What’s the Right Time to Invest?

Imagine for a moment that you’ve just received a year-end bonus or income tax refund. You’re not sure whether to invest now or wait. After all, the market recently hit an all-time high. Now imagine that you face this kind of decision every year—sometimes in up markets, other times in downdrafts. What’s a good rule of thumb to follow?

Our research definitively shows that the cost of waiting for the perfect moment to invest far exceeds the benefit of even perfect timing. And because timing the market perfectly is, well, about as likely as winning the lottery, the best strategy for most of us mere mortal investors is not to try to market-time at all. Instead, make a plan and invest as soon as possible.

Five investing styles
But don’t take my word for it. Consider our research on the performance of five long-term investors following very different investment strategies. Each received $2,000 at the beginning of every year for the 20 years ending in 2006 and left the money in the market once invested. Check out how they fared:

1. Peter Perfect was a perfect market timer. He had incredible skill (or luck) and was able to place his $2,000 into the market every year at the lowest monthly close.
   
   For example, Peter had $2,000 to invest at the start of 1987. Rather than putting it immediately into the market, he waited and invested after month-end November 1987—that year’s monthly low point for the S&P 500® Index (a proxy for the stock market).
   
   At the beginning of 1988, Peter received another $2,000. He waited and invested the money after January 1988, the monthly low point for the market for that year. He continued to time his investments perfectly every year through 2006.
   
2. Ashley Action took a simple, consistent approach: Each year, once she received her cash, she invested her $2,000 in the market at the earliest possible moment.
   
3. Matthew Monthly divided his annual $2,000 allotment into 12 equal portions, which he invested at the beginning of each month. This strategy is known as dollar cost averaging. You may already be doing this through regular investments in your 401(k) plan or an Automatic Investment Plan (AIP), which allows you to deposit money into mutual funds on a set timetable.
   
4. Rosie Rotten had incredibly poor timing—or perhaps terribly bad luck: She invested her $2,000 each year at the market’s peak, in stark defiance of the investing maxim to “buy low.” For example, Rosie invested her first $2,000 at the end of August 1987—that year’s monthly high point for the S&P 500. She received her second $2,000 at the beginning of 1988 and invested it at the end of December 1988, the peak for that year.
   
5. Larry Linger left his money in cash (using Treasury bills as a proxy) every year and never got around to investing in stocks at all. He was always convinced that lower stock prices—and, therefore, better opportunities to invest his money—were just around the corner.

The results are in: Investing immediately paid off

For the winner, look at the graph, which shows how much wealth each of the five investors had accumulated at the end of the 20 years (1987–2006). Actually, we looked at 62 separate 20-year periods in all, finding similar results across almost all time periods.

Naturally, the best results belonged to Peter, who waited and timed his annual investment perfectly: He accumulated $146,761. But the study’s most stunning findings concern Ashley, who came in second with $141,856—only $4,905 less than Peter Perfect. This relatively small difference is especially surprising considering that Ashley had simply put her money to work as soon as she received it each year—without any pretense of market timing.

Matthew’s dollar-cost-averaging approach delivered solid returns, earning him third place with $134,625 at the end of 20 years. That didn’t surprise us. After all, in a typical 12-month period, the market has risen 75% of the time.2 So Ashley’s pattern of investing first thing did, over time, yield lower buying prices than Matthew’s monthly discipline and, thus, higher ending wealth.

Rosie Rotten’s results also proved surprisingly encouraging. While her poor timing left her about $18,262 short of Ashley (who didn’t try timing investments), Rosie still earned significantly more than double what she would have if she hadn’t invested in the market at all.

And what of Larry Linger, the procrastinator who kept waiting for a better opportunity to buy stocks—and then didn’t buy at all? He fared worst of all, with only $61,622. His biggest worry had been investing at a market high. Ironically, had he done that each year, he would have still earned more than twice as much over the 20-year period.

[see also DCA or lump sum?]

The Rich Get Richer

In 1976, Richard Freeman wrote a book called “The Overeducated American.” So many Americans had been getting college degrees that the relative wages of white-collar professionals had started to fall. It no longer paid to go to college and, for most of the ’70s, fewer people did. Just so, incomes of the educated began to rise again.

People like Freeman, a labor-market economist, waited for the cycle to turn. They expected that with white-collar types riding high again, more people would stay in school, and incomes at the top would level off once more.

But they never did. Instead, the rich kept getting richer. Across the spectrum of American society, the higher your income category, the more your income continued to grow. And for a quarter-century, albeit with zigs and zags along the way, that rich-get-richer pattern has held. The figures are striking. In 2004, according to the Congressional Budget Office’s latest official analysis, households in the lowest quintile of the country were making only 2 percent more (adjusted for inflation) than they were in 1979. Those in the next quintile managed only an 11 percent rise. And the middle group was up 15 percent. Do you sense a pattern? The income of families in the fourth quintile — upper-middle-class folks with an average yearly income of $82,000 — rose by 23 percent. Only when you get to the top quintile were the gains truly big — 63 percent.

Some redistribution is clearly good for the entire economy — providing public schooling, for instance, so that everyone gets an education. But public education aside, the United States has a pretty high tolerance for inequality. Americans care about “fairness” more than about “equalness.” We boo athletes suspected of taking steroids, but we admire billionaires.

The extreme divergence of American incomes we see today, however, is actually rather new. For most of the 20th century, America was becoming more egalitarian. The United States seemingly conformed to the standard theory of development, which held that industrialization produces fat cats at first (as factory owners rake it in) and then a more general prosperity as workers become more productive. It’s a feel-good theory that says, “Don’t worry if the rich are prospering; the poor will have their day.”

[via brknews, excerpted]

Traits of Extremely Wealthy People

Have you ever wondered why some people are magnets for wealth and most others just flounder by the wayside? I bet you want to know the secret traits these wealthy people possess.

Steve Jobs got rich creating and selling computers. J.K. Rowling is wealthy because she switched gears and started writing books. Jeff Bezos got rich selling books. Oprah Winfrey became wealthy connecting to people on TV. Wayne Huizenga became rich by hauling trash. Bill Gates started coding software and is a multi-billionaire.

Their businesses have nothing in common. Just look at your community. People are becoming wealthy in a variety of businesses.

What do Oprah, Jeff, Steve, Bill, Wayne, and J.K. have in common?

1. They have Persistence. Overcoming obstacles and moving on is a given.

2. They invest in other businesses and own their own companies. Start your own business.

3. They are creative. Innovation is imperative to becoming wealthy. Constantly observe and generate new ideas.

4. They are doing what comes most naturally to them. If you love what you do, you forget you are working. Imagine that.

5. They give their wealth back. Sharing wealth and knowledge benefits you and others. The more you give, the more you receive.

6. They are constantly learning. Enormously wealthy people understand that your mind is your greatest asset. They constantly read books, listen to wealth-building CDs and attend seminars.

7. They hire out the work. Rich people know they can’t do everything themselves. Bill Gates hires programmers to write software. Doing everything yourself will limit your financial growth opportunities.

8. They are grateful. With gratitude you can’t go wrong. In fact, gratitude allows your mind to focus on creating products that help and uplift other people’s lives.

Notice that all these traits use the power of the mind. Nothing compares to getting your mind to work for you. It’s a tool most people don’t use. Here is your opportunity to take a quantum leap into wealth consciousness.

“It is mathematically certain that you can succeed if you will find out the cause of success, and develop it to sufficient strength, and apply it properly to your work." – Wallace D. Wattles

blue chips not equal to diamonds

"Blue chip" stocks -- the stocks of large, established companies -- were long touted as great investments for "widows and orphans," who weren't expected to manage their money actively. And historically speaking, some blue chips have been great investments. Companies like General Electric (NYSE: GE) and Johnson & Johnson (NYSE: JNJ) have been rewarding shareholders with solid growth and strong dividends for decades. But as hedge fund manager Mohnish Pabrai points out in his recent book Mosaic: Perspectives on Investing, even blue chips don't last forever.

The average Fortune 500 company has a life expectancy of 40-50 years, and given that it can take 25 years or more for a new company to grow to Fortune 500 size, many so-called blue chips cease to exist less than 20 years after they make the list! Size is no guarantee of longevity -- just ask all those Enron shareholders. And even among more established firms, times and businesses change. I'm sure that most of the investors who bought Ford (NYSE: F) 15 or 20 years ago didn't foresee a time when the stock would be trading in single digits and the company desperately clinging to life.

Surprise Anticipation

[6/29/07] Schwab research has found that companies that subsequently perform better or worse than current consensus expectations have some distinct traits. As the "Surprise Anticipation Matrix" graphic below illustrates, stocks with low, but rising expectation levels tend to report positive surprises. To identify these opportunities, we look for stocks with traits such as:

• Low price multiples (e.g., low price-earnings ratios and low price-to-book ratios).
  
• Management that is returning cash to investors (e.g. dividends, share buybacks, debt repayment).
  
• Buying by corporate insiders and short sellers (i.e., "smart money" investors).
  Growing free cash flow (definition: cash from operations less capital expenditures and dividends).
  
• Sales growth exceeding asset growth (i.e., improving operating efficiency).
  
• Recent reported earnings above consensus forecasts.
  
• Recent positive analyst earnings-per-share (EPS) forecast revisions.
  
