You Know You're A Trader When . . .
March 04, 2010

You know you're a trader when:

- You take an SBUX break

- You favorite sports team's General Manager reminds you of a failed car company

- The MCD worker looks at you funny when you order a Supersized KO which makes him want to punch you

- You can't help see the Utilities closet on the way to the bathroom and think XLU

- The majority of your vocabulary consists four letter words

- You're not afraid of SPDRS

- Whenever you see a Ford Model you assume she received an F in school

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Investing For Income: Yield Before Reaching For Yield
February 23, 2010

With interest rates at historical lows (the 10 year Treasury yielding a paltry 3.7%), it's natural for investors to search for higher yields. Dividends are the typical place for investors to begin their quest. But are all dividends the same? Are all dividends inherently "good?" Most people think that dividends are in and of themselves good things. This is a myth. There is good yield and there is bad yield. It is vitally important to know the difference at all times, but even more so in market environments such as today where many product makers are pushing and investors reaching long and far for high yield. It's not the fact that a company does pay a dividend which is meaningful; it's the fact that it can. I'll explain.

You've no doubt heard the expression "If it sounds too good to be true, it probably is." Well in the world of investing, if it sounds too good to be true, it definitely is. Often periodicals such as the Wall Street Journal (WSJ) or Barron's will print a table of high-yielding securities and you will occasionally find listed companies and funds paying out 10% or more. It is very important to dig deeper to determine the source of this yield. There are two major red flags that you should look for.

The first is when a company earnings do not adequately cover its distributions. To assess this, look at the company's payout ratio which is the dividend per share dividend by a company's earnings per share. This important statistic readily available on most financial research sites indicates how likely the company is to continue to pay, or to increase, its dividend over time. A payout ratio of less than 50% is preferable. If a company's payout ratio starts heading north of 70% due to a decline in earnings (by definition if earnings are shrinking and dividends are constant, the payout ratio will increase), this is a sign that the company may be getting ready to cut its dividend. And if its payout ratio is over 100% for several quarters, proceed with extreme caution! This scenario is not sustainable. A company cannot forever finance a dividend payment if it is not making more money than it is paying out - plain and simple. Stay away from these companies as the last thing you want to do is buy into a company just before it slashes its dividend.

Another scenario for a potentially suspect high-yielding security is a fund that makes a so-called "controlled payout." An example would be a fund trading at $10 per share fixing its dividend payout at $1.30 per share so that the fund yields 13%. In most cases, however, the fund or the underlying securities it holds, are not earning enough to cover the dividend. So how is the fund paying a dividend, you ask? The fund is simply returning principal slowly to shareholders over time! As an example, let's say a promoter advertised an investment that guaranteed a 20% annual dividend stream. Sounds too good to be true, right? Definitely. You give him $100 and for five consecutive years he hands you back $20. If he is not earning more on the original money than he is returning to you in the form of a "dividend" then eventually the money runs out and the game is over. The 20% yield provided a total return on investment (ROI) of precisely 0%. This is the bad kind of yield.

Buyer beware. The mere fact that a company or fund pays a dividend is not praiseworthy. It's important to know how a company is paying its dividend. Look for companies that are financing their dividend through continued earnings growth and solid financials, and steer clear of those companies with abnormally large payout ratios. Dividends can be a great source of income in this low interest rate environment. Be smart and those checks will keep coming.


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Internal Memo
February 19, 2010

Dear Trading Platform,

You have proven to be a cornerstone to my business - detail oriented and reliable. Of this I am aware and give thanks. However, I would appreciate your executing tasks I assign you the first time I ask. When it is the third Friday of the month - options expiration as everyone knows - and I am requesting that you to execute complex & timely trades with 3 minutes to go before close, please refrain from interrupting my trading process by asking me, "It is 12:57, there are less than 5 minutes until the market closes - do really want to execute this trade?" Yes. I do. Why else would I have placed the order by pounding the enter key on my keyboard? Further, when I respond in the affirmative to your inane question, please do not continue to disrupt my workflow by asking me, yet again, "Are you sure you want to execute this trade?" I am quiet confident you heard me the first time and really don't appreciate your playing with my mind. No more excuses. Please assume that any job appointed to you needs to be fulfilled immediately.

Sincerely,
The Management

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She's Got Legs (So Know How to Use Them)
February 09, 2010

Like a shark, I am attracted to blood in the water that represents an otherwise quality company that has been beaten down. Learn from my mistakes, however, and refrain from entering a position the day that bad news is released. While a stock that has fallen will occasionally rebound quickly, that is the exception. The first thing to occur after a company's stock falls is that most of the investment banks issue downgrades, adding further selling pressure to the stock. Then, the big mutual funds that have mandates to sell any stock that misses its earnings begin their drawn-out selling process. Finally, a bottom will form days or even weeks after the event that led to the decline. To be sure, the stock's volatility will be at its peak on the days following the negative event. But this is one of the few times when putting premium on the books (assuming the position is entered into via farther OTM short puts) is often best done only after the dust settles. This is so you can be certain that there is no more bad news (which is not an uncommon phenomenon for truly broken companies - first they crack, then they crumble). The benefits to avoiding such an outcome greatly outweigh missing a few points of premium were you to act upon the release of the bad news.

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Out of Sight - The Psychology of Stock Investing
January 29, 2010

Vulcan.  Iceberg.  Cold Stone.  These are nicknames that friends (or perhaps enemies!) have called me over the years.   I'd like to think it is due to the fact that at one point I ate a lot of ice cream, but in reality I know better; it is my uncanny ability to 'turn off' my emotions and analyze circumstances solely with the left side of my brain.  While this is a trait I can take no credit for (I probably have my dad to thank), and without question my pointy ears drove friends and family crazy over the years, it is a characteristic that has served me well in my two plus decade investing career.

To be sure, money in general and investing in particular have an enormous emotional component.  The mantra that greed and fear drive investing behaviors is as right as rain.  Statistic after statistic demonstrates that the typical retail investor unloads stocks after major drops when they can no longer 'take it anymore,' only to re-establish positions once the market is showing clarity (which of course is just code for the market having gone back up again).  This leads to consistent under performance by the average mutual fund investor who regularly gets whipsawed in zigging when the market is zagging.  I hear regularly from potential clients who say when the market is bleeding red that they can't even stand to open up their brokerage account statements.  The reality is that to manage a business or portfolio properly, being informed of bad news is more important than being made aware of good news.  Yet the way most investors brains are wired, emotions take over and people physically cannot get themselves to open up an envelope containing what amounts to a notice of stocks on sale (yes, what a concept that stock price declines can actually be a good thing in the near-term).

Which brings me to the main point of this missive: Know thyself well.  If feelings get the better of you, if you smell fear on your own breath upon rapid market declines, then create a structure that will compensate for these natural emotional tendencies.  I have seen countless occasions when investors put a tremendous amount of time and effort into researching and managing stock picks, only to throw all this exertion away in selling at panic lows (think March 2009).  This would be akin to working out and dieting for a year in preparation for some big event - like a wedding - only to gorge yourself on doughnuts the week before and make all your effort for naught.

That is why one of the biggest roles an investment advisor can play is not just picking great stocks and appropriately allocating assets, but instilling - whether you like it or not - an investing discipline that is in your long-term interest.  A worthy professional money manager is like the boat captain who lashes you to the proverbial mast when the Siren songs are beckoning you to buy or sell stocks at just the wrong moment.  I have learned in life that when I tried to take on a complex subject myself - be it a tax situation or legal issue  with the goal of saving a few bucks by not hiring a professional, the result is my having been penny wise and pound foolish.  Just because something is easy to get into (e.g. opening up a brokerage account) does not mean that it is simple to execute effectively.  When markets are climbing, virtually all investors, even the dart throwing monkey, can make money.  But skilled, professional investors earn their keep during the 100 year floods that seem to show up in the stock market every 12 to 18 months.  And of course these market debacles happen quickly and when you least expect it.  Thus, the typical investor is taking actions not based on a well thought out and pre-determined plan, but rather on whatever the right side of their brain is screaming to them at the time.  It is for this reason that I dedicate so much time during moments of calm to educate clients about how markets work, how they can go down and back up very quickly, so that when the inevitable storms arrive and I tie them to that mast, they don't take out a knife to cut themselves free and throw themselves to the sharks (to mix metaphors). 

Turning a blind eye on your investments is a recipe for financial disaster. If you were not born with ice water running through your veins, find someone whom you trust and who invests with discipline and based on facts, and let them serve as your savior during market turmoil.

The Lost Decade: Were the Ohs Really for Naught?
January 08, 2010

You are likely hearing financial commentators making the statement that we just exited the "Lost Decade." Sure, this makes for a great headline, but how much does it reflect reality in terms of true economic, financial, fundamental progress that was made over the last ten years? More importantly, how do such headlines impact investors making decisions about how to allocate money for the next decade? Let's draw an analogy for some insights.

When Lance Armstrong retired from cycling four years ago he is said to have looked in the mirror and said, "Well, this is the best shape I will be in for the rest of my life." To be sure, he was at a peak in terms of fitness, and any time he engaged in physical activity after that moment his athletic ability and aesthetics would pale in comparison. Fast forward three years later and indeed, by all objective measures he had 'lost' fitness. While he placed an incredible third in the 2009 Tour de France, by his own admission he was not in the same form as when he topped the podium. Yet compared to the average weekend warrior Lance was still a world class athlete. And I am confident that five years from now he will make the typical forty-something male seem out of shape. Compared to that moment in July of 2005, however, his fitness has been lost.

The lesson here is that our reference points matter, both statistically as well as emotionally. How much better did 9,000 on the DOW feel on the way up from 6,700 in 2009 versus on the way down from 14,000 the prior year? The starting point for this decade was an extreme juncture - an aberration of valuation rarely seen in the market. The typical investor only 'lost' over the last ten years if they bought the S&P 500 at the peak in early 2000 and never reinvested dividends (as in, never bought another share). But to how many investors does this scenario actually apply? What if you bought stocks at the nadir in 2003 before a 4 year rally? Or what about if you bought stocks in the spring of 2009? You could very well be up nearly 60% or 70%. What if you owned not just US stocks but foreign stocks that saw great gains over the last 10 years? Or how would your account look if you did as most savers/investors did, which was to add money to their portfolios regularly? Then you would clearly have purchased shares at quotes other than inflated end-of-the-internet-bubble prices, and your account value would reflect the power of dollar cost averaging. Or perhaps you rebalanced your portfolio regularly, selling off recent winners in favor of adding to asset classes that had underperformed. What if you engaged in some active trading rather than just buying and hoping?

The point is that it is highly misrepresentative to take one arbitrary statistic and apply this to an entire asset class. Investors around the country, young and old, are making decisions about whether or not to buy stocks as a means to achieve future financial objectives, and headlines that scream "LOST DECADE - STOCKS GO NOWHERE" cause many people to make allocations that are bad for their financial health.

The reality is that after great 10 year periods for the stock market - think the 90's - then the probability that the next ten year period offers superior returns is reduced. Why? Because the starting point, the price for stocks, was very high at over 40x earnings in 1999/2000. Of course most financial commentators in January 2000 were noting, if not gloating, about how great the previous 10 years were. The average investor then looked in the proverbial mirror and extrapolated into the future - and ended up disappointed accordingly. Today investors are possibly making the opposite mistake. They see the last 10 years of performance and think this is how it will be going forward. Conversely, when I look at a chart that shows the last 10 years as having been down from point A to point B, it puts a smile on my face as this means that future stock returns are likely to be strong.

Most importantly, how do we apply lessons from the past to future actions? Here are the important take aways, or investing principals, that apply as much today as they have for the last two centuries. First, diversify. There were plenty of markets around the world that did just fine during the ohs. Participate in the global economy. The US is not the only place to invest. It might not even be the best place in the coming years. Next, don't be afraid to take profits from time to time, or at a minimum rebalance your portfolio which is just another way of selling high and buying low (what a concept). As always, don't overpay for stocks. Even within the S&P 500, an index that indeed did lose money from 1/1/2000 to 12/31/2009, there were plenty of companies whose stock prices rose nicely during the decade. These were the ones that were trading at reasonable rather than sky high valuations. Lastly, do what the smart investors do - add to your portfolio when the market drops rather than sell. Even if the S&P 500 is at the same level in January 2020 as it is today - an unlikely outcome - there will certainly be periods when the market drops materially, allowing for opportunities to scoop up shares at lower prices and leading to profits even if the overall market is going nowhere.

Don't let headlines fool you or cause you to take actions that you will regret ten years from now. Investing in the stock market always has been and always will be one of the greatest ways to create wealth over time. Be smart, and you will find your way.

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Should I Stay or Should I Go? The Three Most Important Factors to Consider Before Investing
December 11, 2009

I am often asked, "Is now a good time to invest in the stock market" or alternatively, "Is Company X a good stock to buy?" In order to properly answer these questions you need to assess certain key variables. Let me first draw an analogy: If you are about to start a marathon, you should not sprint. You should pace yourself accordingly if your goal is to make it to the finish line 26 miles later. If, however, your house is on fire, you should forget the warm ups and race outside as fast as possible! The point being, the pace must match the distance. The same applies for investing, but rather than distance being a key consideration, it is time.

What is My Time Frame?

