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KPP Publishing Copyright © 2008 by Steve Peasley All rights reserved under the International and

KPP Publishing Copyright © 2008 by Steve Peasley

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Average Above Investing

for the Average Investor

Average Above Investing for the Average Investor
Average Above Investing for the Average Investor
Average Above Investing for the Average Investor
Average Above Investing for the Average Investor

Table of Contents


Introduction: You Don’t Need This Book


One: The Experts Say…


Two: Am I Gambling?


Three: Is the Market forYou?


Four: A Little History


Five: Emotions and the Market


Six: General Rules on Buying Stock


Seven: What to Buy,What to Avoid and Why


Eight: How to Find Stocks


Nine:The Hardest Part of Being in the Stock Market


Ten: Putting It All Together


You Don’t Need This Book

While I thank you and appreciate the fact that you paid hard-earned cash for this book (if you received it as a gift, then I am thanking the wrong person), there are other good sources of the information you’ll find here. I felt compelled to write this because I wanted to write a book about invest- ing that laid out the basics in straightforward language, and in a friendly tone—something I would like to read myself. I will not unveil any mysteries of the stock market, and I cer- tainly won’t reveal any secrets. If I had a crystal ball, I would be using it, not writing about it…at least not until after I set up my own “Gates Foundation” with my own billions of dol- lars. I have attempted to offer enough detail and background to help you understand how the market works, and how it can help you reach your retirement goals. What this book will do is explain how an average person with an interest in the market can turn that interest into the high probability of making money in stocks. It is not rocket science. In fact, it is not a science at all. Instead, it is merely

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buying a piece of America, or at least a piece of the American dream, owning something of value with the possibility of growing that value. I realize that by claiming you are “owning America,” I am stretching a bit, especially when you can own stocks of foreign companies, but that is exactly the point. The world is becoming smaller, and the United States’ system of free markets, despite its home-grown problems and foreign imperfections, is spreading worldwide. Who would ever have thought that a free economic system would be embraced by and flourish in a communist system like China? The free economic system’s impact is growing there, and frankly, I can not see how that type of government is go- ing to be able to stop freedom from spreading as a result. Mainland China is becoming more like Taipei, China. A free market system, almost by definition, will result in more per- sonal freedoms. Of course, it won’t happen overnight, and they are going to eventually hit a wall, a recession, at some point. At that point, China’s commitment to a free economic system will be tested. While China’s free economic system is important and in- teresting, I am straying from the point of this book. The stock market and the prices of stocks have been analyzed by much smarter and deeper thinkers than me, but that does not mean that they have come up with a better way to make money. In fact, a few years ago, some Pulitzer prize–winning mathematicians invented a way to invest using very complex formulas and derivatives of the bond markets and currency market. These guys were actual geniuses, but despite that high-powered intellect, they lost huge amounts of money be- fore they went out of business. Why? Because they focused on their perfect formulas and their precise calculations and ignored human reactions to fear and greed—the only two emotions that mean anything and the ones that control all short-term thinking in the stock market.



There are a lot of smart people in the stock market from stock pickers to analysts, but don’t rely on any of them to help you. One of the great truths in the market is that the experts are usually wrong. Since I do not consider myself an expert, I am hoping this book will help guide you. As a student of the market, I reserve the right to be wrong and accept the strong possibility that it may happen. So, do not look for any great revelations from this book. If you do, you will be sadly disappointed. It will try to ex- plain what moves stocks, both emotionally and financially, and how these two things interact. What makes stocks go up? What makes them go down? Why does the stock mar- ket overreact in both directions, and why is it that a stock always seems to go down just when you buy it and up when you sell it? One last great truth before we move on. The stock mar- ket is a great place to make lots of money—far outper- forming every other kind of investment over time. History does not lie.

One: The Experts Say…

Investing Rule #1: The experts are wrong.

Markets are moved by complex issues and that is precisely why experts are often wrong. Information spreads at incred- ible speeds, and once that information is disseminated, ev- eryone reacts to it. Government statistics are released daily and updated constantly, and corporations are constantly scrutinized as experts pick over every aspect of their busi- nesses like buzzards on a carcass. These analysts, the ex- perts, don’t miss one bit of flesh; yet, time and time again, they come up with the wrong conclusions. Consider the abundance of buy recommendations on Internet companies just before the bubble burst in 2000. Very few experts predicted that many of these stocks would lose, on average, more than 50% of their value and that hundreds of others would go out of business entirely. These experts were, as a group, bullish on the market. The tech- heavy NASDAQ index rose to over 5,100 in early 2000, and by 2002, it bottomed at near 1,100 before it recovered in 2006 to about 2,000. When the NASDAQ was at 5,000, all

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the experts were screaming: “Buy!” They were wrong! Why were the experts screaming at us to buy stocks when a reasonable, rational expert should have been warn- ing us about the possibility of a runaway train poised to crush us when we looked the wrong way? Why couldn’t they see that coming and warn us? We were looking the wrong way because those experts were telling us to. How could that happen? It’s simple. Those experts don’t work for you. They work for a system that makes money by attracting money. The markets crave cash. To fill that insatiable appetite, they need you to give them your money. You can give it to them in the form of your 401Ks, IRAs or a stock account. The money can flow to them through mutual funds, ETFs—a relatively new invention by these same experts, annuities or any form of investment. These experts eat cash and want you to feed them. They make that a priority, so their primary goal is to convince you to be in the market. Since the tech bubble burst in 2000, there have been some changes made to make these so-called “analysts” more independent from the market, but don’t count on those reforms making those experts impartial. They may indeed become more critical in their work, but they still feed on cash. As long as you stay in the market in one form or another, they will be appeased, but they still really want you to buy, buy, buy. I say this with all confidence not because these analysts are bad, but because they can only serve one master— the market—and that master needs to be fed. If these analysts work for a commercial banker and/or brokerage house, which many of them do, that brokerage house is looking to increase their assets under management and grow their earnings, just like any other red-blooded American company. To do that, they attract companies.


The Experts Say

They want to offer corporate America their services as commercial bankers and/or as brokerage firms, just as they like to offer their services to you, the individual in- vestor. When companies want to issue stock to the public or raise cash by issuing bonds, they do that through one of these entities. What company, needing to find a commer- cial banker and/or brokerage firm to raise money for that new factory or to fund the purchase of another company, will pick a firm that has publicly recommended that the public should sell their stock? The experts that work for these commercial houses do not want to have a sell rec- ommendation on any stock. That is why they use words like “neutral” or advise stockholders to “hold” when they really should be screaming: “Sell!” For commercial brokers and bankers, the goal is to keep everyone happy. They need to appease the corporations that need their help in financing and the public that looks to them for sound advice about investing. When it comes to investing, corporations and the public are not necessar- ily on the same side, and the financial industry courts them both at the same time. There are some truly independent analysts, but if you are reading this book and are an individual investor, you can’t afford their reports. These firms are not well known, except by industry insiders, and each stock or sector report they produce costs thousands of dollars. You will never hear what they recommend publicized; they hoard their information for the few exclusive clients who can afford them. However, even those independent analysts are often wrong, and to make money in the stock market, you do not need to hire them. If they are very good, they will become known in the industry and their reports will be widely read. Once that happens, they won’t be very good anymore. That sounds wrong, doesn’t it? But it’s not.

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Investing Rule #2:

When everyone knows something, it is worthless.

In the late 1990s, there was a method of buying and sell- ing stocks called the “Dogs of the DOW,” which became very popular. This method of investing required you to buy the highest yielding and lowest priced stocks in the Dow Industrial 30 every year. You hold them for one year, then rebalance the portfolio the next year by dumping last year’s picks and buying the highest yielding and lowest priced stocks again. This method worked for many years until it became well known. Keep in mind that by the time that you, an individual investor, find out about a stock or a method, all the experts and professionals have known about it for a while. This makes that tip worthless, even if it is new to you.

Two: Am I Gambling?

I like to play poker. That is gambling. I have a long-stand- ing argument with my wife about whether the stock market is gambling. She thinks it is, and I strongly disagree with her. My wife states her case very simply, and to a degree, she is correct. She says you buy stocks hoping that they will go up, and sometimes they do and sometimes they don’t. Since you are spending money and hoping for the best, she sees that as gambling. This is my counterargument. The stock market has some very unusual idiosyncrasies. From day-to-day, its reactions are insane. One day the market is depressed because North Korea shot off a couple missiles or a terrorist bomb killed a bunch of innocent people. But in the long term, stock prices go up and down based on earnings. My proof is just as simple as my wife’s argument. Compare any company that has made money with those that haven’t. Microsoft and Google are good examples of companies that have made money. Or look at Apple Computer’s history in the market. In Apple’s case, the stock ran up with its first personal computer and then languished for years until Apple invented the iPod. Then

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earnings skyrocketed and so did Apple’s stock. If you don’t believe me, name one stock, just one, that made money, then went out of business—causing their stock price to plummet to zero. This fate may have met a few companies because of poor or criminal management, but generally, there aren’t any. Now see if you can find a company whose stock price did not go up when it doubled its earnings year after year. It is possible there is a company out there, but if that company keeps that type of performance up, the stock price will even- tually reward those earnings. Gambling, by comparison, is more random. You can hedge a gambling bet with knowledge and the application of skill, but it all comes down to a random event based on an uncertain set of possibilities. Investing is buying an asset that has value. That value changes based on earnings. The gambling part of investing is caused by imperfections in the pricing system for stocks. The system is highly susceptible to short-term whims and external factors other than earnings and the growth of those earnings. Of course, my wife would say that those external factors are what turn investing into gambling. I can’t win with her, so I’ve stopped trying. As a last resort in this age-old argument between us, I can always point out that while she has lost money gambling over the years, I have made money investing. She hates that.

Three: Is the Market for You?

The stock market is a risky place. Stocks go up and down quickly, and your reaction to the down part is what will tell you if you should be in the market. I have observed that emotional, “Type A” personalities have a much more diffi- cult time being successful stock investors. As I will discuss later, emotion plays a significant part in stock prices. You need to know if you can ignore your emotions and the short- term swings in stock prices. When the stock market is in the midst of these big swings, does it affect your sleep? Highly emotional people and people who need a lot of control in their lives often have a hard time ignoring those big swings. It can be difficult to know if the stock market is right for you. When most people buy a stock, they can’t explain why they bought it, so they have no idea when to sell it. The most successful investor in history never plans to sell his stocks. Warren Buffett prefers to buy a company and hold on to it at all costs, ignoring all market gyrations. We mere mortals do not have that kind of discipline. I don’t expect you to invest like Warren Buffett, but his methods have made him the best stock picker and most successful investor in the world.

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Can you justify buying more of a stock that has lost 50% of its value? If you are honest with yourself, you will probably admit that you can’t, but sometimes when a stock loses half its

value, you should buy more of it. Your ability to do just that is

a good test of your comfort level in the stock market. Don’t mistake a stock’s price with its value. If a stock collapses and is fundamentally a valuable stock, the reasons for its fall must have been short term and unjustified. Why did you buy that stock in the first place? Have any of those reasons changed? Remember, the market’s pricing mecha- nism is fickle. In the short term, its rational judgment can be perfect, but more often than not, it is completely insane. That is why stock prices and values can be so different. That

is exactly why a stock’s price can be cut in half and still be

a great value. You need to be able to see through your own

emotional loss to still see the value of that stock. When looking at your own purchases, do you buy stock when the market goes insane and prices the stock far too gen- erously? Or do you buy when the market collapses a stock un- justly? When Krispy Kreme came out as a public company at around $20 per share and then shot up to $45 within a couple months, I could not understand why flour and sugar, boiled in oil and smothered in more sugar, would be worth so much more than other donut makers who use the same amount of oil, flour and sugar. The market disagreed with me, and for a while, I looked very wrong, but eventually earnings became the common denominator, and as I write this, the stock is priced at $8.20. Of course, it didn’t help that Krispy Kreme’s earnings weren’t reported quite right and that its manage- ment was being a little tricky in pricing some franchises, but

the point is that the market prices stocks at different levels at different times. How in the world are you to know when

a stock’s price reflects its value or when it is over- or under- priced? I confess, sometimes you can’t.


Is the Market for You?

You know that you are a rational, emotional being who likes order in your life. You also know that by participating in the sometimes irrational world of the stock market, you cannot always know the real value of stocks, cannot predict the market, cannot trust analysts, and if you find out about a great stock, it is usually too late. So why should you want to be in the market at all? Are you sure you want to do this?

If the answer is yes, welcome to my world.

