Buying and selling methods for small-cap stocks were covered in the first four episodes of this series. How can you zero down on the most significant companies once you’ve done the legwork to find a market segment that will expand rapidly over the next year to five years? In this bonus tips piece, I’ll explain why believing that “a rising tide lifts all boats” is a dangerous fallacy that can devastate investment returns.
As of this article’s publication in the spring of 2006, several industries had bright futures. Metals, computers, nanotechnology, renewable energy sources, etc. However, investing in high-growth sectors with the assumption that you can buy any company, there is a disaster waiting to happen. Here are three suggestions to aid you in this endeavor.
The first piece of advice is to initially shift your mindset from that of an investor to that of an artist.
Successful investing requires a creative mindset rather than a strictly analytical one. If you know that original thought is not one of your strong suits, you should interview various financial advisors until you locate one whose originality sparks your interest. The best stock prospects will be missed if they are not evaluated from a creative perspective. Sit down with a pen and paper and start thinking about the possibilities in a given industry.
Take the rapidly growing renewable and alternative energy industry as an example. Considerable buzz developed around renewable energy stocks after President Bush’s State of the Union address emphasized creating renewable energy and after news of Bill Gates’ anticipated $84 million investment in Pacific Ethanol (PEIX) was disclosed. First, list all the possible sub-industries within this larger one. Wind, solar, nuclear power, hydrogen and fuel cells, ethanol, biodiesel, biomass power, hybrid autos, and so on might all make your list. This practice aims to record any thoughts that enter your mind, regardless of how ridiculous they may seem at first.
This straightforward ideation method has led me to many unanticipated opportunities in previously unconsidered industry subsets. It’s possible, for instance, that learning more about ethanol can bring you to an unexpected realization about wind energy’s possibilities.
The second piece of advice is to compile a list of all the questions you have, both good and bad, about the field that fascinates you.
This is a crucial step in the process since it will reveal which stocks have the most significant potential for growth and which have the least. At first glance, every company in a given market or sub-industry may seem promising while conducting the initial study. By this logic, it would appear that all the previously mentioned forms of renewable energy—wind, solar, nuclear, and biomass—are advantageous. But after you’ve completed this drill, things should start to make more sense. The following is a possible positive question list:
In the next five years, what do you predict the size of this market to be?
Who could be interested in purchasing this item?
Do you think this product has more potential for local or international sales?
When and how exactly will this product change the world?
Is this product being used in any nations or marketplaces, and if so, what is the uptake and expansion pace like there?
The following is a partial list of your unfavorable inquiries:
When do you expect this product to become widely used?
Is it more likely to be five to ten years from now or one to two years from now?
How is research in this field supported financially, and how stable are the businesses’ funding mechanisms?
Is the product more geared toward a niche market or a larger audience?
Where does this industry stand in terms of political opinion around the world?
How do the companies I’m considering meeting or benefiting from the profit drivers in this industry?
Don’t be embarrassed if you come up with dumb inquiries during this practice. Until you’ve explored every possible route, it’s vital to write down every question that comes to mind. As soon as you have completed generating your list of questions, head online and begin “Googling” for the answers to your questions so that you may start to filter your list down to the top three sub-sectors. Again using energy as an example, you may find that while there has been a lot of hype surrounding biodiesel, ethanol, hydrogen, and fuel cells, wind, solar, and nuclear energy are the most realistic industries for immediate adoption and have already experienced significant sales and applications.
In addition, you might find that certain governments have already committed funding to the research and development of particular forms of energy, making such niche markets more appealing. It is possible to get a general idea of the immediate profit potential of different subsectors by looking at government deadlines for developing alternative energy sources. Select the top 10 companies in each sub-sector from your final list based on your research.
Third, for your top ten lists, respond to the questions you formulated in Step 2.
Companies vary greatly in quality. Since many erroneous businesses operate in seemingly legitimate industries, it is crucial to zero in on the proper ones. Let’s use the example of precious metals to clarify my idea. Even “mining” enterprises with seemingly similar operations and methods can have vastly different appeals in the precious metals industry. For instance, heavy machinery ownership and metal extraction costs can add up to significant overhead for a single mining business. Another mining firm may have no production costs if it does not own any mines or mining equipment and instead relies solely on contracts with other mining firms to acquire the metals they extract. Similar businesses may have 40% different net profit margins due to radically different operational choices.
One must also investigate how successfully these organizations’ tactics match the challenges in such marketplaces and learn where the potential rewards lie. Is there an increase in the price of this metal? In that case, has the company you’re looking at locked in future sales at today’s metal prices, erasing much of tomorrow’s profits? Or do they choose not to hedge their future sales, taking advantage of the current metal price boom? Even though both companies operate in the metal industry, this decision could mean the difference between great success and failure.
If you hire a financial advisor to handle your investments, you should still learn as much as possible about the field independently. Many financial advisors are also salespeople, so when they hear about a promising new industry, they may look for the market leader and tell you that you should invest with them. You should never agree to buy into a stock position unless your consultant can specifically answer questions about why the industry is poised for such rapid expansion and how the company is strategically positioned to reap the benefits of that expansion. Keep in mind that specificity is always preferable to opacity in this case.
One, you need to think creatively to find the best opportunities; two, you need to ask unconventional questions to narrow down large lists of potential companies to a manageable number of top prospects. Three, it’s not investing in the right sectors that will give you excellent performance, but instead investing in the right companies within those sectors.
This article may be republished on another website with attribution to the author, as shown below, along with all active links preserved.
During this ongoing financial and monetary crisis, JS Kim has used SmartKnowledgeU’s exclusive tactics to produce wealth for his clients as Managing Director. The Financial Times, Reuters, and the International Business Times frequently reprint pieces by JS Kim because of the astonishing accuracy of his predictions during the past three years.
You can find helpful information here on amassing riches even amid a worldwide economic collapse.
Click here to read past issues of our investment newsletter.
Read also: There is no need to have a Tax Haven?