Hacker Finances: Growth, Value and Income Stocks

Next entry in the Hacker Finances series.

In the most general sense, stocks fall into 3 categories; growth, value or income. Growth stocks are those that are expected to grow significantly over time. Value companies are purchased by investors who believe their stock prices are lower than their actual value. Income stocks are purchased because they pay dividends.

New companies in newer markets typically qualify as growth companies. Growth is the mantra of many startup accelerators and incubators, as well as VCs in general. Given the immense scale of incumbents, growing into a sizable company quickly is key to long term survival. New companies need to get big before their big competitors can react and squash them. Uber and AirBnb are great examples of this. Neither were taken seriously by their competition until it was too late to stop them.

Tesla Motors is a prime example of a growth stock. The market for electric cars has been around for a long time, but like the iPhone, the market was waiting for someone to get the product right. I’d say Tesla has it right, and so far, the stock market agrees. If they deliver to their projections, and likely they’ll under-perform their own projections but still exceed what we could have hoped for, Tesla will ascend to take the position that Chrysler held in the US. I’ve owned TSLA, the stock but not the car, since they released the Model S, and I am determined not to make Mistake Number 4, Selling Too Soon. Yes, they could totally fall on their face trying to mass produce the Model 3. But to date, betting against them has proven a losing bet. So far, so good.

Taking my ego back down a peg, and continuing with the Chipotle saga, I waited impatiently for Noodles & Company to go public. Noodles was started up and run by the former COO of Chipotle. So it stood to reason that he’d manage the same type of success with Noodles & Company that he’d brought to CMG, and I’d get that second chance I’d been dreaming of. Noodles was a growth story. They were building new stores and expanding. Revenues were increasing. Noodles went public and I bought in.

It’s not pretty:

In short, you can make money with growth stocks if they actually do grow. Noodles & Company sales did in fact grow, but their profits didn’t.

The analysis is that NDLS didn’t train new store management well and customer experience wasn’t where it needed to be. Same store sales languished. The roll out slowed. The stock slid. And slid. And slid. When evaluating the performance of a company that is in a Growth phase, if they don’t grow but their competitors do, there is something wrong with the company. If their competitors don’t grow either, there is something wrong with the market. In the case of NDLS, they are in a saturated market that was growing slowly, and the couldn’t differentiate their stores sufficiently. They grew revenue by opening new stores, but profit margins were very low and declining. Contrast that to ULTA, which maintains healthy net margins as they grow. NDLS is not healthy.

NDLS ULTA

Value stocks are stocks that have a price that’s lower than the company’s actual value. It’s not always obvious when this is the case, but it is true that different market segments go in and out of favor with institutional investors and stocks can become undervalued. Fund managers may transition out of one sector and into another. If several large funds do that at the same time, the ‘from’ sector can get over sold, presenting a value opportunity. It also may be the case that a company encounters a rough patch that is specific to their business. In those cases, strong leadership will usually guide them through it and they’ll come out stronger. That’s why company leadership is a key place to analyze when choosing individual stocks. If you can spot value stocks, and really, I have not learned how to tell when a solid business has a weak share price, you can do well. One signal would be a company that has a low P/E ratio relative to their cohort. However, if they’ve run into long-term profitability issues, the low P/E may be justified.

One possible Value example is Caterpillar. They build earth moving equipment and have a significant international business. The machines are built in the US, which is great for American workers, except that today, the US dollar is especially strong. That makes Caterpillar equipment unusually expensive overseas, and international sales account for more than 50% of their revenue. As a result, they’ve lost significant market share to Japanese competitors like Komatsu. A value investor would postulate that when the dollar weakens again, CAT sales will recover and so will the stock price. So if you have a sense for where the dollar is headed, you might make a little money with CAT. Personally, I haven’t specifically targeted buying stocks for value, so if you have any additional insights, I’d love to hear about them in Comments.

Income stocks are mature long-term businesses that are consistently profitable, but not growing much. These are known as Blue Chip stocks. Blue Chips make money consistently, and have increasing cash positions, but their stock price doesn’t move much. So they sometimes try to increase their stock price by increasing their dividends. Dividends are cash payments made to share holders out of the company’s profits. By paying dividends, the company makes their stock more attractive and increases demand for their shares so that the share price goes up. Some Blue Chips increase their dividends annually. Those that continue increasing their dividends for very long time periods, in effect, 25 years or more, earn the moniker Dividend Aristocrat. Dividend Aristocrats actually, in some ways, become addicted to their own dividends. The management is typically incentivized with stock options. The options are only worth something if the stock goes up. And the only way to make the stock go up for a well run, venerable business that is not growing is to a) increase dividends and b) buy back shares. Buying back shares reduces the number of shares on the market, reducing supply, and thereby goosing the price a tad [1]. But the real juice comes from dividends.

