Purple Chips

Winning in the Stock Market with the Very Best of the Blue Chip Stocks

John Schwinghamer

• Publisher: Wiley
• Year: 2012
• Print ISBN: 9781118294499
• eBook ISBN: 9781118300138
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

How to make money investing in high-quality, low-risk stocks

Purple Chips presents a unique stock-picking method based on identifying great companies based on simple visual examinations of financial health, applying three basic criteria to distinguish high-performing purple chip stocks from mere blue chip investments. The book also delves into the psychology of investing, arguing that most investors are better suited to winning small gains often and losing occasionally, rather than taking small losses often and winning big from time to time. In seven succinct chapters that feature plenty of helpful examples, graphs, and charts, author John Schwinghamer presents a simple and effective way to win with stocks. For more information, please visit www.PurpleChips.com.

Chapter 1

The Psychology of Investing

Human psychology is a key factor in investment strategy. As you know from the Introduction, I am not a psychologist, and I don't pretend to be one here. But what I have to say in this chapter is based on my experience as both an investor and a professional in the financial industry.

I believe that to become a successful long-term investor in the stock market, the best practice is to take smaller, continual rewards rather than the occasional big gain amidst a sea of disappointing misses. Regular success builds confidence, which is fundamental to becoming a good investor. Increased confidence allows you to think independently of the herd, and this mindset is essential to success.

Singles and Doubles Are Better

It's human nature to try to hit a home run, to want to experience the glory and praise that come from knocking the ball out of the park. We yearn to be singled out as the person who has achieved something exceptional. The problem with this strategy is that, in the world of investing, more often than not you'll miss. While you may have the occasional success, over time you are likely to lose your bravado, and fall into an inevitable slump as you wait for your next home run.

Most people don't react well to failure, whether it is the occasional big one or frequent little ones. If you're looking for home runs, you will fail most of the time. The following example illustrates how the human psyche deals with success and failure.

Imagine a game show that presents you with two choices: Door Number 1 and Door Number 2.

The show's host calls you down from the audience and explains the game. “Okay, John, here's how we play this game. I give you $1,000 and you choose either Door Number 1 or Door Number 2. Then I will ask you to decide if you want to continue with your prize or stop playing. You'll have a choice to make, you can walk away at any time.”

“All right,” you say, “let's go with Door Number 1.”

Door Number 1 opens wide to reveal four suitcases, one of which you must pick. You make your choice, the host opens it and you've just lost $300. You have $700 left.

“Pick another one, John. We're not done yet.” You choose again, and again you lose some money, this time $200. You're left with $500, which is half of what you started with, and two remaining suitcases.

The host says to you, “So, John, my friend, would you like to continue or do you want to play it safe and keep what you have?” You reflect on the fact that you began with $1,000, dropped first to $700 and then to $500. Most people, in my experience, would be inclined to call it quits at this point—which in my industry means either changing investment advisors or dropping out of investing in the stock market altogether.

This is human nature and nothing to be ashamed of, as far as I'm concerned. We're all drawn to quick returns and always hope to hit that glorious home run, and if neither comes quickly, we look elsewhere to find that positive experience.

Imagine now that, just for fun, the host opens the last two suitcases. It turns out that one of them held yet another loss of $200, but the final suitcase held a gain of $1,700, our elusive home run. Had you followed through and opened all of the suitcases, you would have gained $1,000, and wound up with $2,000 in the end.

Now let's imagine a different course of events. After the host gives you his spiel and the $1,000, you pick Door Number 2, which, as it turns out, presents you with a different scenario. With your first choice of suitcase, you've won $200. The host asks if you want to continue and, of course, you do. “I've just won $200. I've still got my original $1,000. Let's go.”

Much to your delight, although it would be nice if the amount were larger, the next suitcase gives you a gain of another $100. “You're on a roll,” the host says. “What do you say?”

And with the next suitcase you win another $400, and you're sitting on $1,700 in total. There is one suitcase left and you go for it, and, wonder of wonders, you win another $300 and finish the game with $2,000. Most people would agree that the scenario behind Door Number 2 is a far more attractive one. It's certainly less dramatic, but far easier on the nerves, and one that most people would be far more likely to see through to its conclusion.

The second scenario in this game-show analogy illustrates the psychology of my method of investing in the stock market. I recognize that positive reinforcement helps an investor build confidence, and the approach that I propose in this book is based on incremental success, on strings of singles and doubles, rather than the odd home run. I will show you how to invest in order to realize a high frequency of small- and medium-sized gains. The key is to find companies with long-term upward trends in their stocks' earnings per share (EPS). EPS is a key concept in my method and I will explain it in further detail in the next chapter.