Four: A Little History

Secular Cycles

I have to bore you with a quick look at the past. Try not to fall asleep. It is always instructive and inspiring to review the stock market’s past when I feel particularly blue in the midst of a down market. A quick review of the market helps convince me that, as my mentor, Jerry Klein, once advised me: “America is not going away.” Jerry lived and breathed the market for well over 40 years, and in his late 70s, he’s still an integral part of our firm. The following chart, produced by Rydex Investments, is a look at the market over a 100-year period. Several things should jump out at you; first is that the market has very long bull and bear periods. The shortest is 8 years, and that was the Bull market of the Roaring 1920s. The longest period was the 25 years marked by the Great Depression. That bear market didn’t end until the early 1950s. Throwing out the longest and shortest periods, you can reasonably say that these major cycles are about 10 to 20 years in length. We call these the Secular Cycles. The cur-


A Little History

15 A Little History rent secular bear cycle started in 2000; therefore, we can expect to

rent secular bear cycle started in 2000; therefore, we can expect to be in this cycle for several more years. It is likely to end sometime between 2010 and 2020, although it could be a lot shorter or longer. I believe it is likely to be shorter. This chart also illustrates that the down periods of the market, if measured from its beginning to its end, go down only a little bit while the up periods see big increases. This is the reason why you hear the buy-and-hold crowd talk about staying with the market. They are correct. If you stay the course, eventually you will make money—and lots of it. What they don’t point out is that if you bought stocks at or near one of those peaks, and a lot of people do buy at those peaks, you have to wait up to 25 years just to break even. Most people can’t emotionally commit to a stock for that long, and others won’t live that long.

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Cyclical Cycles

One thing this chart doesn’t show is the many bear and bull “cyclical cycles.” Those cycles are market moves up and down inside these very long secular cycles.

moves up and down inside these very long secular cycles. Source data used to create chart:

Source data used to create chart: Bloomberg

In the 1966 to 1982 secular bear market, there were four

bull cycles and five bear cycles. The up moves representing

a Bull market averaged 44%, and the down moves in the

bear market averaged 27%. These cycles occurred during a period when the Dow Jones Industrials ran up and down in

a 400-point range from 600 to 1000. The conclusion here is that you can make money in al- most any market if you have a good understanding of how the market works and can use a little common sense when buying and selling stocks.

The Current Situation

We are in a secular bear market and that’s ok. Between 2000 and 2003 we experienced a very large pullback in the market. The NASDAQ dropped more than 50% and the


A Little History

Dow about 30%. The Dow recovered in 2003, but we are still in the secular bear market and will remain there until the NASDAQ, the Dow and the S&P 500 exceed their old highs. Don’t expect that to happen anytime soon. It could, but the NASDAQ stock bubble that burst in 2000 was so extended and the pop did such extensive damage that I think

it is going to take years for the market to recover. A big technological advancement—similar to the Internet phenomena—will likely spark the next NASDAQ rally that will push that market index above 5,000. That doesn’t mean it

won’t happen. In fact, I can think of three possible reasons why

it will. The first one is the convergence of the iPod, PDA, lap-

top, T.V., camera, clock and whatever else they can stuff into

a cell phone-sized package. That convergence is coming. The

second possibility is the advent of widespread voice-activated computers, and the third possible market spark is the spread of the Internet, cell phones and computers into the third world countries and specifically into China and India. While these possibilities are on the horizon, we are still currently in a long term bear market and, if history teaches us anything, we know that we will experience up cycles as much as 40% or more and down cycles of 25% or deeper. You need

to be careful, but you need to be buying and selling stocks.

Why Buy Now?

Within each of these short-term stock market cycles, there are times of contraction and expansion in the economy. Do not confuse stock market cycles with economic cycles. They are tied together at the hip, but they are not the same. When the Internet bubble burst in the stock market in 2000, it caused the last economic recession and marked the beginning of the latest secular bear cycle. The economy climbed out of that

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recession in 2003 and the market rallied strongly that year, but it remained in the bear secular cycle. As you invest over the years, you will find that the stock market always looks the worst at an economic bottom, even though, at that point, you should be buying stocks. It is hard to buy at that point because during an economic recession, the stock market often hits the bottom. That leads us to the next rule.

Investing Rule #3: Always buy stocks when everyone hates them.

The worst times in a recession are often the best time to buy stocks. The problem is, of course, where is the bottom of the recession? No one ever screams, “Buy now! We have reached the bottom!” In fact, if you think about how you feel when the economy is in a recession, you will understand how difficult it is to buy stocks at that point. What does your 401K look like? Do you have the internal fortitude to invest more of your hard-earned dollars when the value of your investments are going down month after month? Most of us cannot justify it. In fact, I believe the average person cannot buy and hold stock positions at all. The exception is when the average person forgets he owns them. If you can force yourself to buy at that point, you are not average, and I bet that most people reading this book are not average. You can do it once you understand why. And you have to be able to put your emotions aside. Most people are emotional when it comes to money, es- pecially their own money, and they are particularly emo- tional when they are losing money. It is too hard to earn money and when it starts to evaporate with falling stock and mutual fund prices, the average person can’t handle it. They panic and sell—usually right at the bottom. The pro-


A Little History

fessionals look forward to those panic sells and wade into the chaos to buy when they see it happening. Individual investors need to learn to use their emotions and control their fears to prevent that panic from setting in during a downswing. But how?

Five: Emotions and the Market

Fear and Greed

These are the only two emotions that have anything to do with the market, and on a short-term basis, they are what con- trol the market. When I say that emotions control the market, I must stress that it is only true in the short-term. In the long term, the market is driven by earnings. If you understand how emotions affect the market in the short-term, then you can use it to your advantage. However, it will only work if you can control your own emotions. One of the most difficult tasks you can set for yourself is mastering that control. And don’t think professionals are not affected by their emotions; in fact, sometimes professionals react to their own fear and greed much more violently than the average investor. This emotional response is normal. Humans developed a healthy survival instinct by fleeing in the face of danger. It wasn’t pleasant being lunch for some bigger, faster crea- ture with sharper, longer teeth and painful claws. Fear is what drove us to develop our own sharp teeth—spears and knives. Fear was instrumental in honing our survival skills


Emotions and the Market

by teaching us to focus on gathering and preserving food, building shelters, and developing the wheel. All credit for these advancements should go to fear. It allowed us to survive as a family, a tribe, a country and, ultimately, a species. Fear served us well, and in many ways, it still does. however, when it comes to the stock market, the path to success requires you to ignore fear and control greed. The stock market didn’t develop naturally over centuries; it is a recent, artificial instrument invented by man. It is an instru- ment that operates outside of the natural order of things. Our genes have not developed survival instincts for dealing with the market, so we have to make a conscious mental effort to overcome those same impulses that have success- fully protected us throughout history because those impuls- es handicap us when it comes to investing. Emotions have no place in the market, and because of the effort it takes to control them, most floor traders last only a few years before they develop ulcers and heart problems. Years ago, when I worked near Wall Street, it was common to see the floor brokers in their colorful jackets—that’s how you recognized them—drinking their lunches in the bars surrounding the exchanges. Remember the two-martini lunch? Two for these guys would have been an appetizer soon followed by the full- course meal of straight hard liquor, on or off the rocks. How do you recognize that emotion is controlling your de- cisions or the decisions made by the overall market? There isn’t an “emotional barometer” out there to help us…or is there?

The Market’s Fear and Greed

Actually there are certain indices and patterns that show you fear and greed in the market place. One of the best that I like, and one that will no longer work if it gets too popu-

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lar, is the VIX or the VXN. What are they? According to Investopedia.com:

The VIX shows the market’s expectation of 30-day vola- tility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both calls and puts. The VIX is a widely used measure of market risk. The index is often referred to as the “investor fear gauge.” The VXN does the same thing, but uses the NASDAQ index options. I guess my job is done. I feel so much better now that I gave you the definition. Go forth and apply the VIX and/ or the VXN in your trading life. With these definitions in hand, you will always buy stocks at bottoms and sell them at tops. This stuff is pretty easy, right?

Yeah, right.

After you have read the definition a few times, trying to understand what exactly the VIX and VXN do, and given up, let me explain how to use it. The VIX and VXN are, like everything else in the market, tricky. It is a contrarian indicator, meaning that when it is high, when the so-called smart money is hedging bets with options because they fear a market collapse, you buy stocks; when it is at a low, mean- ing the smart guys think the market is going up forever, you sell. It gauges the fear and greed of supposedly smart money investors. At least that is what it is supposed to be doing. Therefore, by using these two indicators, you are betting against everyone else. That seems wrong, doesn’t it? You will find that a lot in the stock market. When something is going one way, the smart thing to do is go the other way. This is hard to do. As


Emotions and the Market

I said before, it is tricky. It is at the extremes that the VIX and VXN are most useful. You have to look at a chart to see these extremes, and if it was that easy, I could just provide the numbers of the extremes and tell you to buy here and sell there whenever it hits these numbers. When it comes to the market, you will learn that nothing is that easy. The VIX extreme in the depths of the recession of 2002 was about 45, and that was very high. The VIX, being a con- trarian indictor, told us that the opposite of what the smart money thought was going to happen was about to happen and that the market would rally. That smart money was say- ing the market was going to continue to fall. In 2003, the market did rally. That doesn’t make those smart money in- vestors so smart, does it? The VIX hit a low of just 10 again in 2004, after the recession was over. That is your range of 10 to 45 from 2002 to 2004. However, everything is relative. From 2004 to 2006, the VIX chattered between 10 and 20, never ap- proaching 45 again. And in May of 2006, the VIX shot up to a high of 24, and at that point, on our radio show and in our weekly newsletter (which you can order for less than $10 a month at investtalk.com), we were screaming to buy because 24 was an extreme not seen since the recession. But the extreme in the recession was 45, so why were we calling 24 an extreme? The answer was that we were not in a recession, and we had not seen that high of a number, 24, for two years. We saw massive amounts of fear, and we bought it. The fact that the impact of the numbers pro- duced in the VIX and VXN are relative makes them hard to read and even harder to implement. There is another reason why using these indicators doesn’t always work: they do not tell you how far up or down the stock market is going to go or, more specifically, how your stocks will move. This means that these two indicators could

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move from one extreme to another while stock prices may move only slightly. The VIX and VXN do not give you any clues about the potential depth of the move. When we were saying to buy at 24 and it actually peaked at 31. The market eventually did move up. I realize that I’ve advised you to use the VIX and VXN as

a way to gauge fear and greed in the market and buy and sell

stocks, but also gave you reasons why it won’t work. Just like an expert, I am covering my bases without making a clear recommendation. However, if I don’t give you the whole pic- ture of the problems inherent in trying to understand the market’s fear and greed, then I am not doing you any favors. No one can make easy recommendations, because no one knows the future.

Investing Rule #4:

There is no crystal ball.

Your Fear and Greed

Besides watching the VIX and VXN to gauge the market’s fear and greed, you have to closely examine your own per- sonal feelings. The closest thing you can have to a crystal

ball is your own personal fear and greed meter. I believe by using your mind to control your reaction to fear and greed, you can make sound decisions when deciding to buy and sell stocks. My recommendations are very clear: “When you are at the extreme of fear, buy; when you are at the extreme of greed, sell.” But how do you know you are at an extreme in your own feelings? What is your extreme? For me, it’s when

I think I am going to lose every cent I have because the mar-

ket is going straight down—when I see myself on the street, begging for spare change for my next meal. That’s when my


Emotions and the Market

mind tells me to buy more stocks or mutual funds. Don’t think about it and don’t torture yourself if the market con- tinues down from your buy point, just buy more. It will feel wrong, and you will be cursing and condemning this book and wishing that there was a worse place than hell for me to spend eternity. Take a deep breath when that happens, and then buy even more! When determining a place to sell, my mentor, Jerry Klein, likes to say that every time he thought about going out and buying a new boat, he sold stocks, because he was making too much money and was far too happy. That was his personal greed meter. You need to determine your own levels of fear and greed when dealing with your money in the market and react to them properly. Learn from your emo- tions and then learn to control them. This is very difficult. I don’t feel the fear and greed much anymore because I have been doing this for so long that I know what the market does at the extremes. My personal meter is damaged, but I make up for it in other ways. Once you have mastered your personal demons, the next big issue—and it is big when it comes to the market— is: What stocks do you buy when you are fearful? Don’t think that all stocks will go up when fear is at an extreme. Earnings drive the market in the long term, and the growth of earnings is what makes stocks go up—not fear or greed. Emotions have no place in evaluating stocks. We study emo- tions in the market to help you understand how the mar- ket works and how you react to it. Emotions and earnings are two very different dynamics. I cannot stress this point enough. Emotions are not related to which stocks you should be buying and selling. In the long term, the only thing that matters is earnings. You should always buy stocks with strong, growing earnings.

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Can You Ignore Your Emotions?

