Alas, Visa’s stock scares me silly. Why? Amid all the happy things you can say about the company, it’s easy to overlook two important points:

Investors are infatuated with this stock. They seem to ignore the considerable uncertainty and risk that lie ahead. Now up more than 30% year to date, Visa’s shares are priced for perfection and nothing else. Visa’s not invulnerable to the dwindling economy. In fact, it’s extremely vulnerable to consumers’ strength or weakness.
Before you send that hate mail, let me explain.

This is pretty serious stuff. On average, it’s an expectation of 17.4% annual growth, based upon predictions that Visa along with rival MasterCard (NYSE: MA) will ride a global shift from paper to plastic commerce. These assumptions are also based on a business model that accepts no credit risk. Unlike American Express (NYSE: AXP) or Discover (NYSE: DFS), Visa simply makes money off transactions an inherently safe and lucrative business model. It’s great work if you can get it.

And investors know this. They’re so confident, in fact, that shares have been bid up to more than 24 times this year’s earnings, and more than 20 times next year’s.

Think about that for a moment, tend to your nosebleed, and acknowledge this point: Yes, earnings are expected to skyrocket, but shares are valued at a level that entirely reflects this. Growth even tremendous growth is already priced in.

Hence, meeting these lofty expectations will likely result in less-than-awesome returns. Here’s a simple example: Say Visa meets 2011 earnings expectations of $3.95 per share, and still commands a multiple of 20 times earnings. Under these assumptions, it’ll reward shareholders with annual returns of less than 8% per year nothing to sneeze at, but nothing to drool over, either. You can pick apart the assumptions all you’d like, but you’ll be hard pressed to come up with anything that’s both rational and spectacular. That’s just the nature of stocks priced for perfection.

Here’s where things get exciting
Now, curious investors will read the above and ask a simple question: What happens if things don’t go as planned? What if growth doesn’t materialize as investors imagine? This is smart thinking. Expectations of assured and unremitting growth are almost invariably wrong. Anyone alive over the past two years can relate. And with Visa, let me be blunt: I think the hype over its supposed explosive growth in the coming years is spectacularly overblown.

Why? Glad you asked.
As we speak, banks like Citigroup (NYSE: C), Bank of America (NYSE: BAC), and JPMorgan Chase (NYSE: JPM) are slashing credit card lines like their lives depend on it. One estimate tags this number at $2.7 trillion by 2010, which equates to the evaporation of 60% of the dollar amount of extended credit. The era of consumers’ attachment to credit cards is simply toast. This point is sometimes pooh-poohed by those who note Visa’s dominance in debit transactions. Debit, they insist, will pick up where credit left off.

This is true to a point. But perspective is in order. While debit gets all the attention, credit is still responsible for around two-thirds of total payment volume. Some might argue that payment volume isn’t the end-all profit driver, and that the number of transactions where debit is still king matters, too. This is true. But this source of revenue, called data processing fees, represents only 33% of total revenue, compared to nearly 50% captured by service fees, which is tied to payment volume.

Credit is still a main factor in Visa’s bottom line, and that division is and will be weighed down by consumers adjusting to frugality and banks pulling credit lines. This point should not be ignored. It’s big. It’s real. And it’s dangerous for investors to overlook. The growth expectations for which this stock is priced seem out of touch with the credit card industry’s ongoing paradigm shift.

Excitement, meet caution
Again, let me reiterate: I think Visa is a top-notch company. It really is. But there seems to be a disconnect between the odds of faltering and the odds of perfection. Even if my fear of credit annihilation is totally misguided, shares are still priced at levels that won’t let investors fully capitalize on Visa success. Any way you spin it, I don’t see how you can be excited about these prices.

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But looking just for the former, especially if you focus mostly on revenue and earnings, can leave you exposed to the latter.

In order to fully benefit from your winners, you need to spot the ones to stay away from. After all, a 200% gain is completely wiped out by four other picks dropping 50% each. As for that winner, revenue and earnings are not the place to see trouble coming in time to do some good. You don’t want to wait for an ugly earnings surprise that gives your stock a massive haircut before getting out.

That’s why just about the first thing I read is the balance sheet. This is where the company’s financial health is found and where sickness’ warning signs often show up.

One balance sheet tool I like is the cash conversion cycle. This shows how fast the company turns its cash into inventory, sells that inventory, and then collects the cash on those sales. It’s measured in days and, generally, the lower it is, the better. (For details on how it’s calculated, check the Foolsaurus investing wiki entry here.) It is possible to have a negative CCC, as Dell showed to great effect for several years. Seeing CCC increase can mean it’s a company to avoid or exit.