In the world of investing, the most important variable to consider is when you need the money back. Investing is just a means to some other end - retirement, the purchase of a house, college education, a fancy vacation next year. If you need the money in the next few months or even couple years, then you should have money invested accordingly - in near-term instruments like cash, CD's, money markets or perhaps short-term bonds. No matter how good a given stock is, or no matter how strong the market at large is roaring, you need to have the discipline of matching your investments with your time horizon. Microsoft could be a great investment for someone with a three year or more time horizon, but a terrible investment for someone who needs the cash in the next couple weeks. Simply put, the only way to properly answer the question as to whether it is a good time to invest starts with your time horizon. In managing money for my three year old son'scollege education I am little concerned with where the market will be in the coming weeks, months, or even few years. In managing money for my seventy-six year old mom, I look very closely at valuations and asset classes (stock versus cash, for example) since her investments have a different time horizon. Cash for my mom is safe and prudent, whereas cash for my three year old is actually risky. Why? Because cash over time loses money when factoring in taxes and inflation, thus the risk we take is that he will not earn enough in the next 13 years (yes, he will be going to college early) to have sufficient funds to pay for university. Match your assets with your time horizon and you will avoid a key mistake many investors make.

How Much Am I Paying for The Stock?

Think of four quadrants with "Good Company/Bad Company" on the top of the square, and "Good Stock/Bad Stock" on the left side of the square. Your goal as an investor is to be in the "Good Company/Good Stock" quadrant. Let me explain. Coca-Cola has been a good company for decades. But it has not always been a good stock. In the late 1990s-early 2000s it was a "Good Company/Bad Stock" since the price you had to pay for it was excessive at over 40 times earnings. Indeed, nearly 10 years later the company is earning about 3 times more than it did a decade ago but its stock price is down. Now Coca-Cola is a "Good Company/Good Stock." The price you pay for any asset is a key variable for future returns, and the shorter your holding time horizon, the lower the price you need to pay to ensure a positive return on your investment.

Does The Investment Meet My Objectives?

Even if you properly identify your time horizon and find a good company/good stock, you need to be certain that the investment meets your objectives. Some people are looking for growth - others for income. Some investors can withstand (emotionally and financially) near-term volatility while others need or simply prefer a smoother ride. Various securities, by their nature, "behave" differently. When markets drop, certain stocks tend to fall even more than the market (think small company growth stocks) while others typically hold steady (think utilities). Be certain that your investments match your objectives. If you are looking to generate income, seek out strong dividend paying stocks or high yielding bonds. If you are after long-term growth, small companies that reinvest their profits rather than paying them out in the form of dividends could be right for you. Selling Microsoft may be prudent for Bill Gates given his time frame, objective and overall portfolio (high concentration in the stock) whereas for another investor buying Microsoft may be a smart move. The danger behind TV shows where the commentators scream "BUY" or "SELL" is that they do not factor in your particular circumstances. Your house may be on fire and the person recommending that you take your sweet time to warm up is unaware of your particulars. Knowing when to stay and when to go in the world of investing can have a big impact on your near and long-term financial future.

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The Top Five Lessons Learned from the 2008/2009 Financial Crisis
November 24, 2009

With the financial crisis of 2008/2009 still close at hand but far enough removed to allow for some perspective, now is an ideal time to note the important "take aways" from one of the most dramatic stock market periods of a generation.

1. Always invest in the strongest companies. When times are good, even weak stocks can shine. But economies, like markets, go through cycles, and the strong invariably survive while the weak often fall by the wayside. Stick with the #1 or #2 companies in a given industry. There is a reason why Coca-Cola has been around for a hundred years and will likely be around for the remainder of our lifetimes.

2. Balance sheets matter! The 1990s were the decade of top line growth when it was all about the profit & loss statement. Balance sheet analysis was rarely an important consideration. Yet when times get tough, assets and liabilities - whether personal or corporate - can make the difference between thriving and not surviving. Make sure companies you are investing in are not over leveraged (and apply the same lesson to your own financial situation!).

3. Stock prices can move very quickly - in both directions. Even prices of well established companies like Microsoft or others can go down and back up 50% or more in a matter of months. Continue to focus on the long-term, and don't be in a position (read: don't be over leveraged) where you have to sell on weakness.

4. Having a professional at your side can keep you from making permanently damaging mistakes. Money has a large emotional component, and unfortunately most investors' brains are not "wired" to make intelligent investment decisions. By having an objective third party on your team, you can maintain a perspective that will keep you from taking actions in the moment that you will later regret.

5. Make investment decisions based on what could be in the future as opposed to what exists today. As the great Wayne Gretzky is known to have said, skate to where the puck will be, not to where it is. The same applies to investing. When things look bad, as they did in the fall of 2008 and spring of 2009, it seems as though the world is coming to an end. But economies are resilient and markets have rebounded from every tragedy, financial or otherwise, known to man. The key is taking yourself out of the moment so that investment decisions you are making line up with your financial time horizon. If you don't need the money for several years, project what the economy and markets might look like three to five years hence, not how horrible things seem "today." That will lead to better decision making in the present, and a larger wallet in the future.

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The Worst of Times, The Best of Times
September 24, 2009

As a professional money manager, I get to spend my days studying the economy at large, the market in general, and company stocks in particular. I am often asked, "What is the future of the market? Should I invest now? If so, where should I invest?" These are good, important questions I will put a framework around so that each reader can answer these questions for their own particular circumstances. Put differently, my goal here is as much to teach you how to fish in the proverbial stock market waters as it is to point to the fish to be caught.

First, what does the stock market future hold? Ask a weatherman if it will be raining in 5 minutes and he will be able to give you an accurate prediction. Ask him about 5 days and the forecast becomes 50/50 at best. Five month predictions are all but useless. The same applies for the stock market, however the time frame is flipped on its head. What will the stock market do in the near term; the coming hours, days or weeks? No one knows (except for after the fact, when commentators will talk about how "obvious" it was that the market was due for a correction, for example). If someone tells you with seeming certainty that they can foresee near term stock movements, then I have only one word of advice for you: run. Over the medium to long-term, however, as is definitely not the case for weather, stock market movements become much more predictable. Knowing where the market has been over the last 5 - 10 years, and how expensive the market is today (as defined by the price/earnings, or P/E ratio), will allow you to really refine your prediction. And the proper answer to the question "what does the future of the stock market hold" is actually counter-intuitive, or at least counter-emotional. After the market has run up a lot, investor confidence increases, and future stock return expectations rise. The opposite occurs after large drops. In effect, investors extrapolate from recent history and assume the future will be the same. In fact, the reverse tends to be true, namely after long periods of above average returns (think the 1990s) when P/E ratios are high, the next three to seven year return period tends to be below average. So what does that mean for today's investors? Despite the recent run-up from what can be characterized as panic lows in March of this year, the market is still nearly a third below its late 2007 highs, and trading about where it was ten years ago - much lower after inflation is factored in. Further, from a P/E standpoint the market is priced quiet reasonably. To put this important point in perspective, at the market peak in 2000 the S&P 500 had a P/E ratio of about 40 versus around 15 today. The net result is that the next ten year period is likely to offer far better returns than the last ten year period where most market participants saw flat portfolios from point A to point B, even though there were wild swings up and down in the interim.

So, if now is a good time to invest for those with an appropriate time frame of three years or longer (remember, regardless of how attractive the market may seem, if you are in need of funds within three years then you should consider having money in short-term instruments like savings accounts, CDss and money market funds, not the stock market which is subject to near-term fluctuations), where should you be investing your money? Diversification is key for the average investor. It is very difficult to pick, let alone properly monitor, individual stocks unless you do it for a living. Thus a starting point is a good, low cost mutual fund or better yet an ETF (Exchange Traded Fund) that has broad exposure to the US markets. The S&P 500 is a good place to look for exposure to the recovering US economy. Companies within this index tend to be larger, well established, and financially sound. What about international investing? To be sure, having some money invested abroad is a good way to diversify your portfolio and take advantage of growth around the world. Large US companies these days, unlike decades past, often get half or more of their revenues and profits from outside the US, so even if you only invest in large US based companies you will still take advantage of international growth. That said, having as much as one-third of your portfolio in a well diversified international index fund is a sound approach to portfolio management.

In summary, the worse the times seem, the better off you are investing if your goal is to make money from stocks in the coming years. Look at the time frame of later 2008/early 2009 when there was talk of the next Great Depression. With stock prices hitting generational lows, this was a great time to put money to work. Compare this to the end of the 1990s when it seemed like the US economy and businesses could do no wrong. This turned out to be a terrible time to be putting money into the stock market. Bottom line: listen to your gut, and then do the opposite.

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Gimme Credit
September 04, 2009

When you sell an option, your account gets credited immediately with the premium amount sold and you can invest this cash in other securities. This is a technique Warren Buffett has used that is no different from when he sells insurance premiums as a means to generate cash to invest in the stock market. You can have your credited cash earn interest, you can use the cash to buy a put for downside protection, you can go out and spend it, you can buy additional shares...you can take a friend out to dinner. The cash is immediate, it is real. Enjoy!

Don't Get Stung - Let Options Be Your Pilot
August 27, 2009

Most people hire personal trainers not because they are clueless about how to use weight machines, but because they need an external source of discipline to keep making smart physical choices. This function of a personal trainer offers real value. The sale of covered call options can be like your personal trainer - it impels disciplined sales at predetermined levels. When you might otherwise hold on to a stock for too long, the sale of an out-of-the-money call forces you to sell high, to take some profit chips off the table. For this reason alone, options can be a valuable tool in your trading and investing repertoire.

Bye-Bye Buy
July 31, 2009

Check out today's headline from an Analyst firm: "ThinkEquity downgrades First Solar (Nasdaq: FSLR) from Buy to Accumulate."

That is really helpful; instead of buying the stock, I should only accumulate it.

Do It Again, This Time With More Emotion
July 20, 2009

On a major financial news program the commentator was interviewing a prominent investor who was providing statistical data supporting his particular stock call. The commentator interrupted him and screamed, "I need less data and more emotion!!!" This is what is wrong with financial news.

Kick The Can
July 23, 2008

Until recently, many investors I would come across in California insisted that real estate was the only way to go when it came to investing. Real estate is something tangible, something I can touch and feel, I can go and kick a building I own, therefore I am comfortable with it. I can't kick stock would be the usual reprise. To be sure, you can look at an investment property, you can go slam the door and open/close the toilets, but does this make the investment inherently less risky than owning a basket of equities, or for that matter even a single stock? Let's look at some real dynamics of real estate ownership:

Real estate investing is highly leveraged, debt to equity often a 5 or 10 to 1 ratio. It is funny how hedge funds are viewed as highly speculative when they leverage 3 or 4 times, but when someone puts down 10% on their investment property (thus they are leveraged about 10:1) that is viewed as normal if not conservative. To be sure, leverage works for you when prices are rising and income (via rent, etc) supports the cost of leverage (in this case the mortgage), but when, not if, the proverbial price increase music stops and/or when there is a hiccup with rents (e.g. your tenant bails for cheaper rent in Texas), then leverage rears its ugly head and works against the investor in dramatic and economically damaging ways.

Real estate is inherently highly concentrated when it comes to the paying consumer. In the case of a 2^nd home or condo as an investment, you are dependent upon a single customer for your revenue (rent). Imagine a company with the business plan of having exactly one customer. Such a business plan could never be funded given the risks associated with the single customer approach. Compare the reliance on a single renter with the number of customers a company like Coca Cola (KO) has. KO has literally billions of customers in virtually all countries of the world. Its revenue base is highly diversified, the company not being dependent on any single customer but rather hundreds of millions of consumers spread out across the globe.

Real estate is inherently local. If the economy surrounding a given investment property goes south, you can't exactly uproot the business for more robust economic environments elsewhere. In the case of large, multinational companies, they have tremendous geographical diversification such that if a particular region is slow, often other parts of the world are experiencing faster growth and these varied economies can and do offset each other.

At the end of the day, just because an asset is tangible just because you can kick the side of a building does not in and of itself make the investment less risky per se. One must look, sans emotions, at the various economic dynamics to determine the risks associated with real estate and equity ownership. When an analysis is done beyond superficial considerations, a conclusion about the lower risks associated with investing money in a broad portfolio of stocks versus a single real estate property becomes evident.

Hit 'Em When He's Down
June 13, 2008

In life, we are generally told not to do this. To hit a man when he's down is improper etiquette and horrible karma. But what if we're not talking about a person? Does this PC rule apply when we're talking about the market? I say "No, and here is why:

Say the market (DOW) is currently at $13,000. It is expected to reach $26,000 in ten years (7% growth a year is reasonable.) You, as an investor currently have $100,000 in a portfolio invested in the market. Each year, for the next ten years you add $10,000 to the portfolio. What is the most optimal path for the market to follow to maximize your returns? Most answer this question by thinking Up! I will get the best returns as long as the market keeps moving up! While this answer is true in part, the thought process is a little premature.

Let's say there are three ways for the market to get to that $26,000 at the end of the ten year period. It can either jump to $26,000 in year one and stay there for ten years, steadily increase by $1,300 a year, or stay at $13,000 for nine years and jump up to $26,000 in year ten. What will be the best scenario for you as an investor?

Let's choose the first scenario where the market jumps and stabilizes. If you're investing $10K a year, you're only able to buy .38 shares of the DOW each year. At the end of the ten years, you will have 11.54 shares and a portfolio worth $299,940--- Pretty good, but you could do better.

Let's look at the second scenario. The market steadily increases for the next ten years. That means that with each passing year, your 10K will be able to buy fewer and fewer DOW shares. Because the market is increasing, the buying power of each dollar of your $10K into the market decreases. At the end of year ten you're left with 12.83 shares and $333,694.28. Better than before, but is it the best?