The buying and selling of stocks would be so much easier if we could turn off our reactions to emotions. Think of all the sleepless nights you wouldn’t miss by worrying. In the stock market, all you would have to do is look at earnings because the market would price stocks perfectly based on the facts and those facts are all about how much money the company is making and is going to make in the future. In this ideal stock market world, looking at both earnings and growth of earn- ings would be the only measure needed. (Even this perfect market world would be flawed because it can be difficult to decipher true earnings and growth potential. Just look at Enron, a company that had great earnings right up until they went out of business. In case you missed it, they lied.) This ideal world is impossible for us to attain because we are emotional beings and that is reflected in everything we do, especially when it comes to romance, money and, in my case, food. (I get teary-eyed every time I look at my wife’s pineapple upside-down cake. That dessert is emotionally im- portant to me.) Since you cannot be emotionless when buying and selling stocks, even if you try and think you are ignoring your emo- tions—you aren’t, so how do you recognize individual deci- sions that might be based on emotion? This is another dif- ficult task; the stock market is full of hard choices. As I have said before, trickiness is the hallmark of the stock market. Emotions are one of those tricky things. Fear and greed have a way of working undercover to influence your rational side. They worm their way in, forcing you to revisit your personal decisions again and again, gnawing at your reasons for stay- ing with a stock, trying to convince you that your cold hard analysis is wrong. On the sell side, you often feel that you made a sound, rational decision when, in fact, all you did


Emotions and the Market

was justify your fear and actions with some readily available facts. If emotions control the market in the short term and we are emotional creatures, how can we ever hope to over- come them? Let’s see if I can help you fight the twin demons of fear and greed in your personal trading decisions. Let’s say you own a stock and that you bought it for the right reasons—earnings. Let’s also suppose that the stock price is neither going up nor down in price. How long do you hold on to it? If it moves up, where do you sell; if it moves down, how far do you let it fall before you give it up? You should have made an unemotional decision about when to sell that stock prior to your purchase. At that point, you would have been thinking without an emotional attachment because you did not yet have your money at risk. That deci- sion should include how much of a loss you were willing to take or, for that matter, how much of a profit would be rea- sonable. On the profit side, you should have determined the stock’s value based on future or projected earnings. What I am saying is that when you decide to buy a stock you should, without fail, decide when you are going to sell it. It’s a deci- sion of how much you are willing to risk to achieve your up- side objective. Always make your decision about when to sell a stock before you buy it. Once you own that stock, you will be subject to your emotions. You might be good at control- ling them, but you will still be a slave to your feelings; it’s only a matter of degree. That realization doesn’t help you determine how to rec- ognize emotional decisions. Ok, here’s a clue. When a stock goes up and you are not concerned about when it is going to stop going up, greed has taken over. If you look at it only in passing and feel happy, greed has you in its clutches and you are going to lose money. You might not lose money on this particular stock, but rest assured that if greed is in con- trol—you are not.

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If your stock goes down and you are nervous about not

selling, review why you bought the stock. If those reasons are still valid, then you are making an emotional decision if

you sell it. If those reasons aren’t valid anymore, don’t search for reasons to justify holding on to a loser; that would be a strong indication that you are refusing to accept that you made a wrong decision in buying the stock in the first place. You may be afriad that if you get out now, the stock will go up, or greed may be telling you that if the stock is low it is

a good value and you should buy more. If a stock goes down

from the point of your purchase, you are wrong about that

stock. It’s a matter of how wrong do you want to be. Step up and face the facts. You are wrong! If you had decided where to get out before you bought the stock, you would not be in turmoil about what to do. Make decisions beforehand and save yourself some grief.

A very good way to control fear and greed is to look at a

chart of the stock. I like a daily one-year chart. Chart read- ing is an art, not a science, and it takes time and effort to learn this art—and it still can be wrong. However, it is a way for you to make nonemotional decisions. Many chart technicians use the 50-day and 200-day moving average. If

the stock price drops below these averages, they sell. There are other averages used as well. The 20-day moving average is commonly used, but it is a short-term buy-and-sell signal. Moving averages are very instructive and using them helps smooth out the day-to-day volatility of stock movement. Remember, we are trying to avoid emotions and the market is driven by fear and greed in the short term, so anything you can do to reduce your reaction to your emotions is a

step in the right direction. Look into charting and see if that helps you. Our firm uses charts on a routine basis. There are

a number of very good books on chart reading. My personal

favorite is Technical Analysis of Stock Trends by Robert McGee.


Emotions and the Market

Another way to avoid emotion is using “stops” based on

a percentage move of the stock price. A stop is a sell order.

There are investors that use an 8% or 10% rule. If the stock falls by a certain percentage from its high or from where they bought it, they sell. I am not opposed to using percent- age stops sell systems and, in one way or another, often use them, but the problem with them is that you can be taken out of a stock position due only to the volatility of an indi- vidual stock. In other words, if you have a stock that moves up and down 3% in one day routinely, it is very dangerous to place an 8% stop loss because in two or three days of trad- ing, it will trigger a sell. You have to look at the individual stock movement when placing a stop. There is no overall rule you can apply. Some stocks move in pennies a day, and others are much more violent. Also, the price of the stock tends to change the volatility. Low-priced stocks are more volatile than higher-priced equities. It is simple to explain. If a $10 stock moves up or down $1, it is a 10% move. If it is a $50 stock that moves up or down $1, it is a 2% move. Therefore, placing an 8% stop on a low-priced stock may not be a very good decision. You have to look at each stock’s personal trading pattern.

There is yet another method for being emotionless when

it comes to your stocks—never look at them. Buy them and

forget about them for 10 years or more and then one day, open your statement for the first time and see how you did. In fact, this could be a very good way to own stocks. If you stick to large blue chip stocks and have a good spread of them, this will work. I am talking about stocks like Johnson and Johnson, GE, IBM, and Proctor&Gamble. Do not buy small and mid- size tech stocks. Most of them will not be around in 10 years. Something new will come along and destroy the old. To recap: people are emotional and cannot control them- selves without effort. Therefore, the stock market is con-

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trolled by emotions on a short-term basis. Your job is to control and recognize these emotions, both in yourself and in the market. There are only two emotions that mean any- thing in the market: fear and greed. In an attempt to control these two demons, you must use methods that avoid or re- duce their influence. One of the best ways to accomplish this very difficult task in your personal trading of equities is to decide when to sell before you make your purchase. Placing a stop on your stocks can be another effective way of taking emotions out of the equation, but you must be careful to closely evaluate each stock before choosing a stop. The last method for taking emotions out of the process is to buy large blue chip stocks and to just ignore them for ten years.

Sell When You’re Happy

Selling a stock when it goes up is just as hard or harder than keeping a stock that is losing. Why? Because greed is just as powerful as fear. When you have picked a winner, you feel vindicated—you were right, you knew you were going to be right, and it was true! Congratulations! Now what? How long do you think it will go up and to what level? Stocks move in both directions. If you use my third sugges- tion and ignore your portfolio for 10 years, there is no is- sue. You won’t know what is happening. I am talking to the traders, the rest of us who have to look at our statements. In other words, us mortals who can’t ignore our money. One way to sell when stocks are running up is simple: Sell when everyone else is buying. This is a difficult trigger when you are in a winning trade. At what point do you determine that everyone else is buying? Where is that point? Go back to those two charts of the cycles of the market we discussed earlier. You can use cycles to help determine when the buyers


Emotions and the Market

are running the market up. If the current chart tells you that the market is at previous highs, it is time to sell. In the 1966 to 1982 bear market chart, this was consistently true.

1966 to 1982 bear market chart, this was consistently true. Source data used to create chart:

Source data used to create chart: Bloomberg

Study the many times the chart comes to a peak and then a bottom. These tops and bottoms traded in a range in one- to two-year increments. In a perfect world, we could use this pattern and be assured that we would have winning trades when we buy at or near old bottoms of the indexes for the Dow, S&P500 or the NASDAQ. Even the VIX correspond- ed well in that period. This works well in a trading range, but at times, markets break out of ranges. The 2000 to 2003 bear market was a good example: All it did was go down. You can’t just rely on charts because patterns change. So what else can you do? When it comes to selling a win- ning position, I suggest you not only watch the overall mar- ket but go back to why you bought the stock. You should have written down why and what target price you thought it should reach to be at fair value. Do the reasons you bought the stock still exist? Is growth of sales and earnings still ac- celerating or has it stopped? Is the current stock price at or near your target price? These are good solid reasons to sell a winning position.

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Investing Rule #5:

Sell when everyone else loves the stock.

I wish it could be made easier, but it’s not. These rules sound simple, but they are very difficult to consistently im- plement. The market tends to not repeat itself exactly the same way; it is perverse and takes great pleasure in embar- rassing the maximum amount of people possible. You can only do your best to apply the rules consistently and adjust them if they are no longer working. If you want to be success- ful in the market, you should be able to recognize change. I like to sell stocks at double and triple tops; this is a chart pattern in which a stock price goes up to a previous high point. I may only sell half my position if my value is still much higher, and there are times when I will hold on, regardless of the topping action. The hope is that the stock price will continue to go higher, but stocks will often stop at previously reached highs. The reason goes back to human nature. Anyone who held on to the stock the first time it peaked and did not sell it, only to watch the stock fall back down, will decide not to make that mistake again. Because of this tendency, double tops are called resistance levels, and the stock generally stalls near these points once they reach them for the second time. Previous owners who refuse to see their profits go down again may force the stock back down by selling. Selling pressure increases at double and triple tops. When the stock breaks through old tops, then these same tops become support if the stock falls back down. We will discuss charting in more detail later, but using these patterns to sell is a sound technique. If you like the stock and it hasn’t reached your target price, and it breaks through previous tops in a chart, then you should buy it back if you sold it, be-


Emotions and the Market

cause no one knows where it is going once it breaks through. These are very hard decisions to make because if you are selling winners, you will certainly second guess yourself. The first time you sell one and it continues up, you are going to be upset and question your trade. You will remember this book and think that I am as dumb as a rock. Just remember that if it were easy, everyone would be doing it. We’ll be discussing buy and sell signals in more detail, but remember that charting is not a science; it’s a study of human nature and of what people tend to do—and that tendency generally repeats itself. Selling winners is as gut- wrenching as selling losers, and using charts to help with the process will give you some guidance. Always remember that the market is constantly changing and that old patterns morph into new patterns, old methods need to be updated, and the process of buying, selling and evaluating stocks is organic not static. Nothing in the stock market happens the same way every time; the patterns are in constant flux. In time, you will learn that being stubborn will lose you as much money as being stupid. Don’t be either.

Six: General Rules on Buying Stock

What to Buy and What to Avoid

I’ve already given you a few investing rules and there will be more rules to come. If you are going to be successful in the stock market, you will need discipline. For some, that discipline may come naturally, but the rest of us have to work at it. Having rules helps instill discipline. Remember, our goal is to not be controlled by fear and greed. We are fight- ing our inherent nature, so rules work. However, even when diligently following these rules, you will always be subject to your emotions. They are part of your human nature. So let me warn you about these rules. The rules themselves are very sound, but what tends to happen is that you will use these rules and twist them to fit your emotional response. Fear and greed are all-powerful. Just when you think you have mastered them, these emotions resurrect and cause havoc on your wealth. Guard against using these rules to justify your actions.


General Rules on Buying Stock

Investing Rule #6: Always buy stocks that are making money.

It seems like such a simple rule and it overrides all the other rules, but there are many investors who constantly violate this rule and when you talk to them, they explain their reasons and sound so plausible that you almost want to believe them. It’s a bunch of nonsense. Buying stocks that make money does not mean buying stocks that will make money, but stocks that are making money now. I have stated that stocks only move up when they make money and that you should measure a stock and its potential

to rise in price by its growth of earnings. It is a simple prem-

ise. In reviewing history, there has not been a single stock that has increased in value that did not make money. Sure, you will be able to find some examples of stocks that have moved up for a year or two on a story that they were about to make it big but then didn’t. But making it big means making money. If you were starting your own business how would you measure success in that business? It’s about earnings— cash. It’s all about the money. You, as an investor, live in Missouri—the “show me” state—and you need someone to show you the money. Nothing else matters. Preserving assets is important, but only so you can hold on to the asset long enough to make money later. Corporations report earnings every quarter. We call this an “earnings season.” It starts in earnest a week or two after each calendar year quarter end: January, April, July and October. This is the report card time. During this time, companies come out with their Earnings Per Share (EPS) number and an accompanying statement of some kind hint-

ing about the future or explaining what happened in the past.

A stock will often go down even when the earnings report

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is good. There is a saying, “buy on the rumor and sell on the news,” which describes this phenomenon. It is not always true, but it does manage to be true enough that it confuses most amateur stock watchers. When EPS numbers come out, make sure that you are not hearing other earnings news except the actual EPS. Watch out for the term “Pro-Forma Earnings.” What that means is earnings if you take out one-time or unusual expenses. In other words, “Pro-Forma” means: “I am going to try and do a sleight-of-hand trick with the numbers.” A corporation will say, “We made $1 per share in ‘Pro-Forma’ earnings this quarter. Aren’t we good?” If you look a little deeper, you will discover that what they are actually talking about is that with that lawsuit they had to settle and the disaster in one of the factories that they had to rebuild, their actual earnings were zero per share. They will try to convince you not to look at that lawsuit or the disaster because they are expenses that are behind them. They were one-time expenses. They will want you to look forward. It is all lies! Do not listen! There is always another disaster around the corner and another attorney ready to sue anyone and every- one again. Unforeseen and unexpected expenses should be planned for, so don’t let a company convince you that their earnings were better than they were with the words Pro- Forma. Concentrate on real earnings. Before the actual earnings season comes the “earnings warnings season.” This is the month before the end of the quarter. During this period, companies warn that next month they are not going to meet their expected earnings projections. It is an attempt to lessen the pain when the actual numbers come out. If you pay attention, you will see companies trying to manipulate the public. They will use the truth to manipulate; public corporations have to report facts (unless they are practicing fraud and that does happen).


