TREND TIP 1
Play the Six Degrees of Making Bacon
The Ripple Effect of Trends
Most people are familiar with the party game Six Degrees of Kevin Bacon: "I'm friends with Sally who has a cousin who designs sets for a director who works with Kevin Bacon." The point of the game is to link any person to Kevin Bacon through six steps or less, and it illustrates the larger "Six Degrees of Separation" theory that every person in the world is only six contacts away from knowing every other person in the world.
I have made millions by making a different set of connections and connecting the dots to an overlooked pot of gold. One of my most valuable techniques for picking stocks is to look for the "unlikely suspects." These are the companies that thrive as a supplier or the ancillary beneficiary of a trend, societal change, or economic or political driver.
While social scientists have studied how we as people are interconnected, little research has been dedicated to the significance of the relationship chain in financial trends. Economists have drawn up complicated equations for many economic models, but how an obvious trend causes other trends is relatively uncharted territory for even the professional investor. As a result, mapping out causal connections in trends might be one of the best kept secrets to identifying and profiting from these trends. The party game's goal is getting to Kevin Bacon in six steps. In financial trend spotting, finding a service or product that's separated whether by two, three, or six steps from a clear trend can lead to a great investment. For that matter, identifying a company even farther separated, whether 10, 15, or 20 degrees, can sometimes be profitable.
The best part is that it isn't rocket science.
Take the case of corn ethanol. With the rapidly growing interest in ethanol as a more environmentally friendly substitute for gasoline in the last few years, corn prices have skyrocketed. Many investors have jumped to make money off this trend. By now, the prices of corn have already jumped, leaving less potential to profit off the trend. Rather than trying to get in on something that has already become highly valued, you can make better money by applying the Six Degrees of Making Bacon principle, and investing in more affordable options that will benefit from the newfound popularity of corn. While everyone and their brother will be investing in the trend itself, you'll be surprised how many people don't think to invest beyond the trend.
If demand for corn has risen dramatically, farmers are going to be trying to meet that demand. What products or services do they need in order to increase production of corn? For one, they're going to be buying new tractors and other farming equipment, as well as more pesticides and fertilizer. So you might want to look at companies like AGCO Corporation or John Deere, which make tractors, combines, sprayers, and other equipment. Or check out companies like Monsanto, which produces Roundup, a pesticide often used on corn and soybeans (another source of biofuels). Syngenta is another example: among other things, they develop high-performing seeds, including corn seed, and are creating a hybrid corn specifically for improved biofuel. Then there are middlemen like Archer Daniels Midland, which stores, transports, and processes agricultural products, as well as train manufacturers like American Railcar, which makes and services trains used to carry agricultural products. The list could go on and on. Drawing Connections
I find the easiest way to play the Six Degrees game is to draw diagrams. It's fun to uncover how an obvious trend has a ripple effect. You can usually find products, services, and companies worldwide in every direction that are positively affected by a trend.
Don't just think in a linear way. The ripple effects of just one trend can take you numerous steps in many different directions. In order to play the Six Degrees of Making Bacon, all you need is a bit of creativity.
Let's look at an example. Beginning in January 2001, interest rates started to drop. When the Federal Reserve Board lowers the federal funds rate, the prime rate follows the trend downward, as do mortgage rates. The trend of falling interest rates invariably lights a fire under the housing market. When mortgage interest rates are low, people can afford to buy houses that they couldn't buy when the interest rates were higher.
If you bet on housing to be a big market as we headed into the twenty-first century, you were right. The value of residential real estate in the United States rose by about ten trillion dollars from 2000 to 2005, with the average home costing over 60 percent more than it had at the end of 1999. So just one degree away from the trend of falling interest rates, you would have found a great way to profit. But now take it several steps farther. Cheap mortgages mean more people will take a mortgage, which means there will be a spurt in the new-home market. Home builders are ready to rock when those rates fall.
Now take it farther still. When home building is on the rise, what other products and services are positively affected? Building materials, construction crews, home design companies, for starters. When mortgage companies do well, who else does well? Sub-prime lenders, secondary mortgage buyers, and banks, among others.
Once you start the game it's hard to stop. In our country of hungry consumerism, low interest rates also tempt people to stop saving altogether. In fact, they start to borrow at low interest rates and to "cash-out refinance" so they can buy goods they've always wanted (but really can't afford) a new SUV, a cruise, a Jacuzzi on the back deck, expensive shoes. How do they do most of their borrowing? In the form of credit cards. This is good news for the credit companies as well as the companies servicing the credit companies including not just credit card equipment makers but credit counselors and the debt collection companies.