This metric doesn’t apply to every industry, however, such as banks. It’s primarily for companies that interact with suppliers and customers, buying from one, selling to the other.

Dow is in the middle of this group, but despite recent improvements, it still isn’t quite back to where it was five years ago on its cash cycle. TPC is going in the wrong direction, and RPM needs to do more of what it’s been doing to bring that cycle closer to its competitors.

Of course, the cash conversion cycle should not be the end of your research, and it’s best to follow trends over time. However, it can provide useful pointers to either getting in or staying away.

Go past the obsessive focus on quarterly earnings, and you’ll be way ahead of the vast majority of the market’s individual investors. By learning to calculate and use the cash conversion cycle, you’ll more likely spot a deteriorating situation early enough to either avoid the company in the first place or get out before the company “surprises” with a bad earnings report.

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In some money making sectors, the most crucial aspect is to maintain a positive attitude. This will give you the perseverance and determination to push onward with your plans. Maintaining uplifted spirits in making trades can help you a bit but this is not the most important psychological frame of mind to maintain. To truly make significant gains, you also need to mentally latch on logic, discipline and confidence.

Keeping the right trade psychology is easier said than done. It doesn’t take a lot to say you are confident and disciplined. You may even feel that you are playing the role. Once you start losing trading profits however, you will discover that keeping your composure and belief in your abilities isn’t as straightforward as it is supposed to be after all.

What actually happens when losses start showing? Different traders will have slightly different reactions. Most however will feel the urge to start making decisions based on emotions. Some for example may begin to hold on stubbornly to a position even when they are on a losing streak because they are hoping that the trend will turn around eventually. The problem is if circumstances don’t improve, they will have lost more than they can endure losing or more than they can ever regain.

Emotional trading can also be apparent in those who profit from trading in small increments. They may let go of a position as soon as they see small gains because they are afraid of sticking around, thinking that the trend might eventually move down. Although they are saving themselves from possible losses, they are also effectively cutting themselves off from the potential of earning a lot in case a trend does continue to rise.

So what can you do to protect yourself from the kind of psychology that lest emotions make the trade decisions? All that you really have to do is to make sure logic has a tighter grip on your frame of mind. It has to be the kind of logic however that is firmly grounded on facts. You can only ensure that you are thinking correctly and logically if you have a back tested trade system or plan in place.

There are many systems that have ensured profitable trading for their users. You can perhaps study these existing plans and use some of them to your advantage. In most cases though, it is a far better option to create your own set of rules or at least tweak an existing system to fit your specific profile and personality as a trader.

If you’re interested in finding out how to call your own shots, you might want to give trading courses a shot. Since you are the only one who can control your psychological state, it pays to learn what concrete steps you should follow to approach trades in a disciplined, confident and logical way. Take this step and you will finally enjoy great trading profits.

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At the onset, a good set of rules will help you identify when to enter possibly profitable trades. Entry points are essential elements because these are where everything starts for you. Keep in mind though that there is no such thing as a perfect entry indicator. Hence, a trading plan that is advertised as able to give you one may not be worth your money at all. The best process to follow when entering a trade is often the simplest and most direct. Simplicity is therefore one trait to watch out for.

Aside from start signals, your system should also be capable of giving you excellent exit signs. You need to know when it is the best time for you to leave a position. Ideal exit points are those that will allow you to lose only predefined minimum values while securing profits that you’ve already gained. In short, you are able to cut your losses and let your profits run.

Good entry and exit signals are not the only necessary qualities that you need in a system to make trades. Good trading systems also need to incorporate policies for money management. These are the set of rules that clearly define your personal risk levels. With a custom set of rules, you will be able to give yourself the security of never having to lose more than you can bear losing on every single transaction that you perform.

Another good quality to look out for is factual background. It is a must that you follow steps that are firmly based on research. Some traders make investments based on gut instinct, rumors or tips. In some cases however, these are unreliable or even conflicting sources. You can only improve your chances of making profits if you follow trade systems built around solid data.

Research isn’t everything. For trades to give back great returns, you need to make sure your system bears the qualities of strength and reliability that are the results of testing. You might not need to personally perform tests yourself if you decide to use an existing system that has worked for other traders. If you want to follow one that you’ve made yourself, you need to subject it to back testing. For this procedure you simply need software that can simulate trades for you based on historical data. If a system churns out good results based on past information, it is likely to work well enough on the current market.