General Rules on Buying Stock

Generally, the vast majority of corporations tell the truth, but they tell it in a way that makes them look the best. They will give you Pro-Forma earnings and the real earnings and they will warn you of problems, unforeseen expenses, or unusual circumstances. All this is good, but I want you to realize it is all a way to manipulate you, your desire to trade the stock, and your perceptions of the company. It a game, and you need to learn the rules. Watching this dance of earnings every quarter is inter- esting and can be profitable, but it still is a lesson on earn- ings. Stocks go up when earnings go up. Just buy stocks with increasing earnings. How hard can that be? The problem is that the market is not sane. It is made up of very emotional beings, all of whom are trying to beat the other guy, trying to get ahead. They are looking forward to next quarter, next year or the next big, new thing, and they all want to own the stock that will rocket higher because of the next new thing. Examples of this are everywhere. The iPod is one of the biggest new things today, or China—yes, the entire country—with its spectacular growth in the past few years. Everyone is trying to beat everyone else, and this causes stock prices to move in perplexing ways. Recently, UPS reported its quarterly earnings and they beat all expec- tations, but their stock fell about 15%. Why? Because of what the investors saw in a certain sector of their global income. Investors felt that UPS’ growth was slowing in a particular area in the world. True or not, the stock fell sharply. Traders are trying to predict the future, and we all know how reliable that is. Obviously, as investors and speculators guess at the future, they push stock prices around and, in some cases, push them to heights or depths that make no sense. That is why, in the short term, the stock market is not sane. In the long run and looking back over time, stock prices reflect their earnings. Thus, Rule #6: Buy stocks that make money.

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It is in the inaccurate process of looking forward that stocks become mispriced. Who knew that the iPod would be so popular? Or that cell phones one day would replace land-line phones? Or, for that matter, that the horse would be replaced by the car? There is a great book called Creative Destruction by Richard Foster, Pierre Ven Beneden and Sarah Kaplan that describes how our economic system destroys all old systems and products and replaces them with new. You can read that book after you are done with this one. So how do you find these stocks that have consistent growth and/or a new way of doing things? How can you see shapes in the crystal ball’s murky gray clouds? The first step to successfully choosing stocks is understanding what influ- ences current and future earnings. That means you need to be a little clairvoyant. Even though you should not expect to be able to see the future, be aware that the future is always seeded in the present. Success lies in your ability to analyze the current conditions in both the economy and in politics. It takes patience, a lot of reading, a fair amount of common sense and a bit of careful prediction.

Investing Rule #7: Do not buy story stocks.

A story stock is one that has a great story and is “cer- tain” to make money in the future. The story is always very compelling. Biotech stocks have been selling this “future” earnings story for years. There has been just enough suc- cess in the story to keep people buying and selling biotech stocks. Some of these biotech stocks are spending obscene amounts of money by issuing the public more and more stocks while failing to create a concrete business plan. The story is great, the next big cure for cancer or AIDS, but usually that is all it is—a story.


General Rules on Buying Stock

Because investors have to be forward thinking and they want to beat everyone else, they are very susceptible to the next new thing. They are eager to believe any sound and convincing story. I hear it all the time. I call these inves- tors the get-rich-quick group. They purposely seek out story stocks, and guess what, they find them. Why? Because there are always people on Wall Street ready to take your money by selling you a story. What makes you think that anyone on Wall Street is not willing to spin any number of stories to part you from your money? That is what they do for a living. The story will always sound very good. They are masters, and they have a ready, waiting, willing and wanting audi- ence. Despite how good they sound, do not buy story stocks! Buy stocks that make money. If you find a stock that makes money and has a great story, feel free to buy it. Those are the best kind of stocks to buy.

Buy Stocks with Growth and Value

One of the biggest problems people have when they finally find a stock that interests them is that they think that they have to buy it now. Their reasons are usually the same: They just discovered it and it’s going to the moon tomorrow. They don’t want to miss this great opportunity by not jumping on it. That is pure emotion talking. Never ever feel that you have to buy anything today. In fact, never buy anything on the first day you find it. The idea needs to be refined. Pretend it’s a fine wine. You need to swish it around first, smell it, and roll it around in your mouth before you swallow it. Those that just guzzle their wine are usually alcoholics who have no control. In drinking wine and buying stocks, maintain control. Don’t even look at this stock unless it is making money. Dismiss any stocks that are not making money. You can

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watch them, you can research their products, and you can even become an expert on what they do, but do not buy the stock until that company makes money. In addition to mak- ing money, you want to buy a stock that is cheap. Cheap

does not mean the stock is selling for $1 or $2 per share.

A stock’s price has nothing to do with whether or not it is

cheap. A stock is cheap or “dear” only in comparison with

its current and projected earnings. It is in that relationship, between stock price and earnings, that you can determine the relative value of a stock. The stock market always looks forward, so you must too.

It does you no good if you only look at past earnings. Yes,

you should analyze the pattern of earnings, and it is nice

to know how consistent the company’s earnings have been,

but when it comes to buying stocks, look forward. Looking forward means you should look at earnings estimates and

at the relationships of those future earnings to the various

stock-specific elements. What do I mean? To explain, let’s look at some relationships.

P/Es and EYs

Measuring the relative merits of a cheap or expensive stock is usually expressed by its price-to-earnings (P/E) ratio. The stock market’s overall P/E (the S&P 500) ranges from about 7 to 30 but is considered normal at about 17. Normal is a loose term, because it refers to historical norms. However, in studying the P/E ratios, do not assume that a low P/E is where you buy and a high P/E is where you should

sell. During recessions, the “E,” earnings, are very low or do not exist at all, and at the same time, stock prices are very depressed. Despite that situation, the bottom of a recession

is the best time to buy.


General Rules on Buying Stock

Buying Rule #1: Buy relatively low P/E stocks.

So looking exclusively at the P/E ratio is not a good strat- egy. However, in looking for stocks, the P/E ratio is a good relative number to compare. Also, you should compare a stock’s P/E with that stock’s peer group and not just the overall market. A high-growth industry such as tech gener- ally has higher P/E ratios, whereas low-growth industries such as steel or autos generally have low P/E ratios. So don’t get excited or obsess over a low P/E and don’t be frightened of a high one. The relationship between earnings, price and growth is what’s important. I prefer to look at the earnings yield (EY), rather than the P/E ratio. The two are related and, in fact, the EY is the

inverse of the P/E. If a stock makes $1 per share and the stock price is selling at $20, you have a P/E of 20 (20/1 = 20). The EY, using these same numbers, is 5% or .05 (1/20 = .05 or 5%). Therefore, if you know the P/E, you also know the EY. Why do I prefer the earnings yield? Because you can compare the earnings yield of a risky stock to the yield of

a riskless investment such as a treasury bond. Buying stocks

is risky; in fact, buying any investment is risky, but almost all would agree that buying United States bonds are nearly without risks. So if a 10-year government bond is paying 5% in yield, you need only hold it to maturity, and you get your money back plus 5% and if a stock EY is 5%, and stocks are more risky than these government bonds, why in the world would you ever invest in stocks? It makes no sense. What that means for you is that the higher the yield on a govern- ment bond, the higher you should demand from a stock’s EY. In fact, I suggest that you buy stocks that are producing an

EY of 150% or more of the current 10-year treasury bond

yield. I want to be rewarded for investing in a risky stock, so

a 150% premium over a riskless investment is a good place

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to start. Many investors use the current 10-year corporate bond rate, and that is a good measure as well, but it is a riskier investment than a government bond.

Buying Rule #2: Buy stocks with an EY of 150% or more of the yield earned on a 10-year government bond.

Remember, a low P/E ratio is a relative number to the mar- ket, its peer group, its industry and to itself. Do not assume that a stock with a low P/E is a good value. Sometimes when a stock’s P/E is at its highest, it is the best time to buy it. It is very straightforward to examine a P/E ratio in rela- tionship to its peer group. All stocks types are classified by sector and industry, so finding the P/Es for the overall group is easy. Those ratios are all over the Web. However, looking at a historical P/E ratio may be a little more difficult. In other words, look at a stock’s history and determine what your target stock has sold at in the past. I like using the high and low P/E ratios over a five-year period. This provides a good benchmark as to where a particular stock has traded. You then can look at its current P/E and determine its rela- tive stock price based on its history. History doesn’t always repeat itself, but it’s a starting point to determine a proper value for the stock. There are several simple methods to determine the potential future values of stocks and using a historical P/E ratio is one. Again, since we are always trying to determine the future value of a stock and its relationship to its current price, we use next year’s estimated earnings to forecast. Obviously, that means looking at the projected earnings estimates and that does require some guesswork. We try to determine


General Rules on Buying Stock

what the stock’s P/E ratio will be using next year’s earnings estimate per share and the current trading price of the stock. It is a very straightforward method, but when estimating, there is a lot of room for error. Despite the room for error, this is the best system available. While calculating these val- ues, remember that it is all voodoo math and that no matter how carefully you calculate them, our nice, neat formulas and values can still be very wrong. In Investing Rule #1, you learned that “Experts are always wrong,” and that is because they are the ones projecting future earnings. Using next year’s projected earnings and the histori- cal data regarding P/E, you can calculate a stock’s value. Multiply next year’s earning per share (EPS) by the high and low P/E of the stock over the past five years. So, if the low P/E ratio is 10, the high is 30, and the EPS is $1.50 per share next year, this is the formula:

Low P/E times next year’s EPS = Low target price (10 x $1.50 = $15.00)


High P/E times next year’s EPS = High target price (30 x $1.50 = $45)

The price range for this stock is $15.00 to $45.00. Now look at the current price and decide if the stock is cheap or expensive based on historical norms. Easy, isn’t it? Trust me, it is never easy. It might sound that way, but it is not. This is just one of many ways to determine stock value. I mentioned in the beginning of this chapter that deter- mining relative value means looking at the relationships between earnings, growth of earnings and stock price. That gives you two relationships to examine: the relative P/E

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ratio when compared to stock price, and the earnings yield, when compared to the yield of a 10-year treasury bill. There is yet another relationship you should investigate: growth and its role in stock prices.

EPS Growth

While it is important to study the relationship of earn- ings to the stock price, you cannot look at that relationship in a vacuum. All professional investors look at the growth of sales and earnings for the stocks they follow. That focus means you have to understand those investors’ process if you want to compete with them. In that competition, you are trying to gain an edge over them, and to do that, you need to dissect their thought process. You need to clearly under- stand the prospects of growth for their stocks’ sales. If growth of earnings and sales is the primary focus of most analysts, then you can understand why they are pas- sionate about watching the earnings that are reported every quarter by corporate America. There is usually an immediate reaction in the stock price when earnings are reported. The impact of earnings reports is a fact of life for every investor, and you must learn to recognize and embrace it. The stock price will fall or rise on the reporting of quarterly earnings, and most of that move is not based on the actual earnings reported, but on the anticipation of future potential growth or shrinkage in sales and profits. Therefore, the current “expectations” of earnings and growth for a particular stock are paramount, and, in fact, you should have a good idea about prospects for growth in your stock’s sector as well. It’s not getting any easier is it? I will try to simplify it, but it is still a lot of information to comprehend. Earnings, growth of earnings, projected earnings and sector prospects are just


General Rules on Buying Stock

the beginning of what you must understand. Do you have to know and understand these things to be competitive in the stock market? If you want to compete, you do. Being a passive investor is much easier, and it is the right path for the majority of people. If this is all too technical for you and you want to become a passive investor, find either a few good mutual fund managers and give them your money or find a trustworthy money manager and let him worry about your portfolio. If you are still determined to do it yourself, keep reading. The nice thing about the Internet is that the informa- tion you need concerning almost anything in the world and, more particularly, about stocks can be found quickly. When researching growth rates, you will seldom find the actual percentage rate of growth, but what you will find is last year’s earnings per share for a company and this year and next year’s projections. These are three of the numbers that you need to make your calculations and compare the relative value of stock prices.

Stay with me. I know it is getting a little complex.

Simply put, focus on earnings and growth of earnings. To evaluate the price of a stock and determine if it’s overpriced or underpriced, you want to try to estimate future earnings. Even though you cannot accurately determine future earn- ings, you still need to use those numbers to make your cal- culations because everyone else is doing the same thing and that effort, in the short term, drives stocks up and down. Even though they are certainly wrong, you still have to use projected earnings. We not only want to know what those projected earnings are, but we also need to know current earnings so we can determine the percentage of growth of earnings. How fast is

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the company growing? These are fundamental numbers, and once you have them, you can work with them and compare them with other stocks in the same industry or with current growth rates of a particular stock. Also, you can use the EPS (Earnings Per Share) estimate for next year and its growth rate to compute the future value of a stock. This is another, second quick-and-easy way to determine a stock’s future value. Using the last five-year high and low P/E ratios was the first method, and this gives you a second one that is actually easier to use.

