Getting Behind the Buzzwords

09/22/2011 7:30 am EST

Focus: MARKETS

Patrick McKeough

Editor, Successful Investor

Investors hear a lot of insider lingo being tossed around, but just because they hear it—and even use it—doesn’t necessarily mean they really understand its underlying implications, writes Pat McKeough of TSI Network.

Some investors follow a “sector rotation” approach to investing. That’s when you try to hop from sector to sector, underweighting or overweighting holdings in certain sectors of the stock market depending on a forecast of the stage of the economic cycle, or other factors.

Sector rotation can work in any one year, say. However, it’s difficult if not impossible to produce consistent longer-term returns.

Why? You need to guess right three times to profit in sector rotation: You have to pick the top sectors, then pick the stocks that will rise within those sectors, then sell before the sector stumbles.

It’s virtually impossible to consistently succeed at all three over long periods. But that’s not the only problem with sector rotation.

Sector rotation can overweight you in the worst-performing sectors: There are many theories about which sectors will outperform at any given stage of the economic cycle.

But trying to pick winning sectors—and staying out of other sectors—seldom works over long periods. Investors who attempt to do so often wind up with heavy holdings in the worst-performing sectors. That would be devastating to your portfolio, even if you confine your investments to well-established companies.

Our investment advice: Instead of sector rotation, we recommend that you diversify your portfolio by spreading your money out across most, if not all, of the five main economic sectors (Manufacturing & Industry, Resources & Commodities, Consumer, Finance, and Utilities).

This is a key part of our three-part investing program. The other two parts are to invest mainly in well-established, dividend-paying companies, and to avoid or downplay stocks in the broker/public-relations limelight.

If you diversify as we advise, you improve your chances of making money over long periods, no matter what happens in the market.

For example, manufacturing stocks may suffer if raw-material prices rise, but in that case your Resources stocks will gain. Rising wages can put pressure on manufacturers, but your Consumer stocks should do better as workers spend more.

If borrowers can’t pay back their loans, your Finance stocks will suffer. But high default rates usually lead to lower interest rates, which push up the value of your Utilities stocks.

And since earnings season is almost upon us, here’s a few things to look for when your stocks’ reports come out.

A company’s earnings are different from an employee’s salary. Earnings are indefinite and subject to revision, even years later. Companies have to estimate many costs, and make yearly write-offs against earnings, according to arbitrary rules.

Here’s some investment advice to pay special attention to when examining a company’s earnings statement:

  • Research spending. Companies mostly write off research costs when they spend the money, depressing the year’s earnings. Some research turns up nothing of value. But research can lead to new or improved products that generate huge future profits and cause a winning stock pick’s shares to soar.
  • Depletion write-offs. Mining companies take yearly write-offs against earnings for sums that represent depletion of their mineral reserves. These deductions are supposed to offset the cost of finding and developing new mineral deposits as old ones run out of ore.

Mining companies base depletion charges on costs—what they spent to find and develop current mineral deposits. But there’s an element of chance in all exploration. You can never be sure a mine will be profitable until production begins. The same exploration outlay may not turn up an equally rich deposit, or anything of value.

When a mining company exploits a rich deposit, its earnings may be partly a return of the original investment. It is advisable to get professional investment advice when you are not familiar with a stock sector.

  • Goodwill write-offs. When one company buys a business for more than the value of tangible assets, such as land and equipment, it treats the excess as “goodwill,” or “value as a going concern.”

Every year, the company assesses its goodwill and adjusts its value accordingly. For example, if the value of the acquired business has declined, the company will write off a portion of its goodwill.

 However, goodwill needn’t lose value or depreciate every year. With proper management, the acquired company’s value as a going concern may rise.

To profit from earnings, look at them in context, and consider the historical pattern. It’s a good sign if a company makes money every year, and successful investors mostly avoid chronic money losers.

Read more from the TSI Network here…

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