It is no coincidence that the stock of American Express grew steadily in these five years, almost doubling in price, and I recommended its stock consistently on Fox News from 2001 to 2003. It's also no coincidence that Mastercard had a highly successful IPO in 2006, with a nearly 300 percent gain in its stock price.
So now you have drawn yourself a map showing how one trend can spawn so many others. But how can this map be used to make bacon? How does this information help the savvy trend spotter actually make money? Identify publicly traded companies who specialize in the fields that are some degrees separated from an obvious trend source, and consider investing in these companies.
For example, on my AOL blog, I recommended West Corporation in November 2005, back when it was trading just below $40.89. This company collects receivables for other corporations. Knowing that America's debt was getting out of hand, after being spurred on by the rise in home-equity loans, I believed West Corp.'s collection services would be in increasing demand. Sure enough, in late 2006, West Corp. was bought by Quadrangle, and each investor received $48.75 per share. Someone who had bought $2,700 in West Corp. stock back in November 2005 would have sold at $3,219 for a gain of $519, or nearly 20 percent. Not a bad return for a year!
Take another example. During the housing boom, I invested in New Century Financial, which offers sub-prime residential loans. Sub-prime mortgages are high-risk. They are higher-rate mortgages offered to people with bad credit, and the majority of them come with an adjustable rate (they are often referred to as "ARMs"). As interest rates started to rise, I sold New Century, knowing that the increase would be worst for sub-prime borrowers, who tend to be poorer and who often are unable to shoulder the rise in their ARM. Sure enough, at the time of this writing, many of these people are defaulting on their sub-prime mortgages, and New Century has filed for bankruptcy. I'm glad I got out when I did.
In response to the housing boom, I also bought shares of the high-end retailer Restoration Hardware, which sports attractive and overpriced home furnishings and accessories. I also made money in Black & Decker, which was selling all those drills and saws to entrepreneurial contractors and do-it-yourselfers.
One of the great things about buying stocks that rise and fall with the housing market is that it's a way to "play" the real estate market, without having to spend the money (and take on the mortgage) for actual property. In the end, I made more money in the housing-boom market than most "house flippers" ever imagined all without ever buying a piece of real estate! There's No End to the Six Degrees Game
Once you start thinking this way, you'll easily spin your own webs of trends. For example, think about demographics. The aging of Baby Boomers means more future health care needs, such as hospitalization, pharmaceuticals, artificial joints, and even ambulance transport. I own stock in Rural/Metro, a small ambulance company based in Arizona a place full of senior citizens. In time, I am sure that stock will double. I also recommended Sunrise Senior Living in early 2006, right after a delayed earnings announcement caused its stock price to dip. I predicted it would drop from $35 to $25 but then climb back up to $45. Since then, it dropped to nearly $26, but has already come back above $40. Why? Because it is a smart company offering specialized assisted-living services to seniors. With the aging of the U.S. population, I believe Sunrise is destined for decades of strong growth.
Similarly, Cantel Medical produces sterilization and sanitization systems as well as other medical supplies for hospitals, dentists, and doctors. With these products likely to be in greater demand owing to an aging population, it's no surprise that Cantel's price rose nearly 25 percent in the six months after I picked it. Then there's Bio-Reference Lab, which offers clinical laboratory testing services in the Greater New York area. I picked this stock in April 2006, after its price had quadrupled over the previous five years. Despite that growth, I predicted there was still room for more upside for this highly profitable company. Within eight months, the stock price was up another 50 percent.
You may have missed the housing boom or gotten in late on the baby boomer trend, but you can take comfort in the fact that we are about to embark on one of the biggest trends of the past fifty years. This trend encompasses transportation, agriculture, chemicals, manufacturing, biotechnology, and even real estate. I'm referring to the Green Revolution the developments that will take place in clean technology, alternative energy, and environmental enhancements and remediation. You don't have to make your money by investing directly in an ethanol plant or in a solar power company. You can invest in John Deere, for example, which will be needed to produce more tractors to help harvest the preferred crop used for biofuel whatever crop it ultimately turns out to be. Better yet, as more crops are used for fuel instead of feed, the cost of beef and chicken will likely rise and consumers may turn more to other forms of protein, such as fish. So why not look for companies specializing in fish products?
