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In part 1 of this series, I showed you one method of selecting mutual funds and reviewed some basic factors to consider in choosing investments. This month, we look at a simple way to choose individual stocks and review some other investment options.
The Dow 5 Strategy
Although most individual investors rely on mutual funds, a few daring souls relish the opportunity to choose their own stocks. One way to improve your return is to use The Dow 5 Strategy, buying the five stocks with the highest yields and lowest prices from the Dow Jones Industrial Average (DJIA). Start by listing the 10 DJIA stocks with the highest yields. The yield is the dividend computed as a percentage of the stock share price. For example, a stock priced at $50 per share with a $2.50 dividend would have a yield of $2.50 divided by $50, or 5 percent. From these 10 stocks, pick the five with the lowest prices. Then invest equally into each. Keep the stocks for exactly one year, and then repeat the entire process.
This method is meant to be used for at least 10–20 years and is a fairly low-risk strategy. Remember that the DJIA is a list of 30 well-managed, well-known companies that are selected based on their strong performance history. Stock brokerage firms sometimes offer a unit investment trust (UIT) based on the same kind of analysis (saving you the trouble of doing the calculations) for a small fee.
In a volatile market, advisers recommend that you stay with high-quality stocks, which usually means companies that deliver strong, steady results over time. This is based on three factors:
1. Regular dividends of at least 2.5 percent or enough cash flow generated to be able to pay a healthy dividend
2. A “wide economic moat” or competitive advantages that provide strong prospects for growth
3. A return on equity (ROE) of at least 15 percent over the past decade, computed as profit divided by shareholder investment
Exchange-traded funds (ETFs), a form of index fund created about 20 years ago, are sometimes viewed as a threat to traditional mutual funds. A fund company chooses an index to track and creates the ETF. Investors buy shares from other investors, not from the fund and can only trade if another investor is willing to trade with them. Investors pay brokerage commission for every trade; although, some fees are waived. The “bid/ask ratio” may be higher on small funds, so the investor may pay slightly more than desired when buying and receive slightly less when selling.
Look for a fund with a ratio of more than 0.2 percent. A “market maker” works to ensure that the supply of shares equals the demand so that the price will remain close to the value of the underlying securities. There is volatility in this trading arena, so you are safer choosing established funds with at least $30 million in assets. Otherwise, if the fund shuts down, you may owe capital gains taxes.
Warren Buffett’s success is largely based on arbitrage and “special situations investments,” such as liquidations, reorganizations and spin-offs. The per-share profit in these deals is often less than a dollar, and retail brokerage rates (up to 20 times the institutional rate) severely limited individual investor access until online trading removed that barrier.
Here’s how it works: In world markets where commodities, currencies, stocks and other products are traded, arbitrage is the equalizer of prices. Currency exchange rates are uniform, and gold trades at the same price throughout the world. If gold trades at $2,000 an ounce in City A and rises to $2,020 in City B, arbitragers buy in City A and sell in City B, earning $20 for each unit. Eventually, the price goes up in City A or comes down in City B, and the spread disappears.
The same thing happens with stocks. If the stock of Company A is trading at $10 per share, and Company B offers to buy the shares at $25 in four months, the price of the stock may rise to $20. The arbitrager buys the stock at that price and sells in four months for $25, netting $5 per share in profit. The difference between this and a normal stock trade is the certainty factor. Company B has made a solid offer at a preset future price. The arbitrager considers the likelihood that something will cause the deal to fail, and the stock price will fall back to the original $10. It is called “time arbitrage,” as opposed to “market arbitrage,” when there is a price difference in two different markets instead of a present-versus-future price difference.
This kind of trading still favors large individuals like Buffett and hedge fund managers. Check back next month for more on hedge funds and investments.
NORBERG-JOHNSON is a former subcontractor and past president of two national construction associations. She may be reached at [email protected].