You need three bits of fundamental information to make this calculation:

1. This year’s actual EPS,

2. Next year’s estimated EPS and

3. The growth that is derived from these two numbers.

If the current EPS is $1 and next year’s estimate is $1.20, that is a 20% growth rate. In effect, you only really need two numbers because use of those two numbers provides the third. You can get an estimated target price for the stock by multiplying next year’s EPS by the growth rate.

$1.20 x 20 = $24.00

Note: I did not use 20% but rather the number 20 to do my calculation.

Now compare the target price of $24.00 with the current price of the stock. Is the stock cheap or expensive? This is a very good method to quickly determine a future price target and current value of a stock. If the stock is selling for $10 per


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share, it is a great value; if it is currently trading at $30 per share, stay away from it. However, there is a problem. If you use this formula long enough, and believe me when I say I have, you will discover a problem. The formula works fine for midsize, growing com- panies, but for very small companies and very large com- panies, it tends to fail. The reasons make sense. First, if a company is not growing its earnings and is stagnating, this formula won’t work at all. If you are searching for stocks to buy and you are running into this problem with mid-sized companies, be aware that you are considering stagnant, non- growing companies. Why would you do that? Are you buying a story stock? What have I said about that? If it’s not growing and you are considering the company as a buy, you are likely being driven by a story. Many large companies have trouble growing because of their size. If you are looking for large companies because you feel they are safer, do not use this method to determine value. On the other end of the scale, this formula doesn’t work for small companies because they generally grow too fast. It is easy to double your sales and earnings when you are small. The whole world is your market. If you double your earnings, that is a 100% growth rate and 100 times next year’s EPS is your target price. One hundred times anything is not a rea- sonable expectation and you are bound to get hurt looking for those types of earnings. I would love to own a company that grows at a rate of 100% per year, but so would everyone else and I can assure you that the price of that kind of stock will be high in relationship to other fundamental factors. This doesn’t mean you can’t buy large and small compa- nies, it just means you can’t use this very simple formula when considering them. You need to use some common sense.

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By now you should have figured out that I like to study relationships between different fundamental numbers. We have talked about historical P/Es and EY in relationship to bond yields, now I am going to give you another relationship to consider. It is called the GPE and is an examination of growth (G) in relationship to the company’s P/E ratio. The GPE helps calculate the purchase of very high growth stocks which generally have higher than normal P/Es. Everyone wants to buy stocks low and sell them high, and most people believe that a low-priced stock means a low P/E. That is not true. High P/E ratios happen all the time. If a low P/E does not mean the stock is on sale, what should you use to make that determination? The GPE is a good answer. Ideally the growth of earnings should be two times the P/E ratio or more. I constantly mention the GPE of a stock on our radio show and in our newsletter because it is a very important concept. In fact, all the relationships are important and they all need to be computed and compared with each other, but the GPE disregards the P/E entirely. As long as the growth of the stock is two times the P/E or more, you can buy any high P/E ratio stock you want. Growth supports the high price. Growth can make up for a lot of problems when look- ing at stocks. Growth of earnings and sales are so important that almost all the fundamental numbers in this book do not work without growth. Again, determining the growth rate of a stock is easy. If a stock made $1 per share last year and is going to make $1.20 this year, that is a 20% growth rate. If it continues to make 20% next year, then next year’s EPS will be $1.44. It’s a simple mathematical formula. If this seems complicated to you (and if it does, I bet you haven’t balanced your check- book either), then do not consider investing on your own.


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Don’t stress over it, my wife hasn’t balanced our checkbook in years, and she is pretty smart. Some things in life just appeal to a certain type of person. I am suggesting, after you have done the math, that you want to buy stocks that have growth rates of twice the P/E ratio. Using our example of 20% growth per year and our GPE factor of two, you want to buy this stock only if the current P/E is around 10 or less. The higher the growth rate, the higher a P/E ratio you will accept. The P/E can be 100 as long as the growth rate is 200%. Keep in mind that whenever we talk about numbers of any kind and try to determine a good value for a stock, we are looking forward at next year’s numbers. At the risk of repeating myself, current and past numbers are nice and something that you consider when appraising consistency, but all professionals study the future prospects of a company, not the past. There is a theory that states that everything known about a company is already considered and reflected in the current stock price. That theory suggests that you cannot glean any new information from research because all past information is already built into the price, so why try? Remember Rule #1: The experts are always wrong? If that is true, it means that if you do your homework, then you, the individual, have just as much chance of producing superior results in your portfolio as a professional. In fact, I think individuals actually have the advantage. You do not have to worry about the liquidity of the stocks you buy or the size of your position in any one company, unlike a big mutual fund or a trading house. You can be far more nimble, and you can pick smaller, faster-growing stocks. You can beat them, but you have to have knowledge. This brings me to the third buying rule.

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Buying Rule #3: Buy stocks with GPEs of 2 or higher.

You will not always find stocks that meet all three of these rules. In fact, if you are considering large cap stocks, you

will likely not find any that fit rule three. The rules are not set in stone; they are guidelines. These rules define ways to examine relationships. If a large capitalization company has

a low GPE, which will be common simply because they are

large and can’t grow very fast, then stress the EY or its rela- tive P/E ratio or, more importantly, look at its price-to-sales

ratio. Yes, I slipped in another relationship for you to study.

I need to be sneaky about these relationships every now and

then or you might stop reading. Before we get into the new relationship though, let me further explain the GPE. Many experts talk about how they want the PEG ratio (price/earnings growth) to be low. The PEG is the inverse of the GPE. The PEG is the price of the stock, divided by the earnings growth (P/EG), whereas the GPE is growth of the stock, divided by its price earnings ratio (G/PE). Don’t get confused; you want a high GPE or a low PEG. The GPE works best with stocks that are not large. What does that mean? Stocks are categorized by size, as well as by sector, industry, growth, value and many other terms you may or may not be familiar with, but when we are talk- ing about the size of a company, they will be categorized by “market capitalization.” You can find the market cap almost everywhere on the web, but it is important to understand how this is determined. There are three basic sizes of com- panies: small, mid and large. A company’s size is deter- mined by the price of the stock multiplied by the number of

shares outstanding (the number shares available to trade). Generally, any company with a market cap of $1 billion or


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less is considered a small cap company. From $1 billion to roughly $7 billion is considered a mid-cap company, and a large cap company is over $10 billion. I realize there is a gap in my numbers. There is no hard and fast rule on market cap. Some people say a large cap is over $10, and some lower that number to $7 billion. Both definitions are acceptable. The reason that a large cap’s GPE is usually low is because of its growth. Think about how difficult it is for Microsoft to grow today. It has a growth rate of about 12% and a P/E of 15, so its GPE is below 1. It is no longer the growth stock it used to be when its growth was 30% or higher for years. When growth slows, P/E ratios tend to contract. When growth accelerates, they tend to expand. Microsoft has a billion shares outstanding, which is a direct result of that growth. In its growth phase, the stock would go up and split, continue up and split again. The shares grew in number as the price of the stock continued up. Since we measure the earnings growth using the earnings per share number and there are a billion shares outstanding, how much in earnings does Microsoft need to produce to continue to grow to achieve a decent GPE? That number is in the billions. The law of large numbers takes over. You can’t keep growing any company at the same per- centage rate as that company gets larger and larger. Smaller cap stocks have a much easier time growing. They have fewer shares outstanding, so their market cap is small. That means they generally have an easier time grow- ing their earnings per share numbers. Therefore, they can achieve a GPE of 2 or higher. The GPE looks for those stocks that have great growth of earnings but that are still not too expensive in relation to those earnings. Another benefit to the GPE number is that it will always keep you in stocks that have earnings and that are growing. Using the GPE number to choose stocks means that you avoid all companies that don’t have earnings or that have negative growth. That is a

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nice little side benefit. You cannot have a P/E ratio or a GPE without earnings. With all the complexity involved, it is nice to have a little bit of simplicity available.


There is one more important relationship to consider. It’s the one I slipped in on you in the middle of the last section. In all the three previous relationships, earnings ensured that you considered strong stocks. The P/E, EY and the GPE all must have earnings to make them work. You want a rela- tively low P/E, so if the price of the stock is high, you have a much higher earnings number. The same is true for each of the other two relationships. Earnings control the number. However, that is not true for the price-to-sales (P/S) ratio. I mentioned earlier that the P/S is a good number to compare when analyzing large cap stocks because it is very difficult to find GPEs of 2 or higher for large cap stocks. The price-to-sales relationship is nothing more than comparing the market cap to the gross annual sales of the company. That number should be around 2 or less. Some other experts like to use 4 or less, but I feel that is a little too generous.

Buying Rule #4: Buy stocks with a P/S ratio of 2 or less.

Again, I want to stress that these are guidelines and that not many stocks will fit all of these rules. If they do manage to fit all of them, you might want to consider them too good to be true and look for their flaws. You can use Rule #4 in either a flourishing or recession- ary economy. I mention economics because Rules #1–3 need


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earnings to compute the ratio and you will find it difficult to apply them in a recession. Earnings and growth collapse in

a recession, but a P/S ratio improves. Corporations still sell

products in a recession; they just may sell fewer products. They may not show profits because of the shrinking sales growth. Growth and profits evaporate in recessions. As a result, stock prices generally deflate faster than sales. That only makes the P/S ratio look better. In a recession, I recom- mend you focus more on P/S ratio than on the other three

rules because the best time to buy stocks is in the depths of a recession. During a recession, P/E ratios are usually at very high levels or are nonexistent because of flagging earnings. The GPE stinks if the P/E stinks, and there is no growth in

a recession—that’s why they call it a recession. You will find some stocks that meet all of the rules, even in a recession, but they are few and far between. The fifth and last buying rule focuses on Return on Equity (ROE) and Return on Assets (ROA). ROE and ROA are related but not the same.

ROE = net income/shareholder’s equity That’s simple, or is it? What is equity? Simply put, it is the money you, the shareholder, have invested in the company. It is also referred to as shareholder equity. The formula tells us how profitable the company is. It is a measure of a company’s profitability in relation to the dollars invested in the com- pany. Return on Assets (ROA) is a little different because it includes both debt and equity.

ROA = net income/total assets ROA reveals the earnings a company generates on its total capital and how profitable the company is based on its assets. These simplified definitions of ROE and ROA will suffice because you only need to use the numbers. You don’t need

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to understand the accounting that produces these numbers. We are investors—we just demand that the numbers are accurate and then use them in our formulas.

Buying Rule #5: Buy stocks with at least a 17% ROE and/or ROA.

Even though this is the last buying rule I am giving you, there are many, many other relationships that exist that influence the decision to purchase stock. I strongly suggest reading the bible of value investing, The Intelligent Investor. It was written by Benjamin Graham in the 1930s and is still highly relevant. It remains the best book on value investing. It is still in print, and I guarantee you that every professional worth his or her weight in gold has read this book. I also recommend you check out our web site, www.investtalk. com, and read every book on our book list.

To recap the buying rules:

#1: Buy low P/E stocks. #2: Buy stocks with EYs of 150% of the yield on a 10-year government bond or higher. #3: Buy stocks with GPEs of 2 or higher. #4: Buy stocks with a P/S of 2 or less. #5: Buy stocks with a ROE and/or ROA of 17% or higher.

These are the rules I am going to ask you to apply diligently. They appear simple, and you would think that their applica- tion will be easy and lead you merrily on the path to financial success. You would be wrong. I am going to give you some examples that may challenge your application of the rules, but


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before I do, we have to discuss stock and industry compari- sons. When we apply these five stock-specific rules, we have to do it in a way that makes sense. That means we have to make comparisons with other similar stocks within an industry.

