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.

Morningstar Ratings performance

We launched the revised Morningstar Rating for funds in 2002, and each year since then we've updated a study on how the rating has performed. For background, the rating is a quantitative measure of risk-adjusted performance relative to a category over the past three-, five-, and 10-year periods.

Consistent with past studies, the new study shows that 5-star funds tend to outperform 4-star funds and so on. Thus, the biggest performance gap is from 5-star funds to 1-star funds. This was the case when measured by relative performance and the three-year star rating.

*** [9/5/17] ***

While the star rating has inherent limitations given its reliance on past performance, our analysis suggests that it can be a useful starting point for fund research. Indeed, the star rating appears to point investors toward cheaper funds that are easier to own and likelier to outperform in the future, qualities that correspond with investor success.

earnings growth to decline?

Earnings have increased at double-digit growth rates for almost five consecutive years--although many agree that earnings growth may be slowing, it's beyond almost everyone's foreseeable horizon that earnings might actually experience a decline.

Yet a look back at history provides insights about the earnings cycle and what is considered to be normal. Despite the statistics about average earnings growth, the business cycle drives periods of surge and stall. And the stall is generally a year or two of outright retreat, rather than smoothly slower growth. As reflected in Figure 1, earnings typically grow handsomely for three to five years, and then decline for a year or two before again growing. That's usually all that it takes to restore the balance.

why fund managers don't beat the market

Have you ever wondered why the majority of active fund managers fall short of the market? After all, these professionals didn't get to be professionals by being bad investors.

A study done by finance professors Gordon J. Alexander, Gjergji Cici, and Scott Gibson sheds some light on the subject. The study shows that one reason active fund managers have trouble beating the market is their funds' liquidity policies.

Trading Systems (technical analysis)

There are many different systems and techniques that traders can learn to help themselves gain an edge in their trading. Some of these are complex, but they do not have to be complex to be good. The 10-day System is probably the simplest one you will ever learn, yet it can be very helpful, especially during choppy markets.

Investor Returns

We've all heard horror stories that illustrate investors' tendency to buy high and sell low. But just how bad is investors' timing, really? To answer that question, we took a look at investor returns, also known as asset-weighted returns, which Morningstar recently began calculating for funds in its database.

By factoring in the timing of investors' purchases and sales, investor returns depict the returns earned by the typical investor. In aggregate, the data show that investor returns have generally lagged those of funds' published total returns, which assume a buy-and-hold strategy.

Are the anecdotes about investors' poor timing overblown, based on Morningstar investor returns? No. Although most fund categories' total returns and investor returns were fairly close to one another over the past three- and five-year periods, the gap between the two widened substantially over the trailing 10-year period. That's likely because the 10-year period encompassed the late 1990s' bull run as well as the bear market, and both extremes tended to stimulate poor decision-making.

[10/13/09] CGM Focus (CGMFX) and T. Rowe Price Equity Income (PRFDX) illustrate how volatility affects investor behavior. Both are run by excellent managers (Ken Heebner and Brian Rogers, respectively) who have beaten their peers over the long term. Focus' 10-year annualized return of 19.6% thumps Equity Income's 3.7% yearly return through the end of September 2009--as it should, because Heebner takes much bigger risks than Rogers. Heebner makes huge sector bets, holds only about 20 stocks, and even sells short stocks that he thinks are primed for a fall. Rogers aims for a steady ride by focusing on reasonably priced, dividend-paying stocks.

But consider what investors actually earned. Rogers' clients have kept nearly all of the fund's meager gains, earning an average of 3% annualized over the past 10 years. Heebner's have somehow turned their fund's terrific reported results into an annualized loss of 14%. They managed that feat by piling into CGM Focus after its extraordinary 80% gain in 2007, only to get pummeled when Focus plunged 48% in 2008.

[7/27/12] Among the most interesting data points available on Morningstar.com is investor returns, which reflects actual investor experience with a fund as opposed to how the fund itself performed in isolation.

A fund's total return depicts whatever returns its basket of securities earned from one given point in time to another. But not every investor was on board the fund for the whole time period, and that's what investor returns attempts to capture. We calculate investor returns by using fund inflow and outflow data and applying it to fund performance. We can then see how the average investor fared relative to the fund.

To illustrate how total and investor returns can differ, consider a fund that gains 12% in the first three months of the year, then remains flat for the remainder. Its gain for the entire year is 12%. But what about the investor who, seeing the fund's hot early performance, jumps in during month number four? His or her return for the year is zero. As you can see, the difference between investor return and a fund's total return can be quite dramatic.

Two common themes that emerge here are investors piling into funds with excellent track records that are unable to repeat those strong performances, and investors abandoning funds after sharp downturns and thus missing out on the subsequent rebound.