• Recent stock price outperformance vs. overall market.

Conversely, stocks with high but falling expectations tend to report negative surprises. These are often firms with great reputations stemming from strong past performance or firms perceived to have good future growth prospects, but these alluring attributes typically cause investors to bid up stock valuations to levels that leave no room for disappointment. To identify stocks likely to report negative surprises, we just flip the parameters of the criteria listed above.

[5/30/07] Professional stock analysts focus much of their time attempting to forecast companies' future earnings growth. Clearly, perfect foresight of future earnings would be valuable information, but that brings us to our third research principle: The fact that a correct forecast could have value is not sufficient reason to attempt such a forecast—one must also be able to make correct forecasts at a rate higher than chance alone.

To quantify the value of accurate EPS forecasting, a few years ago, Schwab measured the potential returns an investor could have earned with perfect foresight of EPS growth one year into the future. If it were possible in advance to buy the 20% of stocks with the highest subsequent one-year EPS growth, your portfolio would have grown an average of 38.7% annually from 1986 to 2004 vs. only 14.3% annually for all stocks included in our study. By contrast, a portfolio of the 20% of stocks with the lowest EPS growth (a negative growth rate in most cases) would have lost an average of 10.4% annually.

Clearly, accurate EPS forecasting could have a large payoff, but what's the probability of actually making accurate forecasts? Unfortunately, accurately forecasting EPS is extremely difficult. Schwab research has found historically that only 15% of quarterly EPS forecasts are within 1% of actual reported EPS. If at the beginning of each year, you bought the 20% of stocks with the highest consensus one-year EPS growth forecasts, your portfolio would have slightly underperformed the average stock included in our study. In other words, our findings have shown that analyst forecasts have historically been so inaccurate that basing stock purchase decisions on one-year EPS growth forecasts has been a completely futile approach to outperforming the stock market!

Forecast "surprises," not earnings
So if forecasting EPS isn't viable, what should you forecast? It's critical to understand that a company's stock price is based not just on its current fundamentals, but on all expected future cash flows, discounted back to the present according to anticipated risk. In other words, today's stock price reflects consensus expectations of future fundamentals. Consequently, meaningful stock price changes occur only when investor expectations change. And since expectation changes are triggered by the unexpected, a key element to a market-beating stock selection strategy is "surprise anticipation."

Successful equity research must be able to identify stocks that perform better than the expectations embedded in their stock prices at the time of purchase. If your stock picks experience positive surprises more often than negative surprises, you have a good chance to outperform the market in the long run. Unfortunately, investors often fail to appreciate the importance of expectations. For example, they cling to the notion that great companies will be top-performing stocks, forgetting that such greatness is generally already reflected in stock prices.

Surprise anticipation sounds nice, but is it actually possible to forecast the unexpected? The good news is that what is a surprise to most investors doesn't have to be a surprise to you! Behavioral finance researchers have discovered that investor expectations tend to err in two predictable ways.

First, investors seem to believe that successful companies will continue to succeed and that struggling companies will continue to struggle. This tendency to extrapolate past trends drives expectation levels to extremes for many companies. Yet research has shown that the forces of competition typically lead to long-term business success being more likely to reverse than to be sustainable. Therefore, one powerful way to anticipate surprises is to bet on what statisticians call mean-reversion, which is the tendency for high or low values to return to the mean, or average. When investor expectations are extremely low for a stock, you should anticipate future surprises to be positive as the company does better than pessimistic expectations. And when investor expectations are extremely high for a stock, anticipate future surprises to be negative as the company does worse than optimistic expectations.

The second way investor expectations err predictably reflects investors' reluctance to change held beliefs. For example, if a company reports a positive earnings surprise, investors typically notch up their future expectations, but they seek further confirmation by waiting to see if the company can do it again next quarter. Behavioral finance researchers have shown that this "anchor-and-adjust" process creates a tendency for short-term expectation changes to lag behind fundamental reality. Therefore, a second powerful way to anticipate surprises is to bet on systematic underreaction to newly reported information. If recent expectation changes have been positive for a stock, you should expect more positive changes in the near future as expectations play catch-up, but if recent expectation changes have been negative, expect more negative changes in the near future.

We have created a Surprise Anticipation Matrix that encapsulates these general tendencies. As the graphic below illustrates, stocks with low but rising expectation levels tend to report positive surprises while stocks with high but falling expectations tend to report negative surprises.

Schwab Equity Ratings: a surprise anticipation tool
If applying all of these research principles sounds like a lot of work, consider using Schwab Equity Ratings as a time-saving shortcut. Schwab Equity Ratings are, in essence, a sophisticated surprise anticipation tool. Indeed, since the ratings were launched in May 2002, through March 2007, A-rated stocks have reported quarterly earnings above consensus forecasts 74% of the time, while F-rated stocks have beat consensus forecasts only 41% of the time. We believe surprise anticipation is a key reason why A-rated stocks have outperformed the average rated stock by over 5% per year on a 52-week buy-and-hold basis since inception, while F-rated stocks have underperformed by a similar margin.

So in conclusion, successful equity research must be a process of discovering relevant information. When you buy a stock, you are implicitly forecasting that you know something material that other investors don't know. It seems to us that professional analysts who focus their research on EPS forecasting and investors who use those forecasts haven't accepted the fact that earnings forecasts have historically been too inaccurate to be the basis for a successful stock selection strategy. Fortunately, we believe there is a more reliable forecasting strategy available to investors called surprise anticipation.

by Greg Forsythe, CFA, Senior Vice President, Schwab Equity Ratings®, Schwab Center for Investment Research®

[6/14/07] See also Forsythe's article "Are Stocks With High Earnings Growth Good Investments?"

A recent academic paper showed that firms with above-average EPS growth in the previous five-year period were no more likely than chance to deliver above-average EPS growth in the five years that followed.2 Furthermore, since stocks with above-average historical growth tend to have above-average P/E ratios, investors in these stocks often get double-whammied: Not only does expected future EPS not materialize, but P/E ratios contract as investor expectations are adjusted downward to the new reality.

and his article in the Summer 2007 Charles Schwab OnInvesting

Investor expectations of a company's future earnings growth tend to be highly correlated to its past growth. Yet researchers have found that historical earnings growth rates have little ability to predict future earnings growth. Nonetheless, analyst forecasts reflect excessive extrapolation of past growth trends and influence investors to award high (low) price-to-earnings (P/E) multiples to stocks with high (low) EPS growth forecasts. Reflecting this overreaction tendency, research has shown that high P/E stocks tend to underperform as actual results fall short of optimistic forecasts, while low P/E stocks tend to outperform as actual results exceed pessimistic forecasts.

Death, Taxes, and Short-Term Underperformance

Research from Brandes Institute on Death, Taxes, and Short-Term Underperformance. This research focuses on the performance results of a wide range of U.S. mutual funds over the last decade. Observations suggest that underperformance in shorter time periods - such as one quarter, one year, or even three years - is to be expected, even for portfolios that perform strongly over the long term.

DivestTerror.org

What can you, an average citizen, do to help defend America against terrorists sworn to our destruction? How about not investing in them?

A campaign to cut off such investments is gaining momentum. The Center for Security Policy, a Washington think tank, has organized a “Divest Terrorism Initiative” — a campaign to persuade pension funds, college endowments, 401(k) plans, retirement account managers, and individual investors to make sure their money is not used to support regimes that underwrite terrorism.

Highest on the priority list: Iran, Sudan, Syria and North Korea. These countries have been sanctioned by the United States government as sponsors of terrorism, said Sarah Steelman, the Treasurer of Missouri, the first state in the nation whose pension fund has divested from companies doing business with terrorist masters. Investing in terrorist countries is not acceptable to the citizens or the public employees of Missouri.

After the record

According to Standard & Poor's Chief Technical Strategist Mark Arbeter, the technical picture for the S&P 500 indicates the benchmark will probably eclipse its record closing high of 1527.46, set on March 24, 2000, sometime in May or June of this year.

If Arbeter is right (and he usually is) what will that mean for future market action once the adrenaline rush has subsided?

If history can serve as a guide (but remember past performance is no guarantee of future results), we will likely see sub-par price performance in the first month following the setting of a new high, and then find above-average price appreciation in the three and six months after. In addition, the next market top usually occurred around three years after the setting of a record high.

Common Sense buying and selling

James B. Stewart explains his Common Sense guide to buying and selling in his column in the June 2006 SmartMoney.

My traditional focus on buying is one of the reasons that I introduced the Common Sense guide to buying and selling, which has been the underpinning of this column since its inception. At periodic intervals, this system forces me to be disciplined and take some profits when stocks are high. As I've explained in previous columns, my goal is simply to buy low and sell high. When the market drops, I add to my holdings at intervals of 10% declines in the Nasdaq composite index, my preferred barometer. During rallies, I sell some of my stocks at intervals of 25% advances. These numbers aren't arbitrary. They're the midpoints of average bear market declines (20%) and bull market rallies (50%).

Ten Stocks for the Next Ten Years

[SmartMoney Magazine, May 2007] For our 15th-anniversary issue, we've taken what we've learned over the past decade and a half to create another 10-year portfolio. To identify our top-10 stocks this time, we also demanded a demonstrable history of sales growth. Then, as in past years, we sorted through the remaining stocks one by one, looking for common themes that were likely to play out over the next decade. In the end, we identified four themes: clean water, health, wireless technology and global growth.

