Market Down; Stock Picks Looking Better; Mutual Funds for 401(k)

With the stock market going down (especially today after the employment numbers were reported!) my stock picks keep looking better and better. Overall they're down 9%, ranging from 4.8% price increase in Medtronic to a 16.7% price decrease in Cisco. When I say "down," I mean down since I've analyzed them since that is how they're being tracked in my spreadsheet. This basically means that it was a good call not to invest in my stock picks just yet (except for Medtronic, which is actually up).

So, for now I'm holding out on investing in the stock market. This "strategy" can be called market timing, but in my opinion it may be wised to wait a bit to see how everything will get sorted out since bad news keep coming out and a number of stocks on my "final" list are dependant on the overall economy since Coach and Harley-Davidson are in the "Consumer Discretionary" category, while Bank of America is obviously in the "Financials." Of course, there is a reward for taking a risk in the turbulent times, but at this time it's not clear whether the reward is great enough to compensate for the risk. In a way, that's what investing is all about: balancing risks and rewards to maximize the rewards with minimal risks.

Jumping to a different topic. I will be looking at mutual funds (and maybe ETFs), as the time will allow, while stock market is figuring itself out. Most of the mutual funds (although not all!) have already made capital gains distributions, so it's a good time to start investing in them. Also, I will need to pick mutual funds for my new 401(k) plan, which will involve looking over 20+ mutual funds. One thing I'm not clear about is whether load/no-load mutual fund structure matters in 401(k) plans since the benefit administrator has some sort of a pricing structure worked out with the employer. I'm wondering if and whether this differs from employer to employer and how those "load" fees are passed to plan participants. This may make a significant difference in how I choose mutual funds for the 401(k) plan. Any thoughts on this?

Tentative Portfolio Allocation Targets

Now I'm looking at the capital allocation between stocks, mutual funds, etc. Here is the breakdown that I'm currently considering:

• 45% - Stock Portfolio (about a dozen top stock picks)
• 30% - International Mutual Funds
• 10% - Domestic Mutual Funds
• 5% - Speculative and merger arbitrage trading10% - Cash

It is definitely on the aggressive side, but I figure that good research takes away a good portion of the risk and long-term investment outlook (well, with the exception of speculative and merger arbitrage trading) further mitigates the risk. I feel pretty comfortable researching stocks and I think I'm not too bad at researching mutual funds either. I've researched and picked a handful of mutual funds last fall and they have all performed well even though their focus is varied.

Domestic mutual funds are meant to complement the stock portfolio, which represents a mostly domestic exposure. Domestic mutual funds that I'll be looking at will most likely have a relatively concentrated portfolio of mid-caps and small-caps with unorthodox investing strategy since I don't want a fund following the small-cap index, which isn't expected to perform too well now.

International mutual funds will diversify the overall portfolio to make sure I'm exposed to the global market gains. This is somewhat of a hedge against the U.S. economic slowdown.
Speculative and merger arbitrage trading are meant to ennhance the overall portfolio performance. It is to take up only 5% of the portfolio because it is risky and it is also meant to teach me more about markets as I make these trades. You could a call it a "play money" portfolio segment, but money is money and money involved in the speculative trading are just as valuable to me as money in the mutual funds or the stock portfolio.

And cash is there as the backup funding for additional market opportunities. For example, if Bank of America were to tank on the news that it will writing off gazillions of dollars at the end of the fourth quarter, I could use that backup money to pick up the pieces being 100% sure that the company will rebound soon enough.

I might replace some mutual funds with ETFs, depending on how long-term I will be choosing the mutual funds for. We'll see about that. With a 100 free trades from Firstrade, it is that much more tempting to use ETFs.