Finally, take a look at the third scenario. The market doesn't move up until the last year. This means that your $10K is able to buy more shares (.77) of DOW each year than under the previous scenarios. Thus, your portfolio holds more shares. This allows for a greater increase in portfolio value when the market ultimately moves up at the end of the tenth year. Now, you're looking at a portfolio worth $389,940. You can only imagine how much you stand to gain if the market dropped below $13,000 before making its way back up to the $26,000.

The point is this: If the market tends to move up in the long run (which is the truth), a downward swoop or stabilization of the market in the short run can actually be a GOOD move for long-term investors. When you expect the market to be up in the long run, a low market value before the upswing allows you to purchase more shares at cheaper prices. When those shares then jump in value at a later date your portfolio can provide some hefty returns.

So go ahead. Take a swing at the market while he's down. He'll eventually get back up, and when he does, you can take his money and run. How's that for good karma?

Broker's Shouldn't Make You Broke
May 17, 2008

You may have heard about before, various conflicts of interest arising between individual investors and their advisory or discretionary brokers---where the broker makes or advises a deal just so he can get commission or increase company sales. With due diligence laws and the threat of securities fraud, many believe the days of these conflicts are long gone. However, it only takes a glance at the NY Times Sunday edition to shut that belief down. Sales of auction-rate securities are the new culprit, and the reason so many investors are scraping for cash.

Auction-rate securities (bonds whose interest rates are determined via auctions), have been held by corporations and individual investors since the 80's. For the past 20 years, these securities were sold to individual investors as risk-less cash equivalents, better than money-market funds because of their higher return. Recently however, investors were made aware of the risk involved in these securities when underwriters began marking down the value of these securities with investors suddenly unable to liquidate. The question then becomes, why were so many of these investors unaware of the risks involved with these securities?

At the end of 2006, corporations held 80% of auction-rate security market, a hefty percentage. Later, in mid-2007, corporations seemed to have sensed the problems that lie ahead and began bailing out of the market, selling off these securities until corporations only held 30% of the market by the end of 2007. With big corporations selling, they needed buyers. That's where this conflict arises. It seems that corporations began looking to individual investors to buy these securities and take them off their hands. Individuals were sold these securities with faulty promises of liquidity from brokers. The brokers simply needed to find someone to buy these securities and recommended them to clients, regardless of the client's best interest.

Beside the fact that investors have no access to their money, there is very low incentive for institutions to help this market as firms continue to receive auction fees despite the faulty auction. Just goes to show that trust, the truth and integrity in today's world are still hard to come by.

Do Your Homework
April 15, 2008

It's so easy to get caught up in a fad. In fact, that's exactly what so many investors do and precisely why they do it- because it's easy. But the question is whether or not this kind of behavior is smart. When the market is hooked on a price increasing fad, be it for macroeconomic or sector related reasons, that's the time many people look to buy, and precisely the time they shouldn't. They see a stock hitting high and they want in. The more people behave this way, the more the price increases in so on. Pretty soon everyone is buying simply because other people are buying, thinking they must know something I don't. But the reality is that you can, and should, know everything about a company before you buy its stock. Don't trust your neighbors' judgment. See for yourself.

This is not revolutionary thinking. I can bet that you did not buy your car without looking at it. You would not make this kind of purchase simply because someone else thought it was a good deal. No, to the contrary, we make big investment decisions based on our own judgment. We want to see how the car handles, what color it is, and determine the MPG before we buy it. We should utilize this same way of thinking when it comes to buying a company. No, we can't take it for a test run, but we can look at its history, its CEO and its balance sheets and make these kinds of judgments for ourselves.

Under the same logic, it is just as easy to get caught up in a panic as it is a fad. When the market is down in a certain sector, causing a certain company to be down as a result, people panic and sell, at arguably the worst time to sell. If people keep playing according to these rules, everyone would end up buying high and selling low.

They way to make good money is not to follow the market mark for mark, but to invest in good companies. The market gives us an opportunity to buy good companies at good prices. It does not determine the credibility or the strength of a company, that's what the balance sheet is for. There are so many outside influences that can affect the share price a company that really have no influence on the core of the company whatsoever. So rather than looking at an increasing share price to decide to jump in, or a decreasing share price to jump out, look for a strong company. Do your homework, because the best way to invest is to buy stock in a good company that is undervalued by the market.

FAST MONEY? HOW ABOUT NO MONEY...
April 04, 2008

I was riding a stationary bike last night and a financial show I watch from time to time was on the TV in front of the bike. The show has 4 or 5 regular guests the Traders who give sound bites about particular stocks they like, dislike, etc. I have noticed that from time to time the moderator of the show will ask the panel if they own the stocks this is probably both for interest as well as compliance/disclosure purposes. A typical exchange is as follows:

Moderator: Ok, I am going to ask each of our panelists what they think of AAPL good stock, bad stock give us your thoughts.

Panelist #1: Apple is the greatest company on the planet, Steve Jobs is god, the stock is a screaming BUY!

Panelist #2: I agree with my colleague. There has been a run on the iPhone, they are coming out with a 3G phone, this is a fantastic company, you should buy it here or any time you get a dip.

Panelist #3: This company is running on all 8 cylinders. They are immune from the sub-prime mess. People want their gadgets, the iPhone is the hottest product out there right now. The Mac is starting to really take off relative to the PC. You HAVE to own this company.

Then the moderator asks, "So, do you guys own this company." 

Panelist #1, No, but I'd like to buy it at some point.

Panelist #2: No, but it is a great company.

Panelist #3.No, but I am looking at it.

Moral of this story: financial journalism does not equal money management. It is easy to recommend stocks and not be accountable. It is another thing entirely to manage a portfolio. I am not saying these panelists are not smart, successful money managers. In virtually all cases they are highly successful, intelligent (and likely wealthy) investors/traders. What I am saying is the forum in which they are espousing their thoughts is that of entertainment TV. As an investor, you have to know and understand the source and motivations behind the person giving you advice. The company trying to get you to buy their trading software that gives you 3 green arrows for buy and 3 red arrows for sell is in the software business and seminar business. They make money selling software. The owners of financial news shows are in the TV entertainment business. They make money selling ads. Do not let these be your primary, let alone sole, source of investment advice. As with anything in life, seek to have your interests directly aligned with the person/company whose assistance you are utilizing. That will lead to optimal results. That is not to say that financial TV shows are not entertaining, but that is what they are largely meant to be entertainment. The panelists, if you talked to them over beers, would invariably concur.

- Scott Kyle

GETTING MAULED
March 31, 2008

It was recently reported that a major brokerage firm reduced its recommendation on Bear Stearns (BSC) to SELL from HOLD, but at the same time RAISED its price target to $10 even though the stock was trading above $10 at the time of the revised recommendation. Go figure. Another example of large brokerage firms giving recommendations to buy or sell after a given stock has already made a significant move (in this case, BSC went from the 80's to the 50's to about $2 and then a little over $10 in a matter of weeks).

PAIN IS PLEASURE
January 21, 2008

Pain Is Pleasure.

Arnold Schwarzenegger Circa 1982

This is a concept I have subscribed to since I was a kid, namely the notion that (constructive) pain is an actual source of pleasure as it represents growth, challenges overcome, forward motion. Lately the stock market has been dishing out its own doses of pain. To be sure, we have essentially been in a bear market since last summer with major market sectors (certain industries, market caps sizes, etc.) dropping 20% or more. Typical bear markets are not straight down; rather they tend to grind away with upward spikes along the way. But nonetheless, during bear markets stocks drop precipitously over time as they have over the last 6 months.

So what does all of this mean, and more importantly, what should we do about it? First, some perspective and context. There have always been and will forever more be cycles. It is the way life works. The sun rises, the sun sets. Oceans ebb and oceans flow. It rains, then it is sunny. Fall yields to winter yields to spring yields to summer and so on. The same holds true for economic cycles. For over 200 years in the US capitalist-based economy, there have been macro-economic ebbs and flows, real estate booms and busts and stock market peaks and troughs. Always have been, always will be. We just don't know when they will take place, for what reasons or for how long they will last.

The challenge when it comes to equity investing is that the vast majority of humans have mental character traits that are inherently flawed. The very same person who would gladly wake up at 5:00 a.m. the day after Thanksgiving, drive 20 miles and battle hardnosed crowds just to save 30% on their favorite appliance or toy on sale, would take a stock which is also temporarily on sale and go straight to the return counter (as in sell it after having bought at a higher price earlier). Simply put, novice investors do the opposite of what they should do rationally, objectively, mathematically when it comes to investing.

Most brokers (which we are not) will only contact clients when the market is up. I have witnessed this first hand. Why? Simple it is easier to sell (as in have you buy) stocks when the market is on an upward tear, even if that is the worst time for you to buy them. At Coastwise Capital Group, LLC, we offer a different message, a more valuable approach. When the market is down, like it is now relative to last summer, it is the very best time to add to your portfolio. Buying low always has been and always will be the optimal time to purchase equities. For anyone who is a net saver, and thus a net investor (as in anyone who is adding money to one's portfolio via an IRA, 529 plan, a periodic contribution to an individual account, etc. over time), you should be very glad that the market is down. Read that sentence again, because you will not hear it often. Objectively speaking, which is what matters (not your emotional reaction save your emotions for your family or artwork or some other subjective matter), your returns are enhanced over time when you invest more money in a down market. It is just basic math. Even if you are not contributing additional money to your account(s) which you should be doing the reinvestment of dividends at lower prices is an important source of enhanced returns and wealth creation over time.

In summary, it is important to have a paradigm shift when it comes to seemingly endless down days in the market. Remember, when stock prices decline you have not lost money. You have not misplaced it, spent it, burned it, nor has it disappeared. Rather, the market is currently valuing the shares you hold in a business at a lower price than previously. You don't need the money tomorrow if you did, it should not be invested in equities. Cycles come and go. We are likely in a recession as we speak and by the time the government compiles its statistics we will be on our way out of said recession. We are undoubtedly in a real estate bust which we will also certainly come out of as we have every other real estate down turn since the beginning of real estate. The stock market which typically anticipates by 6 months or so major macro-economic trends will bottom out only to head back north as it has done for the last couple hundred years. Will this happen tomorrow or next week or next month or this summer? I do not know anyone who says he has the answer to this question of market timing is not being truthful. But for any net saver/investor, the longer the market stays down the better. Do as I do, which is to put every available excess dollar into quality equities. The market will be where it will be a year from now, 5 years from now, 10 years from now. The lower the price you pay for your shares, the higher will be your returns, plain and simple. Opportunities to buy quality companies at low prices do not come around often. Once everything is clear, then it is too late, stocks will have already rebounded, the sun will have already come out, and everyone will realize in hind sight that the storm was not so bad after all.

A typical recession lasts about 8 months, the average bear market lasts less than that. Put 6, 12 or even 18 months in perspective. A parent investing in a five-year-old child's 529 plan will have more than a decade of investing to do once the next US recession is over. A 45 year old will have nearly 2 decades at least of additional investing for retirement and beyond once the next recession has faded. A recent retiree will likely have 10 or more years to take advantage of the superior return potential equities offer. To be sure, a year is a blink of an eye in the life of an investor. It only seems like a long time because headlines blare dour news minute after minute, hour after hour, day after day.Do not become beholden to such short-term considerations. Do not make the mistake of pulling money out of the market at just the wrong time. Indeed, do the opposite, what the smart money does, namely put additional money to work when stocks are on sale. This is how wealth is created. You will not call the bottom; you don't need to. You simply need to plant as many investing seeds as you possibly can, seeds which will blossom and flourish once the cycle changes, once the sun comes back out, which it invariably will. Today's stock price pain yields tomorrow's wealth creation pleasure.

STARBUCK'S MAKES THE RIGHT MOVE IN CHINA
July 19, 2007

As I noted in the June 2007 issue of the "Coastwise Monthly Dividend" Newsletter (http://www.coastwisegroup.com/News/News.php?archive=11), Starbucks' (SBUX) has had an outlet in the Forbidden City in Beijing for some time. I have seen it on several occasions, and despite the fact that I was SERIOUSLY mocha-deprived when I was there, I did not step foot in the place. To be sure, while I want nothing but financial success for SBUX (and was quite pleased when the stock popped nearly 6% today), I am pleased to announce that Starbucks has decided to close its store in China's Forbidden City. From a cultural perspective, I think Starbucks made an intelligent decision (if you ever have the opportunity to visit the Forbidden City, do so it is truly a historical wonder which is why having a SBUX there was so offensive in my opinion). Further, from a financial perspective, I think the company also made the right move as the negative press and image associated with this one outlet far outweighed the financial benefit especially as the company pursues its aggressive and important international expansion plans. With over 250 stores operating in China, Starbucks' future earnings prospects and international expansion, especially in East Asia, look as strong as ever.

YES, ELEPHANTS CAN DANCE
July 17, 2007

GE, one of the oldest and largest companies by market capitalization in the world has seen its stock go from the mid 34's to a shade under 41, a nearly 20% rise in under 3 months. That is a couple year's worth of gains in less than a quarter for this industrial giant. The stock appreciated after basically going nowhere for a couple years running. The important lesson here is that stocks, even the stock price of a very large company, can appreciate a great deal in a short period of time. You have to be there for the gains. You have to be patient. If the company is making good progress, then one day you will wake up, or return from a 3 week vacation, to find that the stock has headed North markedly. It always seems to happen when you are not looking. Head to the zoo and stare at the elephant, and he will just sit there barely moving. When you turn your back, however, he will do a jig that will earn you profits if you were patient enough to hold (this especially holds true for dividend paying stocks that will earn you ever increasing dividends if you reinvest them over time).

