SECTION 2: STOCKS
25: There's a difference between investing and speculating. Investors think of a stock as a share in a business they'd like to own for the long term. Speculators see stock as paper they buy now in the hope that someone will pay more for it down the road.
26: Earnings drive stock prices. There may be wide discrepancies from one year to the next, but as investing titan Peter Lynch notes, over the long term stock prices tend to follow the path of corporate earnings.
27: Don't discount dividends. Over the long term, dividends have accounted for about 40 percent of the return from stocks. And that was before the recent tax break, which may lead more companies to pay dividends.
28: The two-minute drill. Another tip from Peter Lynch: Before you buy a stock, be ready to give a brief spiel -- to yourself, a skeptical spouse, your dog, it doesn't matter -- explaining why the stock's a buy. Is it a fast grower, a dull but solid value play, a turnaround story? Does its business strategy make sense? Is the balance sheet healthy? Does it dominate its rivals? Simple as it sounds, this forces you to focus your thoughts and your research. And it may help you avoid losing money on hot biotech stock tips from your dentist.
29: The bear case. While you're at it, take two more minutes to elucidate the reasons for not buying the stock. Is the company neck-deep in debt? Are hungry competitors nipping at its heels? Is the CEO as slippery as an eel? Is the stock simply too expensive for its own good? Mastering the bear case will not only help you to understand the company -- it will help you figure out when you might want to sell.
30: Great companies don't necessarily make great stocks. It seems simple: If you invest in only the best companies out there, your returns should be stellar as well. But great companies can falter, and if you pay too much for the stock, your returns may be less than great.
31: A $2 stock can be expensive. A $100 stock can be cheap. What counts isn't the share price, but the amount you're paying for each dollar of the company's earnings, sales, assets or cash flow -- which you learn by checking out the stock's valuation ratios.
32-35: Four ways to value a stock
-- Price/earnings ratio. By far the most commonly used measure, P/E (a company's share price divided by its earnings per share) tells you how much you're paying for each dollar of a company's profits.
-- Price/sales ratio. This figure can be used to identify companies with solid franchises but depressed profit margins that may be ripe for a turnaround.
-- Price/cash-flow ratio. The earnings number that companies report is the product of complicated accounting rules that can be manipulated. Cash flow from operations may offer a truer picture.
-- Price/book-value ratio. This looks at the net value of the company's plant, equipment and other assets. It's often used to find takeover targets.
36: The difference between forward P/E and trailing P/E. Trailing P/E is based on the company's earnings in the current year or from the previous four quarters. Forward P/E is a guess based on the company's expected earnings for the coming year or next four quarters.
37: The difference between a growth stock and a value stock. A growth stock offers the promise of much higher profits tomorrow, while a value stock may sell for less than the true worth of its assets today. Growth stocks are like oil wells: Some turn into gushers, but many turn out to be dry holes. Value stocks, on the other hand, are like kitchen faucets, providing a more reliable and moderate flow of earnings. Over long periods, value stocks have slightly outperformed growth, in part because they tend to fall less in bear markets.
38: The best way to find a cheap growth stock. One tool to use in determining whether a growth stock is selling at a reasonable price: the PEG ratio. To calculate a company's PEG ratio, divide its forward P/E by its expected earnings growth rate. If the PEG is less than 1.2, the stock is a potential bargain.
39-41: Stocks come in all sizes. Size usually means market value or market cap (for capitalization), which is a company's share price times the number of shares outstanding. General Electric is a $340 billion company because it has 10 billion shares trading at about $34. The breakpoints can vary, but in general:
-- Large-cap stocks have market values of $5 billion or more.
-- Midcaps: market values $1 billion to $5 billion.
-- Small-caps: market values under $1 billion.
42: You can begin to build a diversified portfolio of long-term growth stocks with as few as nine companies. When constructing a basic stock portfolio, it's smart to start with dominant companies in five of America's most dynamic growth industries: For example, you could choose Microsoft in technology, Pfizer in pharmaceuticals, Citigroup in financial services, Viacom in media and Procter & Gamble in consumer products. Add inflation protection and exposure to basic industries with Union Pacific in transportation, Anadarko Petroleum in energy, Alcoa in commodities and land developer St. Joe.
43: Don't put more than 10 percent of your money in your company's stock. If you are forced to hold more than that -- perhaps because of rules in your company's 401(k) -- try to offset the risk by investing in areas that do well when your own industry suffers. For example, if you work for a high-tech company, load up on dividend-paying industrial stocks.
44: Don't put more than 10 percent of your stock money into one company. Corporate flameouts like Enron and WorldCom have served to underscore the point: A very concentrated portfolio dramatically increases volatility and the risk of catastrophic loss.
45: Stock splits don't make you richer. When a stock splits, you're no better or worse off than you were before. After a two-for-one split, for example, you end up with twice as many shares, but they're trading at half the price. But some investors see splits as a sign that the company expects good times. And studies have shown that stocks that split do slightly better than those that don't over a one- to three-year period following the split.
46: Most big mergers don't benefit investors. Experience shows that it doesn't pay to invest in acquisitions. The reason: Most companies overpay when they buy other companies, negating any benefit from "synergies." Only investors who own shares of an acquired company before the deal is announced win, and you'd have to be clairvoyant, or a crook, to get that right consistently.
47: Where to find company filings. The best way to learn about a company is by reading its quarterly and annual reports -- the 10-Qs and 10-Ks. You can find those and other financial filings at www.sec.gov. Click on Search for Company Filings and then type in the company's name.
48: Dogs of the Dow. This is the strategy of buying the 10 highest-yielding Dow stocks each January, holding them for a year, then selling the ones that have dropped off the list and buying the stocks that replaced them. The system was said to beat the market, but it hasn't worked all that well lately; for the 10 years ending in 2003, the strategy returned an annual average of 12.9 percent while the S&P 500 index gained 13 percent a year.
49: IPOs don't pay. During the Internet mania, everyone wanted to get in on initial public offerings. But IPOs don't pay off in the long run. They make most of their money on the first day of trading. After that, the typical new issue trails the market over the next three years.
50-52: Three good reasons to sell a stock. Don't unload a stock just because it has fallen, or because the market is in a slump. Valid reasons to get out:
-- One, something significant about the company's business or its earnings prospects has changed since you bought it.
-- Two, you recognize that your original assessment of the company's business or earnings prospects was mistaken.
-- Three, the stock is doing too well -- the share price has risen above what you believe the company is actually worth, or the stock now makes up too big a part of your portfolio.