A Baseball Story

David Gardner was a batboy, Ron Washington an unspectacular weak-hitting middle infielder.

Democratic victory could lead to stock selloff

NEW YORK (CNNMoney.com) -- With strong earnings, lower oil prices and a slowing economy to focus on, stock investors haven't exactly been paying attention to Tuesday's congressional elections. But maybe they should be.

Various reports indicate the Republicans are in danger of losing 20 to 35 seats - and their majority - in the House. In the Senate, the GOP is expected to lose at least four seats, in which case they would still be in control, or as many as six, which would swing the Senate to the Democrats.

Either scenario would mean the president and the Congress will no longer be controlled by the same party, aka gridlock. And for stocks, that's a mixed bag.

In the short term, a change in control of at least one of the chambers of Congress would probably spark a stock selloff, investors and market experts said. That's because traditionally Republican Wall Street would seem to prefer to have Republicans in control of Capitol Hill as well as the White House since the party's policies are widely viewed as more big business friendly.

Should the Republicans hold on to both chambers of Congress, "we can anticipate an upward - though likely short-lived - trend" in the market, said David Leblang, a political science professor at the University of Colorado, Boulder.

But in the long term, having either party in full control is not necessarily a good thing. In fact, in the long term, "the market actually likes the executive and legislative branches under different leadership as it reduces any damage coming out of Washington," said John Davidson, president of money manager PartnerRe Asset Management.

That was certainly the case in the 1990s when the pairing of Democrat Bill Clinton in the White House and a Republican-controlled Congress coincided with the longest economic expansion in the history of the United States - the famed tech-driven 90's boom.

A recent Ned Davis Research study suggests the market could weaken between the elections and the end of the year, if the last 104 years are any guide.

That's because 2006 is a mid-term year for a second-term president. In such years, a change in one or both houses of Congress has usually coincided with the Dow gaining in the months leading up to the election, and then sputtering or sliding through the end of the year.

* * *

[S&P's Sam Stovall offers a slightly different viewpoint.]

The mid-term elections are upon us. Control of the Senate and House of Representatives is up for grabs. Even though the Democrats may take control of the House, the odds are long for a total sweep. But as Harry Truman proved in 1948, anything is possible.

Currently, the Republicans control both the executive and legislative branches of the U.S. government. So the obvious question is: What happened to stock prices when one party surrendered partial or total control of Congress? This scenario has occurred six times since 1945 — twice to Democratic presidents and four times to Republican chief executives. Interestingly, Wall Street responded favorably to the change, with the S&P 500 posting an average price advance of 4.8% during November and December of those years (five of the six times, the S&P 500 had a gain for the year). Remember, however, that what worked in the past may not work again in the future.

So, what can investors expect in 2007?

Next year marks the third year of President Bush's second term in office. Historically, stock prices have posted their best performances in the third year of the presidential cycle, rising an average of 18% since 1945 vs. an average of 9% for all four years. What's more, third-year advances have been very consistent, as the S&P 500 climbed 93% of the time (the market was flat in 1947). The last time the "500" declined in the third year was 1939. The fourth year's 8.6% average increase is second highest.

* * *

[11/8/06 Tomorrow's News Today] The U.S. stock market had a solid rally in October and now the major indices might be due for a pause, some technical analysts say.

Merger and acquisition news and solid third-quarter earnings have pushed stocks sharply higher over the last few days.

On Tuesday, the Nasdaq Composite index finished at 2376, roughly three points below its recent five-and-a-half year closing high, hit on Oct. 26. The broad Standard & Poor’s 500 index ended at 1383, only six points lower than its six-year closing high.

Both indices are now looking a little overextended, based on weekly stochastics that measure of how overbought or oversold stocks are, said Katie Townshend, chief market technician at MKM Partners.

Their uptrend off their summertime lows is much too steep to appear sustainable, she said.

Already momentum is beginning to slow in sectors like utitities and real estate investment trusts, she said.

A Great Company Can Be a Great Investment

Gary Smith, an economics professor at California's Pomona College, thinks as many informed investors do that despite its triumphs now probably isn't the best time to buy shares of Genius Corp. Why? As Smith himself teaches his students, a great company doesn't necessarily make a great stock. By the time a company and its CEO are touted on the cover of a magazine, everyone already knows about them and how wonderful they are. Their virtues are already factored into the share price, leaving it nowhere to go but down. This is known as the efficient market hypothesis.

That's what makes the results of a study co-authored by Smith called "A Great Company Can Be a Great Investment" all the more surprising. The Pomona professor found that contrary to the efficient market hypothesis certain popular companies that have become household names tend to outperform the broad market.