You can’t slip with effective trade systems. You do have to make sure though that whatever you choose to follow bears the right qualities. Evaluate a system carefully before taking the risk of using it to help you make investment decisions.

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By regularly reading business news on CNN.com, Briefing. com and watching CNBC, you will be alerted to these investment opportunities as they happen. While there is no sure way to guarantee that a stock will fall below our breakeven point, there are 4 key criteria that I use to increase my chances?

1. Screen for Stocks that Decline Significantly on High Volume

I screen for stocks that suffer a significant one-day (intra-day) decline on high volume. Usually, stocks that suffer such a drastic fall in one day experience some kind of significant negative news.
I also look for stocks that decline by more than 20%-30% with volume exceeding at least 300,000 shares. The easiest way to screen such stocks is to go to www.moneycentral.com.

Use their “Power Search” tool to screen for “Intraday High Volume Losers” or “Gapping Down Today”. If you can not find any on that particular day, select “Weekly High Volume Losers” or “One Month Volume Losers” to see if any stocks fit the bill over the last week.

2. Ensure Bad News with Sustainable Effects

Remember that we are only interested in news that has the potential to create long-term or permanent damage to the company’s financial stability or profitability. Again, the ideal bearish play would be an accounting scandal that could drag on for months and result in a long lasting sell-off in the stock. Sometimes, a major strategic miscalculation could lead to a company losing its competitive advantage and cause long-term effects on its profitability.

A good example is when Ford Motor Company made a strategic mistake (failing to focus on smaller, fuel efficient cars) that caused its market share to decline consecutively over 10 years, sending its stock price down from $16 in 2004 to as low as $6 in 2006.

By going to http://finance.google.com or any other business news site, you can read about the news that has triggered the price fall. Bear in mind that it is not every day or every month that you can find a stock that fits these criteria.

3. Fundamental Criteria
You would also want to ensure that the stock that you are betting on is highly overvalued, giving a good reason for the market to correct the stock downwards.

Applying what you have learnt in the chapter on value investing, use the “Intrinsic Value Calculator” (found on www.thewaytomakemoney. com) and calculate the intrinsic value of the stock. You will want to make sure that the current share price is higher than the intrinsic value. It is also important that the current share price is above $8.

4. Technical Criteria
Screening for potential momentum stocks that would move up in price, we need to ensure that “Technical Indicators” are strong indicating a “buy signal”. In the case of buying Puts on falling stocks, we are looking at the opposite. We are looking for weak indicators that signal a “sell signal”.

With these 4 indicators, you are now able to estimate when a stock may dive.

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Broad Diversification Versus Focus

Fund managers and financial experts often advise clients to broadly diversify their money across many different financial instruments such as stocks, bonds, currencies & money market funds. The logic is that by spreading your money into different areas, you reduce your risk. Master Investors like Warren Buffett believe that although broad diversification reduces risk, it also reduces any potential of return. If you invest in 50 stocks, then for your portfolio to double in value, you must find 50 stocks that double in value. That is almost impossible! At the same time, by investing in so many companies and instruments, it is impossible for you to become an expert in anything. He believes that people diversify into everything to protect themselves against
their own ignorance! It’s like asking the great tenor Luciano Pavarotti to diversify into Heavy Metal, Country & Western, Techno, Hip Hop and R&B in order to reduce his risks in case he does not do well in Opera.

Instead, Warren Buffett believes in focusing all his money into a few, very well selected stocks that he knows will double in value. He believes that an investor must only invest into a few companies that he understands very well and can track very closely. He calls it investing within your circle of competence. Does this mean that you should bet your entire savings on one or two companies? Of course not! That is too dangerous. It is still important to spread your money across at least 8-10 stocks that you know inside out. However, once you buy more than that, it becomes harder to invest intelligently.

Following the Market Versus Going Against the Market

Fund managers & the investing public tend to be very short-term performance focused. They tend to buy a stock when there is lots of good news (i.e. economy is strong, company’s earnings beats forecast, launch of a new product etc) that pushes the stock price higher and higher. Consequently, they tend to jump out of a stock when bad news sends the stock price falling. Actually, there is nothing really wrong with this approach.

By doing so, you are investing along with the trend. This strategy is known as ‘momentum investing’. However, the danger with ‘momentum investing’ is that it is all about timing and the ability to read into investor psychology. The trouble is that most average investors who lack these skills jump in too late (after all the professional funds have entered), when the stock price has already risen near its peak! Sure enough, they find that the stock prices start falling the day after. Out of fear and panic, they sell the stock and end up with a loss. This is why the typical
investor always experiences their stock price falling soon after they have entered the market.