Industry Comparisons

It will help you apply the buying rules I have outlined if you learn the differences the stock market places on the val- ues of various industries and sectors. The most obvious and striking difference, and one you might already know, is how the market tends to place higher values on the tech industry than most other industries. That has been changing since the Internet bubble burst in 2000, but there is still a bias to over- reward tech stocks with above average P/E ratios, low EYs and much higher P/S ratios. The reason is fairly straightfor- ward. It is because that industry is a very high-growth part of our economy. High-growth stocks deserve high P/Es. Therefore, it is wise to stress the GPE in tech stocks when you consider owning them. As explained, this ratio allows for high P/Es for companies with much higher growth rates. Again, always look at the relationships between a stock’s fundamental numbers. Can earnings and more importantly, the growth of earnings support a higher stock price? On the other hand, steel is a basic industry group which is generally thought of as a slow-growth industry; therefore, stocks in this sector deserve and attain low P/Es, but at the same time, they usually have low P/S ratios. If you are look- ing for stocks in these kinds of industries, expect low GPEs and concentrate on low P/Es, high EYs and low P/S ratios. Almost all types of commodity stocks are slow-growth industries. At least historically that has been the case. In the last few years, oil and commodities have shown constant

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higher growth, but the perception is still that they are slow- growth industries; therefore, their P/Es are low. These various characteristics of different sectors and industries mean that you cannot get excited at finding great values using our rules without first considering the funda- mental idiosyncrasies of the sectors and industries involved. Let me make it simpler than that. If you see low P/Es in

a high-growth stock in a high-growth sector with a great

GPE, then you can get excited. The best way to hunt down value in a particular sector or group is to compare the target stock with the average fundamental numbers in its group or sector. Just what you wanted to hear, more work for you. Although it’s sometimes tedious, you should really do this type of research if you are serious about investing. I met with an investment club some time ago and tried to explain the need to do this kind of work. They showed me their recent investments, and it was obvious that they totally ignored industry comparisons. They bought a high P/E stock in a low-growth industry and didn’t understand why this great company—and it is still a great company—did not go up in price. You can’t fight the market. If the market says certain types of stocks deserve low or high P/Es, then you better pay

attention. Remember who makes prices go up and down. It

is the professionals, not you. They are what matters when

valuing stocks, so you need to know what they think. What you think doesn’t matter. Too many individual investors fall in love with the stock they pick and that was exactly what happened to this investor group. The companies they were buying were very strong companies with great prospects, but when these investors bought these companies, their stocks prices were too high for their industry. Peter Lynch, a retired mutual fund manager—and the most successful mutual fund manager in history—wrote sev- eral very good books. His main advice to individual investors


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is for them to buy what they know. I think this a very good idea, but I have observed that when individual investors do that, they become infatuated with their picks. Just like the early stages of any teenage love affair, they become blind to the problems that will certainly develop later. The in-love investor fails to see the slowing growth, overvalue, or the progress of a bigger and better competitor. The investor only sees the great products they use and like, how busy their local store might be, or that all their friends own those prod- ucts and love them too. How can the company not be great? Maybe the company is great, but the stock price might not be. Always run the numbers and insist on very good num- bers. Always do your homework. Teenagers fall out of love just as fast as they fall in, but when you buy a stock, it’s like getting married. Make sure it’s a good pick for the long run, that it has staying power. At least when you marry a stock it is cheaper to divorce. Even if you fall in love with your stock, don’t be afraid of a divorce if it’s not working out.

Are You Up to the Challenge?

By now, I’ve given you 7 investing rules and 5 buying rules. While I want you to obey these rules, I cannot guarantee that you will become wealthy by applying them. In truth, I strongly believe that they will help you choose stocks more wisely and make money, but anyone who tries to guarantee performance or a huge return when dealing with stocks and the stock market is a charlatan. These rules work and they work well, but implementing them successfully is a fantas- tically difficult job. For example, I gave you two investing rules that are related: Rule #5: Always buy stocks when everyone hates them and Rule #6: Sell when everyone else loves stocks. How in the world are you supposed to know

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when love and hate exist in the market? I tried to give you some guidelines to recognize those times, but implementing these rules can be incredibly challenging and the timing so nebulous that most investors will get it wrong. When you add in the fact that your judgment is clouded because you are trying to control your own personal fear and greed, it makes the process even more difficult. Did I just tell you that you can’t apply my rules? Not at all.

I’m just saying that it is a challenge. If you are still with me,

I think you have a good shot at getting it right. All you have

to do is realize that you are going to be wrong and wrong often—and just accept it. But if you learn from those mis- takes and diligently apply these rules, you will make money. The question of how much depends on how good you are. Part of your success understanding valuations and ratios is in your ability to see stocks in a larger context. Numbers are important and relationships between those numbers are very important, but looking at numbers without comparing them with their peer group and the overall economy is an exercise in futility.

Buy Stocks That Compare Favorably within Their Industry

According to Vector Vest, a database of about 8,000 stocks, there are about 40 sectors and 190 industry groups. Every stock belongs in these groups. You will need to study sectors and industries because stocks tend to perform as well as their overall group. For instance, the Steel sector has two industry

groups: Steel (Basic) and Steel (Alloy). If you are looking at a steel stock in the Basic industry, there are 19 companies. The average P/E ratio is 8, the EY is 12 and the GPE is .97 with

a P/S ratio of 1. All these numbers are very good, except for


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the GPE. If you were looking at a stock in this industry, would you want to buy the best one in that industry? If all the num- bers for all the companies in the group are very good, what does that tell you about the industry? What this should tell you is that this industry is full of inexpensive stocks for a reason. That reason, historically speaking, is that it is a slow-growth area and deserved a low P/E ratio and a high EY. With an average GPE of under 1,

I would be careful about buying stocks in this industry, and

I would look for GPEs of stocks in the group that are much

higher than that group’s average. Those GPEs may still be lower than the rule I gave you of 2 or higher, but that doesn’t mean you should ignore the entire group. The lesson here is that all industries and sectors trade at different average P/E ratios, EYs, GPEs and P/S ratios. It is your job to pick the best in the group. Learn which indus- tries deserve and, thus, trade at higher or lower multiples. To start the process of understanding relative funda- mental numbers, you need to start with the S&P 500. Why do I suggest the S&P 500 as a starting point? Because it represents about 80% of the entire market. Its long-term average P/E ratio is about 17. That number changes, but

it gives you a basic understanding of where stocks gener- ally trade. In times of low inflation, the average tends to be higher and in high inflation, it is lower. What about the long-term EY, P/S ratio and GPE for the S&P 500, and what about the other indexes? There are many other indexes. Where do their P/E ratios trade? This exercise can get very detailed, and there are a lot of analysts out there producing these numbers. I do not want to bury you with this minutia. Just remember that when you do your homework before picking stocks, be sure to compare that stock with others in its industry and that industry’s average P/E ratio with the overall market. This knowledge will

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bring you an increased understanding of the market and help eliminate the handicap you would have without it. When looking for stocks, I strongly suggest you buy stocks in rising sectors and rising industries. I don’t want to make it a rule, but I feel it is important enough that you need to make note of it. Notice: I did not say buy stocks in the top industry or sector. In a bull market, you can buy the top stocks in the top industries and probably do well, but I tend to shy away from them because I don’t want to buy the top of the market. I would rather buy industries that are mov- ing up, relative to other industries. This movement is where you will find the winners. Do not buy industries that are moving off of the bottom either. Look to the middle of the pack and buy those movers. They have to show you that they are for real: off the bottom and moving towards the top— not on the bottom and not formerly at the top but moving toward the middle. Do not buy stocks in industries that are beginning to slow down. They may be near the top, but if a particular industry is beginning to weaken, you should avoid stocks in that industry. This industry and sector stuff is not easy, but by now you could not have been expecting easy. Still, you cannot ignore it. The industry and its relative historical valuations is some- thing you should, at the minimum, understand before buy- ing a stock.

How to Use These Rules in Real Life

The rules are to be applied to all companies at all times, but you have to bend the rules depending on market cap, industries, sectors and economic conditions. The buying rules are very sound, but if pressed, I would say they work best for companies that have market caps of from $1 billion


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to $10 billion and in growing economies. These are the middle-sized companies. If you are looking at smaller com- panies, they tend to have very large growth rates or none at all. Also, the rules do not work with companies that don’t make money. You can’t have a P/E ratio, GPE or an EY if you don’t have any earnings. Without earnings, three of our ratios cannot be calculated. Always remember Buying Rule #6: Don’t buy stocks that don’t make money. Your goal in buying stocks is always to make money. Earlier I have said the big capitalization companies are best analyzed by focusing on the P/S ratios; however, that doesn’t mean you get to ignore the other rules. All that I am suggesting is that you focus on the P/S ratios—not use them exclusively when considering the big companies. As I discussed before, big companies have a hard time growing very fast, and these ratios tend to undervalue the big guys. For instance, General Electric, one of the largest U.S. cor- porations, is currently sitting on a GPE of .71—far below our target in Buying Rule #3 of 2 or higher, an EY of 6.39, a P/E ratio of 15.67 and a P/S ratio of 2.35. So I ask you, is this a good value for GE? To answer this question, we need more information. What about its industry? How does GE compare to its peers? GE’s growth rate is about 10%, and that is in line with the rest of the industry. The industry’s P/E ratio is 15 and so is GE’s, and in fact, GE is so large that the entire industry weights their average to GE’s. However, there is one little thing that is dragging on my sense of right and wrong and that is the industry’s P/S ratio of 1.2. GE’s sits at 2.35—almost twice the industry standard. I don’t like that. If I was considering buying GE, and if everything else was equal, the P/S ratio, the very ratio that I am suggest- ing you use when looking at large cap stocks, would tip me into not buying the stock at this time. I am saying that even

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though GE’s P/S ratio is close to our desired number of 2 or less, since it is only 2.35, I would not consider GE because its peer group, the sector that GE belongs to, has an average

P/S ratio of only 1.2. In relationship to its group, this means that GE is expensive. This exercise has absolutely nothing to do with whether or not GE is a great company; in fact, it is a great company.

I like their 3% dividend yield; they are the leader in their industry, and they have consistently grown their earnings

per share year after year, even in the most recent recession. What is there not to like? I also approve of their focus on worldwide growth not just growth in our domestic market.

I want to own GE, but I want to own it at a reasonable price.

How to determine a reasonable price for a stock will be dis- cussed later, but with a P/S ratio of twice its industry aver- age, GE is too expensive for me…at least for right now. Let’s look at another company I want to own, Johnson & Johnson. This is another large cap leader in its field, with a market cap of $189 billion. You should have a greater appre- ciation of Johnson & Johnson’s size when I remind you that large cap companies are defined as having $10 billion or more in market capitalization. (For comparison, GE sports

a market cap of $348 billion, Microsoft is $261 and Exxon

Mobil is $415. These are a few of the largest companies in the world.) Since market capitalization is based on the price of the stock multiplied by the number of shares outstand- ing, how could any of these big companies grow by more than single-digit or low double-digit percentages? They can’t! There are a finite number of people in the world who can buy a company’s products, and if the company already sells its products to them, then you have to discover major new markets to grow your sales. This lack of strong growth means you can’t use growth as a main component to evalu- ate the big stocks. At the risk of repeating myself, I want to


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make sure you understand that you have to look at different company sizes and sectors differently. Did you think it was going to get easier? Dream on! Johnson & Johnson (JNJ) is a 100-year-old company. It is growing about 8% per year. Its GPE is .43, its EY is 6.1, its P/E ratio is 18 and its P/S ratio is 3.67. I am looking for a GPE of 2 or higher, an EY of 150% of the 10-year treasury (which, at this time, would be about 7%) and a P/S ratio of 2 or less. This stock meets none of my criteria. But let’s look at its industry—Drug (ethical). When I discovered that JNJ is in the drug industry, the first thing that popped in my head is that JNJ is not just a drug company. There is a large drug component of the com- pany, but they also sell consumer staples: shampoo, soap, Band-Aids, and anything to do with related consumer and medical devices. So when looking at its industry, you are going to have to take it with a grain of salt, it just doesn’t fit in with any one industry. The Drug (ethical) industry has a P/S ratio of 1.86 while JNJ has 3.6—again, almost twice as high. Based on those numbers, I would not consider JNJ. Here’s the trick, just to make your life more complex—I believe that JNJ may actually be a good buy. Why? It goes to what value I place on this stock. What should this stock price be? What other indicators of fun- damental value should I consider? Finally, is it fair to put JNJ in the Drug industry to compare price to sales ratios? These are questions for experts to answer. You do not have the time or knowledge to deal with them, so don’t worry about them. There are just too many other stocks we can analyze that will match up nicely with my rules, so let’s move on. The time to consider JNJ is when everyone else hates it; that’s the best rule to consider for a stock like this. When everyone else hates JNJ, it will mean that the stock will have collapsed. At that point, JNJ’s numbers will look

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a lot better, or at least the P/S ratio will. That is when you should consider buying it. How about stocks that are not large cap but that are more in line with our target group of $1 billion to $10 billion in market cap size. Let’s look at a few we, at Klein Pavlis & Peasley Financial Inc., owned when this book was written in the latter part of 2006. Here is a short list:

AXS – Axis Capital – Market Cap of $4.7 Billion AAUK – Anglo American PLC – Market Cap $65 Billion AINV – Apollo Investment Corp – Market Cap $1.57 Billion PCU – Southern Copper Corp. – Market Cap $13.1 Billion TTM – Tata Motors Ltd – Market Cap $6.9 Billion IO – Input Output Inc – Market Cap $738 Million

Let’s start with Axis Capital (AXS). It is an insurance company. The industry is Insurance, but there are several sectors in Insurance such as Life and Health and Property and Casualty. It is important to understand that you need to make comparisons in the same sector and not just in the same industry. The numbers are:



Industry-Insurance (PC)
















It started out looking very good with a lower P/E and higher EY than the industry and the entire industry aver- age exceeds our rules for both of them, and AXS is even


General Rules on Buying Stock

better than average in its industry. The GPE is almost 400% better than its industry. The P/S ratio both for AXS

and the industry is well below our target of 2 or less, but the industry average is better than AXS and the ROE is bad for the industry and worse for our stock. This is a mid cap stock with a $4.7 billion market cap, so my focus is on growth. Therefore, the number that really impresses me about AXS is the GPE. The growth rate of this company is about 30%. Can it keep up that kind of growth? This is


very important question because the P/E is very low, so


growth slows and the stock price goes up, my GPE will

turn sharply downward. I do not put much weight in the P/S issue because it is below my target of 2 or less, even though the industry is lower. I think for this stock it is a nonissue. However, I am concerned about the ROE for both AXS and the industry, and those numbers make me feel hesitant. The lesson here is that you can’t have everything. As you will see in the next few examples, it is a common situation. Not all your numbers will line up perfectly most of the time, so don’t even expect it, but most numbers should. Keep your eye on the market cap since that will affect the numbers. Remember

your target market cap? Let’s try another example. Anglo American PLC – adr (AAUK). This is a com- pany out of the United Kingdom. You can tell it’s a foreign company trading on our exchange by the “adr” designa- tion. That means American Depository Receipt. The easi- est explanation is that in these situations, a block of foreign shares of this company has been deposited in the U.S. and those shares are packaged to sell on our market. To do that, the foreign company has to meet U.S. standards in corporate disclosure of statistics about the company. That is all you need to know about it.