Smith put together portfolios based on Fortune magazine's annual list of the 10 most-admired companies in the U.S. For the study, Smith took the top-10 companies from 1983 to 2004 and compared those returns with the S&P 500 index's returns. He found that the Fortune portfolio, which usually consisted of big-name blue chips like General Electric (GE), Dell (DELL), Berkshire Hathaway (BRK.A), Starbucks (SBUX) and Microsoft (MSFT), outperformed the S&P 500 by an average of six percentage points during the year following the publication of the list.

The results, Smith says, didn't jibe with his typically contrarian investing outlook. "There may be something to buying stock in great companies, which I never believed before," he says.

[via Russ@value_investment_thoughts]

Are growth funds poised to outperform value?

Morningstar shows that growth funds look a lot more like value funds than they did in March 2000.

* * *

Is it time for value to hand the baton to growth? The contrarian in us wants to say yes. Morningstar's large-cap growth category has lagged every domestic diversified stock fund group more often than not during the past six years. Based on performance and the idea that value won't trample on growth indefinitely, it seems reasonable to conclude that large-cap growth funds are ripe for their turn at the head of the pack.

Hold on, though, while we examine a few crucial facts. Large-cap growth funds may indeed be due for a comeback, but as a group they are not screaming buys, according to underlying fundamentals. In fact, large-cap growth funds don't look drastically different from large-cap value funds in some regards.

Keep It Simple

Successful investing doesn't require a lot of work, research, or attention. Although you may miss out on the best-performing investments, you can achieve the most important of your financial goals simply by doing two things: saving enough money, and buying sound, diversified investments that provide solid returns.

1927-1923 Chart of Pompous Prognosticators

"Stock prices have reached what looks like a permanently high plateau. I do not feel there will be soon if ever a 50 or 60 point break from present levels, such as (bears) have predicted. I expect to see the stock market a good deal higher within a few months."

- Irving Fisher, Ph.D. in economics, Oct. 17, 1929

[via tairbear00@chucks_angels]

The Little Book of Value Investing

[2/12/07] The Tweedy, Browne semi-manifesto and roadmap to superior investment returns, What Has Worked in Investing: Studies of Investment Approaches and Characteristics Associated with Exceptional Returns is a wonderful compilation of some of the most important studies of both domestic and international stock market returns. Investors of all levels of experience can benefit from it. It's free as well, which makes it particularly nice for the cost-conscious.

According to the research of Tweedy, Browne, there are five characteristics that tend to mark superior investment opportunities.

[12/21/06] What started with the deceptively simple and entertaining The Little Book That Beats the Market has quickly grown into the "Little Book, Big Profit" series. The second installment comes from another renowned investor and is aptly titled The Little Book of Value Investing.

Author Christopher H. Browne is a managing director at Tweedy, Browne Company, a storied investment firm he joined in 1969. Tweedy, Browne is an esteemed member of the Superinvestors of Graham-and-Doddesville, a designation awarded to a select group of investors that first followed Graham's teachings. Buffett named seven successful investors in a talk given at Columbia University in 1984 to commemorate the 50th anniversary of Security Analysis.

This Little Book is full of references illustrating what it means to be a value investor and why investors should take notice. In Browne's words: "Why value investing? Because it has worked since anyone began tracking returns. A mountain of evidence confirms that the principles of value investing have provided market-beating returns over long periods. And it is easy to do. . Yet in the face of compelling evidence, few investors and few professional managers subscribe to the principles of value investing."

[10/31/06] With all the books in print (200,000 new ones published last year alone), what could Christopher Browne's The Little Book of Value Investing add? Almost nothing -- but that's the point. Innovation is less necessary than the value investing framework. Buying stocks for less than they are worth is an easy concept to grasp. The idea doesn't need much scholarly refinement. Maybe that's why few business schools offer value investing classes.

Dividend Aristocrats

[10/19/06] Standard & Poor's launched its Dividend Aristocrats index in May 2005. The index is made up of 57 companies that raise dividends for 25 or more consecutive years. It is distributed among a broad range of industries and split roughly 50/50 between growth and value stocks.

The end result? A well-balanced portfolio of stable, blue-chip cash cows that offers better-than-average returns with less volatility.

-- from a post by cougar3@chucks_angels

Stock Picking Shortcuts

Investors can be entranced by “hot new investment strategies” and “shortcuts to beat the market.” Often, such rankings are also based on limited amounts of data, such as the level or consistency of historic growth rates in sales or earnings, or the level of projected earnings growth.

To analyze the predictive capacity of some of these stock-picking shortcuts, we looked at the largest 1,600 U.S. companies by market capitalization over the past 15 years. No silver bullet emerged.