WATER SERVICES
Fresh water is becoming an increasingly important commodity. Water-infrastructure and water-treatment companies will clean up as emerging and developed economies build and rebuild their systems.

Tetra Tech (TTEK) is a consulting firm specializing in water-resource management and environmental cleanups.

At first glance, you might not think a company that invented a hot-water valve in the early 1900s would be a high-growth prospect for the next decade. But Watts Water Technologies (WTS), which supplies water-control, purification, safety and flow devices to the construction industry, should see strong gains in the years ahead.

HEALTH
Demographics favor medical-equipment manufacturers, from dental equipment to respiratory care to imaging systems. Natural foods, too, will continue to grow as Americans adopt healthier lifestyles.

Sirona Dental Systems (SIRO). It may be that no one enjoys a visit to the dentist, but health- and appearance-conscious baby boomers are sure going.

Viasys Healthcare (VAS) is a cluster of high-technology medical-equipment and diagnostic companies that focus on respiratory care and neuro diagnostics — the monitoring of the brain and nervous system.

OSI Systems (OSIS) is a hybrid medical/defense company, with half of its revenue from medical equipment and half from scanning and inspection equipment and optical gear used by the defense and aerospace industries.

Wherever you run into organic produce, chances are it got there thanks to United Natural Foods (UNFI). The company is the largest national distributor of organic and natural foods, offering more than 40,000 products from 17 distribution sites nationwide.

WIRELESS TELECOM
As broadband-like speeds come to wireless communications, demand for ever more sophisticated handsets and the infrastructure that powers them will drive the industry's next leap forward.

Powerwave Technologies (PWAV) makes the amplifiers, antennas and other equipment that enable wireless phones and handheld devices to transmit and receive voice and data.

Brightpoint (CELL) is the middleman for the wireless industry and should be ideally positioned to profit from its continued growth.

GLOBAL GROWTH
Globalization is creating new opportunities in areas as disparate as market research and global air transport. Our two picks give investors worldwide reach as the global economy grows.

Best known for its Harris Poll, ubiquitous during American election campaigns since the 1950s, Harris Interactive (HPOL) is one of the top 15 market-research firms worldwide.

Atlas Air Worldwide (AAWW) offers an unusual opportunity to profit from growing global trade, a trend we expect to intensify in the coming decade.

Mason Hawkins

Mason Hawkin's six principles than any true investor must have in order to succeed in the long-term:

1. You need a sound philosophy
2. Good Search Strategy
3. Ability to value businesses and assess management quality
4. Discipline to say no.
5. Patience
6. Courage to make a significant investment at the point of maximum pessimism

-- via brknews

Seth Klarman pulled it off

Manager Frets Over the Market, but Still Outdoes It

By GERALDINE FABRIKANT
Published: May 13, 2007

EARNING 22 percent on your investments while holding half of your portfolio in cash is no easy trick, but last year Seth A. Klarman pulled it off, and it was not the first time.

Mr. Klarman, a 49-year-old hedge fund manager, has turned in market-beating performances since 1983, while perpetually warning that the markets were dangerous and that investors should minimize risk.

What is his investment approach? He will not spell it out, although lots of people would like to know. On the Web, the price for his out-of-print 1991 book — “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor” — has gone for $1,200 on Amazon and $2,000 on eBay.

At a time when hedge fund managers seem to be grabbing headlines with stories about their homes, hobbies, philanthropy and outsize compensation, Mr. Klarman keeps a low profile, and is reticent about the investments of his $7 billion Baupost Group of hedge funds, which has been closed to new money for the last seven years.

But his book, his letters to investors and other fund documents provide some clues about his thinking, and he added to the picture in a telephone interview. Mr. Klarman clearly sees himself as a deep value investor, in the mold of Warren E. Buffett or Benjamin Graham, the Columbia professor who pioneered value investing.

He is also a world-class worrier. In one letter, Mr. Klarman said, “At Baupost, we are big fans of fear, and in investing, it is clearly better to be scared than sorry.” In an earlier note, he wrote, “Rather than ratchet up risk, our approach has been to hold cash in the absence of opportunity.”

Last year, the cash holdings of his hedge funds amounted to 49.8 percent of assets, an enormous proportion for actively managed investments, but not an anomaly at Baupost: a year earlier, the cash holdings amounted to 45.8 percent. To add safety to his portfolios, he said that he usually eschews leverage, or debt, in his funds, using it only in some real estate investments. Instead, he has profited handsomely from investing in the debt of other companies, particularly those in financial distress.

Mr. Klarman, who is based in Boston and works with a team of 24 people, does not make bets on the overall market. Instead, his funds look for specific opportunities that he deems worthy. But he warns that Wall Street often tries to sell customers overvalued assets. For example, he said that he is wary of new issues because in the pursuit of large fees, banks may underwrite overpriced or highly risky securities.

Mr. Klarman’s record has generated intense loyalty from investors. Since he began Baupost in 1983, it has posted an average annual total return of 19.55 percent, according to data provided by the hedge fund group. Declines have been posted in only 11 of the total 97 quarters since Baupost’s debut.

In 2006, Baupost’s portfolio held an array of assets, including United States, European, Asian and Canadian equities, which accounted for 17.1 percent of the portfolio; debt and real estate, which each made up 10 percent; and 4.7 percent in private equity funds. And there was that big dollop of cash.

“Seth has a remarkable record, and even more so when you realize that he has achieved it by holding significant amounts of cash,” said Jack R. Meyer, who until 2005 ran Harvard’s endowment, which has been a longtime investor in Baupost.

“In other words, his risk-adjusted numbers are spectacular. What is unusual is the high return and the high cash levels,” added Mr. Meyer, who now runs the investment fund Convexity Capital.

Mr. Klarman grew up in Baltimore, where his father was a health economist. After graduating from Cornell with a degree in economics in 1979, he worked for Max Heine and Michael Price at Mutual Shares for a year and a half, then went on to Harvard Business School, where he graduated with an M.B.A. in 1982. Immediately afterward, four wealthy families, including those of two Harvard professors, put up $27 million for Mr. Klarman to manage.

While his actual compensation has not been disclosed, years of high returns have made him wealthy. Baupost charges a 1 percent management fee on investments in its funds, as well as 20 percent of annual profit. It was managing roughly $6 billion at the end of 2005 — which would mean a $60 million management fee for Baupost. In addition, its 22 percent return on investments last year would suggest profit of about $1.3 billion — generating a 20 percent share for Baupost of about $260 million. The only leverage Mr. Klarman said he used was on the 10 percent of holdings in real estate, where the leverage was one to one.

Despite more than two decades of smart choices, Mr. Klarman seems to obsess continually about potential crises. In his most recent letter, he said that while investors had been upbeat because of relatively low market volatility and inexpensive credit, he was worried about trade imbalances and high levels of consumer debt, which he said could set off market declines. Writing about the stock market rally in 2006, he said: “There was nothing about this party that would have made you want to leave early, unless you were a value investor. The only adverse trend was the scarcity of mispricing opportunities.”

One place in which he said he had found some mispricing was in the shares of News Corporation stock, which rose 37 percent in 2006. While Baupost sold 1.8 million shares last year, at the end of December, it still owned 4.19 million shares, according to company filings. Last week, Mr. Klarman said he believed the stock was still undervalued. He added that he was not concerned about Rupert Murdoch’s bid for Dow Jones & Company, at a price many have described as extremely generous, because it would be a relatively small transaction for a company the size of News Corporation.

Other Baupost equity holdings include Home Depot and Posco, a Korean steel manufacturer, two stocks that happen to be held by Berkshire Hathaway, Mr. Buffett’s company.

Figuring out which distressed bonds Baupost owns is more difficult. For competitive reasons, Baupost does not name the companies, but last year Mr. Klarman told investors that its second-largest single annual gain came from an holding in NationsRent, a company that rents equipment to builders. NationsRent filed for bankruptcy in 2001. The next year Baupost invested about $100 million in the defaulted bank debt.

A year later, NationsRent reorganized. Baupost put in about $50 million in fresh capital in exchange for stock and ended up with a total of more than two-thirds of the stock. Last year, Sunbelt Rentals bought the company for $1 billion in cash and the assumption of debt. Mr. Klarman said that Baupost more than doubled its investment.

In the interview, Mr. Klarman said that he found bankruptcy investing appealing because the process of bankruptcy itself can help unlock the value of an investment.

“There is a catalyst,” he said, “because the way you make money is dependent on specific situations; the bankruptcy process itself will deliver you securities in the reorganized company.”

DESPITE Baupost’s stellar returns, Mr. Klarman’s team continues to take out what he calls “disaster insurance.” Last year it emphasized gold, which would appreciate if the dollar and other currencies declined in value. Although Baupost did not indicate the size of its wager, it did tell investors in one of its funds that 2.87 percentage points of about 20 percent in total fund profit came from a bet that the precious metal would rise. He wrote that gold was underpriced because investors in this “goldilocks” era have not worried enough about currency devaluation.

Baupost has had its setbacks. In 2006 it lost money on an investment in TRM, which operates automated teller machines. “It seemed cheap on cash flow, but its business deteriorated after Hurricane Katrina,” Mr. Klarman said. “It did not turn out to be as stable a business as we thought.”