The Green Revolution isn't the only trend on the horizon. The great part about this game is that it is a tool for constantly identifying new opportunities. Not Every Company Connected to a Trend Is a Winner
You can play this game to great profit, provided the connections you make in linking one category to another are sound and you select companies in the best positions to thrive from the trend. Don't assume that just because, say, nails are needed for the home-building boom, Nails and Screws, Inc. necessarily will prove to be a good investment. Don't throw your money into every company involved in any of the six (or more) degrees separated from a trend. Just because the trend is a winner doesn't mean a particular company is capable of or positioned for taking advantage of that trend.
There are two crucial things to keep in mind when following all the trend tips I'll introduce for deciding whether a company you think will be positively affected by a trend is worth pouring your money into:
First, whenever possible, invest in a company you know and like. If you are constantly impressed when you visit a Lowe's, then it's likely that others feel the same way. On the other hand, if you find yourself frustrated and dissatisfied when you visit a Home Depot, then I doubt that you are alone. In early 2006, I wrote a scathing AOL blog entry about my experience shopping in a Home Depot, where I could never find anyone to help me with what I was looking for. Most people I know had the same experience. I predicted this would eventually hurt the company, and I was right. Several months later, the stock had dipped nearly 23 percent. To be sure, Home Depot was also hurt by the softening housing market, but its rival Lowe's, which was hurt by the housing market as well, dropped less and made up more ground faster. In my blog pick, I praised Lowe's customer service, and I'm certain that quality of service has had much to do with Lowe's better results.
Next, study the company financials, which you can find painlessly on the internet both in the company's own reports to investors and on many reliable financial sites. Remember what I said about always doing your homework. It is important that you educate yourself about how to read a balance sheet and an income statement. It is also important to go to the source. Look directly at the company's balance sheet, which can be found in its annual report to investors and also on the SEC's sec.gov website (in the form of the annual 10-K and the quarterly 10-Q filings). There are many good books and online sites that can educate you in the basics of investing and analyzing the strength of a company. In the appendixes you'll find more information to help you understand the specifics of this analysis.
The key metrics that I examine when assessing a company are the company's financial fundamentals, profitability, rate of growth, stock value, and management. Here's a quick overview of rules of thumb to follow.
BASICS OF ASSESSING THE STRENGTH OF A COMPANY
1. Financial fundamentals: A company must have solid fundamentals. To assess these, you can easily calculate these ratios:
a. Quick ratio: This figure is called the "quick ratio" because it gives you a quick snapshot of the company's solidness. It measures the liquidity of a company its ability to make good on its obligations. Take the current assets of the company, subtract from them the inventories, and divide this figure by the current liabilities. And if you don't feel like doing math, many reliable financial sites will have calculated the number for you (see Appendix A). The higher this number in comparison with other companies in its field, the more financially sound the company.
b. Debt/equity ratio: Heavy debt is a bad sign. By dividing the debt of a company by its equity, you can calculate this ratio. The lower this figure, the better. If the number is nearing 40-50 percent, you should take a very careful look at why, particularly if the company has a low quick ratio, indicating that it could have potential problems paying off debt in the near future.
Companies with that high level of debt traditionally will be using a large portion of their annual earnings to pay interest and principal on that debt, rather than using it to pay dividends or to invest in future growth, both of which would help you as an investor.
2. Profitability: The profit margin is the gross profit (or the profit once you've subtracted out the cost of the goods) divided by the total revenue, and it indicates the efficiency and profitability of a business. The higher this number, the better. Investors like to find companies that continue to increase their profit margins over the years, signaling that they are staying competitive while remaining profitable. Again, compare the profit margins of a company with those of competitors in its industry to gain insight into the strength of the company relative to other companies in the same business. (Average profit margins of companies in different industries are all over the place: from 20-25 percent in certain types of manufacturing to well over 70 percent in some service businesses.)
3. Growth: A company may be debt-free, but unless it has strong growth potential, your investment won't be likely to have strong growth potential, either. One indicator of a company's growth potential is its historical growth rate. Look at the growth rate figures to see if there has been fairly consistent growth (in profits and/or revenues, depending on the industry) over the last year, five years, and ten years, and compare the figures with those of other companies in its industry. (See Appendix A for where to find these growth rates.)