• Forecasts fall flat. Stocks with the highest long-term earnings-per-share growth forecasts underperformed stocks with the lowest earnings-per-share forecasts by over 5% per year.

• History isn’t always prologue. Stocks with the highest five-year historic earnings-per-share growth rates performed no better than stocks with the lowest five-year historic growth rates. The same was true for historic sales-per-share growth rates.

• Stability can be overrated. Stocks with the most stable five-year earnings-per-share growth rates performed about the same as stocks with the most volatile trend lines. The same pattern held for sales-per-share growth rates.

• Even combos fall short. Combination strategies using sales and earnings growth rates, forecasts or stability measures showed no consistent predictive power.

There are two big problems with these shortcuts: They encourage the tendency of individual investors to project long-term trends while ignoring recent events, and most of the data is already accounted for in the prices of the stocks.

[now for the ad]

To develop a better stock selection power ranking, investors need to look beyond easy-to-compute growth rate measures and forecasts that are known to everyone else. They need to dig deeper using more inputs to analyze how that growth was and is being achieved in order to get a more accurate view (versus the consensus) of what that growth is likely to be. Sound complicated? It is. That’s why Schwab came up with its Schwab Equity Ratings to do the homework for you, and to help investors focus on what we believe is important: long-term capital appreciation—not expected or historic earnings growth at any price.

Overall, Schwab Equity Ratings favor healthy companies that are expected to deliver positive earnings surprises not anticipated by the consensus of Wall Street analysts. That means A-rated stocks favor companies exhibiting a stable growth pattern, and we expect them, on average, to keep growing beyond consensus expectations.

By Brian Burda
CFA, Vice President, Schwab Equity Ratings®
Schwab Center for Investment Research®

The Superstar Portfolio

Paul Farrell presents another way to build a well-diversified portfolio. It's very simple: You pick nine winners diversified across Morningstar's nine style boxes.

Here are the four steps you need to follow, once a year:

1. Scan Morningstar's database and pick the top no-load equities in each of the nine "style box" categories, from large-cap growth to small-cap value funds.
   
2. Invest an equal amount in each of the nine funds.
   
3. Save regularly, add new money and stay close to your allocations.
   
4. Then next year scan Morningstar's database again: If the nine funds you already own aren't still near the top, replace them. Otherwise, hang onto your winners.

We asked Morningstar research analyst Mark Komissarouk to search the company's database for us. (Anyone can screen their database using their software.) We targeted no-loads open to new investors. You'll see that all the funds picked outperformed the 10-year averages of the S&P 500 (8.9%) and the Dow (9.4%). Even more important, every single one of them outperformed their peer category, often by a wide margin.

So check the results of this grand-slam opportunity: If you had invested $10,000 in each of these nine funds a decade ago, your nine-fund portfolio would have enjoyed a fabulous average annual return of 13.4%, which is 50% higher than the S&P 500's 10-year average return of 8.9%!

current bull market is four years old

The S&P 500 received official bull market status on May 9, 2003, when it closed at 933.41, more than 20% above the October 9 close. (Standard & Poor's defines a bull market as an advance of at least 20% from the low set during the prior bear market.) Today the S&P 500 is 75.5% higher than it was on October 9, 2002. Yet this milestone, while certainly positive, raises a few questions. For example, how does this bull market stack up with prior bull markets, and how much longer does this bull have to run?

It should be encouraging to people who constantly worry about investing at the top of a bull market that after one year of a new bull market, an average 86% of the prior bear market's decline is recovered. It may also be surprising to learn that, on average, all of the prior bear market's decline, and then some, is recovered by the second year of the new bull market. The bull markets of 1942, 1974, and 2002, which followed bear market declines of more than 45%, are the exceptions.

-- By Sam Stovall, S&P Chief Investment Strategist

Momentum Investing from a value perspective

Morningstar's Paul A. Larson explains how a value investor uses "momentum".

Newton's first law of motion essentially states that an object in motion will stay in motion unless acted upon by another force. As applied to stocks, it is my experience that equities also carry momentum, for a little while at least.

No, I don't plan on suddenly switching gears to play the "greater fool" game, buying the market's hottest stocks at high valuations and hoping to sell even higher. Quite the opposite. My plan is to take advantage of this momentum when it causes stocks to not reflect the intrinsic value of the underlying businesses they represent.

Usually a stock starts to fall when a company announces some bad news. But then investors start to get concerned about their paper losses, worrying that they perhaps missed something, and the selling continues. This additional selling begets more selling, with everyone fearful they are about to lose big. Momentum and fear have taken over, and the stock price often disconnects from the fundamentals.