Baupost has done better with real estate. Last year, Coastal Management Resources, a company in which Baupost has an equity stake, bought the neighboring Cojo and Jalama Ranches north of Santa Barbara, Calif. Although neither the size of Baupost’s investment in Coastal Management nor the purchase price of the ranches is known, the asking price was $155 million.

The ranch purchases may reflect Mr. Klarman’s passion for horses. He has owned racehorses, and even at the track his penchant for details is manifest. One of his horses, now retired, is named Read the Footnotes.

[4/8/08] Klarman can clearly be an active seller of stocks. He sells when a stock reaches fair value, but he also replaces current holdings with better opportunities as they come along. It's not rocket science, but it isn't a strategy most investors follow.

Chasing Performance

Know When to Hold ... and When to Fold

New research turns conventional wisdom - a buy-and-hold strategy is best - on its head.

ANY GAMBLER will tell you never fold with a winning hand. And yet all investors know not to buy a fund simply because it has been doing well. That's called chasing performance, and that's bad. We've said it ourselves countless times. The thing is, though, that advice may be wrong.

No, we're not suddenly advocating jumping on any enticing investing bandwagon. But Dan Weiner, founder of AdviserInvestment, which manages $1.1 billion primarily in Vanguard and Fidelity funds, has quietly shared some interesting research positing that strategic buying and selling of top performing funds can beat the market.

Simply purchase the top-performing diversified equity fund (pick domestic or international, but avoid sector funds) in the past 12-month period. Hold it for one year. Sell it and purchase the new No. 1 fund. AdviserInvestment backtested the strategy on Vanguard funds and found it delivered average annual returns of 20 percent over 10 years, compared with an average of 13.7 percent for the Standard & Poor's 500. Jim Lowell of the Fidelity Investor newsletter, came up with similar results based solely on Fidelity funds. Morningstar found the strategy worked best with domestic stock funds showing a 23 percent annualized return over 20 years, handily beating the broad market's 11.6 percent.

The reason for the phenomenon is simple: Trends don't confine themselves to any given 12-month period. Interestingly, some months seem to be stronger than others. Buying the top funds in June or October worked better than buying and selling in February. If the top-performing fund is closed to new investors, go ahead and buy the second best.

So what might work now? Based on our preliminary look, two good options appear be Fidelity International Small Cap Opportunities (FSCOX) and AIM Trimark Endeavor (ATDAX), a midcap fund.

-- Dyan Machan, SmartMoney, May 2007, page 33

Spike Higher?

[5/1/07] Major stock market tops are characterized by elation, ecstasy, and euphoria - not the fear of falling prices. We believe the combination of a fairly vibrant stock market and rising levels of fear is bullish for stocks, as sentiment gauges are best read from a contrarian perspective. We would use the bear's misguided feeling to our advantage.

One way to gauge market sentiment is to watch the short-interest ratio on the New York Stock Exchange. First, the short-interest ratio is the number of shares sold short divided by average daily volume. This is often called the "days-to-cover ratio" because it tells - given the stock's average trading volume - how many days it will take short sellers to cover their positions. Short sellers are, of course, betting on a price decline.

Since 1994, the NYSE short-interest ratio has oscillated between 3.7 and 7.5. The higher the ratio, the more investors are betting on a market decline. The lower the number, the more investors are looking for a rise in stock prices. The average ratio over this period has been 5.4. We view readings of 6 and above as bullish and readings of 4.6 and below as bearish. The current NYSE short-interest ratio is 7.4, or right near the top of the range since 1994 and just below the all-time high of 7.5 in October 1996.

With the ratio very high once again, and the market doing relatively well, the bears must have a case of severe indigestion and will, in all likelihood, be forced to cover their mistakes at even higher prices, adding more fuel to the fire.

* * *

[4/4/07] Mark Arbeter, S&P Chief Technical Strategist, sees a higher market.

It's not often we predict a spike higher. That fraternity of market mavens who, among other non-bull's-eyes, have called nine of the last six recessions is just not where we'd care to be.

That said, certain technical measures we follow suggest higher prices could be in store later this year.

We're talking about the put/call ratio, which tracks options contracts purchased on the Chicago Board of Options Exchange. Puts are, of course, options to sell; calls are options to buy. The ratio is used widely as a gauge of market sentiment. When there are more calls than puts, Mr. Market is bullish. More puts than calls, and Mr. Market is bearish.

Recently this measure hit an all-time high, suggesting Mr. Market had just taken a room at the Bates Motel — a glut of fear, in other words. Interestingly enough, this occurred during what was by historical standards a relatively modest pullback. This excessive fear is, we suggest, bullish.

And so on.

bubble territory

The Street.com excerpted some of the more salient quotes from Grantham's recent newsletter. From their site:

"While euphoria sweeps stock markets here and worldwide, there are at least a few voices of dissent. One, unsurprisingly, is legendary value investor Jeremy Grantham - the man Dick Cheney, plus a lot of other rich people, trusts with his money. Grantham ... has been a voice of caution for years. But he has upped his concerns in his latest letter to shareholders. Grantham says we are now seeing the first worldwide bubble in history covering all asset classes.

"'Everything is in bubble territory,' he says. 'Everything. The bursting of this bubble will be across all countries and all assets.'

"'From Indian antiquities to modern Chinese art,' he wrote in a letter to clients this week following a six-week world tour, 'from land in Panama to Mayfair; from forestry, infrastructure and the junkiest bonds to mundane blue chips; it's bubble time!'

So, does he counsel you to run for the hills? No. Their study of bubbles suggests there is a short but dramatic "exponential" phase before the bubble bursts. He writes:

"My colleagues suggest that this global bubble has not yet had this phase and perhaps they are right. ... In which case, pessimists or conservatives will take considerably more pain."

The Big House

Investors looking for stock-picking tips might find the answer right at home—not their own, but where chief executives live.

A new study makes the case that there is a strong correlation between executives’ home buying behavior and stock performance. The bigger the CEO home, the worse the company’s stock fares, according to two academic researchers. They also found that companies with CEOs living in more modest abodes often see their shares outperform.

Earnings slowdown

Corporate profits have, until recently, been on a tear. From the second quarter of 2002 through the third period of 2006, the S&P 500 posted 18 straight quarters of double-digit increases in year-over-year operating earnings. The fourth quarter of 2006, however, slowed to an 8.9% rise, and Standard & Poor's equity analysts don't see another double-digit quarter until at least the end of this year.

DCA or lump sum?

Dollar-cost averaging -- the practice of making an investment in regular intervals over an extended period of time, rather than all at once -- is a favorite recommendation of full-service brokers, an occasional subject of lively debate on the Fool's message boards, and a technique that has found some favor among Fool writers. Yet there's a growing body of academic research that claims to show that dollar-cost averaging is largely ineffective in practice, and may even be harmful to your financial well-being under some circumstances.

Last year, Texas A&M University finance professor John G. Greenhut looked at various academic studies of DCA, hoping to be able to explain why the strategy continued to be popular despite a growing body of evidence that it didn't work -- and why a few studies had, contrary to the majority of the research, found DCA to be a successful approach on occasion. His analysis is complicated (as you'll see if you click that link), but the gist of his conclusion is that lump-sum investing (abbreviated as "LS" in his article) is the better approach most of the time -- i.e., when the market is trending upward -- and that illustrations showing DCA at an advantage almost always use hypothetical stock-price patterns that don't match real trends.

Gurufocus Strategies

[4/29/07] This is the second article in the series that we study the strategies on how to use Gurus’ ideas to achieve outstanding gains over long term. This study is for the Most Weighted Portfolio, which has returned 26.5% since incepted in Jan. 2006.

The Most Weighted Portfolio consists of the top 25 stocks with the highest combined weightings in the aggregated portfolios of Gurus. The combined weightings are defined as the total of the positions of a stock in Gurus’ portfolio. For instance: if Guru A holds 17% of WMT in his holding, and Guru B holds 5%, and Guru C holds 4%. The combined weighting of WMT is defined as 17+5+4=26. The portfolio is rebalanced once every 12 months. The last rebalance was Jan. 4, 2007.

[4/13/07] When we started GuruFocus, the first questions we have were: does it really work?

As GuruFocusers know, most of GuruFocus reports on the Gurus’ picks and portfolios have a time lag of 1-4 months from time the trades are made, except the Real Time Picks we have created for Premium Members. Does it make sense to buy what Gurus bought several months ago? If you are a believer of value investing, it does. Sure, a lot of times the stock prices have gone up after the Gurus bought. But there are about equal number of times the prices went down. This means that you can buy the stocks Warren Buffett or Martin Whitman have bought and pay less than what they have paid. Does that sound a good deal? It should.

We have created Guru Bargains portfolio to prove that. The portfolio was incepted in June 2006, and the stocks were selected from those Gurus have bought during the first quarter of 2006, and have the biggest price declines since the Gurus have bought. How did these stocks do? Miserably! By the end of 2006, this portfolio underperformed S&P500 by more than 20%!

Reacting to market declines

Nothing ignites the fear of losing one's hard-earned money like a violent, short-term stock market correction. For many investors — even those with a long-term perspective — the natural human reaction to a sudden plunge in the stock market is to reduce or liquidate one's exposure, with the goal of trying to stem further loss of capital and soothe a rattled mind.