An anomalous short-term burst of growth yesterday means little today. Steady upward growth, however, indicates it will likely continue into the future, if everything else about the company checks out. Good smaller companies (those with less revenue) should generally have higher growth rates than larger companies (those with more revenue).
4. Value: Check out the company's price-to-earnings ratio (known as the P/E ratio), which is the price per share divided by the earning per share, and compare it with that of others in the same business to determine if the company is "overvalued." In the simplest sense, the P/E ratio tells you how much you need to pay to own $1 of the company earnings. A high price-to-earnings ratio thus might indicate that investors think the company is poised to grow. However, compare it with other companies in the same industry. If Nails and Screws, Inc. has a P/E ratio of 30, whereas its competitors have P/Es of 15, it may be that Nails and Screws, Inc. is overvalued. But refer back to the growth rate before deciding to punt it. Perhaps Nails and Screws, Inc. has comparable profit margins, but enjoys a much higher growth rate than its competitors, warranting its higher P/E ratio.
Remember the principle to buy low, sell high. You are looking for the gems: undervalued, solid companies that are about to benefit from a trend. A low P/E in the Six Degrees of Making Bacon game is a good sign that you could really profit from the investment, and if the growth rate is strong as well, then you have likely found a good target.
5. Management: Make sure the company has effective and experienced management in place. You can find the professional backgrounds of top executives on the company's website. Another positive sign is when management holds significant amounts of stock in the company several times their base pay. (This information is available on sites like Yahoo! Finance and MSN Money.) It indicates that the leaders are personally vested to make the company work in the long term; since they aren't just working for a paycheck, they actually own part of it. It's even more encouraging when they're buying additional shares with their own money. Take a look at the pay structure. Are executives reasonably compensated in comparison with other heads in their fields? Are the senior executives overcompensated compared with their peers? And look, too, at the company's dividend policies, found in their annual reports. A good leader is thinking about how to spend, invest, or distribute company profits fairly to his or her shareholders. Ask whether the company management is forward thinking, preparing to capitalize on the trend you've identified as coming their way. Is Nails and Screws, Inc. in a good place to beat competing nail manufacturers? Are they putting money toward research and development of new and improved nails? Are they creatively and effectively marketing their screws? You can get a sense of a management team's thinking on these issues from the CEO's annual letter to shareholders in the company's annual report and from the presentations to investors (usually in the "investor relations" section of a company's website).
One other key tip is to always take a look at the pending-litigation section of the SEC documents. Although every company is at one time or another the subject of some lawsuit usually frivolous I have also found insights into pending issues that will become important with time.
One critical item to remember in this analysis is to compare companies in the same line of business. Otherwise, the actual ratio, margin, rate, or multiple doesn't have much meaning. After all, Google, for example, will (and should) have very different profit margins from, say, Coca-Cola. But it matters a lot more how Coca-Cola performs relative to its peers, like Pepsico, when evaluating how well an investment in that company's stock can ride the wave of a trend. Let's say you conclude that the beverage industry is poised for growth. After doing some homework, you find that the growth rate for Coca-Cola is higher than that of the beverage industry overall. You know then that Coca-Cola's growth isn't only from capitalizing on the growth trend in the beverage market, but that the incremental growth means it's actually doing a better job of capitalizing on that trend than its competitors (perhaps even taking business away from them). So if you want to take advantage of the beverage industry growth trend in this example, you'd probably be better off investing in Coca-Cola over its competitors.
Okay, so let's take a look at how you could have played the Six Degrees game, following these rules of thumb, at the start of the housing boom. Let's say you did some shopping around home improvement stores in the public market space. You checked out the fundamentals of Lowe's home improvement stores and they seemed solid. You'd been to Home Depot and had concerns about their customer service that worried you about the company's long-term potential. Then you discovered that the only other real competitors of Lowe's were Sherwin-Williams, Ace Hardware, and TrueValue (and the latter two are privately held and therefore not traded as stocks on any exchange). In any case, the sales generated by Home Depot and Lowe's dwarfed those of the other three (even combined), so it was down to a two-horse race. Toward the end of February 2001, you picked up 100 shares of Lowe's at $14.25. In 2004, when interest rates were again on the rise, you decided that the home improvement market might begin to suffer, so three years after your stock purchase, toward the end of February 2004 you sold the 100 shares at $29.00 per share. In three years, your $1,425 investment became $2,900. That's a home run where you finished your jog around the bases without breaking a sweat. How to Know When a Trend Is Peaking
It's well and good to identify a trend and to ride it, but unless you jump on and off at the right times, the exercise will be pointless, and you can lose money. You need to be careful about your timing, about evaluating where you are on the trend curve. You have to know whether the trend is still growing or whether you're too late. This is the "vigilance" part of being patient and vigilant. New Century Financial is a perfect example of that. Investors who didn't pay attention to the changing landscape and held onto New Century lost quite a bit of money. Don't wait for the brokers and analysts to warn you. Keep your eyes open and remember that gravity and momentum bring us down faster than we rise. The last thing you want is to invest on the slippery slope of the other side of the trend's peak.