On the other hand, value investors like Warren Buffett take a Contrarian approach. They go against the market psychology and trend. They buy the stock of a good company when nobody else wants it. This is when the stock price is extremely low and attractive. They then wait patiently for the stock to come into favour again. When optimism returns and the crowd starts to push the shares of the company higher and higher, the value investor will then sell his shares at a nice profit.

High Risk, High Return Versus Low Risk, Low Return

While many financial experts preach the concept of having to take high risks in order to make high returns, master investors like Warren Buffett believe that it does not take high risks to make high returns. Instead, it takes a high level of financial and business competence to make high returns! In fact, he will only make an investment when there is a very low risk of loss and a very high probability of gain. He does this by only investing in companies that are selling way below their true value. In this way, he gives himself a wide margin of error. Which means even if his calculations are off, he will still be making money.

Invest Only when there Is a High Probability of Success

The trouble with professional managers of mutual funds is that they are pressured to invest 80% of their cash into the market, even when there is nothing attractive to buy. This happens after a prolonged bull-run when stock prices are so high that companies are way overvalued. On the other hand, Buffett would happily keep all his money in cash and only invest when there is a golden opportunity. This is exactly what happened in 1999-2000 (stock prices were insanely overvalued) when Buffett was criticized for not making a single investment and keeping all his money in cash. Buffett only moved in to buy after 2001, when stock prices had crashed and companies could be bought for a steal.

Before you can successfully model a person’s investment strategy, you must first model their beliefs. It is a person’s beliefs about investing that shape their decisions, their actions and their results. So, if you want to be able to consistently beat the market and make higher returns than anyone else, shouldn’t you begin by adopting the beliefs of the world’s greatest investor?

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Believing that nothing is within your sphere of control is the fastest route to considerable losses. It’s as if you are putting yourself at the mercy of the unforeseen forces of fate. If this is an accurate description of market investing, then you are just as likely to make profits on a gambling table.

The truth is that there are two things that you can control. These are your trading psychology and your market risk management rules. Both of these factors are part of a greater whole that comprises your trading plan. Managing risks however, often plays a more important part because it can influence your thoughts and feelings in such a way as to allow you to trade more logically and make profits possible.

The term isn’t too difficult to understand. It simply involves, setting the rules that will determine the kinds of losses that you are willing to sustain. This means, you are given the power to indicate your loss limits so you never have to endure too many falls or too big a loss.

Some people have a slightly incorrect notion of a risk management strategy. They may think that any approach that limits the number of losses is an ideal one. They forget however that the size of each loss can have a significant impact on how successful a specific tactic is.

Take for instance a single loss that can instantly cut down $1000 from your account. Compare this to five losses that amount to no more than a $100 each. In these scenarios, it is clear that your single loss can be more devastating than you string of small losses. A good method therefore considers more than just the number of failures that you sustain.

A comprehensive approach to investment risk management looks at several different factors. You need to look into how much you are willing to set aside as capital for trading. You also need to figure out the number of units you will purchase on each trade. Once these are set, you have to determine the maximum amount that you are willing to lose on any single trade and the predefined loss figures that will give you the sign to exit specific trades.

Proper control of your risks is not as straightforward as you would imagine. Creating a solid plan can take some time to think over and to establish. It is however, a step that you can’t afford to skip. Because it is one of the very few factors that you can completely get a grip on in trading, you should take full advantage of it. Start incorporating a risk management strategy into your trading plan. Doing so can only mean greater gains for you.

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A lot of investors have good reasons to shy away from studying what experienced traders know. One common reason is that they may not have the luxury of time to learn. They may be too busy with family and work. This is why they simply invest in managed accounts. On hindsight, this is a good option even if you eventually become a part time top trader. Holding on to a job even as huge earnings come in will secure you from possible market problems.

Another usual reason for not wanting to learn how to make trades is the lack of interest. Anyone who has ever attempted to make sense of traders’ lingo will attest that the initial experience can be unnerving. For a beginner, there can be too many overwhelming technical terms that can’t be explained in simple ways. Again, the number one option for people who do not want to learn is to invest in managed accounts.

Because profits are within reach even for those who aren’t experts, some people see no sense in learning professional trading. They think it is simply best to leave everything in the hands of people who have a passion for unraveling the technical difficulties of making trades. Before you discount learning the ropes yourself, you should realize that there are advantages to learning complicated details.