Signing up for Firstrade / Trading Plan Update

So, I've signed up for the Firstrade individual trading account yesterday. It will a few days before I can do any trading since it takes about 5 days for ACH bank transfer to complete. I think it's a good idea sign up for an account sooner rather than later if you're expecting to make trades in the near future even if not necessarily today or tomorrow because it does take a while for account to become active. Also, if you choose to go with the Firstrade, and sign up before the end of 2007, you will get 100 free trades. That is only $695 worth of trades ($6.95/trade x 100). If it wasn't for the promotion, I was strongly considering signing up with Tradeking which has $4.95 trades.

I have not explored the account options in detail yet, but I was pretty happy to see the S&P stock and fund reports and various market commentaries/analysis. Those additional research sources will work well in conjunction with the Morningstar analyst reports.

Once the account is set up, I will check S&P reports on my top picks so far and if I find any interesting and/or significant points, I will post them here.

So far, I have not been punished for my delay in buying the top picks. Most of those picks lost a few percentage points in price and only Medtronic and Coach are making an effort to upset me a little by their gain of 6-8%. I'm not worried about those two too much though: if you look at it short-term, there is a good chance that they'll go down again and I'll buy them at same low price that I analyzed them at; or, if you look at it long-term, they're still a large upside to both of them, so there is still plenty of gains to be made.

Final Stock Picks and What I Plan On Doing With Them

So, at last I have a handful of companies that can be invested in. Eleven, to be exact. Well, more like eight actual "investment grade" stocks + two strong candidates + one speculative play.

Capital One is the speculative play, which as tempting as it may seem I will probably pass on. After reading a Fortune article pointing out that UK has been ahead of us by about 18 months for the past several year as far as the economic conditions go and besides the subprime mortgage that they've experienced two years ago, they've also had a problem with credit card default rates afterwards. When I thought that Capital One's stock was beaten down because of its subprime exposure, I figured that extent of the downward pricing pressure on the stock was uncalled for, but now it almost seems justified if U.S. economy will keep on following UK's behavior as it has so far.

Having said what I said above about potential credit card problems, I'm still bullish on Bank of America. It'd be a shame not to snag one of the financial companies at these beaten down share prices and this company seems to be in the better position than others with an excellent balance sheet and a limited exposure to the subprime mortage mess.

Two stocks that I'm undecided about right now are Walgreen (WAG) and 3M (MMM). I've only done financial analysis on them and not the full analysis, have not really looked at their 10-K statement yet. Walgreen has a higher margin of safety and a solid track records of revenue and profit growth. 3M, on other hand, seems to have these cyclical declines all the time and although the margin of safety is only 18%, the company, it seems to me, is likely to bounce back up quicker than Walgreen if previous stock price history is any indication. So, I might take a position in both, with 3M being the smaller investment.

Out of the remaining eight picks, only two have margin of safety (MOS) under 30%: Medtronic (MDT) at 27% and Coach (COH) at 22%. Medtronic is close enough to the 30% benchmark, while a good price for a position in Coach might be worth waiting for. Coach went up 12% since I analyzed it three weeks ago, but I'm sure it will go down before keep on going back up.

So, with the exception of Coach, other seven picks (including MDT) can be invested in. What I'm waiting for right now is the Fed meeting on December 11th, which will determine what my actual final pick will end up being and the size of positions I will take in each of those stocks. What I'm concerned about is Fed's seeming unwillingness to cut the interest rate further. If the rate is not cut once again, there is a strong belief among reputable economists, such as Ed Yardeni, that such action (or rather inaction!) will induce a recession with a significant economic downturn. I figure it's worth waiting another two weeks to see what's happening, but I would prefer to make the trades before the end of the year, this way I'd have an option of taking long-term capital gains by the end of 2008 if my tax situation will be suitable for such a move. Obviously, the trades are not made for tax reasons alone and I will most likely buy those stocks anyway, but might as well do it at the time that might be tax-advantageous in the future as well.