Since 1926, the stock market had a positive return in 58 out of 81 calendar years-or nearly three out of every four years. Because the long-term trend of the stock market has been upward, one must also recognize that there are significant opportunity risks accorded with trying to accurately time the market's peaks and valleys in search of outsized gains. The odds are stacked against successfully timing short-term market fluctuations, particularly because long-term investors must also effectively time their re-entry.

An examination of historical flows to U.S. stock mutual funds and the performance of the U.S. stock market reveals that, on average, individual investors have done a poor job of market timing. In general, they tended to increase their exposure to stocks just prior to a sell-off, and reduce their holdings ahead of a period of stellar appreciation. For example, investors allocated a record $219 billion in net new money to stock mutual funds during the 12-month period ending October 31, 2000, which preceded a decline of 27% for the S&P 500® Index throughout the following year. Another example of poor timing took place soon thereafter. After three straight years of stock market declines, flows turned negative (redemptions exceeded sales) during the 12-month period to February 28, 2003. However, from that point on throughout the next year, the S&P 500 rallied 35%. In other words, most investors were selling out of equity funds prior to a significant rebound and at exactly the time when they would have benefited the most by owning a higher percentage of stocks.

Some of the best periods to have entered the stock market have been during periods of particularly gloomy sentiment and market turbulence. Since 1926, the best five-year return in the U.S. stock market began in May 1932-in the midst of the Great Depression-when stocks rallied 367% (See table below). The next best five-year period (when the stock market rose 267%) began in July 1982 amid an economy in the midst of one of the worst recessions in the post-war period, featuring double-digit levels of unemployment and interest rates. Investors might use these lessons from history to remember that staying fully invested can give them an opportunity to fully participate in the market's long-term upward trend. Waiting until the backdrop feels "safe" to make an investment in stocks has historically not been a good method of achieving future returns. Many of the best periods to invest in stocks have been those environments that were among the most unnerving.

[The entire article is here.]

Falling Knives

We [The Brandes Institute] examined the performance of falling knives in the U.S. stock market from 1986 through 2002. While the falling knives we identified did post a relatively high bankruptcy rate over the three-year period following their initial drop, they also outperformed the S&P 500 by wide margins. We followed up our study of U.S.-based falling knives by extending our falling knife analysis to markets outside the United States – and we concluded that non-U.S. knives also tended to outdistance their benchmarks.

Overall, we find that falling knives around the world continued to offer significant outperformance potential. Our research also yields a variety of specific conclusions:

• Bankruptcy risk was higher than normal among U.S. falling knives, but even when bankruptcies are counted, the average U.S. knife outperformed the S&P 500 substantially
• While falling knives in non-U.S. markets went bankrupt at a much lower rate than their U.S.-based counterparts, these non-U.S. knives posted similarly strong outperformance figures
• The information technology sector yielded a high proportion of falling knives, and these knives generally outperformed substantially; knives in the utilities sector also tended to perform strongly
• The positively skewed distribution of returns for both U.S. and non-U.S. falling knives suggests that stock selection could be critical to successful falling knife investment
• Enterprise-value-to-sales ratios could help investors identify the most compelling opportunities among falling knives

[10/18/09 - new link via chucks_angels]

***

[4/28/13] Your ability to maintain focus on the long term comes from experience. You go through a couple cycles where everybody else is screaming at you not to try to catch a falling knife, and then when you do so and make some money, it does wonders for you . . . and for your ability to do it next time.

—Howard Marks, Oaktree Capital [excerpt from The Art of Value Investing]

Market Crashes

I hope this isn't news to you: Another stock market crash is on its way. That's the bad news. The good news is that it isn't necessarily right around the corner.

At about.com, Dustin Woodard reviews our 10 worst stock market crashes.

Notice though that the crashes have always been been followed by recoveries, and the market trends upward in the long run. You sometimes have to wait a long time for a full recovery, though.

Mad About Mega Caps

[3/20/07] Megacaps are now much cheaper than their smaller brethren. The top 100 U.S. stocks by market capitalization are trading at a reasonable 14 times operating earnings, Inker notes. Companies that rank in size from 501 to 1,000 trade at a steeper 21 times operating earnings, while the ones ranked from 1,001 to 3,000 go for a whopping multiple of 28.

"That's quite high by historical standards," says Ben Inker, director of asset allocation for Boston-based money-management firm GMO. "Normally you get bribed to own small caps in the form of lower P/Es, but these stocks have been on a tear." So if earnings growth does slow, there's not much room for the inevitable earnings disappointments among small caps.

[11/16/06] For the first time in years, corporate giants like American Express, IBM and Johnson & Johnson are shaping up as great values. Not only are these mega-cap stocks topping Schwab Equity Ratings’ list of highly rated stocks, but they are also trading at lower price-to-earnings (P/E) ratios relative to small- and mid-cap stocks than they’ve done in years. And for the first time since 2002, mega caps are outperforming the rest of the market. This year through October 31, the S&P 100 Index, which is a proxy for the 100 largest U.S. stocks, rose 14.4%, vs. 12.0% for small caps and 7.4% for mid caps.

What’s behind these stocks’ recent boost? As the economy slows, large, broadly diversified companies are typically better positioned to weather drops in consumer demand than small- and mid-sized companies. That may help explain the recent relative outperformance of mega-cap stocks (see chart line). The other major factor, in the chart’s shaded areas, is the relative cheapness of mega caps. Currently, the average P/E for the S&P 100 is 18.2, versus 22.0 for mid caps and 21.8 for small caps.

Buy the best?

One widely recognized and easily digested measurement of corporate quality is the annual Fortune list of "Most Admired" companies, which could be an easy and valuable investing tool. Academic research shows that money invested in the Fortune most-admired companies would have outperformed the S&P 500 (PDF file) by a tidy margin between 1983 and 2004.

That seems to suggest it'd be in your best interests to bet on these companies yourself, except for one little detail: The "Least Admired" companies provided even better returns.

Don’t Overpay Today for Growth Tomorrow

Any list of long-term stock market winners is dominated by companies that grew earnings per share (EPS) much faster than market averages. Therefore, the key to future portfolio success must be to buy stocks with the highest earnings growth prospects, right? Wrong!

If each year from 1986 to 2006 you had purchased the 20% of stocks from the 3,200 largest market capitalization public companies with the highest five-year EPS growth forecasts, your portfolio would have lagged the average stock by about 1.5% annually, while being much more volatile.

There are two primary reasons why stocks with high EPS growth forecasts tend to underperform:

1. Stocks with high growth expectations tend to have high current valuation levels—that is, high price-to-earnings (P/E) ratios. Stocks with strong earnings potential are typically well known, and investors are usually willing to “pay up” for potential growth.

2. High expectation stocks tend to deliver actual earnings growth far short of optimistic forecasts. When such stocks report negative earnings surprises, prices tend to fall and P/Es to contract.

Lower P/E stocks have tended to provide higher historical returns for any level of expected EPS growth. Interestingly, this effect is more prominent among value stocks with low EPS growth expectations than among growth stocks with high EPS growth forecasts. In other words, high growth expectation stocks with low PEG ratios still tend to underperform.

Building a portfolio of stocks with the greatest likelihood of outperforming the market over the long run is a process of tilting the odds in your favor. While there are exceptions to every rule, history suggests that buying stocks with high EPS growth forecasts or high P/Es is fighting the odds. Here are three useful rules of thumb:

1. Avoid stocks with P/E ratios above 25 (use EPS over the last four quarters from continuing operations before extraordinary items).

2. Avoid stocks with five-year consensus EPS growth rate forecasts above 25.

3. Avoid stocks with negative current EPS and five-year consensus EPS growth forecasts above 15%.


Perhaps the most practical lesson that can be taken from our “P/E vs. Growth” matrix is to ignore consensus five-year EPS growth forecasts altogether and simply emphasize buying stocks with low P/E ratios. While a diversified portfolio of low P/E stocks will not always outperform and definitely makes a bet on value stocks, historically such portfolios have outperformed the broad stock market and been simultaneously less volatile—not a bad combination.


By Greg Forsythe, CFA
Senior Vice President, Schwab Equity Ratings®
Schwab Center for Investment Research®

How Good People Make Bad Investments

Investing isn't hard work. And that's just one of the problems.

For many folks, managing money is an exercise in frustration. We summon the skills that work so well in the rest of our lives, apply them to the financial markets -- and end up with lackluster results.

Here are just some of the qualities that help us at home and at the office, but leave us flailing around in the stock and bond markets.

We Stay Busy

If we want to get ahead at work or we want to whip the garden into shape, we get busy. Activity doesn't just seem virtuous. It also gives us a comforting sense of control, especially if we're dealing with a crisis.

But in the financial markets, staying busy is a bad idea. To be sure, if our portfolios are messed up, we will need to straighten things out initially. But once we've finished revamping our investments, often the wisest course is to keep activity to a minimum.

"The less investors do, the better their results," says Meir Statman, a finance professor at Santa Clara University in California. "If you trade, in all likelihood, you have a portfolio that's not diversified. You are hit with both unnecessary risk and trading costs."