Nothing NEW
February 13, 2007

New Century Financial (NEW), a company big into the subprime mortgage industry, 'surprised' Wall Street by announcing that losses on their risky mortgages would be bigger than expected. These are the same mortgages that writers for the WSJ and other financial periodicals have been saying for months or more were suspect to accelerating default levels as teaser intro rates converted to higher fixed rates - - combined with the cooling off of home prices.

Investment bank analysts are paid to forecast future stock price movements based on company fundamentals. But, more often than not, their recommendations simply reflect what has already happen, and thus, to be blunt, are less than worthless.

In the case of NEW, many prominent investment banks had equivalent of hold (as in keep - it is good) or buy (as in, if you don't own it already, get some now) recommendations on NEW while it went from the high 40's to the low 30's. Then, one fateful day last week, the stock cratered from about 30 to 19, a massive one day drop on top of what had already been huge stock price losses in the previous months.

Only AFTER the stock dropped to 19 from the high 40's did these investment banks tell you to sell. While the stock was getting clobbered they advised you to buy or hold it, and AFTER shareholders heeding this advice lost over half their money, THEN the analysts said sell (some actually downgraded the stock from buy to hold - meaning, if you take their recommendation at face value, they are telling you to keep your position. Of course, what they REALLY mean is that you should sell - that is what HOLD means - but for some reason they can't actually be direct and say SELL).

As a related aside, now that most of the damage has been done in the risky mortgage lending industry in terms of providing loans to people who can ill afford them, NOW companies are clamping down on their lending standards. The GREAT companies are disciplined during good times and bad, they don't wait until the bad times to tighten the screws, in fact, the better the times, the MORE disciplined they become, why, because THAT is when bad times are likely to follow. It is very hard to take this approach as inevitably a company forgoes some profits when maintaining if not heightening scrutiny and standards during the good times, but they weather if not thrive during the inevitable down times due to this ongoing discipline.

So back to the investment bank analysts, THE POINT HERE IS THAT, OVER AND OVER AND OVER, INVESTMENT BANKS CHANGE RECOMMENDATIONS TO BUY AFTER A STOCK HAS RUN UP AND CHANGE RECOMMENDATIONS TO SELL AFTER A GIVEN STOCK HAS ALREADY COLLAPSED. THUS, IF YOU ARE RELYING ON SUCH ANALYST RECOMMENDATIONS, YOU ARE PROBABLY BUYING HIGH AND SELLING LOW.

I can't put it any more plainly than that.

The Secret Sauce (of Life Success)
January 04, 2007

Take out a pen and paper. Draw 3 circles that overlap (not concentric circles with the same center, but 3 circles that overlap in the middle). Label one of them "Skill", another "Passion" and the 3rd "Hard Work". Take any discipline of worthiness - the arts, athletics, business, etc. Find someone who is engaged in an activity for which he or she has Skill, Passion and Hard Work, and you will find a person of success in that activity. Throw in some competitiveness and a bit of luck and you have someone at the top of the game.

If you can find something in life for which you have a Passion & Skill - and you work hard at it - you are blessed as you have found the secret sauce to success. And of course these things feed off of each other. You enjoy something, you have a love for it and you tend to work harder at it. You work hard and you build skills. You get better and you enjoy it more (think surfing, golf, the piano, etc. once you get past that initial hump....). And so the virtuous circle continues.

If one of the ingredients is missing, you can do OK, but you won't be the best. I have learned this lesson many times. I have been blessed several times in life to fit smack dab in the center of these 3 circles (with a VERY large dose of competitiveness thrown in there and of course the usual luck). I found this with education, with athletics, and many years ago with my work activity of investing. When it came to sailing I was blessed with a natural ability, I arguably worked harder than anyone in the sport, I loved what I was doing - I could not wait during harsh Chicago winters growing up to literally go break the ice on nearby lakes and sail in any body of water I could (of course, there will always be challenging times, but I mean a fundamental love for what you are doing), and I developed skills over time. This lead to several national and world titles.

Compare this with my experience in crossing the English Channel (not by boat - I wish! - but via swimming). I had 2 of the 3 ingredients. I worked very very hard in my training. Nothing was missing there. I had the skills. But I did not love what I was doing. I tried to force the passion, I tried to convince myself that I loved swimming for 8 hours at a time in 60 degree water. I read a book by Anne Cox entitled "Swimming To Antarctica" to motivate myself (she has a serious passion for open water swimming), but at the end of the day - as the English say - I was fighting an uphill battle. So I fell short in my quest.

Lesson? If you want to succeed at a high level in something, find an activity for which you have a Skill, Passion and willingness (you won't even think of it as work) to work hard. Then you will be on the road to success.

If you are looking to others to assist you in a given area, say money management, assess them on those 3 fronts (along with competitiveness - luck is just that, luck) and if they come up scoring high, you probably have a winner.

Here We Go Again...Microsoft Finally Gets Its Upgrade
November 20, 2006

Today Microsoft (MSFT) was up over 1.5% on a generally flat day for the broader market. Why such a big up day for MSFT? Surely some kind of favorable financial or operating news, right? Nah, rather the company got an upgrade to "Outperform" from "Neutral" from Credit Suisse. This will likely be one of several upgrades the company gets as it hits new highs.

Let's compare this upgrade with what was occurring back in April of this year, a mere 6 months ago.

On April 28th, MSFT announced strong earnings and revenues but investors were nervous about how much spending the company was going to be doing in the near term so the stock COLLAPSED - and OVER A HALF DOZEN BROKERAGE FIRMS DOWNGRADED THE STOCK. Read that again - after the fact, once the stock had already crashed over 10%, THEN these brokerage firms downgraded the stock. Of course, as I have written about repeatedly and taken specific investment actions consistent with the simple notion that I would rather buy great companies at LOWER prices than at higher prices, even if that means I am likely to be 'wrong' in the near term.

So fast forward a scant 6 months. Like other great companies before them - companies with great franchises, strong financials, rock-solid balance sheets and great management - that are going through non-fundamental, short-term challenges, MSFT has come back with a vengeance. Was the low that fateful day in April the low the stock saw? No, if you 'call the low' you are simply lucky - don't kid yourself that you can consistently call highs or lows of stocks or markets (and you do not need to be able to in order to materially outperform the market). But, it was within a couple of bucks of the low (and the company was trading at a reasonable valuation - a key metric for successful investing) and the stock is up nearly 24% from the lows on April 28th and up nearly 33% since its lows shortly thereafter. That is one of the biggest companies in the world up by nearly a third in a matter of months. There was a relatively brief window to take advantage of this situation. The window was foggy and cracked and ugly and likely to cause some bleeding in the near term, but the window was there for those willing to endure some short-term pain for some medium-term pleasure.

So, if you listened to Credit Suisse who had a neutral rating on MSFT while it has been going nothing but north the last few months, or worse yet, if you had taken action based on all the DOWNGRADES back in April, just as the stock was hitting its lows for the year (this is not a unique event readers, this happens all the time. Of course you need to distinguish the otherwise great company which is only going through a temporary challenge from the one that is truly experiencing fundamental deterioration. See my write up on the importance of BALANCE SHEETS for more insights on this topic) you would have missed out on a great investment opportunity.

Sure, it might be more 'comfortable' to buy the stock after it has gone up 30% as opposed to after it has dropped 30% - just like it is more 'comfortable' for investment banks to upgrade stocks AFTER they have run up, and just like it is easier for I-banks to downgrade stocks AFTER they have already gone down, but THE FOCUS HERE IS NOT ON WHAT IS COMFORTABLE. THE FOCUS IS ON MAKING INTELLIGENT INVESTMENT DECISIONS. THE FOCUS IS ON MAKING MONEY. THE FOCUS IS ON PUTTING EMOTIONS ASIDE, ON TAKING ADVANTAGE OF THE BLOOD IN THE STREETS.

Such an approach is neither easy nor comfortable, but it sure is profitable.

The Single Habit of Highly Effective Investors (Another Look At 'The Count')
November 17, 2006

I am not generally a big fan of 'self-help' type books. One such tomb I read a while back, however, The 7 Habits of Highly Effective People resonated on various levels. In the book, the author discusses, among other topics, the idea of creating a matrix with 'to do's' that fall into 1 of 4 quadrants: not important and not timely, not important and timely, important but not timely, and important/timely. Most people, he espouses, focus on times which are not important but rather happen to be in the person's face - emails that pop up, etc. I am not doing the topic justice - read the book one day if you have the chance.

Similarly, I believe highly effective investors have various 'habits', or behaviors, that separate them from less successful investors. Some, albeit very few investors, are born with these behavior traits, the appropriate mind set, but most need to learn, or actually 'unlearn' bad investing habits that we humans are cursed with. Here is a simple construct that will help to get you 90% of the way there in terms of making good investment decisions and more importantly, avoiding bad ones.

Start by drawing a square. Divide the square into 4 quadrants so there are 4 smaller squares within the larger square. Label the upper left hand side of the large square "Good Stocks", the lower left hand side "Bad Stocks" the top left side of the square "Good Company" and the top right side of the square "Bad Company". So now we have a matrix with the upper left corner square being the "Good Company/Good Stock" quadrant, (going clockwise) the upper right hand quadrant being "Good Stock/Bad Company" the lower right hand quadrant being "Bad Stock/Bad Company" and the lower left hand quadrant being "Good Company/Bad Stock".

Let's broadly define each. By "Good Company" I mean a company that has consistently made profits, has a strong balance sheet, is a leader in its industry and so forth. By "Good Stock" I mean that the price of the stock relative to the value of the company is favorable - let's use the price earnings ratio.

The goal of a highly effective investor is to reside in the "Good Company/Good Stock" quadrant. The next best quadrant is "Good Company/Bad Stock". "Bad Company/Good Stock" is a little worse and the place you definitely do not want to be is in the Bad Company/Bad Stock quadrant.

As with most things in life, when something is taken to the extreme, the point becomes very clear. In the world of investing, the late 1990's/early 2000's were a time of extremes, thus this is a good place to learn from the notion of investing in Good Companies/Good Stocks. Coca-Cola (KO) is a great example of a Good Company/Bad Stock in the late 1990's. To be sure, KO has consistently increased its profits over the last 5 years, yet its stock is down approximately 50% from its high in the late 1990's. Why? Simply put, while KO was still a great company, it was a bad stock when it was selling for over 70X earnings (compared to approximately 20X now). The stock was simply too expensive to provide adequate returns in the short-term. Will KO eventually provide positive returns to investors who bought it in the late 1990's? Indeed, it is very likely that within another 5 years or so, namely 8 - 10 years after the stock hit its previous high - especially once reinvested dividends are factored in (dividends have continued to be increased each year despite the stock's decline - why? Because earnings have been increasing, thus the company can afford to increase its dividend - that is a hallmark of a Good Company). KO had and has a strong franchise, it is in a good industry, the company has a good balance sheet, etc - none of those things has changed and they will likely not change for years if ever during our lifetime. The price one has to pay for this greatness, however, changes from time to time - catch KO or other such strong companies when they are both Good Companies AND Good Stocks, and you will increase your chance for good investment returns over reasonable time periods.

Compare the above KO scenario with a company like JDSU. In the late 1990's, Bad Stock, Bad Company. Why? They are myriad, varied reasons but on the bad stock side, valuations were off the chart, the company was not making any real profit to speak of, the closest thing the company ever made to a dividend was a reverse stock split recently which are not the words you want to hear....

Will those who bought the stock in 2000 at a split adjusted price of over $1200 (no, that is not a typo) per share (the stock is now around $18 after that nasty reverse split) ever get to break even? Likely not while they are alive. Bad Stock, Bad Company.

THE MOST IMPORTANT 2 WORDS YOU WILL EVER HEAR IN INVESTING: "THE COUNT".

I have written before about the idea in black jack where professional card counters count the number of face cards - the fewer face cards that have appeared, the greater the count and thus the more likely the player is to win the next hand, hence the more they bet. If a lot of face cards have already appeared, the count is low, the remaining deck unfavorable, and the less the player should bet on the subsequent hand.

THERE IS A COUNT IN THE STOCK MARKET AND IT IS CALLED THE PRICE/EARNINGS RATIO. The higher the count, the less you should 'bet' (as in, the less likely you are to make decent returns). The lower the count, the more you should 'bet' (as in the higher your returns are likely to be over time). Why? Simply put, over the long-term, 2 things drive the price of stock - the earnings of the company and the multiple people who are willing to pay for the earnings. If, as in the case of KO above, or a basket of companies/stocks like KO, or the broader market, the price you are paying is low - let's say 10X earnings, then over time earnings will rise, the P/E ratio is also more likely to rise than fall (since its historical average is somewhere around 15 depending on how you calculate it), thus you have 2 things going for you which will increase the price of your stock.

To reiterate, look at the count - if the P/E ratio for the company, or better yet basket of stocks you are considering is low by historical standards (and if these are GOOD COMPANIES that are able to consistently increase their earnings), then you have math on your side - you have the forces of investing on your side - the E part of earnings is going up and the multiple people who are willing to pay is more likely to go up than down, so THAT is when you want to be placing big 'bets'. When the count is against you, when the P/E ratio for a given stock or basket of stocks is high, take your chips off the table. You will eventually be dealt a better investing hand, just be patient.

Employ the most important habit of highly effective investors - buy Good Companies AND Good Stocks and you will have positive returns over time.

If A Tree Cheers In The Forrest And No One Hears It....
November 13, 2006

is it still a cheer?

