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Two 10-Second Tests That Tell You If Your Stocks Are SafeBy
Thursday, August 11, 2011
"That was amazing. How did you do that?"
I have to pat myself on the back. While most investors have had a stressful week, the readers of the newsletter I publish – The Palm Beach Letter – were able to relax.
The S&P 500 fell 11% from August 3 to August 8. Overall, our portfolio dropped only half as much. And the five recommendations we've made in our monthly newsletter lost only 1.8% on average. (Three of them actually gained in value.)
We received many grateful letters from our readers. Some wanted to know how we did it.
In today's essay, I'm going to show you my technique for picking safe stocks. Don't be surprised. This technique is incredibly simple. My two tests will take about 10 seconds each to perform.
If your stock passes these two tests, it's safer than 99% of all stocks in the world.
The first test I do is open up a chart of the stock and see how it performed in 2008.
The 2008 financial crisis was the worst market crash since the Great Depression. The S&P 500 declined more than 50% in less than a year. Many riskier stocks fell 90% or more. It was a true massacre.
So if your stock held its value during this crisis – or better yet if it was one of the rare stocks that actually rose – it's worth evaluating further. It might be a safe haven.
But if the stock tanked in 2008, I won't touch it. It goes in the trash.
A great analogy for this is the car market. A car manufacturer might tell you its car has airbags, side impact protection, an onboard computer, and anti-lock brakes. But until you've driven that car into a wall at 110 miles per hour, you won't know it's safe.
It's the same with stocks. You might find a great business with an honest CEO and a prudent management team. But until you've seen how that business performs in a crisis, you can't know it's safe.
A bank in Connecticut called People's United Financial passed this test. Fast food giant McDonald's and the mining royalty firm Royal Gold held up as well. There's also an insurance company from Canada called Fairfax Financial. It rose 36% in 2008.
The second test I do is my debt test. The fact is, if a company doesn't have debt, there's no way it can go bankrupt. Any company can go out of business if it can't make a profit. But if it doesn't have debt, it can't collapse – like Lehman Brothers did.
So the first thing I do is look at a company's long-term debt. Ideally, I like to see a big fat zero there. Often though, companies have debt, but they have more cash...
Take a company like Johnson & Johnson (NYSE: JNJ), for example. Johnson & Johnson has over $17 billion in debt. But it has over $26 billion in cash. In accounting terminology, Johnson & Johnson has zero "net" debt. I consider these companies safe, too.
The easiest way to run the debt test on a company is to compare its "enterprise value" with its market cap. You'll find both these statistics on Yahoo Finance's Key Statistics page.
Enterprise value is market cap plus net debt. So if a company's enterprise value is less than its market cap, then the company has more cash than debt. It's safe. But if its enterprise value is greater than its market cap, then it has debt. It fails the test.
What you'll find is that a lot of companies have tiny market caps in relation to their enterprise values. If you'd run my test before Lehman Brothers went bankrupt, you would have seen its enterprise value was 30 times greater than its market cap.
These companies are among the riskiest in the world. They go bankrupt the day Wall Street stops lending them money. (And I'm constantly amazed how many American companies operate their businesses like this.)
In sum, to figure out if your stock is safe or not, perform my two 10-second tests. First, look at its chart. Did it maintain its value in 2008? Second, look at its enterprise value. Is it less than its market cap?
If you can answer "yes" to these two questions, you have a safe stock in your possession.
Good investing,
Tom Dyson
Further Reading:
Read more common sense investment advice from Tom here:
Tom's friend Meb Faber recently crunched the numbers on dividends and other cash payouts, and he found something amazing…
There's no better way to compound wealth and generate income than this strategy.
Market NotesRISK OFF! If you think you're diversified right now, think again. An important trend we've been highlighting in these pages is still going strong… The trend is the extreme correlation between stocks and commodities right now.
To recap, many folks take a position in commodities like crude oil, copper, sugar, and corn because they think they're "diversifying" their portfolio. And that's often the case. But in the past few years, stocks and commodities have joined at the hip to move in lockstep with each other. They now move up and down in the same fashion, at the same rate... according to beliefs about global economic growth.
This development turns "diversified" portfolios into dangerous superconcentrated bets. We now live in a world that's either "risk on" or "risk off."
For much of the past few years, investors have made solid gains with the "risk on" strategy. Stocks and commodities have soared. But as you can see on the right-hand side of our "performance chart," stocks (black line) and commodities (red line) jumped off the cliff together and plunged. If you're wondering, "Should I buy stocks or should I buy commodities?" keep this trend in mind and ask yourself, "What's the difference?"
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