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Industry-Mining (Other)
















So what is so impressive about this one? It is the Mining (other) industry. It’s “other” because it is very diverse. It has mines all over the world looking for industrial minerals, gold, platinum, base metals, and coal and also has large interests in forest products. Still, why do we own it? Did you note the market cap? It is large, and yet this company has a GPE of 2, which means this huge company is growing at twice the P/E ratio. That is not easy. The industry average is only .75. All the other numbers are in line, except for the low ROE, but again, for a large company, it’s not bad. In looking at these numbers for a large cap stock, you should be very impressed with its GPE of 2. It is rare to have such a large company growing that fast—especially in a slow-growth industry like mining. We were impressed. You can see already that you need to use judgment. I have mentioned the merits of the different industries and discussed how you should decide to be in a particular indus- try at all. Generally, you want to be in industries that are relatively strong in relation to other industries, but to deter- mine that, I would need to analyze each industry and sector, and that is not the focus of this book. For our purposes, let me say that you need to stay away from weak industries and concentrate on stronger ones. Is that vague enough? Need a little more help? Ok. Recently, the commodities industry has been strong.


General Rules on Buying Stock

The next investment to analyze is Apollo Investment Corp (AINV). This is a company that develops businesses by investing its money in middle-sized companies by selling them senior-secured loans.



















Great P/E, EY and a fantastic GPE, but the P/S is a disas- ter and the ROE doesn’t look so good either. We, at Klein, Pavlis & Peasley, focus on GPEs for these middle-sized com- panies. While it is generally the first number we look at, it is not the only one. However, you should insist, as we do, on strong GPEs in these types of middle-sized companies. There is one other number we like about this company. It pays over a 9% dividend. That is a balm to a nervous heart. You need to make sure the company has enough free cash flow to maintain that dividend—and this one does. If I have not already mentioned the significance of divi- dends, remember that they are very important to your stock portfolio’s overall return. All things being equal, you pick dividend-paying stocks over all others. Of the six stocks I listed at random that we currently own, all but one of them pay dividends. I didn’t pick these stocks from the 40 or so we own entirely because they pay dividends, but most of our positions do. I picked these six stocks because, while sitting at my desk writing, they were the first six that came to mind. I am a simple man.

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The next stock is Southern Copper Corporation. This company is out of Phoenix, AZ, but their mining interests are in Southern Peru and Mexico. This mining company is a copper producer.



















Even if you ignored this stock’s 9% dividend—which you shouldn’t do, this stock is undervalued compared to its peers. The only number that is suspect again is the P/S when compared to its industry, but that slight negative is far out- weighed by not only the dividend but also by the outsized ROE number. The only question you need to ask yourself is: Do you think commodity-type stocks are a good place to be? My answer is that we have had a multi-year bear mar- ket in commodities until 2005, when most commodities started to make a run. I think we can expect a multi-year bull market in these issues. Yes, there will be fits and starts in commodity prices, but it has a lot of market potential for strong growth in China and India, home to well over 2 bil- lion people who are just beginning to warily discover the benefits of consumerism. Demand for everything from toilet paper to gasoline to food is going to rise sharply. Think of all the miles of copper wiring needed to build homes and busi- nesses or anything electronic in those two countries. Next is Tata Motors Ltd. (TTM). It is an Indian manufac- turer of heavy/ medium/ light commercial vehicles, private


General Rules on Buying Stock

passenger cars and utility trucks and accessories. It is the largest manufacturer of vehicles in India. I hope you are not getting the idea that we invest mostly in foreign stocks, because we don’t, but at the same time, you should properly assume we are currently leaning on them as a significant part of our overall portfolio. The last chapter of this book deals with portfolio management, a subject that addresses the risks and talks about controlling those risks. If you only have mining stocks or foreign stocks in your portfolio, you are dramatically increasing your risk. Look at the tech stocks the NASDAQ index peaked at 5,000 in 2000. Today, seven years later, they are priced at less than half that amount. Do you still have a 1990s portfolio? Did you not diversify properly?

Let’s check out TTM.



















There is nothing really striking about the numbers. They are good except the GPE, which is well below our desired number of 2 for a company that is only $7 billion in mar- ket cap size. That is not impressive, but it is twice as high as its industry group. The ROE is two and half times the industry’s average, and that is impressive. But if you corner me in a back room somewhere, I would have to admit the reason we like this company is because it is India’s leading motor company and we think India, the largest democracy

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in the world, has great prospects. Just because we feel that way does not mean we ignore the numbers. They are in line with their industry and meet most of our strict criteria. It doesn’t hurt that there are fewer than 10 vehicles per 1,000 people in India, so they have no where to go but up. At least in my opinion. However, these numbers also mean we may not stay with this stock for very long. Remember, we live in the show-me state. The stock price has to show me its ability to go up. If not, I am gone. Finally, Input Output Inc. (IO). They provide seismic products and services to the oil and natural gas industries. They produce some unique technologies in the business of looking for energy, so you can understand the basic reasons we like this industry when oil prices are $50 to $70 dollars per barrel.



















This one is a speculative play. It is acceptable to take a risk sometimes, and we are doing so on this one. Even though we view this as a speculation stock, we still insist on earn- ings; otherwise, we would not have a P/E, EY or a GPE. Why did we buy it? The growth of sales and earnings are at near 50% and have been accelerating. If that stops, we are in trouble because it already has a high P/E. Earlier when I was examining P/Es, I wrote that you can have a high P/E as long as the growth is twice the P/E number. IO has that


General Rules on Buying Stock

relationship. This is a small company with high growth, so

it could be a very big winner or it could fall flat on its face.

Therefore, we will have our finger on the trigger if it falls. Did you note there is no mention of the stock price at all in looking at these securities? The price of a stock has nothing to do with fundamental analysis. You should not care what the current price is. Stay focused on what’s important— earnings and growth of earnings. Stock price plays a part and so does the trading volume of a stock, but that part is a minor part of the picture for you as an individual investor.

It makes me crazy to hear that someone doesn’t want to buy

a stock because the price of the shares is too high. If a stock

goes from $100 a share to $120 a share, that is a 20% return. It is the same as a stock going from $10 a share to $12. It’s the return you want, so who cares about the stock price? Applying my stock rules is not as simple as just looking at the numbers. As you can see from the stocks we own and my comments about them, there are other considerations. Should you be in foreign stocks or commodity stocks, and when might tech stocks come back into favor? How does an individual investor anticipate what might work well in the future? In the following chapters, I will address that issue. Picking stocks is more than finding the right numbers. There is a vast sea of stocks, complete with currents, eddies and both turbulent and stagnant water. Still other stocks are full of growing life. The sea is always changing, and if you expect to survive and thrive, you need to ride the various waves as best you can. That is even a little too poetic for me. Suffice to say that you can look forward to a couple more sugges- tions that will help you determine where, when, and at what price to buy or sell stock.

Seven: What to Buy, What to Avoid and Why


There is no getting away from talking about economics when discussing the stock market and potential stocks to buy. Buying is a positive action, a fun exercise. It only turns ugly when the stock you buy goes down and keeps going down. This chapter is about the fun part of investing—buying stocks. Unfortunately for you, we have to go over economics and its effect on stock prices first. I know you are tempted to skip this section, but don’t. If you don’t like economics or choose to ignore it, then you are doomed in the stock market. You might as well buy the indexes and hold them forever because you will not understand why stocks go up or down or the economic cycles that dictate broad stock market moves. At the beginning of this book, I showed you a couple of charts that tracked past cycles in the market. There is a large but imperfect correlation between economic expansion and contraction and broad-based movements in the stock mar- ket. It is vital that you understand the how and why behind those economic patterns.


What to Buy. What to Avoid and Why

Fundamentally, stocks move up and down with earnings and earnings increase or decrease depending on economic growth or shrinkage. It is an imperfect relationship. The stock market looks forward and tends to move up before eco- nomic turmoil ends and tends to move down at a peak in the economy. That leads me to the first subject on economics. There are basically four phases of any economy: expan- sion, peak, contraction and trough. Since the end of World War II in 1945, there have been ten economic business cycles. The average number of months from peak to trough in those cycles has been 10 and from trough to peak—57 (Source: Public Information Office, National Bureau of Economic Research, Inc.). Expansions last much longer than contractions. In 2006, when writing this book, the most recent expansion currently being enjoyed is about 40 months long and still going. However, when finally finding time to rewrite the initial draft it looked like we were heading into a contraction phase. That was confirmed in 2008 and we are still in a contraction phase. Though rare, we have expe- rienced expansions from trough to peak extending over 100 months. There is no telling how long any one cycle move will take. Analysts look at history, but I fear too many people put too much emphasis on trying to deduce what is going to happen based on past experience. The average length of the expansion/contraction cycle is a good guide, but each has its own characteristics and each is different. Once you understand these cycles, you may conclude that by recognizing the peaks and troughs in the economy, you can match the returns of the stock market. You would be wrong. Have you noticed that it is never as easy at it seems? It is true. In this case, every trader out there is trying to get ahead of everyone else. In doing that, they are guessing about when the economy will turn and their guessing alone is enough to move markets. The professional traders have the massive amount of

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money needed to move markets and they do so. The consumer also has considerable power. If he feels good about himself and the future, he will keep spending, and that spending keeps the economy going. It’s a self-fulfilling prophesy. Traders do the same thing. If they think the economy is going to recover from a recession six to twelve months from today, they start buying stocks—pushing stocks higher. You can see this pat- tern in stock charts discussed in a later chapter. This action results in an imperfect relationship between the stock market and economic cycles. Therefore, you cannot ignore human nature. We all are trying to beat the other guy when determining the turning points of an economy. There are hundreds of statistics and economists who analyze those statistics, but that will only help us better understand the past, not predict the future. Then, in addition to the mountain of data, some unknown and unforeseeable event could happen to throw us into an economic slump. I am not trying to be negative or mini- mize the importance of understanding the economy, but the very reasons experts are often wrong is because there is a lot of guesswork and crystal-ball gazing. As uncertain as that seems, it means that you, as an individual investor, have just as good a chance of succeeding as anyone else. Have you ever driven in the fog? There is always a fog surrounding economics. That fog makes large potholes hard to see. September 11th was one of those potholes. The eco- nomic impact of that event didn’t last long, but it rippled throughout our economy. Understanding how economics affect earnings helps you look through the fog. It doesn’t offer any answers, just guidance. When studying the economy, we look at economic reports from various government offices and private economists. These reports are divided into two broad groups. They are called the “leading” and “lagging” economic indicators.