Here is a list of stocks listed in the spreadsheet above linked to their analysis pages:

• Johnson & Johnson (JNJ)
• Cisco (CSCO)
  
• Medtronic (MDT)
  
• Capital One Financial (COF)
  
• Bank of America (BOC)
  
• Coach (COH)
  
• McGraw-Hill Companies (MHP)
  
• Progressive Insurance (PGR)
  
• Walgreen (WAG) - no analysis
  
• 3M (MMM) - no analysis
  
• Harley-Davidson (HOG)
  

Choosing an Online Brokerage: What's Right for Me?

When it comes to online brokers, there is plenty to choose from. It's not as easy as I thought it would, it's just about the commissions costs it turns out. Each brokerage has its own pricing structures, its own set of features, and its own customer support which can vary wildly from one broker to another. So, I dived into this craziness and this post shows the results of my research.

What I'm looking for:

• First and foremost I'm looking for the cheapest trade execution around
• Even though I don't plan on making many trades, I want commissions to have the most minimal effect on my returns possible
• Low fees on other things besides the trades (funds transfer, etc.)
• High interest rate on cash sitting in the account
  
• Relatively easy to use web site
• Reasonable amount of paperwork involved in opening and maintaining the account

Other minor things that would be a plus:

• If possible, a good selection of no-load mutual funds with free transactions, but I have no problem dealing directly with the funds so this not a deal breaker for me


• Research tools and other trading-related feature would be nice, but this is not a big deal for me either since I use Morningstar for stock and fund research

I've found a number of web sites that reviewed and ranked various online brokers, they are listed at the bottom of the post. So far, my favorites (yes, mostly because of their low prices) are TradeKing ($4.95/trade), Scottrade ($7/trade), and Firstrade ($6.95/trade). Besides the difference in commission rates, they also vary in other features:

• Firstrade (www.firstrade.com)
• 4.39% default interest rate on cash
• doesn't charge any fees to buy/sell any of its no-load mutual funds (1900+ total funds offered)
  
• has one of the least user-friendly web sites
  
• had the least number of run-ins with the law and customer disputes
• they currently have a "100 commission-free trades" promotion if you open your account before 10/31/07 and fund it with $2,000+ within 30 day of opening the account; you must also keep that balance for at least 9 months
  


• TradeKing (www.tradeking.com)
  
• 1% default interest rate on cash and about 3.3% if you elect to
  
• few stock/fund research tools
• lacks a good selection of no-load mutual funds and offers less than 1,900 mutual funds in total
• charges $14.95 to buy or sell any of the mutual funds it offers (including no-load funds)
  
• doesn't provide cost-basis information for your trading activity, which will cause a hassle at tax time if you don't keep track of all trade details yourself
  


• Scottrade (www.scottrade.com)
• 3.25% default interest rate on cash
• offers less than 1,900 mutual funds and less than 1,000 of these funds without a transaction fee
  

Other cheap online brokers:

• SogoInvest (www.sogoinvest.com)
• $3/trade or as low as $1 if you get a subscription plan
• have not heard much about it, but SmartMoney has ranked it very low in most categories in the recent broker survey
• it seems to be one of the newest brokers around and its quality and offering might improve in the future


• Zecco (www.zecco.com)
  
• free 10 trades a month and $4.50/trade after that
• $2,500 minimum required balance
  
• many users have reported hassle with paperwork related to everything starting from opening the account to transferring the funds
• skimpy customer service
• since this broker uses ad revenue to offset its costs, web site can be somewhat cluttered
  

My Strategy

I'm thinking it might make sense to open two accounts: one for stock trading and one for mutual funds. Before I'll make any final decisions, I will need to decide on the mutual funds I'm interested in and then see which discount brokers offer it as a no-fee fund (it's not the same as "no-load" fund, brokers can charge a transaction fee even for no-load funds). At this point, best combination of brokers would be: TradeKing account for stock trading and Firstrade for mutual funds. This way I would have the low stock trading commission rate of $4.95/trade and no fees related to mutual fund trading.