The other day in my gym locker room I caught a glimpse of some football game (personally, I like to engage in athletic activities rather than watching, but in this case I was changing into running clothes and could not help but see what was on the TV) where the quarterback was about to get sacked. At the very last second, he threw the ball such that it went incomplete. The crowd cheered wildly that the quarterback was able to throw the ball without getting tackled, without getting intercepted and without getting called for intentional grounding. He had essentially neutralized what could have been a really bad outcome.

And I mean the crowd went REALLY wild.

This got me to thinking. I have played a lot of sports over the years, albeit ones that are not as crowd friendly/gathering as football - e.g. sailing, triathlons, etc. That said, having competed at high levels, I have had my fair share of people cheering me on from time to time.

But, when I make smart investments, or more importantly, WHEN I AVOID MAKING BAD INVESTMENTS, NO ONE CHEERS. Not a peep. Not even from the folks who entrust me with their hard earned money. Not once have I received a call or email stating in effect, "Hey Scott, saw you didn't buy company X today. Good job. Keep it up."

Yet that is the essence of what good investors/money managers do, professional or otherwise - they avoid mistakes. And the stock market provides plenty of opportunities for making mistakes. On any given day, one can buy any one of tens of thousands of different stocks, bonds, REIT's, mutual funds and so on. Yet only a small handful of these would make good investments given one's objectives, time horizon, valuation and prospects for the investment, etc.

So deciding AGAINST a particular investment, passing on it, can actually be of tremendous value. Returns are affected as much, if not more, by the mistakes that we make - the things we did but should not have done - than by the things we did right. Take out the top 2 or 3 worst performing investments that were made for the wrong reasons - that were flat out mistakes - and returns can go up materially.

(Related aside, just because something works out does not mean having done it was a smart thing. If I decide to cross a busy highway on the road rather than taking the long route of walking across a bridge inconveniently located down the way - and make it - that does not mean the original decision was a wise one. Similarly, if you make some stock investment/trade that works out, but the parameters of the original decision were flawed, the outcome does not justify the decision - it was just as wrong to make the bad investment even if it worked out OK - so don't make the mistake of giving yourself credit for the outcome).

Yet no one cheers when I purposefully say no to an investment opportunity after much consideration. This is probably the single most important thing a professional investor can do - NOT take action when the action contemplated has a likelihood of not meeting the client's objectives.

So, maybe I will buy one of those applause machines and the next time I throw the proverbial ball out of bounds so as not to make an investment mistake, I will push the button and take in the accolades for a job well done....

Shark Insurance Redux - The Great Buffet(t)
November 10, 2006

Not long ago I wrote a piece about options selling and likened it to selling (or buying) insurance. The general message/lesson is one I espouse regularly, namely DO THINGS WHEN YOU DO NOT HAVE TO do them (as then it will be at a minimum more 'expensive' if not too late). Don't buy fire insurance when you get the first smell of smoke, rather, buy it during the rainy season when no one is interested in fire insurance and hence rates are cheap (the analogy for stocks being, if you want to protect against the downside for a given stock or the market in general, buy the puts, buy the insurance on strength, when the stock/market is up, not after you wake up to a collapse and the price of insurance is through the roof).

Similarly, I made the point that if there were such a thing as shark insurance that I would be the one selling it each year or every other year that invariably there is some cover story on Time Magazine blaring about how the world has changed and that the number of shark attacks is going up, when in reality it was just some random coincidence that a few people were attacked in a short period of time (and, oh, if anyone of fame were to ever get attacked by a shark, then FOR SURE the sharks must have unified under a new cartel to ensure the demise of all humans...) and Time Magazine knows that "SHARK ATTACK" makes for a strong selling cover story in the Summer time. When there is figurative if not literal blood in the water, that is when others are willing to pay a hefty price to insure something that is highly unlikely - or to put it differently - to overpay for protecting against an event that heretofore was not even a concern for them per se but is all of a sudden a major threat. Be on the OPPOSITE side of that transaction I counsel, as that is where the real bucks are made.

Well, the Great One (and no, I am not talking about Jaws) announced his company's (Berkshire, BRKA) earnings recently, and what do you know, a big part of the company's strong gains came from nothing else but THE SALE OF HURRICANE INSURANCE POST KATRINA.

Now, your immediate reaction may be, 'how can people/companies take advantage of others' misery' or some such thing. Save it. If you want to be a successful investor, you have to put your emotions aside, you have to grow your Vulcan pointy ears and you have to use an IV to put ice in your veins...

When I read that BRKA made money selling hurricane insurance at great rates (for the seller), I smiled a pearly white smile, like Mack The Knife.

Hit 'Em While They're Down (The Lesson of Microsoft)
November 09, 2006

I get calls all the time from big brokerage firms seeking to win my trading business. I usually give them a minute or 2 to allow them to give their pitch - just to be kind - before cutting them off. They are always coming up with new terminology that gives me a good laugh. (Did you know that brokerage firm sales guys are now saying that they are looking to 'cover' their clients? That is their lingo for getting a new client - to 'cover' a client, like an analyst 'covers' a stock. Strange).

In any case, one guy asked me how often I get 'hit'. I thought, 'well, maybe this guy has done his homework and knows I do martial arts and is asking me how often I get punched' but that was not it. Rather, getting 'hit' was lingo, like that of blackjack, where to 'get hit' means to be forced to buy a stock, usually because one is short an option that goes against you, thus since you are the seller of the option someone else forces you to buy the stock, or 'get hit' with the stock. Now I see where these firms come up with obtuse stock recommendations like 'OVERWEIGHT' that can cause more confusion than clarity.

As I have communicated in other entries, I am always on the lookout for otherwise good companies whose stocks have recently taken a beating. Take McDonald's (MCD) for example, a couple years back when everyone thought Mad Cow Disease would be the end of this venerable chain and the stock plummeted under 15 (yes, look at the charts). There are countless instances, and I am not talking about just small, high-flyers. From time to time you get major league companies selling as though they were minor league has-beens.

But it is really, really tough to buy these stocks when everyone hates them. Unless you happen to get lucky and buy at the low, you WILL be wrong for some period of time. But these things can come roaring back. Look at MRK over the last year. Or, more recently, Microsoft (MSFT). When they announced the delay of their new operating system, the stock was battered worse than a Floyd Merriweather opponent. The stock dropped quickly into the low 20's. Analysts downgraded (after the fact, as is typical, once the damage was already done).

HIT THEM WHILE THEY ARE DOWN.

Of course MSFT isn't going away any time soon. The company has a dominant market share in many areas. It has more cash on its books than it knows what to do with. Its valuation, unlike back in the late 90's, is reasonable. There was just bad news, temporary bad news. THAT IS THE SWEET SPOT YOU ARE LOOKING FOR. AN OTHERWISE STRONG COMPANY GETTING BEATEN DOWN FOR A REASON THAT IS NON-FUNDAMENTAL AND WILL EVENTUALLY GO AWAY. I am not saying I or anyone else could have called the bottom. However, I can tell you who can call the bottom - the analysts and commentators, after the fact.

What I am saying is look for strong companies that are making headlines because of some non-fundamental problem, and HIT THEM WHILE THEY ARE DOWN. You may be 'wrong' - you likely WILL be 'wrong' - for some period of time, but it is amazing how quickly these things can reverse themselves. MSFT, one of the biggest companies in the world by market cap, is up almost 30% in less than 6 months.

Remember, the obvious but at times difficult goal is to buy low and sell high. When do prices tend to be low? When everything seems to be going wrong, when there is blood in the streets, when analysts are downgrading the stock, when it is the toughest time emotionally to buy a given stock (of course you have to do your homework and make sure there is no long-term, fundamental issue that could lead to permanent capital loss). When such conditions exist, put on your gloves, take a deep breath and HIT THEM WHILE THEY'RE DOWN.

The Importance of Balance Sheets - The Lesson of Merck
November 08, 2006

Investors place most of their emphasis - and time - in assessing a company's income, or profit & loss, statement. While this is certainly an important financial consideration, a company's balance sheet is just as, if not more, important in determining a company's ability to provide returns to shareholders over time, especially during challenging periods.

Look at Merck (MRK). In brief, this company has been a disaster for the last 12 - 18 months. Key drugs have been questioned by regulatory authorities, myriad lawsuits have been filed by patients and the government is suing over tax issues...not to mention the drug/pharma industry has been in a general funk in recent years due to the dearth of new blockbuster drug releases combined with the real threat of generics.

So you would think given all this that Merck would be on its way out a la some bad car or airline company. Yet, look at the company's stock - it is right where it was before all these seemingly disastrous events took place. Why? In large part due to the strength of the company's balance sheet.

If MRK had a weak balance sheet, if it were highly leveraged with little to no cash on its books, it would probably be 'game over' for the business, or at a minimum, the stock price would have been decimated.

Yet here MRK is, going strong (I am not making any commentary on validity of the patient claims in terms of MRK's historically most popular drug - I am simply focusing coldly, objectively, on financial matters), paying its dividend quarter after quarter, a dividend that has been paid since 1935 and which has been consistently increased in recent decades.  Compare this with the recent dividend cuts made by automakers Ford (F) and General Motors (GM). Why did these companies feel compelled to do what all companies loathe to do, namely cut their dividend? In large part due to their weak balance sheets.

All companies, at some point in time, will invariably go through some sort of financial struggle. It might be related to competition, it might be something unique to the company's industry, it might relate to a recession - the reasons and causes are as diverse as the universe of publicly traded companies. The strength of a company's balance sheet will play a major role in the company's ability to withstand these inevitable challenges - and continue to stay in business let alone provide returns to shareholders over time.

Lesson? When in doubt, invest in companies with rock solid balance sheets; look for the industry leaders, the best of breed companies that will not be the ones shaken out when the inevitable business and financial challenges arise. Sure, their stock prices may not rise as rapidly as some 3rd tier company trying to make its way into the industry, but when the proverbial merde hits the fan as it will when you least expect it, your Fort-Knox-esque investment will survive another day, likely continue to pay you dividends along the way (which, if you so chose, will be invested at lower prices if and when the stock price temporarily goes down as it did for MRK), and keep you from having to experience the 'excitement' of watching your hard earned money undergo permanent capital losses as is often the case for companies that are over-leveraged and unable to withstand a stormy day.

For Whom The Bell Tolls
November 03, 2006

For those of you who have read some of my previous entries, you have come to understand that from time to time (ok, ALL the time) I find many of the activities and practices of the large brokerage firms to be perplexing at best. Here is a great example.

Recently the esteemed Morgan Stanley came out with an OVERWEIGHT rating on Toll Brothers (TOL). Now, to be honest, I have never much understood these various monikers used by different brokerage firms - Accumulate, Underweight, etc - what exactly do those mean and how can I specifically apply action based on these recommendations? hat happened to Buy and Sell (we all know that HOLD is a euphemism for SELL - when was the last time you saw a stock rating changed to HOLD from BUY and the stock NOT drop on the news...if the stock is a HOLD, why would people SELL?!?)?

OK, so even if OVERWEIGHT is not a super clear directive, at least reasonable investors could conclude that Morgan Stanley thinks highly of the company/stock, that they think it is headed up, etc - I mean, unless we are talking about someone's waistline, OVERWEIGHT has to be good, right?   They are telling me, in their own obtuse (read: cover their arses) way that the stock is heading north, right?

WRONG.

Their price target associated with this recommendation was $23 per share, over 20% LESS than the stock price that day.

HUH?

They have an OVERWEIGHT rating yet they think the stock is going to crash? Imagine if Morgan came out with a proclamation that they thought the stock market was going to collapse 20%...investors would start jumping off roofs!!!

Talk about mixed signals. To be fair, and for full disclosure purposes, they did say that the overweight weighing is based on the fact that they think TOL will perform better than their peers. In essence 'if you have to own some crappy housing stock that is likely to crash, you should own TOL'.

But that is my whole point/contention with some of the information put forth by big brokerage firms - it is inherently confusing if not misleading...if not full of conflicts (that is another chapter entirely - I am sure you are familiar with the myriad research reports produced by Wall Street in recent years driven more by the firms desire to get investment banking dollars from the company being researched than by objective, arms-length analysis). Unfortunately, most people only get as far as "OVERWEIGHT" and take investing decisions accordingly that will certainly not make their bank account OVERWEIGHT.

Timing Is Everything - Just Not The Timing They Are Selling You
October 03, 2006

In today's WSJ there is an article discussing the launch of a new international fund by Templeton. In referring to the marketing of the fund, the article notes that, "Templeton's timing is better now from a marketing perspective than when it launched its BRIC Fund (this stands for Brazil/Russia/India/China). In the third quarter the MSCI Emerging Markets Index rose 4.6% and is up 9.9% year to date. When it introduced the BRIC Fund, emerging markets had just taken a drubbing as the fears of global interest rates in May knocked some formerly highflying stock market indexes down nearly 20%."

The translation - when stocks were cheap it was a bad time to try to get people to invest in them, but now that they are more expensive, it is easier to convince people to buy them.

I have said it before - this is absurd. Do not fall prey to this psychology, this 'marketing' of assets that have already gone up in price and thus more susceptible to declines. Indeed, while maybe not the best time to market for the company pushing the product, but by mathematical definition the best thing for the consumer considering buying the product, the lower the purchase price, the greater probability of making money.

Lesson - whatever the big mutual fund companies are NOT pushing is often a good place to look for investment opportunities. When dozens of new mutual funds spring up around an asset class that has gone nothing but up in recent times, you can be pretty certain the good times are already passed....