When Mr. Market goes into a panic like this, there are often bargains to be found. We haven't had any screaming panics in the portfolios this year, but do consider Wrigley (WWY). Sure, the company has hit a speed bump with its acquisition of some of Kraft's (KFT) old brands, but is a few pennies in lost (or merely delayed) earnings per share really worth the stock falling by more than $10 per share since the beginning of the year? I think not.

I will also look to take advantage of inertia on the upside. When a stock I own starts to rise merely because it has recently risen and then trades well above our estimate of its intrinsic worth, that is when I will consider selling. (Early year 2000, anyone?) One might say I will attempt to take Warren Buffett's advice and be greedy when others are fearful, and fearful when others are greedy.

Inertia not only applies to things in motion, it also applies to things that are stationary. As Newton's law tells us, an object not in motion will remain not in motion, unless acted upon by another force. But in this case, Newton's first law is not always obeyed by Mr. Market, and the only force that matters in the long run is cash flow. Sometimes, the fundamental forces of an improving competitive position and growing profits apply a strong force on a stock, yet the stock does not move. This is a time to buy.

I've described this scenario before as a "pressure- cooker" situation, and at the moment, there appear to be many opportunities of this type. Take Berkshire Hathaway (BRK.B) and Wal-Mart (WMT), both of which we currently own in the Tortoise Portfolio. These companies have all steadily improved their core businesses and grown their profits in the past couple of years, yet their stocks have a lot of stationary inertia and have not gone much of anywhere in years, only recently showing some signs of life. In my view, it is only a matter of time before the forces created by the cash flow will be felt and these stocks will rise even further.

Insider's reaction to new market high

How did corporate insiders react last week to the stock market’s new high?

That’s an important question, since insiders presumably know a lot more about their companies’ prospects than do the rest of us. They are a company’s officers, directors and largest shareholders.

The news turns out to be surprisingly good.

This might not be immediately obvious, since the data show that last week they sold $3.20 worth of their companies’ stock for every $1 of stock that they bought, according to the Vickers Weekly Insider Report, a newsletter that keeps track of the insider transaction data reported to the SEC. But, placed in context, this sell-to-buy ratio of 3.20-to-1 is bullish.

A bit of historical perspective helps us to understand why this is so. Perhaps the most important thing to keep in mind is that the average insider almost always sells more of his firm’s stock than he buys. That’s because a big chunk of insiders’ compensation comes in the form of shares. Insiders’ predisposition to sell has become even stronger over the last decade, in fact, because of the increased portion of insiders’ compensation that comes through options.

According to Prof. Nejat Seyhun of the University of Michigan, who has extensively studied insiders’ behavior, the normal ratio of insider selling to insider buying now stands at around 6.5 to 1. The current ratio of 3.2-to-1 therefore represents less selling than average.

The other important piece of historical context to keep in mind is that it is entirely normal for insiders to speed up the pace of their selling as the market rises. This doesn’t mean that they are particularly bearish on their companies’ prospects, but simply reflects their opportunistic behavior to take advantage
of higher prices.

For that reason, according to Vickers, last week we should have “expected ongoing deterioration in the [sell-to-buy] ratio.”

But, in fact, that didn’t happen. The week before last the sell-to-buy ratio was 4.14-to-1, according to Vickers. So in dropping to 3.20-to-1 last week, insiders actually cut back on the pace of their selling as the market reached new highs.
That’s bullish. If insiders as a group felt that the market’s new highs were only temporary, and that a pullback in their companies’ shares was imminent, they presumably would be much heavier sellers right now.

- from Tomorrow's News Today

Gonzalo Garcia-Pelayo

Garcia-Pelayo is not your average roulette player. In the early 1990s, this Madrid native discovered that certain roulette wheels were not completely random. In fact, they were biased. Because of small imperfections -- tiny flaws in the roulette wheel's gears, differences in the sizes of the pockets, or even an unlevelled floor -- some numbers tended to come up more often than others. Garcia-Pelayo painstakingly recorded the winning numbers on thousands of spins, then conducted a statistical study on this raw data.

By continuously betting on the numbers that his analysis showed came up most often, Garcia-Pelayo turned a 5% disadvantage into a near 15% advantage over the powerful casinos of Europe. What can an individual do with such a favourable proposition? Well, over a span of a just a couple of years, Garcia-Pelayo and his family exploited this edge to win more than two million euro.

the fall season

[10/11/06] Jim Jubak gives five reasons to expect a fourth-quarter rally this year

[9/7/06] Sometimes a market trend is so strong, and so historically reliable, that you should just go with it. That's the case with the market's tendency to slump from late August well into October. Then the market, most years, rallies into the end of the year.