That said, even investors with rock-solid portfolios will likely make a few trades each year. Every 12 months or so, you should rebalance, so you maintain your target portfolio percentages for sectors like large stocks, smaller companies, foreign shares and bonds. You might also do some occasional selling in your taxable account to realize tax losses.

We Work Hard

Athletes who train hard are more likely to win. Students who study conscientiously are more likely to get good grades. What about investors who diligently research their stocks? They'll probably earn mediocre returns.

The fact is, the markets are full of savvy investors, all hunting for cheap stocks. Result: If there are any bargains to be had, they don't stay that way for long. Indeed, much of the time, share prices are a pretty good reflection of currently available information.

"If you put in more effort, you'll end up with worse results," reckons Terry Burnham, co-author of "Mean Genes" and director of economics at Boston's Acadian Asset Management. "It's not the work. It's the action that comes out of the work that's the problem."

Every time we buy a supposedly bargain-priced stock, we incur commissions and other trading costs. In addition, if we trade in our taxable account, we may trigger big tax bills, further denting our returns.

We're Optimistic

Our hard work and our preference for activity lead us to trade too much and to make undiversified investment bets. But the damage to our portfolios is also driven by one of our more endearing traits: Our optimism.

"There is good evidence that optimists are more likely to remarry, they recover faster from surgery and they adjust more easily to life transitions like leaving home for college," Prof. Statman says. "But unrealistic optimism is something you want to check at the door when you enter the financial markets. Being optimistic about your investment abilities will lose you money."

We Look to the Past

Need to buy a refrigerator, find a new doctor or book a trip to Paris? For advice, we'll often turn to folks who have recently grappled with these issues -- and that's usually a smart strategy.

But with investments, relying on what's recently worked well can be a disaster. "In the financial markets, your backward-looking brain decides it likes a particular stock or a particular asset class," Mr. Burnham says. "The problem is, others with similar backward-looking brains reach the same conclusion. Now, you've got an investment that's popular -- and that makes it a bad investment. By definition, popular investments are overpriced."

We Buy Quality

When we shop for a new computer or a new stereo, we typically assume that greater sophistication is better, that reputation is worth something and that a product's price bears some relationship to its quality. But Wall Street is different.

If a mutual fund charges high fees, it is more likely to lag behind the market. If a company is widely admired, its shares may be overvalued. If an investment product is deemed sophisticated, it's often difficult to figure out how it will really perform.

"I never buy or recommend an investment product I couldn't explain to my 9-year-old son," says Allan Roth, a financial planner with Wealth Logic in Colorado Springs, Colo.

We Play to Win

We want to get that promotion, have a greener lawn than our neighbors and see our favorite "American Idol" win. "It's un-American to try to be average," Mr. Roth notes. "A tie is like kissing your sister."

Yet, in the financial markets, aiming for average is the surest way to come out ahead. We can't all outperform the market, because together we are the market. In fact, once investment costs are figured in, we will collectively trail the market averages.

What to do? We could tap into our optimism and commit to working harder and trading more. But all that will likely do is generate a fistful of investment costs and leave us lagging further behind the market averages.

That's why I favor building a globally diversified mix of index funds. You might put, say, 45% of your portfolio in an index fund that tracks the broad U.S. stock market, 15% in a foreign-stock index fund and 40% in a bond-index fund. You could build this sort of portfolio with mutual funds from Fidelity Investments, T. Rowe Price, Charles Schwab and Vanguard. Alternatively, you could use exchange-traded index funds.

Your index funds will simply replicate the performance of the underlying markets, minus a small sum for fund expenses. Sound dull? You may be more excited when you look at your results -- and you realize they're so much better than those earned by optimistic, hard-working active investors.

GETTING GOING
By JONATHAN CLEMENTS

StockScouter

[3/2/07 Richard Jenkins writes in This Week on MSN Money:] Even if you're a buy-and-hold investor, a market swoon like Tuesday's 416-point drop is bound to get your attention. It may also start you down the risky road of questioning your strategy.

It got me to wondering how our StockScouter rating system performed in the last bear market. (I'm not saying that we're entering a bear market here, just wondering.)

We didn't launch Scouter until the bear market that began March 24, 2000, was well under way. But from Scouter's launch on Aug. 1, 2001, to the end of the bear market on Oct. 9, 2002, it vastly outperformed the wider market indexes. The 50-stock portfolio outperformed the easier-to-trade 10-stock list, but even that eked out a small gain while the major indexes lost from 15% to 28% during the period. (The portfolios turn over monthly to reflect top-rated stocks.)

Here are the numbers:

 StockScouter versus indexes in the last bear market

Top 10 Top 50 Nasdaq S&P 500 Wilshire 5000 Dow industrials
1.6% 10.0% -28.2% -22.8% -21.3% -15.5%

As all savvy investors know, a big part of making money is not losing it. StockScouter was sorely tested in its infancy and came through with a solid, even spectacular, performance. I hope you find it useful in your own investing.

* * *

[2/22/07, Jon Markman writes] Want to get rich? Here's all you have to do: Buy 10 stocks. Hold them for six months. Sell and repeat.

If that sounds too good to be true and you want to stop reading now, I can't blame you.

But that would be unfortunate because this advice is a twist on a strategy that has worked really well for 5½ years, through hell and high water. Or at least war, recession and flood.

If you follow it in a low-cost trading account, particularly one in which gains compound tax-free, then there is a distinct chance -- though not a guarantee, of course -- that you could make serious, life-changing money.

Of course, you can't just buy any old 10 stocks. They've got to be the ones ranked at the top of the class by MSN Money's StockScouter rating system. You have to be ready not just to buy them at times when you think it is a terrible idea, but also be ready to sell when you love them so much you can't bear the thought.

Four states

Arnold Van Den Berg says there are four great psychological states you should look for when buying stocks (among many other topics) in this article from OID. [via toddfinances@chucks_angels, 3/4/07]

Value Line reports on the Dow

Value Line has made available (as a free sample) their reports on each of the 30 stocks in the Dow. [from financebguy@chucks_angels, 1/13/07]

Preys, Predators and Markets

Anthony Ogunfeibo compares financial markets to the cycle of lemming population.

The value of doing nothing

[3/6/07] Thanks to a study by Berkeley's Terrance Odean, who looked at thousands of real-life transactions and found that when investors sold a stock and buy another with better prospects, that new stock trailed the old stock by more than 3 percentage points over the following 12 months. That's right, trailed. As in worse.

[2/28/07] The performance of the Closed-End Country Fund Report newsletter just keeps getting curiouser and curiouser.

As I [Mark Hulbert] have several times mentioned over the past 18 months, this newsletter has not been published since mid 2004, more than two-and-one-half years ago. But since James Libera, the newsletter's editor, did not formally kill the service, instead indicating that he might someday resume regular publication, the Hulbert Financial Digest has continued to track the newsletter's performance by keeping watch over the last-known sighting of its model portfolio.

And what a performance it has been.

Since that last-known sighting, the newsletter's model portfolio has gained a total of 139.2%, according to the Hulbert Financial Digest. The newsletter was not only one of the top performers for calendar 2006 (coming in fifth out of the nearly 200 newsletters the HFD tracks), it has now emerged as the top performer for the past five years.

[story link from Chuck Brotherton at value_investment_thoughts, 1/20/07]

it's a scam

how can you tell if an investment pitch is a scam? Here are six telltale signs.

Dorfman's nine lessons

[John Dorfman writes] In 1997 I began writing a stock- market column for Bloomberg News.

Today I'm putting away my quill to devote fuller attention to Thunderstorm Capital, an investment firm I founded in 1999. For my last column, I'd like to highlight nine lessons that emerged from writing the column in the past nine years.

Eugenia Dodson

Eugenia Dodson came to Miami from Minnesota at age 20 in 1924, got work as a beautician at the Flagler Street Burdines, married well, invested wisely after her husband died, lived frugally to almost 101 and now has surprised her community by donating $35.6 million to local diabetes and cancer research.

10 Stocks to last the decade revisited

Back in the summer of 2000, Fortune, a highly respected publication and home to many fine pieces of journalism over the years, published an article titled "10 Stocks to Last the Decade."

An easy enough challenge, one might surmise -- simply picking 10 companies that would, umm ... not disappear. Actually, the article promised more than that. These stocks were specifically predicted to be winners.

Buy the worst or buy the best?

If you were given the choice of investing in one of two portfolios, which would you choose? Portfolio 1 consists of an equal dollar amount in the 10 S&P 500 subindustry indexes that posted the worst performance last year. Portfolio 2 contains the 10 best performers from 2006. Many investors would choose the worst-performers portfolio, on the expectation that such a beaten-down group is ripe for recovery. Those choosing the best performers might believe that momentum is on their side. Which does history say is the better choice?

During the past 37 years, the S&P 500 posted a 7.7% compound annual growth rate (CAGR) - price appreciation only, no dividends reinvested - and had a 16.3 standard deviation, which is a measure of volatility. Its risk-adjusted return (return divided by risk) during this period was 0.47. (The higher the number, the better.)

An investor who chose the "worst" portfolio saw a 7.8% CAGR but an increase in volatility. This portfolio beat the market only 49% of the time, as shown in the frequency of outperformance column, and its risk-adjusted return of 0.30 was dramatically lower than that of the S&P 500. Hence, the return was not worth the risk, in our opinion.