This approach is not as glamorous as a home run, but a steady succession of small to medium gains will give you a better chance of sticking to a plan than will several losses followed by a large gain. Only an investor with an iron stomach, or a gambler's unfailing faith in his luck, would see the first game-show scenario to its conclusion. This point is so important that it bears repeating: The second scenario builds confidence, which helps investors see a plan through to its conclusion, which in turn makes for a better and more successful investor.

Tune Out the Noise

We've just seen the value of going for singles and doubles rather than home runs. Another significant part of this approach involves tuning out the noise. “Noise” is my term for all the news and events that occur in the stock market after you invest. These bits of information, which may be inaccurate and speculative, are distractions that will keep you from reaching your goal. They eat away at your confidence, leading you to doubt your original plan.

As investors, one of the hardest things to overcome is our emotions. It takes enormous discipline to develop a plan, avoid distractions and follow the plan to completion. When you think of placing your capital in an investment, you usually have buy and sell targets in mind, as well as a time frame. Then you are distracted by the noise and you're led astray.

For example, imagine that you bought shares of Johnson & Johnson at a low valuation (i.e., underpriced in light of their potential to increase in value), but then a short time later you read that several analysts are expecting a correction, a general downward trend, in the stock market. Hearing this news from “the experts” could lead you to sell your Johnson & Johnson shares for fear of a decline in stock price. If you are susceptible to noise, your exposure to the analysts' predictions may cause you to change your plan.

What separates truly gifted investors from average ones is their level of discipline. A superior investor follows a plan and has the confidence to ignore the noise and distractions that could otherwise disrupt the plan.

Consider the following. Most investors who own a house are disciplined investors. There are at least two reasons for this:

1. They need a place to live and they have no intention of selling their home.

2. They are not aware of the changing value of their investment in their home.

Imagine if all houses had electronic billboards attached to their fronts so that homeowners could see the changing value of their houses every day. If a house price moved like a typical stock, then it would not be uncommon for a $300,000 house to go up or down by 1%, or $3,000, in a day. For many people, this would probably be equivalent to the cost of a week-long vacation in a nice place. Most people would be unnerved knowing that on any given day they had just made or lost the equivalent of a nice holiday. Because homeowners don't see the changing daily values of their houses, they are much less affected by these changes, and so follow their plan to stay where they are, unaffected by fluctuations in value.

If homeowners knew that their houses were going up or down by large amounts, there would be more trading, and less long-term investing, in houses than there currently is. A disciplined investor, like most homeowners, has a plan and sticks to it, knowing full well that there will be ups and downs on the way to reaching the long-term goal of seeing an investment strategy through to completion.

Discipline in investing means being able to follow a plan and avoiding all the obstacles and distractions that the market will place in your way.

EPS Explained

Let's now take a more concrete look at singles and doubles using the Purple Chips approach.

In the following exhibits, I refer to C.R. Bard, which trades under the stock symbol “BCR” on the New York Stock Exchange (NYSE). C.R. Bard is a large American maker of medical devices that are used in hospitals around the world. Before I go into details, we need to understand the concept of “earnings per share,” because it is the foundation of the Purple Chips method. EPS is simply a measure of how much money a company has earned in its most recent four quarters, or one-year period, for every share that is owned by shareholders.

Exhibit 1.1 shows the EPS for C.R. Bard from December (Q4) 2009 to December (Q4) 2010. If we add up the four quarters of EPS in 2010, we get what is referred to as the trailing twelve-month EPS of $5.61 per share for the one-year period ending December 2010 ($5.61 = $1.54 + $1.43 + $1.39 + $1.25). Note that the trailing twelve-month EPS is sometimes also referred to as the rolling twelve-month EPS. For the purposes of this book we will use only the former term, which is...

Table of contents

• Cover
• Title Page
• Copyright
• Dedication
• Acknowledgments
• Introduction
• Chapter 1: The Psychology of Investing
• Chapter 2: Purple Chips versus Blue Chips
• Chapter 3: Understanding and Seeing Valuation
• Chapter 4: What Else You Need to Know
• Chapter 5: When to Buy and Sell
• Chapter 6: Practice Case Studies
• Chapter 7: Purple Chips Summarized
• Endnotes
• Index
• About the Author