Everyone knows that September is historically the worst month of the year for the stock market, with August and October running close behind. In most years since 1950, after a brief rally into the third week in August, stocks have trended lower into September before making a bottom around the 20th of October that sets up the traditional year-end rally.

Fortune's Formula

[3/0/07] Munger comments on the Kelly Criterion

[11/2/06] Emil Lee demonstrates how to calculate the Kelly Formula

[10/6/06] Suppose there were a simple and elegant formula that helped you to maximize your long-term investment returns while minimizing the risk of total ruin. Sounds like something you'd like to use for your portfolio, doesn't it? In his recent book, Fortune's Formula, author William Poundstone details the development, use, and criticism of an equation that purports to do just what I have described. It is known as the Kelly Formula.

Dow's high may draw in investors

By hitting its highest level ever, the Dow Jones Industrial Average may end up heightening awareness and stir interest that will bring new investors in and old ones back.

The DJIA’s feat solidifies the transition between the bear market bubble and the generally more orderly approach that has evolved when it comes to investing. The DJIA, after all, is made up of sturdy blue chip companies and that’s what investors chose in making it the first major stock barometer to recover.

The Standard & Poor’s 500 Index is still off about 200 points away from its peak of 1527.46. And the Nasdaq Composite Index is down about 2801 points from its peak.

It’s been a long road back for the Dow. From Oct. 9, 2002, its lowest point between the last record on Jan. 14 and the new one made on Tuesday, the Dow has gained 4469.08 points, or 61%.

And the Dow’s accomplishment may have major reverberations in terms of aiding the market, some analysts feel.

“People in the financial field live the market day in and day out,” said Art Hogan, chief market analyst at Jefferies. But when the Dow makes a new high people on Main Street start taking note. “They say we’re past the bubble and that can bring
them back in.”

In other words, according to Hogan, “It’s a broad wake-up call. It proves the market is back.”

And aside from more retail-type investors, investors in gold, real estate or other areas may feel the stock market has more appeal.”

And the Dow isn’t done, Hogan said. “I think the market will go higher from here because the dynamic that got us here isn’t going away. We’ve got consistently low energy prices and a Fed that has stopped raising interest rates. Barring some
external forces, this market sees the path of least resistance is to the upside.”

There are others who believe that the Dow’s ascent bodes well for the market.

“From a psychological standpoint it adds confidence and gives investors a sense of security,” said Andre Bakhos, president of Princeton Financial. “The money is telling you that the market is OK.”

Other strategists are hoping the rally will become more broad based.

“Oil dropping below $60 is helping the general market psychology and drawing money towards financials and technology again,” said Barry Hyman, equity market strategist at EKN Financial Services. “As long as that psychology develops that way its going be hard to sell off the market.”

That said, some traders aren’t convinced that the Dow’s record will have a wide impact.

-- from Tomorrow's News Today

The Harvard advantage

Begin with what "everyone knows" -- that a Harvard graduate will, by virtue of possessing a Harvard diploma, get better job offers, earn a higher salary, and become more of a success in life than a graduate of ACME University. But according to a landmark study published in 1999 by Princeton economist Alan Krueger and Mellon Foundation researcher Stacy Dale, the accepted wisdom has the facts completely backwards. Elite colleges don't make successful students -- successful students apply to elite colleges.

To dig down to the truth of the matter, Krueger and Dale collected admissions data from students who entered college in 1976 at a range of schools, both prestigious and less so, from all across the nation. Fast-forwarding 20 years, the researchers examined the salaries that these students were earning in 1996. They focused their study on two groups of students, both of which had applied to and been accepted by elite colleges. Students from the first group -- let's call them the "Ivies" -- accepted the offers, graduated, and entered the workforce carrying their Ivy League sheepskins. In contrast, the "non-Ivies" were also accepted, but turned the elite colleges' offers down and chose to enter more modest schools (with more modest price tags.)

Result: There was essentially no difference between the salaries earned by the two groups of students. To the contrary, the Ivy student who entered college with a 1,200 SAT in 1976 was, on average, earning about $1000 per year less than the non-Ivy student with the same SAT score. The same non-Ivy student who had turned the elite school down.

Conclusion: Smart kids tend to choose elite schools. But if kids are already smart, whether they choose to "go Ivy" or not makes no difference to their success later in life.

The Billionaire Strategy

[10/12/06] Last week, Foolish colleague Tim Hanson revealed some of the secrets of the world's billionaires. Surely his findings were obvious to most: Master investors make oodles of money, especially those who faithfully follow a strategy that plays to their inherent strengths.

What he didn't mention is that entrepreneurs dominate the same list of Forbes billionaires, including five of the top 10.