Since I am sailing into retirement soon, one vehicle I’ve started investing in is dividend stocks. I look for companies that increase their dividend payout every year. Effectively, that increases the yield on the initial investment every year as well. It’s like buying a certificate of deposit that increases the interest paid every year. Over a medium term period, like 10 years, this has an interesting effect. From 2006 to 2016, AT&T’s share price rose from $26.62 to $40.34. This is not huge. It’s a 4.2% annualized growth. However, over the same time period, AT&T increased their dividend from $1.33 per share to $1.92 per share. Over those ten years, the dividend yield, which is simply the annual dividend divided into the price you paid, increased from 5.0% to 7.2%. That means that the combined yield, assuming the performance continues, is now 4.2% + 7.2% = 11.4%. If you take a really long view, and can identify the true Aristocrats, you can do really well with dividends. One of the all time greats, like it or not, is McDonald’s. In 1991, MCD was paying 9 cents per share on a share price of $8.75 (adjusted for splits) which was a 1.1% dividend yield at that time. If you’d bought the stock in May of 1991 and held till now, the current dividend is $3.56 per share. That is a 42.5% annual cash yield on the initial investment.

When you’ve got a long horizon, at least 15 years, try to identify growth stocks. If you are less than 15 years to retirement, start a transition and gradually shift into dividend stocks as one of your investment vehicles. When choosing them, look at their dividend history and see that they’ve kept paying dividends through thick and thin. Thins like the Internet Bubble and the Housing Bubble Financial Crisis. Choose those that increase their dividend each year, without fail. Keep an eye on the payout ratio. The payout ratio is the % of their profit they are paying out in dividends. If the payout ratio is high, say, over 70%, you’ll want to be cautious and take a look at some other things, like how much cash and short term investments the company carries on its balance sheet. If it has a high payout ratio and little cash, there is a risk that they’ll not have the cash to pay dividends and may stop or reduce them. That will send their stock price into a sharp decline. For what it’s worth, the verdict is still out on my dividend strategy. I started buying specifically for dividends about one and a half years ago. The stocks have done well overall, both in terms of dividend yield and share price. I targeted higher yielding stocks, which generally meant they were in a price trough for some reason and most have since come out of their respective trough. And they have increased dividend yields, as their histories suggest they would. The current average among the several I hold is 5.2% dividend yields. Four that I’ve invested in are McDonald’s (MCD), AT&T (T), Mattel (MAT) and Prudential (PRU). If you’re wondering what kind of mood I’m in today, take a look at how these four are doing.

The scary thing about Dividend stocks is that if their business really hits a rough patch and they have to reduce, suspend or stop paying dividends, it can really kill your returns. In many cases, if they’ve suspended dividends, they’ll resume in a few years. But you can never be sure whether they’ll fully restore them. Check back with me in 5 years or so and I’ll tell you how I did. Let’s hope I don’t have a Kodak Moment [3].

And in any case, be sure to diversify such that dividends are just one component of your portfolio, and you don’t have all your eggs in the dividend basket.

Those are the basics of buying individual stocks. There is a lot more to stock investing, but those other, more advanced approaches are not for novices or part time stock investors (or me). I’ll discuss them each a bit, but seriously, until you have your finances on very solid ground and you can afford to lose some play money, don’t mess with this stuff.