But how do you know when a trend is nearing its peak? There is no hard and fast rule of thumb, but looking at examples of similar trends in stock market history will help. Let's take the housing market again. Take a look below at how, as interest rates fell in the last boom, various sectors benefited -from home builders like KB Home, to home improvement retailers like Lowe's, to mortgage providers like New Century.
Interest rates reached lows in 2002 and 2003 and then began to rise. New Century stock started to fall before 2005, while Lowe's continued to ride generally upward through 2006, as did KB Home. No question, other factors impacted these specific companies, and you as an investor will benefit from looking at many charts from similar companies in the home building sector to get a feel for this, but it gives a general sense of trend curves.
In making the timing decision, it's fine not to worry if you jump off a bit early or a bit late. You might not make every single cent that you could have made, but you will still have profited, which is the name of the trend-riding game. And sometimes a stock will take a temporary dive down or a jag up, so don't assume that any down tick is the trigger to sell.
Keep your eye closely on your investments, as there are so many developments that can adversely or positively help a company (sometimes, things that have nothing to do with trends like lawsuits). Check your portfolio weekly to make sure the stock isn't slipping downward, and do your own reality check on the company to make sure it still is the strong, trend-riding company that you thought it was when you bought it. I also set "alerts" through websites like Google, Yahoo!, MarketWatch, MSN Money, and broker sites so that when a company is in the news, I receive an email. Another great way to get continual updates is to sign up with companies themselves to receive their press releases.
Because the Six Degrees game is so enjoyable, it's also easy to go too far. That's why it's essential to follow some basic guidelines in using it as a trend tool:
Don't ignore human nature. Humans don't change easily, so be careful in the kinds of connections you make. For instance, you might look at the hole in the ozone layer, which has led to an increased incidence of skin cancer and the growing use of sunscreen. Naturally, you might think, the popularity of tanning booths would decline, following this trend. But people love being tan, and vanity often wins out over common sense. Men and women are still soaking up the rays, and tanning booths are thriving. Trend Tip 3 delves more deeply into the role of human nature in determining trends.
Don't force connections. Don't assume too much or push a connection too far. Easy does it with this type of investing method. Be smart in connecting the dots, and do your research. Take nuclear power, which could be an alternative energy source as we try to limit greenhouse gases. You might think Toshiba, which owns Westinghouse, which is building nuclear energy facilities in China, would be a good bet. But there are still many concerns about nuclear waste, and it will take a long time before the world makes a significant move to nuclear power. Make sure you think things through and do your homework before jumping to invest.
Don't jump on every wagon. Just because a company is in an industry that has potential to benefit from a trend doesn't mean that the company will be a winning investment. If the company's financials, management, or other fundamentals aren't strong, it will likely not succeed, despite the positive environment in which it competes. Of course, in the very short run, even trendy companies that aren't well equipped for the future enjoy the wind beneath their wings, but they ultimately crash or at least underperform.
Nothing is written in stone. While trends are great indicators of a company's potential, external factors can arise that add kinks into the equation. The genius CEO might get hit by a bus, an act of God might ruin the crops, or a war might keep people from leaving home. Or a new company or technology might enter the scene and render everyone else obsolete. As with all risks, assess them based on sound information. This is exactly why I stressed diversifying your portfolio, so that you spread your risks around a number of companies and sectors. Even if an unforeseeable factor hurts one of your trends or stocks, being diversified across different trends and stocks should allow you to come out ahead in the long run.
When telling yourself not to sweat too much over missed opportunities, remember that investing is like driving. You need to always be looking forward instead of in the rearview mirror. Save looking back for reflecting and learning, not for regretting.
Copyright © 2007 by Hilary Kramer