23 stock-picking lessons learned for 2005

Every investor suffers a few losses. For the new year, I'm turning what I learned in 2004 into a stock-picker's survival guide.

By Harry Domash

Every investor makes mistakes. We're told that's how we learn. If that's true, I learned plenty last year. I counted 23 different learning experiences that I'd prefer not to have to learn again in 2005. Rather than dwell on the mistakes, I've translated them to a set of guidelines that I call my 2005 Survival Guide, which I'm about to share with you.

I've grouped my survival rules into categories: behavior, tips, price action, and fundamentals. Have a look, and have a better year in 2005.

Mind your behavior

I will not try to predict the direction of the market. Making decisions based on my view of which way the market was headed didn't work. I was wrong more than I was right. No more! Now I'm basing my buy and sell decisions on each stock's fundamental and technical outlook. I'll let the market take care of itself.

I will not invest based on my prediction of:

* Oil prices
* Price of gold
* Value of the dollar
* Interest rates, etc.

Some very smart people have gone broke over the years trying to predict such things.

I will not place a limit order when I'm buying or selling. I know; conventional wisdom says limit orders are the way to go. Maybe it's just me, but I often outsmart myself when I use limits. If I'm buying, I'll end up not getting the stock and paying more the next day, and vice versa. Worse, I waste time all day checking on my trade. It's not worth the hassle to save 20 cents per share.

I will not check on stock prices during market hours. Some days I drive myself crazy watching my stock's minute-by-minute price moves. That's when I realize that I need a life.

I will not check after-hours trading prices on my stocks. Somebody sells 100 shares at $1 below the close and I'm up all night stressing over it. Then, the next day, the stock makes up that dollar in the first trade. No more.

I won't make decisions based on how much I've made or lost on a stock. It's crazy! Say I buy a stock at $5 and it goes to $10. So I sell because I don't want to be greedy. Then the $10 buyer makes the same decision and sells when it hits $20. The market doesn't care what you or I paid for the stock. It's all about its future growth prospects.

Tune out the tips

I will not buy a stock based on a guru tip. Okay, the guy on TV has beaten the market every year since Madonna's first kiss. But 2 million other investors are hearing the same tip. It's too late.

I will not buy a stock based on a tip I hear at the gym. The guy at the gym probably got it from the guru on TV.

I will not buy a stock because most analysts are rating it "strong buy." My experience says "hold" or "sell" rated stocks perform just as well, if not better, than "strong buys." Think about it. Analysts change their ratings frequently. If the rating is already at "strong buy," the next change has to be a downgrade. (Here's a link to more on that topic.)

I will ignore market predictions from gurus who predicted the last market crash, the start of the last bull market, etc. Last year, a guru who supposedly predicted when the bubble would burst, scared the you-know-what out of me when he saw even worse times ahead. It didn't happen. At any given time, there's always someone predicting just about anything. Just because one of them got it right once doesn't make him or her Nostradamus.

Price action protocol

I will only buy stocks trading above both their 50- and 200-day moving averages. Despite my best research efforts, sometimes I get it wrong. A stock's price chart is a valuable second opinion. Stocks trading above their 50- and 200-day MAs are in uptrends, meaning the market agrees with my assessment. Downtrends means it doesn't. Chances are, I overlooked something or there's unannounced bad news lurking.

I will not buy just because a stock has gone up a lot. Sometimes stocks go up for all the wrong reasons. In the end, fundamentals rule. You have to do the research.

I will not average down. It's bad news if a stock heads down, instead of up, after I've bought. It means that the market doesn't agree with my assessment. Averaging down means buying more shares to reduce your average cost. Bad idea! All too often, the market's right.

I will not buy stocks making new lows. As much as I've tried, I still can't pick the bottom. New lows all too often lead to more new lows.

I will not place sell stops. It's uncanny; I have a great knack for placing my sell stop at the bottom. Once it hits my stop price, the stock usually soars and never looks back. For me, it works better to evaluate the problem that caused a stock to drop and make my decisions based on its fundamental outlook.

Focus on fundamentals
I will only buy stocks with real sales, earnings and cash flow. No more! I've bought too many stocks on the premise that sales and earnings are about to materialize big time. Somehow, it doesn't happen. Starting now, I want to see real sales, say at least $10 million in the last quarter. But sales aren't enough. I'm not touching a company unless it also reported positive earnings and operating cash flow. The dollar amounts aren't important. I just want to see money flowing in, not out.

I will always sell when management significantly reduces sales or earnings forecasts. I must be too gullible. Company execs always portray shortfalls as one-time events, and I believe them. That's usually a mistake. Bad news leads to more bad news. From now on, I'm selling at the first sign of faltering growth.

I will not buy stocks with price/sales ratios (P/S) greater than 14. Most growth stocks have P/S ratios in the 3-8 range. Anything much above 10 is in la-la land. Sky-high ratios signal over-exuberant expectations that will soon be deflated. Count me out.

I will only buy stocks if I understand what they do for a living. I can't analyze a firm's prospects if I can't figure out what it sells.

I will sell any stock when a competitor says business is tough. It's a godsend if a competitor announces bad news before your stock does. The competitor's stock probably drops big time, while you stock merely hiccups. Your company's execs will say that the competitor's problems are company specific. Wrong! Everybody in the same sector faces the same problems.

I will diversify my portfolio between industries and sectors. It's so tempting to load up on a bunch of stocks in today's hot sector. But it's not like the good old days when strong sectors stayed that way for years. Now it's more like 15 minutes.

I will sell any retail or restaurant stock when it reports negative same-store sales growth. Same-store sales growth is the sales growth at units open at least one year. Trust me on this one. There are dark days ahead for any stock whose existing store sales are shrinking instead of growing.

I will not make a buy or sell decision based on a stock's "fair value." Analysts have bought into the concept of calculating the "fair value" of stocks they're covering. They advise buying stocks significantly below, and selling those at or above, "fair value." Problem is, their "fair value" formulas are based on unrealistic assumptions. They are meaningless. Consider a downgrade to "hold" or "sell" based on valuation alone as a buying opportunity.

In my experience, investing success is more about discipline than fancy analysis. Start with my rules. Change them if they don't work for you. The key is following a set of rules that you keep improving over time.