bonuses you receive, training (or retraining) yourself to work in an occupation that offers a higher salary, etc.;

  • Expense Side: Moving into a house or apartment that has lower rent, finding a roommate, renting out rooms in your own house, driving a reliable but affordable car, going out to eat less frequently, spending vacations closer to home, looking for sales when shopping, buying necessities and not luxury items, etc.

  • The point is that you've got to figure out a way to save some money that will serve as the "seed" to start investing. You might think that $100 or $1000 is "small money," particularly if your financial dream is to become a millionaire, multi-millionaire or billionaire. However, for the sake of your own long-term financial health, you must, as early as possible, establish personal habits that are conducive to wealth-building. In my opinion, successful investing really begins with having the discipline to "live within your means," spending less than you earn and thereby continually augmenting your investment capital. Once you are a prudent manager of your own personal money, you can begin to supplement your investment portfolio with other's people's money.

    Using Other People's Money

    Having access to sources of money other than your own, which typically means borrowing or using OPM to leverage your own capital, can potentially produce higher investment returns. Some authors (like Kiyosaki, as you cite) make a distinction between: "good debt," like a mortgage on rental property, which can be serviced using rent paid by tenants; and "bad debt," like an auto loan, which you might take out on a new car and now have to service with your own money. Others distinguish between good debt on appreciating assets, like real estate and stocks, and bad debt on depreciating assets, like cars and elegant wardrobes. Still another useful point of view is that good debt produces cash flow, while bad debt does not.

    To these dichotomies between good and bad, I would add a measure based on lowest cost of capital:

    Good debt is necessary borrowing within reasonable risk limits at the lowest available cost of capital, regardless of source, so long as the expected return on your overall investment portfolio exceeds your cost of capital. Bad debt is borrowing that doesn't meet the specified good debt requirements.

    Here are some examples to help illustrate:

  • New Graduate in New Job: You've recently graduated from college and taken a career-oriented job. Your income from work is enough to cover your rent and living expenses, make payments on your student loan, and save a few hundred dollars each month. You are eager to start investing in stocks, have faith in Steve Jobs' leadership, and want to buy Apple (Nasdaq: AAPL), thinking that the stock will continue to rise on the strength of the company's newly released iPhone and upcoming lower-priced model. Your available sources of investment capital are: $2000 in a savings account, a cash advance on your credit card at 18% interest, or a private loan from a friend who says you can pay him back in a year with interest in arrears at 10%.

  • My suggestion: Continue to save what you can from your paychecks. In a year's time, when you have a few thousand dollars more in savings, reconsider making the proposed investment if you still have the same outlook on Apple's business prospects. Neither the 10% private-party loan nor the 18% credit card loan is attractive, since your investment return could easily fall shy of these levels if Apple's sales or earnings falter or the stock market sags on unencouraging macroeconomic news. Also, you ought to maintain a few months' living expenses in your savings account, as a buffer against unpredictable changes in your job situation. Be patient. During the upcoming year, you might find even better investment opportunities than what you are seeing today.

  • Homeowner Buying a Car: Suppose you are buying a factory-certified, pre-owned Toyota Prius, since your gas-guzzling minivan has blown an engine gasket and you are in dire need efficient wheels to get around. To pay for the car, you have three choices: sell $15,000 of stock or other investments, borrow on your home equity line at 8% APR, or take out an auto loan at 7% APR. Based on the bad-debt-on-depreciable-asset thinking, you would eliminiate the auto loan from consideration. The bad-debt-if-you-have-to-service-it-yourself thinking would knock out the home equity line choice as well, leaving only the investment liquidation alternative. But you don't really want to sell stock that you currently own, since you feel confident that you can continue to achieve returns higher than 7% on your investments, since you've been averaging 10% over the past seven years, through both down (2000-2002) and up (2003-2006) markets.

  • My suggestion: Assuming you are comfortable with the additional portfolio leverage and have adequate cash flow to cover the debt service payments, take out the auto loan, since at 7% it is your lowest available cost of capital and is lower than the 10% return you expect on your investments. Think of the auto loan as not a wasteful loan on a depreciable asset but as your most efficient way to borrow funds within the context of your overall portfolio.

  • Investor Considering Second Mortgage on Investment Property: You have been out looking for investment property and have found a $500,000 apartment building that looks attractive and will, at 75% loan-to-value, provide positive cash flow with an expected 10% total return. Banks will lend only up to 65% loan-to-value ($325,000), and you can take out a second mortgage for the remaining 10% ($50,000). The interest rate on the second loan is 9%. You may alternatively tap your home equity line at 8% interest to come up with the remaining $50,000 needed to buy the apartments.

  • My suggestion: Even though the home equity line directly involves payments that you will have to make on your house instead of on the apartment investment, it is your lowest available cost of capital. Therefore, go ahead and tap the equity line on your house, and proceed to make a back-to-back loan into your investment property with terms matching your home equity loan. By effectively transferring the financial burden from your house to your investment property in this way, you achieve your lowest cost of capital and optimize your expected investment return on an overall portfolio basis.

    Crossing the Finish Line

    Investment capital, then, comes from a combination of your own money and other people's money, with the mix depending on your situation. A few key tenets to keep in mind are:

  • Savings: Anyone who is seriously interested in starting to invest ought to be able to save some money. Even putting aside just $100 a month is enough to begin to accumulate significant capital for investing.

  • Patience: However eager you may be to begin buying stocks or real estate, realize that market opportunities will change but will not go away. Getting started a year from now with investment amounts and risk levels that suit your own financial situation is better than rushing to get started today with excessive leverage or using other people's money on terms unfavorable to you as borrower.

  • Risk Management: So much of successful investing is risk control. Of course, we all seek higher returns, but knowing how much and on what terms to borrow is important. Do not borrow at rates that are higher than you can honestly achieve through your investments.

  • I think it is helpful to view investing as a life-long race in which you lead with your own money and add, as follow-on, other people's money when you can do so prudently. Relying solely on your own money, you may end up growing your net worth more slowly but you'll never go bankrupt and you will finish the race. At the other extreme, relying too much on OPM, you could grow rich quickly, but you also run the risk of losing it all and never crossing the finish line. Ultimately, the art of successful investing involves pursuing the optimal path at each stage, walking the fine line between too conservative and too aggressive.