Additional resources:

• ConsumerSearch.com: Online Brokers (Feb '07; summarizes reviews from 12 different web sites)
• SmartMoney: Finding the Best Broker (Aug '07)
  
• Kiplinger.com: The Best Online Broker (July '06)
• USA Today: Online brokers step up competition with free trades (Jan '07)

• MoneyBlog: Zecco Review (May '07; blogger's personal account of his experience with Zecco plus what seems like a 100+ comments of users sharing their experiences with Zecco)
• MoneyBlog: TradeKing Review (Aug '07)
  

Investing: Phase II - Stock Weeding - Maxim Integrated Products

So, one of the companies that came up in my screening process is Maxim Integrated Products (MXIM 29.71). Here is what the company does:

Maxim Integrated Products makes high-performance analog and mixed-signal integrated circuits. The company offers a wide range of products serving a host of analog-intensive applications, including power management and data conversion. Maxim supplies its diverse array of about 5,000 circuits to a broad base of customers in end markets, including communications, computing, industrial, and consumers. Roughly 70% of the firm's sales are based outside the United States.

Yeah, exactly. That didn't make much sense to me, so there was no reason to continue with the analysis. Sometimes you can tell that no matter how much more you will (reasonably) read about the company's operations, it probably will still be too vague to be able to confidently invest in it. The stock, has also been underperforming for the past 5 years. Even though that may mean that now will be the time that it soars, I don't feel like taking that chance.

Investing: Phase II - Stock Weeding

Alright, after I ran my stock screen I've come up with about two dozen companies that met my criteria. Out of them I removed companies the following sectors and industries: Financials, Drugs, Biotech. Financials require a more unique way of analysis than for other stocks and I'm not familiar with that - there is already enough risk in my investment process, I don't need to add anymore. Plus, you don't know which companies will be affected by the subprime mortgage crisis and subsequent private equity downturn. As for Drugs and Biotechs, first of all, I really don't understand them and second of all, they seem to be cyclical. I'm trying to avoid cyclical companies, as that is another form of risk, and yes, I don't need anymore of that.

Even though I might seem very "risk-averse", fact of the matter is that I'm trying to eliminate as much risk as possible where I can control it because once I make the picks the only thing that will be controlling the performance will be Mr. Market and the underlying economics of the companies I'll choose. So, I want to make my choices count.

Investing: Phase I - Stock Screening

So, I feel fairly confident now about the investment process after reading a book about Warren Buffett, reading various literature, and what I found especially useful - a free online course from Morningstar.com.

I'm definitely not an expert, but I think I at least know my limitations. Now I'm should be ready to start looking for companies to analyze and make my picks for the virtual mutual fund that I will run on Marketocracy.com.

First things first - I need to select a pool of stocks from the whole stock universe (6000+ U.S. listings) to play with. Since I know that my knowledge and experience are very limited, I will be very conservative with my choices, but conservative shouldn't mean minimal returns. I think it's reasonable to expect 10-15% annual return if the task at hand is approached carefully.

On the more basic level, I intend to look at companies whose basic business I can reasonably understand since if I don't understand I cannot make any sort of realistic valuations of the business or forecast its future growth, both of which are essential when evaluating a stock. Then, I will look at companies with consistent sales/earnings growth as well as steady free cash flow margins. The company I will consider must have a long track record of consistent returns and a history of innovation (be it in marketing, their products, etc.), which would be a strong indicator of how a company might perform in the future. Yes, I know that they say "Past performance doesnt't guarantee future results," and yet a company that was profitable for decades is unlikely to turn the corner without any hints of business going bad.

Another reason why large-cap stocks would be a good choice right now is because they have underperformed for the past 6-7 years while small-caps soared. Currently, the market seems to be turning the other way - when there is a lot of uncertainty the markets people tend to prefer to invest in the more stable, blue-chip companies. Besides, many small-caps are already bid-up so high, there is not much room left for stock growth since they're overpriced now.