I fell in love with the stock market when I was in college. I became president of my university’s investment club and also decided to start investing the small amount of money I had personally.
One stock I analyzed had a solid business with great numbers. Its dividend was high but well covered by earnings and had been raised every year like clockwork for the previous 20. This stock would go into my portfolio as the rock and cash cow.
I bought it at $42 and six months later it was up to $47 – and churning out a 7–8% yield on top of that. I was ready to hold that stock for years.
Unfortunately, my priorities in college were not where they should have been and I wasn’t careful with cash. As I got to my last semester I needed to buy textbooks and didn’t have the funds. I ended up selling my stock, painfully.
The year was 2006 and the stock was New Century Financial, the second largest sub-prime mortgage lender in the country. By early 2007 the company got into serious trouble and in April it filed for bankruptcy. It was the first major casualty of the financial crisis.
The stock went to $0. I sold it a few months before to buy textbooks.
That was the greatest stock trade I ever made.
I learned some important lessons from this.
1) The numbers are important, but they can’t predict the future
New Century Financial was the second largest sub-prime mortgage lender in the country. (For more on the companies and CEO’s involved in the financial crisis check out the excellent book All the Devils are Here by Bethany McLean and Joe Nocera.) Of course the numbers were great while the housing market was booming, but once house prices started declining, their business imploded.
If you are looking at projections for a stock, you have to ask yourself – what could make this story blow up? I looked at the numbers and just expected the trend to continue.
The number one error investors make is to extrapolate trends indefinitely into the future.
2) Sometimes you are better lucky than good. Acknowledge it and learn from it.
My investment would have been wiped out if I didn’t need the cash. I got lucky and dodged a bullet. When analyzing how a trade worked or did not, you should not focus on the result, but on the process.
3) If a trade looks like a slam-dunk, the radar needs to go up.
My analysis of New Century Financial made it look like a no-brainer. Anyone who has done a discounted cash flow model knows that high dividends, high growth, and high return of equity will make a stock look like it’s worth a ton. That may be the case, but it depends on those numbers continuing on into the future. You need to be skeptical when the analysis looks too good.
Just because I got lucky, it doesn’t mean I can’t learn something. The close calls can still give you valuable experience, with the added benefit of less bruises.
Until next time….
“Don’t confuse luck with skill when judging others, and especially when judging yourself” – Carl Ichan
Photo Credit – Luis Villa Del Campo via flickr.com