Managed accounts are fairly good forms of investments. The trouble with them is that you never truly know what will happen to your money. It is pooled along with other people’s investments and used by financial establishments to make trades. Although you can trust the expertise of these outfits, many decisions are out of your hands. In most cases, professional trading institutions simply stress that before you can leave your money with them, you have to accept the risk of suffering losses.

Another issue with managed accounts is profit potential. Some institutions give investors the option to choose risk levels. If you pick low risk investments, you may not earn much at all. On the other hand, if you choose high risk options, you could end up perpetually worried over the prospect of losing a lot.

The main issues with managed accounts are the reasons why you should consider learning how to perform trades yourself. Learning doesn’t necessarily require you to quit your job after. The main purpose of studying professional trader strategies is to be able to place trades with a broker on your own and determine when you want to enter or exit.

A good course will teach you that there are factors that you can control even in unpredictable markets. Moreover, you will learn how to manage these factors so you can boost your profit potential and become an expert even if you only trade part time. It makes sense to hit the books and be taught by experts if only to find out what will happen to your money every time you decide to invest.

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One mistake that traders make is believing that there is a method that can automatically and magically provide perfect indicators and signals. They think that there is such a thing as a holy grail which can give them the luxury of full automated trading. Sometimes, the perceived perfect plan takes on the form of a black box system.

Techniques that are known as black box trade systems are meant to be used with little thought. All you need to do if you have one is to input a minimum amount of information and leave everything in the hands of an automated program. This is supposed to give investors the benefit of a hassle-free procedure that can be left on its own so users can focus on other more pressing concerns. Such methods are appealing to people who do not have a lot of time to monitor their investments. Black box concepts however have their own inherent disadvantages.

Anything that fits the description of a black box framework can leave you dangerously out of control. One of the few aspects of trade systems that you can control is risk management. With a ready program, there is little you can do about creating guidelines that will help determine the level of risk that you are comfortable with. Because everything is already set, you have no choice but to go for whatever is included in a package. When your personal standards are left out of the equation, you will lose more than you are willing to let go. This is how boxed strategies can lead to devastating losses.

Sensible traders prefer to devise strategies that they can customize according to their trading personalities and risk preferences. This involves determining how much one is willing to lose in a single trade, how much capital is available for investment and how much time can be spent on the market. You have a better chance to profit from trading if you carefully look into these factors on a personal level.

A customized strategy can therefore do more than keep you organized. It is also the one secret that can help you proceed logically and with as little emotional involvement as possible. Because you know you have a sound framework on hand, you can make decisions without having to suffer doubts, nervousness or insecurity. In other words, your personal blueprint can give you the right degree of confidence that you need to pursue significant gains.

You will get even better results if you take the time to back test your custom strategy. Various back testing tools can run your method into simulated trades using historical information. You will then be able to tell if your strategy has a high chance of performing well if it were used in the past.

You simply can’t go wrong with a good trading plan. Always keep in mind though that to earn well, you have to use more than the strategies that come in rigid boxes. You are far more likely to earn if you follow a system that fits you perfectly.

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For instance if you mainly trade large-cap stocks in the FTSE 100, it’s not enough to just look at individual companies. You also need to think about how the FTSE 100 index is going to fare over the coming months. You could easily pick a great company that’s underpriced, growing it’s overall profits each year and paying a healthy dividend, but if the FTSE 100 falls substantially after your share purchase, then the share price is almost certain to fall as well.

This is why I personally don’t feel that this is a great time to be buying shares in large-cap stocks. At the time of writing (January 2010) the FTSE 100, and indeed the major stock markets all around the world, have posted gains in the region of 30% as the global economy starts to come out of recession. This upward trend may well continue but I don’t see a great deal of upside in 2010. In fact I think we will probably finish the year roughly where we are now.

So in my view you basically have two choices. You can either wait for a retracement and then start seeking out good quality companies that may then be oversold, or you could focus your attention on small-cap stocks whose share price movements are driven by individual company news. My own strategy is to apply both of these strategies because I always like to have a mixture of small and large-cap stocks.

Anyway the point I want to make is that you should always keep on eye of the wider stock market and make your trading decisions based on these markets. For instance if you’re a UK trader like myself, it’s generally a good idea to use technical analysis on the FTSE 100 to see when it is oversold. Then you can start looking for decent companies knowing that the price is likely to rise as and when the FTSE 100 recovers. Plus the rise is likely to be greater if you pick those companies that offer the best value.

Stock market investing is all about timing. The key to success is to buy low and sell high, and the best time to do that is when the overall stock market, whether it’s the FTSE 100, Dow Jones, DAX or the Hang Seng, for instance, is temporarily oversold.

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