The investor who selected the "best" portfolio, however, received a 13.8% compound return, for an annual outperformance of about six percentage points. And despite an increase in volatility, we believe the risk was worth it because the risk-adjusted return was higher than that of the S&P 500. Finally, this portfolio beat the market seven times out of every 10.

price-to-book (p/b) ratio

The price-to-book ratio (P/B) is one metric that has long been held as the ultimate valuation measure. It's one of the foundational principles of Benjamin Graham's investing philosophy.

[The article is based on a chapter from Aswath Damodaran's book Investment Fables.]

Sell high?

What do you do when your stock is up 100% or more? Crazy question, I know. But in this situation, people can make costly mistakes in terms of opportunity. Many prefer to sell at least half their position in order to "lock in some gains," and others will sell it all, thinking there can't be much upside left in the stock after such a big run-up.

But oftentimes that thinking is wrong.

Annuities

Annuities--which are part insurance policy and part investment product--often seem like some of the most complicated and intimidating financial instruments around. Sometimes, they resemble IRAs or other savings accounts, and other times they resemble pensions that generate income streams. In this article, we'll try to reduce the intimidation factor by reviewing the basic kinds of annuities and discuss when they do--and don't--make sense as part of your investment plan.

IRAs

[2/16/07] IRA rollovers and inherited IRAs

[2/4/07] Do you know the difference between a traditional IRA, a Roth IRA, a rollover IRA, and an inherited IRA?

More Than You Know

More Than You Know is a book written by Michael Mauboussin, chief investment strategist at Legg Mason.

[1/31/07] Right now, as we speak, there are silent killers living in our brains, destroying our potential returns. No, it's not the plot to a sci-fi horror film. These sinister agents are decision-making biases, and they're chronically hurting your portfolio.

But have no fear. Help is on the way.

To learn which biases hurt investors the most, I asked Michael Mauboussin, chief investment strategist at Legg Mason and author of More Than You Know. In this interview, he tells us which ones to look out for, and he offers some simple tips to combat them.

[1/31/07] The Indianapolis 500 is touted as "The Greatest Spectacle in Racing." And there's a fascinating quote about what it takes to win the big race at the fabled Brickyard: "To finish first, you must first finish."

To me, that means winning is not just about going fast. It's also about survival, because 500 miles is a long haul.

I think this statement also applies to the stock market. You can have a great short-term run, but if you blow up along the way, you still lose. So what must we do to survive the investment race? I posed some questions to my friend Michael Mauboussin, chief investment strategist at Legg Mason (NYSE: LM) and author of More Than You Know, to find out.

[1/30/07] About skill and luck in investing.

[2/27/07] Mauboussin talks about guppies <! bloomberg link added 7/24/07, see value_investment_thoughts 6/17/06 ->

[4/14/07] Mauboussin on Strategy is a series of commentaries published on the Legg Mason site

[6/3/07] Here are three psychologically-difficult barriers great traders and investors must overcome: loss aversion, frequency versus magnitude, and the role of randomness. How individuals cope with these barriers provides good insight into their investing temperament.

[7/24/07] When you're a zebra being chased by a lion, there's no use thinking about next week. With humans, it's the same thing. A portfolio manager worries if a stock will work out in the next three days; he doesn't think if it will work out in the next three months or three years. <! value_investment_thoughts 6/17/06 ->

[8/6/08] More articles and commentary by Mauboussin

[3/11/13] Mauboussin has left Legg Mason

[3/4/14] an interview with Mouboussin

CAPM is CRAP

CAPM woefully under predicts the returns to low beta stocks, and massively overestimates the returns to high beta stocks. Over the long run there has been essentially no relationship between beta and return.

2007 Market Outlook

[3/26/07] where do we stand heading into the second quarter? The median stock in our [Morningstars's] coverage universe is about 4% overvalued, in our opinion. Not too hot. Not too cold. For some historical perspective, the highest the median stock has ever gotten was 14% overvalued, back in December 2004. The lowest: 22% undervalued in October 2002. At current levels, we'd expect the typical stock to offer positive--but single-digit--returns to long-term investors.

[1/28/07] Coming off of double-digit market returns in 2006, we asked three respected industry experts for their thoughts on what may be in store for 2007. Read what Jeremy Siegel, finance professor at the University of Pennsylvania Wharton School of Business and author of Stocks for the Long Run and The Future for Investors; Robert Shiller, economics professor at the Yale University School of Management, chief economist at MacroMarkets LLC, and author of Irrational Exuberance; and Sam Stovall, chief market strategist for Standard & Poor's,® said.

Q. What's your outlook for the stock market in 2007?

Stovall: Our target for the S&P 500 is 1,510 by year-end 2007. On average, bull markets, as measured by the S&P 500 Index, last four and a half years. (The current bull market reached the four-year mark in October 2006). We have had six bull markets that entered a fifth year. The average gain has been 8%. Four of the six bull markets celebrated a fifth birthday. In addition, the market has never declined in the third year of a president's term since World War II, with an average gain of 18%.

Shiller: The stock market looks overvalued to me, in terms of the way I calculate P/E ratios. Corporate earnings are looking weaker and the market is still highly priced. I think there is some downward risk potential.

Siegel: My feeling is we'll have a healthy market. I don't think it's a runaway market and I don't think it's a crashing market. But I think we will have a healthy market since earnings are rising and interest rates look like they'll be stable. I don't see a recession in the cards for this year. Unless you get strongly rising interest rates, it's very hard to keep the stock market down under those circumstances.

[1/15/07] Six months ago, the stock market looked reasonably priced when compared with Morningstar's collective fair value estimates. Since then, the market has been on a tear. Between July 21, when the median fair value of our coverage universe bottomed, and Dec. 31 the Morningstar U.S. Market Index rose 15%. As a result, we're heading into 2007 with a fairly pessimistic view of the stock market.

In fact, the median stock is priced to return single digits over the next three to five years, in our view. If you threw a dart at our coverage list, your expected three-year return would be 8.8%, down from 10.5% four months earlier. The median stock in our coverage universe of 1,800 stocks trades at a 12% premium to our estimate of fair value.

Quality, blue-chip companies, which tend to be larger, appear relatively cheap. When we look at valuations weighted by market capitalization--which give greater weight to larger companies--the stock market appears more fairly valued. The S&P 500, a cap-weighted index, trades very close to our bottom-up measure of fair value. When we weight by capitalization, three out of our 12 sectors are currently undervalued: software, health care, and consumer services.

Mid-Caps

[1/27/07] For each asset class there are many arguments pro and con. But S&P Equity Strategy recommends that market participants take a good look at the mid-caps - those companies with market capitalizations of $1 billion to $4.5 billion. In addition to very competitive long-term returns, the S&P MidCap 400 index was up 0.8% this year through January 18 vs. a 0.6% gain for the S&P 500 and a 0.9% decline for the S&P SmallCap 600.

We think mid-caps represent the "sweet spot" of the U.S. equity market. Earnings growth is faster than among the large-caps, while volatility is lower, and valuations are more attractive than those of small-caps. In addition, while most institutional and retail investors already have sizable allocations in the large- and small-cap asset classes, mid-caps remain largely undiscovered, paving the way for strong money flows as this asset class draws greater investor interest.

Magic Numbers and Relative Valuations

Many people seem to believe there are some "magic numbers" out
there that equate to stock-picking success.

Two things in particular that I hear over and over again
relates to P/E Ratios and Price/Book Values.

For some reason, many people believe that P/E Ratios of 20 or
less and Price/Book Values of 1 or less are these so-called
"magic numbers".

Unfortunately, statistics prove otherwise.

Looking at the best-performing stocks of 2006, only 41%
started with P/E's (using 12-month EPS Actuals) of under 20
while the other 59% were over 20. ("Best-performing" is
qualified by stocks that were trading at $5 or higher at the
beginning of the year, traded on average of 50,000 shares a
day and that have increased in price by 50% or greater by the
end of the year.)

This may or may not sound like a big deal. But, if you limited
yourself to only those stocks with P/Es under 20, your screen
would have excluded nearly 60% of the best-performing stocks
from your radar screen. And that is a big deal.

True, there were/are stocks in there with P/Es under 20, but
you would've missed a lot of fantastic winners if you excluded
those over 20.

As for the Price/Book Value, the median P/B was 2.9 at the
beginning of the period and nearly 4 (that's right, 4!) by the
end. Percentage wise, only 2% of the stocks had P/Bs of less
than 1 at the start. Which means, using the `magic number' of
1 for a P/B value would have excluded nearly every top
performer of 2006.

So if you're determined to look for stocks with `low'
valuations (P/E, P/B), try looking for `low' valuations as
compared to their Industries.

Why? Because 68% of the stocks on that list of winners had
P/Es under the average for their Industry and over 62% had
P/Bs under the average for their Industry. This means the
majority of the best companies would have made it through a
relative valuation screen, giving you a chance to buy them.