The Talented Mr. Ripley (It's Not Your Fault)
September 28, 2006

Me: "It's not your fault."

You: blank stare.

Me: "Really, it's not your fault."

You: "Stop saying that."

Me: "It's Ok, I understand, you can't help it, it's not your fault."

You breaking into tears, "I know, I know, I can't help it!!!"

Scene fades....

When it comes to making regular, fundamental investing mistakes, it really is not your fault. You were not built mentally, you were not wired, to make good investment decisions. After the great Warren Buffett donated 30 billion whatever dollars to the Gates Foundation, he said in effect that his investing success was not a function of being good at reading annual reports or performing complex mathematics, rather it was due to how his brain was wired, his ability to process information and act, or behave, in certain ways. This is no different than prodigies in music or other disciplines in society (sports, science, etc). To be sure, the hard work factor is always there, but the reality is that without certain given talents and without the right mental makeup - confidence, focus, ability to endure pain, etc - there is no amount of training that would make you, for example, an Olympic gold medalist marathoner. To achieve such greatness, in addition to the hard work, your body must be built a certain way (not too tall, light bone structure, etc) and your brain must be programmed a certain way (to be able to endure the hard workouts, the pain, etc).

Investing is no different. As with chess, successful investing is largely a mental pursuit. But what are the good mental characteristics that make up great investors and why is it that most people do not possess these traits? A few of the obvious ones.

The first is an ability to think and act very long term. Whether it is how we are built or the influence of today's society where instant gratification is emphasized (and promoted) over long-term, hard work - the MTV era and generation - most people are unable or unwilling to think and ACT in a long-term manner. Rather, they are looking for quick fixes, the latest trend or fad - in large part because product manufacturers and the media push such short-term, no-work-required fixes.

"Get great abs in only 6 minutes a day, 3 days a week!" (or any other of the myriad get in shape in only minutes a day with little or no effort schemes out there - now a company is even marketing a machine that you just SIT ON in order to lose weight!). Of course, in each of these print ads or TV infomercials which shows the person before and after, it says in small print, "this result not typical." They tell you in bold words that such and such a person lost 65 lbs while doing almost nothing 3 days a week or whatever, and then they say in small letters that you should not expect the same thing to happen to you.

Or take the diet fads. Literally thousands of books have been written espousing different diets. A week does not go by without the introduction of some new diet to end all diets. They all go basically like this. "The Dorm Room Diet is the latest and very best diet based on studies of college student in dorm rooms. blah blah blah and you should eat lots of fruits and fish and vegetables and reduce your sugar intake." Or, the Chi Diet. "In the Chi Diet, we did thorough studies of energy levels using eastern philosophy and blah blah blah and it is important that you eat lots of fish and fruits and vegetables and reduce your sugar intake."

A thousand more diet books will be written in the coming decades and most assuredly the % of the population considered overweight, obese, etc - which is a shockingly high number - will only remain constant if not go up. The issue is predominantly not that of knowledge, but rather that of implementation, of discipline, of a MENTAL ability to stick with something long enough to see the results. People know that a piece of fruit is better for them than a Krispy Kreme doughnut - information, knowledge is not the issue. Diet books focus mostly on the wrong things - they espouse what people should eat, as though if the reader had a gun put to his head he would not be able to identify foods that are good for him from foods that are bad, or he would be unable to make the statement if he were to work out more and eat less he would lose weight.

Indeed, as with diet, it is not a lack of knowledge in most cases that causes sub-optimal investment decisions, rather it is a lack of discipline and an ability to simply execute what our rational mind knows is right but which our emotions will sabotage. Investors know rationally that they should buy low and sell high, but time and time again - whether it is a particular stock or the equities market in general or real estate or gold, people become interested in making an investment only after the prices have run up - once it has made the cover of Business Week. They make the purchase, then invariably the price begins to fall and fall and when the investor can't stand it anymore, he sells in frustration. Then, eventually prices rebound and the investor who has long forgotten about that investment has his interest piqued again once the surging prices are front headlines once again and only after he can't stand hearing about his neighbors making so much money on gold or whatever does he then jumps back in, and the cycle continues.

It is extraordinarily difficult to be buying something when it is out of favor. 1) You often just don't know about it. It is not making headlines. When the price of oil was $8 per barrel, no one was talking about it, but when it went over $60 per barrel, it was headline news. And of course, to state the basic, you can't invest in something you are not aware of. So, as a first step, in order to invest in something that is out of favor, you have to be actively looking for securities, markets, etc that are NOT making the headlines. 2) Emotionally, it is much much harder to put money into something that is falling, or has recently fallen, than something whose price has been marching steadily upward in recent history.

YET FORTUNES ARE MADE BY THOSE WHO MAKE CONTRARIAN MOVES. Instead, most people find themselves saying, "Ah, I can't believe I didn't see that as well - it was SO obvious that I should have bought MO back in 1999 when it was trading at 1/3 of what it was today and everyone thought the company was going to go down under the weight of litigation...."

But we are not mentally wired to do this. Which is strange because when it comes to purchasing other assets, like cars or shoes or what not, people are not MORE inclined to buy the asset when the price rises, rather they are more inclined to buy when the price goes down. Why? Because they have confidence that the great shoes from Nordstrom's that they had their eyes on are the same at $175 that they were at $250 the week before.

But when the price of a company drops from $28 per share to $22 per share, because few people know exactly WHAT they are buying, and because it is very difficult for them to think long-term, they are more apt to buy at $28 and sell at $22 then vice versa. Just look at the mutual fund dollar flows that demonstrate time and time again that the typical investor pours money into a given sector after it has already seen most of its gains and pulls money out after it has seen most of its losses.

It is a fatal investment flaw, one that keeps most people from making good returns, but one that the disciplined, properly wired investor can take advantage of over and over and over.

When You Have To Be Right...Right Now (The Lesson on the Amaranth Blow Up)
September 28, 2006

There is being wrong and then there is being WRONG. When you buy a high quality company - let's say Pfizer (PFE) that has a strong balance sheet, is profitable, has strong cash flow, pays out an ever increasing dividend, etc, there is some level of security that in the coming years the value of the stock you purchased will be higher than it is today. This is especially true if you bought the company at a reasonable price - e.g., at 15X earnings rather than at 40X earnings. Even if you overpaid for the stock, it is quite likely that over time you will earn money on your investment, especially if you reinvest dividends as you will then be buying more and more shares at lower prices if the stock drops in the near term. Sure, it might be painful buying PFE at 30 a year ago and seeing it go to the low 20s, but in the interim you have been paid those handsome dividends - payments that have actually increased every year for decades. So, sure, you might consider the initial investment decision wrong in the near term, but eventually you will be right (for any one company, of course, there is a chance for permanent loss of capital, but I am really speaking here of constructing a portfolio of 10 - 20 such companies that have the financial characteristics described above. In that case, the probability of total loss of capital is extremely low and the chance of gain is strong, again if the price paid was reasonable and the holding period is consistent with that of equity ownership - 3 years or more).

Let's contrast this with the 'investing' strategy of commodities traders. I realize it is more complex than I will describe here, but in essence these traders use whatever information they gather - weather reports, etc - and make directional bets on commodities prices. They either bet they will go up or go down. And they don't just bet their investor's money, they bet their investor's money plus money the banks lend them.  Namely, they are leveraged. So the margin of error is much thinner. If you go to Vegas with $100 and sustain 10% losses, you lose $10 and walk away with $90 - not a great outcome, but not financially devastating. Take that same $100 initial capital amount and leverage it 10 times (not an unusual leverage amount when it comes to future trading). Now a 10% adverse swing causes a TOTAL LOSS OF CAPITAL.

That is called being really WRONG.

You think this Amaranth debacle is a one-time thing, but it is not. It has happened before in different shades (anyone remember Nic Leeson?) and it will certainly happen again. The causes are virtually always the same - the 'investment' in financial instruments that have no inherent value in and of themselves (commodity futures versus the stocks of companies that themselves produce profits) via massive leverage. In the case of Amaranth, in order to make money on a futures contract that gains in value only if you bet on the right direction at the right time, you have to be really right...right now (or within some short time frame - before the futures contract expires which is usually within months or weeks). When investing in a portfolio of quality companies via its equity (stock), you just have to be mostly right eventually.

Sure, it is more exciting to hit it big in the near term, and maybe one can get lucky a few times in a row, but history has proven that those who play with the fire of leverage eventually get burned. I would rather be able to sleep well at night knowing the companies in which I am invested are consistently making money and that eventually, whether it is one month or one year or 5 years, the stock price will reflect the improved profitability - and in the mean time I have been paid dividends to reinvest or spend as I wish. Maybe this is less exciting, but I try to reserve my need for adrenaline for the gym or ocean or mountain or other appropriate venue - not my bank account.

Sorry, Your House Is Already On Fire
September 28, 2006

You see it happen all the time. A given company comes out with bad news, the stock collapses, THEN people rush to buy puts (the equivalent of insurance - to protect against a further slide in the stock price).

One of the most important lessons in money management, if not life, is to do things when you do not have to. Call a friend/associate just because - not when you need something from him/her. Buy fire insurance in the middle of the rainy season - when it costs less. Shop around for a new mortgage long before your ARM approaches its fix date.

Yet most people, especially when it comes to investing and protecting their hard earned money, are reactive in nature. They take action only once the bad thing they were hoping would not occur (or never even contemplating might occur), has already taken place.

Instead, if you own a stock that has gone up a lot in price, buy puts THEN. When you wait to buy fire insurance until after you spot the first flames, at a minimum it will cost you a whole lot more to buy that fire insurance, but more likely it will be too late and the thing you are trying to protect - namely your house - will soon be up in flames.

While I am in no way a big proponent of buying options - 99/100 I am the seller of options, the seller of fire insurance to those who just discovered their house is on fire and they are sans fire insurance, if you feel the need to provide short-term protection for an asset, buy the insurance from a position of strength - when your asset has good value and the insurance is cheap, not after the stock has unexpectedly tumbled.

Are You In Control?
September 11, 2006

I want you to do an exercise. No, not physical exercise - although it would be great if you did that regularly as well, but this is more of a mental exercise. The results of which can change your life dramatically for the better. Get a pen and piece of paper. Draw a small circle. Then, around that circle, draw a bigger circle. Finally, around the 2nd circle, draw a 3rd circle. Label each circle as follows: 1) inside the smallest circle write "control". In the 2nd circle write "influence". In the 3rd circle write "awareness". Label the drawing "Spheres of Control". Draw arrows coming out of each arrow heading to the outside of the page.

These 3 spheres represent the various levels of control you have over things in life. Every situation, every circumstance, falls somewhere in your sphere of control. Some things you have total control over, some things you can only influence but have no control over, some things you are only aware of but neither influence nor control, and some things you are not even aware of. Of course, a given circumstance or set of facts may cross over and transcend the various circles. The goal, of course, is to expand each of these circles over time - to engage in life such that we are aware of increasingly larger amounts of information, facts, feelings, etc.

BEING AWARE OF, BEING COMFORTABLE WITH, BEING ABLE TO DEAL WITH ON AN EMOTIONAL AND PRACTICAL LEVEL, THESE VARIOUS SPHERES IS LIKELY ONE OF THE BIGGEST DETERMINING FACTORS ON OUR SUCCESS AND HAPPINESS IN LIFE.

Time and time again, when you listen closely to successful and (presumably) happy people, you will hear them use language consistent with an acute awareness, intuitive or otherwise, of these various spheres.

"Doesn't it really upset you when the fans think you did not give 100% in a game?" Michael Jordan will be asked.

"I can not control what others think of me," he would reply. "I just focus on doing my best on the basketball court."

You hear this all the time from successful people. Conversely, you will hear from people who appear unhappy, unsatisfied and unsuccessful constant discourse about things over which they have no control. "I am so upset that it is going to rain this weekend. My whole weekend is ruined." Or, worse yet, you will hear them complaining about their jobs or bosses in a way that suggests they are helpless in areas over which they in reality do have some level of control if not influence.

Rather than focusing on things over which one has control, and maximizing these areas, people dedicate inordinate amount of time to discussing if not griping about things over which they have no control whatsoever.

The stock market is one such area where so much of people's attention is focused on things over which they have no control. If you think about it objectively, it is quite perverse. So much thought, so much time, so much communication, so much emotional energy, so much stress, so much prospective and retrospective analysis is dedicated to things over which people have no control, principally short-term movements in the broader market. Even if you dedicated your entire life, even if you were Warren Buffett, there is not one single thing you could do to influence not to mention control the movement of the US stock market. Nothing.

Yet people behave as though the stock market is their little domain - a battle which they either win or lose each day, a competitor who is out to get them or an ally who is on their side (depending on how the investor did that day).

IF THE AVERAGE INVESTOR DEDICATED EVEN HALF OF THE TIME HE OR SHE SPENDS (READ: WASTES) ON MATTERS MARKET RELATED OVER WHICH THEY HAVE NO CONTROL - READING ABOUT HOW THE MARKET DID THE PREVIOUS DAY OR PREDICTING HOW IT WILL DO IN THE NEAR TERM - AND DEDICATED THAT SAME TIME ON WHICH THEY HAD CONTROL - READING REPORTS ABOUT COMPANIES, NOT TAKING ACTION WHEN NO ACTION IS WARRANTED, etc. Instead, most time is spent reading absolutely useless commentary about what happened in the market the day before - as though 1) the so-called analyst really knows what drove the market that day given the virtually infinite # of variables which drive the stock market in the short-term, and more importantly, 2) it really matters why the DOW went up or down on any given day.