[10/2/06] What does the Forbes 400 tell you about the correct strategy to use to become a billionaire?

Wall Street Losers

If there were a Bad Trade Hall of Fame, Brian Hunter would have just secured himself a prominent spot.

Losing $5 billion in a week will do that.

Hunter lost that amount earlier this month, according to The Wall Street Journal, making big, risky bets on natural gas prices for coming winters.

The Trader's bell curve

Writes Price Headley, "MOST OF YOUR TRADES ARE GOING TO BE MEDIOCRE AT BEST. The huge homeruns are few and far between. But, you'll have enough of them over time to generate some big profits."

hot stock tips

[9/25/06] The title of a paper by Laura Frieder and Jonathan Zittrain gets right to the point: “Spam Works: Evidence from Stock Touts and Corresponding Market Activity.”

Incredibly, while Internet users will readily delete emails touting Free Medz and good deals on V-i-a-g/ra, investors have plenty of time to read the email touts, find the ticker symbol, and buy the touted stock.

The authors reviewed a sample of Pink Sheet stocks touted in more than 75,000 emails. After all that number crunching, they concluded that the stocks went up on heavy volume the day they were touted. Stocks also showed unusual strength the day before the spamming as the spammers were no doubt buying into the names they were about to blast around the Internet. In the days following the big spam day, the stocks went down as the spammers continued selling and volume from new buyers dried up.

[9/21/06] According to a recent study of more than 1.8 million investment spam messages by Laura Frieder of Purdue University and Jonathon Zittrain of the University of Oxford, the purpose of investing spam is to provide enough liquidity for those touting the stock to sell their shares at a profit. For the hypesters, average returns from the day before the spam was sent to the day of heaviest touting was as much as 6%. What if you were one of the ones who received the spam and decided to "take a flyer" when you got the email? Your average loss would be as much as 8%.

[4/19/06] Have you ever wondered if you're missing out on a great investment opportunity by NOT investing in the "hot" stock tips you receive in your e-mailbox?

Joshua Cyr decided to find out. On May 5, 2005, he decided to track what would happen if he purchased 1000 shares of every stock for which he received a hot stock tip via spam.

Naturally, he didn't actually waste money on this experiment. Instead, he just pretended to buy the stocks and kept track of their value on a website he created (so he never actually bought the stocks). He simply tracked what would have happened if he had actually purchased these stocks based on the stock tips.

Joshua expected that he'd get temporary, short-term windfalls on all these stocks and then see big losses. What he found instead surprised him. Almost ALL of the stocks went up a few cents at most, and then dropped dramatically the next day. So, no short term windfalls.

Joshua tracks the stocks real time at his site, so you can see how he's doing at any moment.

The Presidential Election Cycle

[9/20/06 Keith Fitz-Gerald] In case you’re not familiar with it, the Presidential Effect suggests that the second year of any president’s term, regardless of party affiliation, is the least productive in terms of how the financial markets move. Years three and four, on the other hand, are the better performing ones and are typically made possible by all of the free money promises that get made during the election process by both parties. These promises then get translated into market gains.

According to the Stock Trader’s Almanac, the 12-month period beginning in October of the second year of the presidential term has enjoyed average total returns of more than 28%. And since 1933, not a single third year 12-month period beginning in October has registered a loss (the worst return was a gain of 6.6%).

On average, since 1914, the Dow has jumped a whopping 50% from the bottom it hits in the second year to the top in the third year. This bounce ties in with other statistics that show the second and third years of the four-year cycle tend to be the best for stock markets as the party in power gears up for the following year’s election by trying to keep investors happy.

[7/5/06] Martin Zweig makes this observation in the Zweig Fund quarterly report.

"Based on statistics, there may be trouble ahead of the market. According to Standard and Poor's, the S&P 500 Index has lost 2% on average in second quarters of second years of presidential terms since 1945. Third quarters show average losses of 2.2%. Given the historically weaker mid-year trend, we will proceed cautiously."

[3/31/06] as the first quarter of 2006 ends stocks are smack in the midst of what is notoriously the most dangerous year of the U.S. political cycle -- Year Two of a presidential term. Of the 12 declining years endured by the Standard & Poor's 500 Index since 1960, a check of my Bloomberg indicates, six occurred in the second year of a presidential administration. Those included the punishing declines of 24 percent in 2002, 30 percent in 1974, and 13 percent in 1966.

On top of that, we're nearing the part of any year, from the end of April through October, that has gained a reputation as most difficult for stocks. Recall the boardroom adage, ``Sell in May and go away.''

[3/29/06] Liz Ann Sonders takes a look at the current presidential cycle.