Buying stock on margin is a way to amplify your gains and your losses. When you buy stock on margin, you borrow cash from your brokerage to buy more shares. The shares you bought are collateral for the loan. You pay interest on the amount you’ve borrowed. If the shares go up, you’re in great shape and you’ve made more than you would have if you hadn’t borrowed. If not, you’re going to lose more than you would have. If the stock goes down a lot, and your brokerage begins to think that the value of the shares might become less than the amount you borrowed, they may make a ‘margin call’. Margin calls are really bad news. It means you have to come up with enough cash to get the account back into solvency, usually by selling a large portion of the shares. As an example, let’s say you wanted to buy 100 shares of LinkedIn at $140, but you only had $7,000 in your brokerage account. Once you’re signed up for margin trading, you’d place the order for 100 shares anyway. Your broker would buy the shares with your $7,000, and they’d loan you another $7,000. You’d start paying interest on the $7,000 that you borrowed. Then, as long as the LNKD shares stayed somewhat above $70 per share, your broker would be copacetic because if needed, they could compel you to sell your 100 shares in order to get their $7000 back. If LNKD headed up, you’d amplify your gains thanks to the borrowed funds. If it headed down, you’d amplify your losses. If you get a margin call and are forced to sell to cover the loan, you’re basically wiped out and you’ve lost 100% of your original principle. In our example, it means you’ve lost all $7,000, plus the interest you paid along the way. This is not the Hacker way, unless you really want to juice up your day with more than caffeine, and can afford the losses easily. Though, if you have to borrow to buy the shares, maybe you can’t afford the losses.

Another somewhat less controversial trading approach is to buy options. Options are like insurance. They minimize your down side exposure. For example, as of this writing, you can purchase an option to buy MSFT at a price of $52.50 for a time period of three months. What that means is that if MSFT goes up over the next 3 months, you can buy it at $52.50 and then immediately sell and pocket the difference. If it does not go up, you do nothing and the option expires. There is a price for this right, and as of this writing, the price per share for this option is $3.10 per share. So for example, if you bought the 3 month option on 100 shares, you’d pay your broker $310. Then, if at any point in the next 3 months you saw an opportunity to exercise the options, you’d do so. The $310 is spent, regardless. But if MSFT goes down, you do nothing and are only out $310.

There are actually 2 primary types of options, Call Options and Put Options. Call options give you the option to buy a stock at a specified price over a specific time period. Put options give you the option to sell at a specified price. Essentially, if you buy a Call Option, you are betting the stock will go up. If you buy a Put option, you are betting the stock goes down.

Options are really for sophisticated investors who like more finesse in their investing. Options can limit your downside, but if you are wrong too many times, they can still eat into your portfolio. Generally, they will take more of your focus than you likely would want to commit, so don’t bother with them. I never bought an option, and I don’t feel like I’ve missed anything important. Perhaps when I have more time on my hands, I’ll learn more about the mechanics and strategies and give it a whirl. But not this day.

If you’d like unlimited down side, short selling is for you. I’m tempted to say just don’t, and try to erase the term from your memory completely. There is no good reason for a sensible hacker to short a stock, unless they have definite inside information, like, that Renaud LaPlanche was going to abruptly resign [2]. Of course, if you did know in advance, and you did short LC just before the announcement, you’d have done splendidly up to the point that the FBI slapped handcuffs on you.

If you buy a stock ‘long’, it means you are expecting it to go up. In essence, your upside is unlimited. As long as it goes higher, your gain goes up. Short selling means you are selling a stock you don’t actually have. If the stock goes down, you then buy it and cover your short position. Your profit is the difference in the prices. Short selling is done when investors are dead certain a stock is headed down and that they will be able to profit from the drop. If you short a stock, the upside is limited to the share price you shorted at. The best you can do is that finite amount. However, if you take a short position and the stock goes up, that’s where true heartburn sets in. The higher it goes, the greater your potential loss. There is no upper limit to your potential loss.

When heavily shorted stocks go up sharply, they can trigger what is called a short covering rally. When this happens, the investors who have shorted the stock start to lose faith in their short position and buy to cover their shares, taking a loss. If many of them cover at the same time, the additional buying drives the price up further and still more short investors lose their nerve and cover. This is great for those of us who are long since we get an additional kick in the rally. It’s devastating for the shorts. Personally, I put short sellers in the same category as undertakers. They’re just not the kind of people you want to be.

[1] http://www.fool.com/knowledge-center/does-a-stock-buyback-affect-the-price.aspx

[2] http://ir.lendingclub.com/file.aspx?IID=4213397&FID=34233669

[3] Okay, it’s a really weak play on words. Kodak had a tag line: “Kodak Moment” which meant the moment that you take a snapshot. They also had one of the worst ‘dividend collapses’ of all time, after paying increasing dividends for several decades. http://www.dividend.com/dividend-education/the-biggest-dividend-stock-disasters-of-all-time/