How often do you read well thought out analysis in the mass media of where the market is going to be in 3 - 5 years? Virtually never, why? Because 3 - 5 years does not sell advertising.

Here is an actual quote from the top analyst at a major firm, "There's been enough negative sentiment for days, so any sellers have probably sold. Whether there is another bounce to move us higher from here is unclear." Translation, the definition of a seller is someone who has sold; no one can predict the future.

Another classic commentary by a TV personality I heard recently was, "There is a big debate about where this market is going. I think we'll have to wait until the market takes its own pulse before we get clarity." Excuse my French, but no merde!!! I mean, this guy gets paid to say in obtuse language that no one knows where the market will be in the near term but once it has gone wherever it is going to go, then we'll know where it went!

Yet otherwise smart people get paid a lot of money to make statements like that every day, and otherwise smart people spend time reading and listening to comments like that.

Whenever you are tempted to dedicate time to something relating to the market, break out your Spheres of Control diagram. If the subject matter you are contemplating spending precious time does not fall at least somewhere in the "Influence" or "Control" circles, take a pass and go to something productive and/or enjoyable.

Flatliners (Today Is A Good Day To Die)
September 08, 2006

It has taken me over 2 months to write this post - not because the topic is particularly complex. In fact, just the opposite - this is one of the most basic, fundamental investment issues one can address. Simply put, I thought it best to let some time lapse between the time I heard the conversation I describe below and my providing commentary. Even though much time has now passed, my reaction is still the same; disbelief and sadness about the money management profession in general.

Some brief background. I work in the heart of the Village of La Jolla, CA. There are a dozen or more brokerage firms within a stone's throw of my office. All the big names. So suffice it to say that if you pass by some guy in his early 30's wearing a tie he is probably a Financial Advisor or whatever title they give to these types these days (Salesman is probably most appropriate, although not great for marketing). When not at cocktail parties trying to gather assets - or maybe because of all those fattening appetizers consumed at these social events - these sales guys spend a fair amount of time at the gym which happens to also be less than a block from my office. I will readily admit I spend time there as well - some of my best idea generation is done while 'in the zone' on a treadmill or better yet running along the coast.

These broker guys tend to congregate at the gym, not surprisingly, around 1:05 pm CA time, just after the market closes, which is somewhat ironic given that their jobs actually have very little or nothing to do with managing money or the markets in general. So why they feel the need to - or are required to - be in the office until the market closes is beyond me. But in any case, I would never even need to open up a newspaper or internet browser to know how the market performed on any given day. All I need to do is read their body language and listen to their chatter and I know within a few points how the market did that day (why they are so interested in not to mention driven by day to day movements in the DOW is also a mystery - but one I think I solved by listening to the following exchange).

I want to preface this by saying that the following exchange is rather typical of what I hear weekly. You may not want to hear this - you may very well prefer not to know how the proverbial sausage is made, but I find this stuff very interesting. So here goes.

Broker/Financial Advisor/Sales guy #1: "Do you know what the market did today? I was on the golf course all morning."

Broker/Financial Advisor/Sales guy #2: "Yah, it went through the roof - DOW was up like 200 points."

Guy #1: "Awesome, THIS IS A GREAT DAY TO CALL MY CLIENTS."

Guy #2: "Yeah, totally agreed, I'll be making calls this afternoon after our workout for sure."

The market is up strong, and it is a good day to call clients?!? MMMMM, let me guess, they will be phoning their clients and saying something along the lines of the following, "Hello Jim. How's Nancy? The kids? Great. Hey, not sure if you saw it today, but the market really rallied hard today. As you know, we think that it is important to buy low and sell high. Consistent with the time I phoned you when the market was collapsing and advised you to buy more, now that the market has gone up strong, I would recommend that you sell some of the stocks you hold with us. Put them into cash. Maybe even withdraw some of the funds and invest in art or some other asset class that has gone down lately. I'd be happy to execute your sell orders."

NOT!!!

I would bet my life - well, at least one of them - that the calls these guys were about to make were to let their clients know that the market is up and thus it is a good time to buy - the market is doing well (read: the market has gone up recently), thus you should buy some shares.

Imagine any other industry where this perverse, do-the-opposite-of-what-you-should-do behavior took place. Imagine your Personal Shopper at Nordstrom's (JWN) calling you up and saying, "Hey, got some great news. Those shoes you have had your eye on the last few months, well I am pleased to let you know we just marked them UP 30%, so now would be a good time to pick them up."

When it comes to owning quality companies for the long-term (aka investing), why people act with emotions contrary to their well being I will never understand. It just comes down to how most people are wired. As the stock market goes down, people get more and more nervous, more and more upset, until they can't stand it any longer and they sell off their holdings. Then, after the market has gotten some 'clarity/stability/visibility' - or whatever stupid word you want to use for 'gone up' - then people feel comfortable putting their money back into stocks. I realize it is very difficult emotionally to be hanging on, let alone BUYING stocks when the market is dropping like a dumbbell after a tough set of curls. But this is when you have to have strength of mind, conviction, a long-term outlook, a stomach of steel.

A few things are certain. 1) There will NEVER be clarity when it comes to the stock market. Actually, there will be clarity, it is called what happened yesterday (which is why every day people get paid to tell you why the market went up or down the day before). 2) There always have been and will forever more be unforeseen events that will impact the world, the economy, the stock market - welcome to life. 3) At least for our lifetimes - as in the next 50 years - the US economy and stock market will survive any and all challenges it faces. There has been no period in history when the US has been free of major negative events - no year, let alone decade, without wars or political changes or natural disasters or recessions or whatever it is that scares people out of the market in the short-term. Yet the stock market has survived all of these events.

The next time your broker calls you up telling you the good news that the market is strong and thus you should invest more, ask him to phone you back when the market is on sale, when the point size on the New York Times is at its largest, when there is blood in the streets. Investing any incremental dollars then is how you make the real bucks.

Pop! (On Being There When a Stock Moves Big)
September 06, 2006

This happens all the time. A given stock trades within a range for weeks, months, or even years. You watch it regularly and it seems to go nowhere (if it is a quality, dividend paying company then at least you are getting paid dividends which you are either investing elsewhere, spending or reinvesting to purchase more shares in the same company). Then, 'one day' you wake up after having not monitored the stock for a while and it is up 25%, 30% or more.

I am not talking little companies with typically volatile stock prices. I am talking about the stock prices of some of the biggest companies in the world - Walgreen's (WAG), Microsoft (MSFT) and others. What seems like overnight, the stock can go from 40 to 50 as WAG's stock price did recently after trading in a tight range for quite a while. What caused this huge surge - what can amount to several years' worth of gains in a matter of months or weeks?

IN MOST CASES ABSOLUTELY NOTHING.

Look at WAG. Nothing is fundamentally different about this company today versus a couple months ago, yet the stock has gained nearly 30% in a couple months, billions of dollars of market cap value. This is not some start up - to be sure, WAG has been around and at the top of its game for decades. It has consistently paid out dividends since 1933. This is no high flyer, yet the stock price popped dramatically in a short-period. If you looked at the chart you would think they made some major announcement in the last couple months. Yet all they did is what they have done month in and month out for years - provide good products and services to their customers in a way that allows them to consistently increase revenue, earnings and dividend payments.

The point here is that you need to be there when a stock moves. It can happen any time for any reason - or no reason at all. You have to be patient. Getting paid a nice dividend certainly helps with patience - which is one of many reasons why I like dividend paying stocks (see an article I wrote entitled "Why I Love Dividends"). On the other side of the coin, stocks of very large, high quality companies can move down quickly and dramatically as well, completely independent of the overall market movement. Witness MSFT, one of the largest companies in the world by market cap, which saw its stock drop nearly 20% in a matter of weeks earlier this year (it has since gone back up nearly 20% as quickly as it went down). While for another day entirely, it is important to know when to take some profits after a big run up - even if a high quality company (remember: a great company can be a bad stock and visa versa) - or at minimum hedge the position. We'll get more into this later.

Shark Insurance - A Lesson In Options and Investor Irrationality
September 04, 2006

The easiest way to think about options is to relate it to insurance, a concept we can all understand. When you buy fire insurance, for example, you are paying money (the insurance premium) in order to protect against the occurrence of an event (a fire). If the event does not occur, you lose your entire premium which is gladly kept by the insurance company. If the event occurs, then you receive whatever your contract calls for - e.g. the replacement cost of your house, etc.

Stock options work the same way. Let's say you are planning to buy a house sometime in the next year. You will need $25k as a down payment on the house. You own 1,000 shares of Pfizer (PFE) which currently trades for about $27 per share. For tax or other reasons - perhaps you think PFE will go up in the coming months - you do not want to sell your shares today. However, this is your sole source for the down payment on that home, so you want to be sure that you have at least that $25k when it comes time to buy the house. How do you ensure if not insure this outcome? Well, there is stock insurance you can buy; in this case you can buy a PUT option. A put option gives you the right, but not the obligation, to sell a stock at a given price for a given period (a CALL option gives you the right to buy a stock at a given price for a certain time period).

Just as with fire or any other kind of insurance, options have a certain cost associated with them (the premium), and cover a certain period of time (most insurance is for 6 months or 12 months, for example - similarly, you can buy stock insurance for 1 month or 3 months or 6 months).

So back to our soon-to-be home owner, in this case you might buy PFE insurance to be sure you will receive at least $25 per share for your shares. In other words, you would buy - pay a premium for - a put option which would give you the right, no matter what happens with PFE's stock price - to sell your shares at $25 per share even if the stock trades below $25 per share. You may buy the insurance for 1 month or 6 months or longer. As with regular insurance, all things being equal, the longer the period being insured, the higher the premium paid for the insurance. In this case, by paying perhaps $500 ($0.50 per contract for 10 contracts each covering 100 shares, or 1,000 shares total at 50 cents each), your PFE investor could be certain to have at least $25,000 of stock when it came time make your down payment.

Other than for the purposes of protecting against specific events like the one described above, buying options is generally a loser's game. Certainly as a means for speculating on big stock price movements, the purchase of options is a fast way to losing money. Just as with the insurance you buy for your home or car, most stock insurance policies (AKA options contracts) end up worthless - the entire premium being collected by 'the house' and the policy never collected upon.

That is why for over a decade I have been the seller of insurance; I have been the house. I gladly sell stock insurance to others. But I am very selective about when I sell the insurance. When am I most likely to sell insurance? When everyone is scared of the event they are trying to protect against and thus premiums are high. I do not know if it actually exists, but if there were a market for shark insurance, I would be the guy down at the beach selling shark insurance when Time Magazine had its cover story about shark attacks in the US.

Here is how it works. There are fewer than 100 deaths by way of shark attack in the US each year. The annual numbers vary of course, but the number is always exceedingly small. Usually the attacks are spread out and random, but every couple of summers there will be 3 attacks in the same week, at least one of which will be in some fairly prominent place, and many of the major periodicals will run headline stories about this great prominence of shark attacks. Never mind that statistically speaking the number of shark attacks has not increased - and it is still exceedingly unlikely that an ocean-goer will be attacked and killed by a shark - but these headlines - AND HERE IS THE PUNCH LINE OF ALL OF THIS - actually make otherwise intelligent and rational people choose to not go into the ocean. I have witnessed it firsthand here in La Jolla where there is a big contingency of open water swimmers. It is like clockwork. Sometime around July or August, there is a 'string' of shark attacks in Florida and Hawaii, 3 or 4 in a short period. It makes the papers, one of the victims is some pretty surfer who makes the talk show circuit, and swimmers here in California say that they no longer want to go swimming in the ocean.

THAT IS THE TIME TO SELL SHARK INSURANCE.

When everyone is scared, when people are willing to bid up the price of insurance to unreasonable levels for what is still a highly unlikely event - that is when you want to sell as much of the stuff as you can.

While not as extreme nor dramatic, there are opportunities every day to sell 'shark insurance' to so called investors in the stock market. An otherwise great company has some short-term, non-fundamental issue with it, AFTER the stock has already gone down people rush in to buy insurance (puts), thus bidding up the price of this insurance dramatically. When there is proverbial (and perhaps literal if I can find a way to sell shark insurance) blood in the stock market waters, that is when you will find me selling away. Fortunately, the stock market is a large and diverse body of water, thus there are many many opportunities to take advantage of people's over reaction (based on emotional responses) to events - and happily accept the premiums they are willing to pay for insurance that will likely end up worthless for them and highly profitable for me.

The Lesson on Options Back Dating
August 15, 2006

Sure, sure, it is a sad commentary on Corporate America that so many executives at companies are being found out to have back dated options grants to themselves and others. But the fact that there is still malfeasance in the work place is not the big story for investors looking to improve their returns. The lesson here, of course, is the most important aspect of investing, namely to buy low!!! This may seem obvious, but how many times have you been able to muster up the fortitude to buy buy buy as the market and/or otherwise high quality stock is heading lower.  Most weekend warrior investors know in theory to buy low and sell high, but when times get tough, just when such opportunities best present themselves (namely, the market is getting crushed), just when you need to have the biggest cajones on the block, their emotions take over and they say to themselves, "I can't stand it anymore. I'm going to sell now before it gets any worse and wait until there is more clarity in the market before I get back in."  Of course the translation of this is, 'even though the market is going down and by mathematical definition I am better off buying now rather than selling, I will sell now and wait for the market to go higher before I buy again because I am not emotionally wired to do it any other way.' Learn the right lesson here - he who pays the lowest price wins.