[3/22/06] Looking ahead, there is one slight possible negative for the market relating to the presidential election cycle. Statistically, the postelection year and the mid-term year, which we are now in, have not been great years. Based on historical performance, the next pre-election year (2007) and election year (2008) would turn out to be better years according to this cycle.

While we are not strongly supportive of this particular thesis, data going back to 1949 indicates a significant market bottom occurs about every four years. Our last market bottom was in 2002 and it’s possible we may experience the next bottom in 2006. However, we are far from convinced that this will be the case.

-- Martin Zweig in the Zweig Fund annual report

[11/17/04] Several studies purportedly show that presidential elections do indeed affect the stock market and that the best times to own stocks are the two years before an election. Conversely, stocks apparently do not do as well during the first two years of a presidential term. One study, for example, shows that from 1941 to 1995, every bear market but one has occurred in the first or second year of a president's term; none have occurred during the last year, right before an election.

Strategy Performance

Validea has been keeping model portfolios of their various strategies since 2003. Leading the way is their Validea Hot List, followed closely by Martin Zweig and David Dreman [link from screenvestor of MFI, 9/18/06]

AAII has backtested various stock screens going back to 1998. Zweig is second again. O'Shaughnessy's Tiny Titans leads the way. [link from Michael Gallagher of MFI, 9/14/06]

Bears

[9/15/96] (Mauldin writes] The market, my various mentors have all told me, is designed to cause the most pain to the largest number of people. And while I am not in pain, the recent move up in the various market indices is certainly not in keeping with my thoughts that the economy is going to slow down and thus should exert downward pressure on the equity markets. Has the world transitioned to a kinder, gentler Mr. Market?

... this statistic from Paul Robinson: What happens when you have 3-plus years without a 10% correction in either the S&P 500 or DJIA? On March 15th, 2006 the market sustained 3 full years without a substantial sell-off from a 6-month high. This long a bull run has occurred only 3 other times in the past 100-plus years of market history and led to an average decline of 18.5% between the 3 occurrences.

In summary, I think it is too early to throw in my bearish towel. A slowdown means that earnings are not going to grow as fast as currently projected. That means some disappointments may (will?) be coming our way in the next few quarters.

Disappointments are the stuff that makes for bear markets.

[7/27/06, via investwise] Dr. Marc Faber says "Most asset markets including stocks and commodities are extremely overbought, and there is far too much speculation in all investment markets. Therefore, severe downside volatility, also in precious metals, should not be surprising in the period directly ahead.

... we can say that, yes, the Dow has been in a bull market since October 2002 in dollar terms, but it has been in a bear market in gold terms. This is an important point to understand. In case we should experience continuous monetary inflation, which could lift, over time, all asset prices such as stocks, real estate, and commodities, some asset classes will increase more in value than others."

* * *

[6/15/06] There are market bears--and then there's Barry Ritholtz. Some might call him one of the grizzliest forecasters on the Street. Although the Dow Jones Industrial Average came close to its all-time high of 11,722.98 earlier this year, Ritholtz expects the Dow to finish the year at 6,800. He's also forecasting that the Standard & Poor's 500 Index and Nasdaq will lose more than 25%.

[via investwise]

* * *

But even Ritholtz may not be as bearish as Doug Casey who believes that another depression is practically inevitable. On the bright side, he hasn't totally given up hope. "Perhaps friendly aliens will land on the roof of the White House and present the government with a magic technology that can undo all the damage it's done."

Current Account Balances

This is an interesting list from the CIA world fact book:A Rank Order of Current Account Balances...

http://tinyurl.com/eseet

[from chucks_angels]

[9/14/06] [Bill Bonner writes] Fallen into our hands is a report from the CIA, ranking nations in order of their current account balance. The current account, we remind readers, is like the operating statement of a business or an individual. Income must exceed outflow or your upkeep is your downfall. The difference between what comes in and what goes out, if it is positive, accumulates as though it were a profit. If it is negative, it builds up - but not necessarily, in the form of debt.

Last in line are the nations of the Anglo-Saxon, English-speaking debt-based empire! New Zealand has a deficit of nearly $10 billion. Then, South Africa...and India...and Australia all have deficits too. Among the major former colonies of the British Empire, only Canada seems to have any sense. It runs a surplus. The others are all debtors. The UK itself is third from the bottom with a $57 billion negative current account balance.

For no reason we can think of, the penultimate on the list is Spain. And then comes the worst of all...the United States of America, with a current account balance of a minus $829 billion.

Add up all the deficits of the entire world and you get a figure barely half of the U.S. total.

The U.S. economy makes up a quarter of the world total...that it should have more than half of the world's current account deficits is a spectacular success - only made possible by its great wealth and status.

[I guess that's one way of looking at it.]