-- Kevin Matras, Zacks.com

Long-term sustainable growth rate

A company grows based on how much it reinvests and the quality of its investments. Companies that pay out dividends have less capital left over to reinvest; therefore, their long-term sustainable growth rate is expected to be less than the return on equity. As the payout ratio increases, the chance for price appreciation decreases, along with the diminishing expected growth rate:

Expected Long-Term Sustainable Growth Rate = (1 - Payout Ratio) * (Return on Equity)

The Robot Portfolio

[1/11/07] After seven consecutive years of beating the market, the Robot Portfolio underperformed the Standard & Poor's 500 Index in 2006. It was close. The Robot, helped by gains in U.S. Steel Corp. (54 percent), Ashland Inc. (43 percent) and Gold Kist Inc. (41 percent), posted a 13 percent return. The S&P 500 was three points better, at 16 percent. All figures are total returns, including capital gains or losses as well as dividends.

This year's ten-stock portfolio contains five homebuilders. The ten stocks for 2007 are Encore Wire, Meritage Homes, Lennar, Ryland Group, MDC Holdings, Champion Enterprises, Building Materials, Georgia Gulf, Overseas Shipholding, Valero Energy.

[1/13/06] Shai passes on this story about the Robot Portfolio that has beaten the S&P 500 for the seventh consecutive year. This year, it outperformed it 29.2% to 4.9%.

What the Dow is worth today

[1/10/07] Morningstar calculated (as of 12/29/06) the fair value of the Dow Jones Industrial Average to be 12,922 as compared to the actual value of 12,463. So it was 3.6% undervalued (compared to 9% three months prior).

[9/22/06] Back around Christmas of last year, [Morningstar] estimated the fair value of the Dow Jones Industrial Average to be 11,694 when it was trading at 10,837.

Since Dec. 19, the market prices of 23 of the Dow stocks went up compared to only seven decliners. The top three gainers over this time frame were General Motors (51%), Merck (MRK) (30%), and AT&T (T) (29%). The worst three performers were Intel (INTC) (-24%), Home Depot (HD) (-13%), and 3M Company (MMM) (-5%). Consistent with how the Dow index is measured, none of the figures above includes the effects of dividends; they are simply the changes in stock prices from Dec. 19, 2005, to Sept. 20, 2006.

As of the close of business on Sept. 20, [Morningstar] estimated the Dow's fair value to be 12,623, about 8.7% higher than its actual closing price of 11,613 on that day. In other words, we think the Dow as a whole is roughly 9% undervalued today. It's worth noting that the market closing price on this date was within 100 points of the Dow's all-time high set in early May of this year.

Morningstar's current list of five-star stocks are MMM, AA, KO, XOM, HD, JNJ, JPM, MSFT, WMT.

Despised Stocks

Wall Street Analysts Stumble on 2006 Stock Tips: John Dorfman

By John Dorfman

Jan. 9 (Bloomberg) -- The four stocks that Wall Street analysts most despised at the beginning of 2006 posted an average 21 percent return for the year.

The four stocks they most loved returned only 2.4 percent, which was far worse than the return of almost 16 percent on the Standard & Poor's 500 Index.

In short, the despised stocks walloped the favored ones. Is that a freak result?

No, it is not.

For nine years, I have been studying the annual performance of the four stocks that analysts most unanimously recommend, and the performance of four stocks on which they issue an unusually large number of ``sell'' recommendations.

The analysts' darlings lost 3.7 percent a year, on average. The stocks they hated declined 0.2 percent.

Both groups of stocks did worse than the S&P 500, which returned 7.4 percent a year, on average, during the period of the study: 1998 through 2006.

Analysts are tastemakers in the investment world. They set the frame of investors' expectations, provide much of the information on which the public invests, and move stocks with their ``buy'' and ``sell'' recommendations.

Yet as my little study shows, they are far from infallible.

I don't begrudge Wall Street analysts their successes when they have them. I simply say that you should make an independent decision when you invest. Analysts generally can't foretell the future any more than you can.

Underdogs Win

When 2006 began, five analysts had published opinions on the stock of Martha Stewart Living Omnimedia Inc., and four of those opinions were ``sell'' recommendations.

Based in New York, the company publishes magazines, licenses merchandise, and produces television shows, all promoting a stylish, elegant lifestyle.

It was easy to see why the analysts were negative at the start of last year. Founder Martha Stewart had just served five months in prison for obstruction of justice, and was barred from running the company in the future. It had posted losses in eight of the past 10 quarters.

So what did Martha Stewart stock do? It rose 29 percent in 2006, even though red ink continued to flow. Investors liked the rising revenue of the company, which they expect will turn profitable in 2007.

An even bigger gain that analysts didn't foresee was that of CBOT Holdings Inc., parent company to the Chicago Board of Trade. It was up 62 percent last year, even though five analysts out of seven slapped a ``sell'' rating on it.

CBOT Is Overvalued

Truth to tell, I would have agreed with those analysts. I think CBOT stock was overvalued then, and is even more so now at 56 times earnings, 12 times book value (assets minus liabilities per share) and 14 times revenue.

The analysts were right about Sycamore Networks Inc., which fell 13 percent. The other stock they hated a year ago was Washington Federal Inc., which turned out to be a modest gainer in 2006, up 6 percent.

And what about the stocks they loved a year ago?

SI International Inc., which was unanimously recommended by 11 analysts, rose 6.1 percent but didn't do as well as the S&P 500. The Reston, Virginia-based company provides information technology to the federal government.

Petrohawk Energy Corp., beloved by eight out of eight analysts, dropped 13 percent. The Houston-based company explores for and produces oil and gas.

Another loser was Sunterra Corp., a timeshare-vacation company with headquarters in Las Vegas. It declined 15 percent even though all seven analysts who followed it recommended it.

Best Performer

TAL International Group Inc. was the best performer among the adored stocks. The Purchase, New York-based company leases large freight containers that can be moved by ship, rail or truck. Last year, it jumped 29 percent in price, and returned 32 percent including dividends.

For the past nine years, I have gotten key data for this study from Zacks Investment Research Inc. in Chicago. This year, I was unable to find the information on its Web site, so I am taking a new tack.

Using Bloomberg data, I looked at analysts' recommendations on the 30 stocks that make up the Dow Jones Industrial Average. Bloomberg publishes average ratings for each stock, on a scale where five equals a ``strong buy,'' three is a ``hold,'' and one is a ``sell.''

Altria Group Inc., a New York-based company that owns Kraft Foods and is the largest U.S. cigarette producer, is analysts' favorite stock among the 30. Its average rating is 4.64.

Altria, AIG

There are many things to like about Altria, among them a dividend yield of almost 4 percent, and a return on equity last year of more than 31 percent. However, the stock has quadrupled since the end of 1999, and I think it is now fairly valued.

American International Group Inc., United Technologies Corp., General Electric Co. and Honeywell International Inc. also get high analyst ratings, ranging from 4.30 to 4.62. Of these, I prefer AIG, which sells for only 15 times earnings.

Analysts don't like General Motors Corp. (2.22), yet I wouldn't be surprised to see it do well in the year ahead. Merck & Co. and Intel Corp. get lukewarm grades (3.57 and 3.58). I like them but don't love them after recent run-ups.

Disclosure note: I own shares of Merck personally, and Intel for one or two clients.

(John Dorfman, president of Thunderstorm Capital in Boston, is a Bloomberg News columnist. The opinions expressed are his own. His firm or its clients may own or trade investments discussed in this column.)

Julian Robertson

Hedge fund manager, investment conference impresario and newsletter publisher Whitney Tilson has a terrific piece in the latest edition of his Value Investor Insight in which he does a mea culpa to legendary hedge fund manager Julian Robertson, who quit the business in 2000 at the height of the last round of stock-market insanity.

The mea culpa deals with comments Tilson, a big fan of Warren Buffett, wrote when Robertson threw in the towel. He noted that Robertson and Buffett have different styles, reflected in their portfolios at the time: Buffett likes high-growth companies with high margins, great balance sheets and returns on equity that exceed their cost of capital. Robertson opted for the ultimate value stocks with high debt, low margins, poor returns on equity and erratic growth. "This is a lame collection of companies...which deserve to trade at a low average multiple," Tilson wrote.

Fast-forward to today and, as it turns out, Robertson's 2000 portfolio shows why he, too, is considered a legend: In a period when the S&P 500 slipped 7%, his portfolio boomed by 120% compared with a 38% rise for Buffett's Berkshire Hathaway. Both, Tilson points out, handily beat the market.

Speaking of the markets: Robertson quit because he felt it was too irrational. What does he think now? "Surely you don't see the same degree of irrationality today that existed then?" Tilson asked. "Oh yes sir, I do," Robertson shot back. "There's a more serious bubble today than there was then."

[via Tom@chucks_angels]

A Rate-Cut Bump

Nothing excites Wall Street more than the possibility of a new round of rate cuts by the Federal Reserve.

Stock market history shows that when the Fed started cutting rates, investors typically received a greater than two-for-one stock price return - in other words, more than a year's worth of stock market advances (based on the average annual gain for the S&P 500, since 1945, of 9%) in six months.

The Sharpe Ratio

An essential element in evaluating any investment is knowing the level of risk involved. If an investment involves too much risk, then it may not be suitable for your portfolio even if it has the potential for high returns. Conversely, you may be willing to accept lower returns on an investment if its risk level is relatively low.

In order to take risk into consideration, you need to find a way to compare different investments that looks at more than just performance. One measurement, called the Sharpe ratio, can help you incorporate the risk of an investment into its overall return. By looking at the Sharpe ratios of different investments, you can better understand how much of an investment's return comes from the risks it assumes.