Taking a Flyer - Lessons on Emotions and Investing
August 10, 2006

I sailed for about 20 years - even won a couple world and countless (at least I stopped counting) national championships. While I am certainly biased - I truly believe my competitive sailing during my formative years (I started sailing about the same time I learned to walk) helped to shape me as an investor. As it turns out, qualities that make a good sailor are also characteristics shared by excellent money managers. The ability to look into the horizon (literally and figuratively), navigate the short-term waves while focusing on the bigger and longer-term picture, dealing with harsh realities and taking appropriate actions accordingly - these are all attributes that make up world champion sailors and investors.

One of the most profound investment lessons I learned from sailing relates to what is called 'taking a flyer.' At its very core, taking a flyer in sailing is sticking with a certain course even though all the wind, current and other trends are working against you. If you think of a sailing 'field' like that of a baseball diamond and your goal is to get from home plate to 2nd base and back, you can travel anywhere within the parameters of home plate, first base, 3rd base and 2nd base. Only in sailing, unlike when you run, you can't aim directly at 2nd base and simply run there. Rather, you have to criss-cross back and forth - called tacking against the wind, taking 45 degree angles to your destination. Thus, some sailors stay close to the middle of the course, tacking frequently and taking a fairly conservative path. Others go way out to the right side of the course (in this analogy, first base), and then tack back towards 2nd base. Others will go way out to 3rd base before heading back to their destination. When someone goes to an extreme - all the way to first base or 3rd base before shifting course and heading to 2nd base, then they are taking a flyer. Further, when they do it not because they think it is the best course of action, but rather because the conditions 'force' them to do so, then they are REALLY taking a flyer. It gets very complicated, and I am simplifying here, but think of the conservative course to getting from home plate to 2nd base staying pretty close to the line that connects them, criss-crossing out from it and back to it as you tack your way up the course. Taking a flyer is when you go way off to the sides of the course - you may end up a big winner, or you may end up at the back of the pack.

What causes people to tack flyers and how can we learn from that to make ourselves better investors? Sailors typically take flyers when conditions on their side of the course - closer to 1st or 3rd base - begin to deteriorate and they are willing to essentially double their bets that eventually their 'chosen' side of the course will improve in conditions and thus save them. But they take it to the extreme. Rather than looking - I mean physically looking at the entire course and cutting their losses early, heading back to the middle of the course where conditions are better, most sailors will blindly stay the course. They won't even look - they don't even want to know - what is going on elsewhere on the course. They are too emotionally committed to their choice and they just won't even consider an alternative.

Think about how many times, when the market is falling day after day, week after week, you hear your friends say that they "can't even open up their brokerage statements and look at how their chosen mutual funds or stocks are doing." I am sure YOU have never done that, I am of course talking about the other guy who was not born with Vulcan ears and a stomach of steal (along with other body parts). The investor who, for months on end, won't even look at his brokerage statement because he would rather not even know (not because he is investing for the long term - let's not mix up issues here - if the same investors stocks are doing well, you can be sure he would be reading the Wall Street Journal every day to see how rich he is getting) is no different than the sailor taking the flyer. Fortunately, I learned this painful and costly lesson early in my sailing career.

When you compete in a major sailing championship, you typically sail about 8 races; think of them as rounds in golf. Your scores are all added up, and as with golf, the lowest score wins. You could not win a single race, but if your total score across all 8 races is lowest, you win. Some sailors have finishes that are all over the map - they'll win a race, then get a 25th place, then a 3rd, then a 19th, etc. Other sailors are very consistent - they'll get a 5th, then a 3rd, then a 6th, then a 2nd, etc. These are the sailors who win world championships and these are the investors who get good returns. How do these sailors avoid the double digit scores that invariably drop them down the overall rankings? They discipline themselves to not tack any flyers - they open their proverbial brokerage statements and they analyze the information with raw, cold, emotionless calculus.

I remember when I first started competing in major championships. I was nervous as hell. I was sailing against a hundred of some of the best sailors in the world - guys I had read about who had represented the States at World, Pan Am and Olympic competitions. When I would get on the sides of the race course, when the conditions were working against me, I didn't want to know what was happening elsewhere. One minute I would be next to some top competitor, things would be looking bleak, and 5 minutes later I would be on my own, further out on a limb that was getting weaker with each minute I kept on this path. My wiser competitor would have assessed the situation and tacked back towards the center of the course, cutting off his losses. He would end up 5th or 6th in the race and I would end up 29th for having thrown good money after bad. Once in a while my flyer would pay off and I would win the race big, but my inconsistent scores would invariably lead to an out of the top 10 overall finish. I would analyze the scores of the top 5 and noticed tremendous consistency. THEY MADE FEWER MISTAKES THEN I DID, THEY CUT THEIR LOSSES AND WENT FOR SINGLES AND DOUBLES RATHER THAN HOME RUNS AND STRIKE OUTS.

I soon changed my ways, I stopped taking flyers - more importantly, before I even got into such a position, I opened my eyes and assessed the conditions with brutal objectivity. How am I doing? What are the conditions like where I am positioned? Are they likely to improve any time soon? This was the first step towards my success.

Most people invest with emotion. If they buy a stock and it starts working against them because there is something fundamentally wrong with the picture (let me be perfectly clear here, I am not referring to the normal short-term ups and downs of a market or stock - to be sure, these are opportunities to buy more of a good thing, not to bail out. I am talking about when conditions have fundamentally deteriorated with an investment and are unlikely to get better within a reasonable time frame), he will often feel a need to 'beat' the stock, to hold onto it until it at least gets back to his purchase price. Worse yet, he will stop even looking at fundamental news as the price drops week after week, month after month. He doesn't even want to know.

The big lesson here is that you need to invest, to compete in the financial marketplace, sans emotion. You need to be able and willing to take in any and all information - no matter how bad - and take decisive action accordingly. Most people are simply not 'wired' to behave this way. They take the opposite course of action than what objective, rational analysis would indicate they should. They watch (or more likely don't watch) a stock drop and drop until they can't take it anymore, then they sell. A separate subject entirely, but this timing usually coincides with a series of Wall Street analyst downgrades and stock price target reductions (how convenient for them to change their recommendation to a sell from a buy AFTER the stock has dropped dramatically and the news causing the drop already factored into the stock price).

If you do not have the ability to approach investing with a Vulcan-esque mindset, find someone you trust who does have such an approach and let him or her ensure that you do not take flyers your pocket book will soon regret.

Dog Days
August 07, 2006

There is an article on today's TheStreet.com about mutual funds that use the Dogs of The Dow investment approach. While more a marketing ploy than an investment strategy per se, this investment methodology of buying the 10 highest yielding Dow components each year has produced some interesting and promising relative performance figures in years past.

Unfortunately, the money manager (who will remain nameless, at least from me) ruined it for me when he was quoted at the end of the article as saying, "You are not going to get the absolute highest return with these funds, but our philosophy on this is that it's not what you make on the upside, but what you don't lose on the downside."

I'm sorry, but he lost me at "it's not what you make on the upside." Unfortunately there is a deep seeded mind set in the mutual fund world about asset gathering (as in gather as many as possible) and relative performance (as in, as long as we lost less than the index, then we are ok). To me the appropriate mind set is like those great NYC news channels - All Profits, All The Time.

Counting Cards
July 04, 2006

There have been several excellent books written lately regarding people or groups who have developed card counting systems in black jack allowing them to 'beat the house.' Bringing Down The House and Fortune's Formula are 2 such books that deal with the notion of card counting systems that facilitate the likelihood of the player receiving a favorable card in the next hand. The simple version is that the player counts the number of face (favorable for the player) cards that have been dealt thus far. The fewer the number of face cards dealt thus far, the more likely that a face card will be dealt on the next hand, and thus the higher the 'count' is. The higher the 'count,' the more the player should bet on the next hand, the lower the 'count,' the less he or she should bet. By placing large bets when the 'count' is favorable and smaller bets when the 'count' is unfavorable, the player can maximize his returns.

Few people know it, but there is actually an automatic 'count' when it comes to making bets (read: investments - I actually find it amusing if not down right misleading when people refer to the stock market as a big casino where people gamble. Sure, some people - in fact many people - may approach the stock market as a casino, but its purpose is to give people the opportunity to own pieces of publicly traded companies with the goal of receiving sufficient returns on their investments over time - not to gamble away hard earned money. Save that for Vegas) in the stock market. What is this count? It is called the Price Earnings multiple of the market. Here's how it works: The lower the 'count,' the more likely an investor will have a winning hand over time (i.e. make money). The higher the 'count' (the P/E ratio) of the market when an investor puts money into, for example, an S&P 500 fund, the less likely the investor will make money over time.

When the 'count' (the P/E ratio) for the S&P 500 was over 40 back in 2000, that was the absolute worst time to make an investment. And indeed, over 6 years later, an investor in the S&P 500 would still not have made any money on his investment. Compare this with time periods when the 'count' for the S&P 500 was very low - let's say when it was below 10. Look at the returns provided by the market over the subsequent period and you will find that they were favorable.

It takes mental discipline and strength to place your investment 'bets' when the market is going down and down, but it is when the market is down, when the P/E count is low, that you are most likely to make money in the following 1, 3, 5, 10 years.

Stock price vs. valuation
June 06, 2006

Last night at dinner I overhead 2 guys talking about stocks. Which would you rather own, a stock trading for $40 or a stock trading for $300? Of course the one trading for $40! exclaimed the first guy. I totally agree, said the second. It is much easier to sell to my clients a stock that is trading at a lower price than one that is trading for a higher price, he continued. Now, if this weren't a fine restaurant and if these two portly gentlemen were not clearly already full of themselves, I would have gone over to them and fed them a piece of my mind. Do not be sucked into that fallacy, loyal readers. The price of a stock in and of itself is meaningless. It tells you nothing about how much you are paying for the company of which you are buying a piece. Yet people repeatedly buy stocks of companies that are trading for under $10 because they associate a low stock price with a cheap stock and a high stock price with an expensive stock price. It is like someone saying to you, "I'll sell you water for $5." Is that a good buy or a bad buy? Well, if they are proposing to sell you a shot glass full of rancid water, it is a bad buy, but if they are actually offering you 10 gallons of Perrier's finest, then buy that water all day long. It is only when you know what you are buying and at what valuation that you can make a good investment decision. Whenever you hear someone talk of stocks that are cheap because their stocks prices are low, run the other way. They are probably more interested in what my two dinner friends were most focused on, selling someone something that appears cheap on the surface but which may end up being an expensive investment lesson.

Investing For Income: Yield Before Reaching For Yield
November 30, 1999

With interest rates at historical lows (the 10 year Treasury yielding a paltry 3.7%), it%u2019s natural for investors to search for higher yields. Dividends are the typical place for investors to begin their quest. But are all dividends the same? Are all dividends inherently %u201Cgood?%u201D Most people think that dividends are in and of themselves good things. This is a myth. There is good yield and there is bad yield. It is vitally important to know the difference at all times, but even more so in market environ­ments such as today where many product makers are pushing and investors reaching long and far for high yield. It%u2019s not the fact that a company does pay a dividend which is meaningful; it%u2019s the fact that it can. I%u2019ll explain.

You%u2019ve no doubt heard the expression %u201CIf it sounds too good to be true, it probably is.%u201D Well in the world of investing, if it sounds too good to be true, it definitely is. Often periodicals such as the Wall Street Journal (WSJ) or Barron%u2019s will print a table of high-yielding securities and you will occasionally find listed compa­nies and funds paying out 10% or more. It is very important to dig deeper to determine the source of this yield. There are two major red flags that you should look for.

The first is when a company earnings do not adequately cover its distributions. To assess this, look at the company%u2019s payout ratio which is the dividend per share dividend by a company%u2019s earnings per share.  This important statistic readily available on most financial research sites indicates how likely the company is to continue to pay, or to increase, its dividend over time. A payout ratio of less than 50% is preferable. If a company%u2019s pay­out ratio starts heading north of 70% due to a decline in earnings (by definition if earnings are shrinking and dividends are constant, the payout ratio will increase), this is a sign that the company may be getting ready to cut its dividend. And if its payout ratio is over 100% for several quarters, proceed with extreme caution! This scenario is not sustainable. A company cannot forever finance a dividend payment if it is not making more money than it is paying out %u2013 plain and simple. Stay away from these companies as the last thing you want to do is buy into a company just before it slashes its dividend.

Another scenario for a potentially suspect high-yielding security is a fund that makes a so-called %u201Ccontrolled payout.%u201D An example would be a fund trading at $10 per share fixing its dividend payout at $1.30 per share so that the fund yields 13%. In most cases, however, the fund or the underlying securities it holds, are not earning enough to cover the dividend. So how is the fund paying a dividend, you ask? The fund is simply return­ing principal slowly to shareholders over time! As an example, let%u2019s say a promoter advertised an investment that guaranteed a 20% annual dividend stream. Sounds too good to be true, right? Definitely. You give him $100 and for five consecutive years he hands you back $20. If he is not earning more on the original money than he is returning to you in the form of a %u201Cdividend%u201D then eventually the money runs out and the game is over. The 20% yield provided a total return on invest­ment (ROI) of precisely 0%. This is the bad kind of yield.

Buyer beware. The mere fact that a company or fund pays a dividend is not praiseworthy. It%u2019s important to know how a company is paying its dividend. Look for companies that are financing their dividend through continued earnings growth and solid financials, and steer clear of those companies with abnormally large payout ratios. Dividends can be a great source of income in this low interest rate environment. Be smart and those checks will keep coming.