What to Buy. What to Avoid and Why

Lagging indicators:

1. Labor cost per unit of output in manufacturing

2. Prime Interest Rate

3. Outstanding commercial industrial debt

4. The Consumer Price Index

5. Credit level as a fraction to personal debt

6. Unemployment rate

7. Ratio of inventories to sales

Leading indicators:

8. Average length of the work week

9. Initial jobless claims

10. Factory new orders for consumer and material (Factory Orders Report)

11. Vendor performance (Purchasing Managers Index)

12. Manufacturers’ new orders for non defense capital goods

13. Building permits (from Housing Starts Report)

14. The level of the S&P 500

15. Measure of M2 (Money Supply Report)

16. The interest rate spread between the 10-year trea- sury and the fed funds rate

17. The expectations report (Consumer Sentiment Index)

Obviously, we are going to focus our attention on leading economic indicators because we are trying to pick up hints on the future economy, not the past. This chapter is about buying stocks, so we keep our eyes firmly fixed on the future so we can ferret out the winners from the losers. To do that, we must have a firm understanding of future earnings for not only the companies we are buying but for the entire economy. Leading economic indicators can help us. If this chapter were on selling stocks, I would be saying the same thing—keep your eye on the future, not the past. These leading indicators are the place to focus, but remember that

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everything is in flux. Speculating about what the economy might do in the future is difficult, so all you can do is make your best educated guess. All the experts, traders, economists and pundits are reacting to what they see in the future. You have to do the same thing. The truly best investors see things differently than the norm, but you have to know what the norm is so that you can be one of those different investors. Keeping up with the statistics by examining the list of leading indicators probably seems like a monumental task, and I have to admit it is time consuming and can be confus- ing. However, just think how hard it would be to compile this information yourself. Thankfully, we have both private and public agencies that do it for us. Both daily and weekly, we are bombarded by reports on the economy. Once a week, we get unemployment claims. That is the number of people filing for unemployment benefits for the last week. A one-week report is virtually meaningless; therefore, all the experts look at the four-week average to ferret out a trend. You will have to do the same. How do you know that? You don’t, unless you study this stuff, and that is something most people do not have the time or the desire to do. I am going to try to make it a little easier. I will list the indicators again, and this time, I will describe what you should look for in each report and how to relate it to the economy.

T h e A v e r A g e W o r k W e e k . This number is expressed in hours per week and is reported monthly in the employment report. The average work week is usually below 40 hours. Just as when you are examining economic or company-specific numbers, you want to seek a trend and, more specifically, a change in the trend. So, if the average work week is shrink- ing, that generally means companies are laying off employees. It is an indication of a weak employment picture, a possible


What to Buy. What to Avoid and Why

slowing of the economy. Shorter work weeks mean less money for employees to spend, and since the consumer is 66% of our economy, he/she is the engine that drives the train. If they spend less, corporations make less. Increasing earnings drive stocks up and decreasing earnings drive them down. Wouldn’t it be nice and easy if just a glance at the average work week provided enough information to make our buy and sell decisions? That’s just not how it works.

I n I T I A l J o b l e s s C l A I m s. This one is a weekly report, but you only need to consider the four-week average. It is generally considered good if the four-week average on unem- ployment claims is under 350,000. If it is above that number, the job market is in decline and there is a possible recession in our future. Again, look for trends. Is the number rising or falling? Is it flat? Below 350,000 and shrinking is good, and above that number and growing is bad.

n e W FA C T o r y o r d e r s. This is a monthly report that gauges the health of factory production. There are a lot of components to this report. These numbers often exclude transportation because the buying and selling of airplanes and automobiles can be very erratic from month to month. Since we want to understand the underlying strength or weakness of factory production, it makes sense to exclude those things that blur the picture. That does not mean you ignore transportation, but just that it doesn’t weigh heavily in the equation. Obviously, increasing factory orders indi- cate economic strength.

P u r C h A sI n g m A n A g e r I n d e x . This gives you a view of the health of the vendors and an idea of if they are going to be buying or cutting back on purchases of goods and services.

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FA C T o r y o r d e r s r e P o r T . This analysis is a monthly report on the manufacturing sector and its increasing, decreasing or steady order flow of capital goods. Look at it with and without defense orders. They can be very volatile from month to month.

b u I l d I n g P e r m I T s. This report comes out weekly, but you should use it to look for monthly trends. It gives you a look at the future health of the building industry. Distinguish between home building and commercial building. Sometimes they are very different.

T h e l e v e l o F T h e s& P 500. The stock market is a very good barometer of the health of the economy. Investors are focused on prospects of future earnings, so when the market goes down, it usually does so before the economy begins to weaken, and it goes up in advance of an economic rebound. That is why it is considered a leading indicator.

m o n e y su P P l y . This is an inflation gauge. When money supply goes up, expressed in M1 or M2 by the government, it suggests that the economy is either growing strongly or that the Fed is easing money to try to grow the economy. If it shrinks, the Fed is generally trying to slow the economy.

I n T e r e s T r A T e sP r e A d . This is a measure between short- and long-term interest rates. Short-term is the 1- or 2-year treasury bill, and long-term is the 10-year treasury bond. It is the direction of the interest rate spread and degree of spread that is important. It is normally referred to as the yield curve. A normal curve would be one in which the long-bond yield rate is higher than the short-term rate. An inverted yield curve is one in which the short-term rate is higher than the long-term bond rate. An inverted curve is


What to Buy. What to Avoid and Why

considered a sign of a future slowing of the economy or of a looming recession. Therefore, you look for the expansion or contraction of the spread between the two rates.

C o n su m e r se n T I m e n T I n d e x . This index is produced

by the University of Michigan, and the expectations part allegedly tells you what the consumer may do in the future. I think this monthly report is not very accurate because the consumer is constantly changing his or her mind, and this index vaguely measures their expectations of the future. These indicators are made up of many individual reports released by many agencies, primarily agencies of the Federal government. There are a few other important reports you might want to study.

b e I g e b o o k . This is released by the Federal Reserve board eight times a year and is a report on the current economic conditions.

C o n su m e r C o n F I d e n C e I n d e x . This is released by the Conference Board and is a sampling of 5,000 U.S. house-

holds on a monthly basis. It tries to gauge the consumer’s attitude towards their present and future economic pic- ture. Another report that does almost the same thing is the Michigan Sentiment Index.

T h e CPI A n d PPI . This index is released by the Bureau

of Labor Statistics and is a measure of inflation at two dif- ferent levels. The CPI (Consumer Price Index) is a measure at the consumer level, and the PPI (Producer Price Index) measures it at the wholesale level. It’s a monthly report. There are more reports on housing, retail sales, employ- er’s indexes and much more. The onslaught of ongoing revi- sions and the release of new ones is bewildering. It is your job

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to understand what they mean and what weight you should place on each. Simple, right? However, put most of your effort in understanding and following the leading economic indicators. Their function is to attempt to predict the future, and in that attempt, they can be wrong, but when the numbers are released—right or wrong, they tend to move markets. All the reports that make up these indicators are important, but you and I are not economists, we are investors. Our job is to understand the implications these statistics may have on the economy and the market. And if you look at them carefully and boil it all down to what they are really saying, you are just asking every one of these reports the same question: What is this going to do to earnings for public corporations? If the economy slows, earnings go down. What part of the economy is slowing? Which stocks will be affected and how fast? Is there going to be a steep reduction in earnings? Are we going into a recession? Even though we can’t look into the future with any degree of accuracy, we still try, and that effort moves the market. Understanding economic cycles and the components that make up the economy is important. You can buy the best stocks in the world, but if the entire market is going down because the economy is tanking, your great stocks will lose value. They still will be the best stocks out there, but that will mean little when your overall portfolio value goes down. Now that I have depressed you with all the information you need to have at your fingertips (and just so you know, I only lightly touched on the subject), let’s move away from the dry subject of the economy and on to a more interesting topic.


What to Buy. What to Avoid and Why

Buy Stocks That Make Money

I can’t say it any simpler than that. It sounds easy,

doesn’t it? However, a large part of the investing public is willing and, in fact, begging to buy stocks that don’t make money. Before you scoff, I would hazard to guess that you have as well. Everyone is looking for the next Microsoft, though they will likely never find it. The average investor wants to buy something that will make them rich for just

a few pennies or a few dollars per share, and they want

to do it before anyone else finds out about it. If you in-

sist on these characteristics, you will buy stocks that don’t make money. These stocks tend to be low-priced stocks but aren’t always. They are usually priced low because no one else wants them. You buy them because you think you will beat other traders to the punch. The smart money, however, wants to sell these types of stocks to you. There is a reason why no one else wants them.

If it was a great stock, the price would be much higher. I

suggest you not try and compete in this highly speculative area of trying to find the next big winner, but just leave it to the professionals who have the expertise, time and money. Remember who it is that you are competing with. Low- priced stocks are priced low for a reason. Note: I did not say anything about cheap stocks. Some stocks can be cheap at $100 a share. Cheap denotes a rela- tionship. It is a relationship between earnings and the price of the stock. A low P/E or high GPE with a high EY can be considered cheap, but low P/Es don’t always mean a cheap stock. If I lost you, refer back to the rules. So a high-priced stock can be cheap as long as its earnings are much higher

and it fits the relationship I have suggested. Let me repeat that one more time: Buying a cheap stock has nothing to do with the actual price of the stock.

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A few years ago, a client called and stated he wanted to buy Lucent Technology. He said that it was on sale at $6.00

a share and that it used to be $50 per share, so it had to be a

bargain. He said it was “cheap.” I begged to differ. I looked at Lucent’s earnings and saw that it was losing money and going to be losing money again next year. I told him the stock was expensive, not cheap. I talked him out of buying it, and it eventually ended up selling for less than $1 per share before rebounding to $5 and then falling back down to $2. It never recovered to $6 before it was bought by a competitor.

Do not focus on the price of the stock. It means nothing.

I realize there are examples of stocks that, while not pro- ducing stellar earnings, experienced great moves in price ap- preciation. Anyone can look back and pick winners. I can show you biotech stocks that haven’t made money in years or, for that matter—ever, and yet move up and down dramatically.

I realize that. But you and I are not gifted with second sight.

We have to live and work in the real world and that world, in the stock market at least, is a lot more predictable when you use companies making money than when you take a chance on those that don’t. I am not suggesting that, even when you use companies that produce earnings, you can predict the market, but I am saying your odds of being successful increase signifi- cantly if you buy stocks that make money. Let’s take it a step further. Not only should you only buy stocks that make money, but you should also buy only those with prospects to make more money next year. The stock market looks forward, not backward. Traders are trying to estimate next year’s earnings and, in fact, the current stock price is trading based on those traders’ guesses about future


What to Buy. What to Avoid and Why

earnings. That guess is often a bit wrong and sometimes quite wrong. Earnings estimates are just that—estimates. They are imperfect and constantly changing, but they are all we have to work with. In an ideal world, you want stocks to increase their earn- ings every year, and there are stocks that do just that. Wal Mart is a good example. Year after year, Wal Mart has grown its earnings. You would think that because it has been able to do that, the stock price would go up every year, but you would be wrong. Wal Mart’s stock price hasn’t gone up since 2003. Earnings and sales have gone up, but the stock price has not. It is trading in a range, like many other stocks from the same period of 2003–2006. So just because earnings are going up every year, doesn’t mean the stock price will appre-

ciate too. There is always a lag or anticipation in price. You have to look at more than just earnings. Earnings and the growth of earnings are all important and looking at them is

a great place to start, but that is all that it is—a start.

Stock Valuations

Once you have developed a list of stocks that all fall within

a range of all my guidelines (and I will list them again be- low), you should set a target price for your stocks.

Buying Rule #1: Buy low P/E stocks. Buying Rule #2: Buy stocks with EYs of 150% of the 10-year government bond or higher. Buying Rule #3: Buy stocks with GPEs of 2 or higher. Buying Rule #4: Buy stocks with a P/S of 2 or less. Buying Rule #5: Buy stocks with a ROE and/or ROA of 17% or higher.

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Yes, I am talking about doing some more math. Setting a target price will help you determine your risk level with each stock. Everything in life is risky. Our rules try to reduce the risk inherent in buying stock, and if you know what the stock price should be or at least what it should be based on some basic valuation calculations, then you will know if you are buying a stock below, at or above value. The higher the current stock price is, over and above the stock’s intrinsic value, the higher the risk you are taking. I have several very simple, time-tested ways that you can use to calculate the value of a stock. Jerry Klein, my mentor, has used them for four decades. They are also not perfect. I know we have discussed these methods in a previous chapter but let’s go into more detail.

Quick-and-Dirty Method

The first and easiest calculation is the “quick-and-dirty” method. To use it, take next year’s earnings per share and multiply it by next year’s growth rate. So if a stock is es- timated to earn $1.20 per share next year, and it earned $1.00 per share this year, you have an earnings growth rate of 20%. Multiply 20 times (not 20%) $1.20 and that will give you a target price of $24.00 for the stock. Pretty sim- ple, right? This method of determining the future value of a stock usually works best for assessing risk in mid cap stocks (companies between $1 billion and $10 billion in size). Why? The reason is fairly straightforward. For very small companies, the growth rates can be outsized at 100% or more. If I buy $1 per share in current earnings and it is going to grow to $2 because it is a very small company and can eas- ily double its earnings, then applying the formula produces a stock value of $200. Do you think it deserves a 100% P/E?


What to Buy. What to Avoid and Why

No. That number is just not reasonable. Also, very large com- panies have a much more difficult time growing their EPS. If they achieve a single digit growth rate, which is normal for a very large company, then this formula will undervalue those kinds of stocks. So, at the ends of the spectrum of stock com- pany sizes, the numbers get distorted when you use this quick- and-dirty formula. In those cases, you may want to use one of the two other methods to smooth out a target price.

Past-and-Future Method

The second method looks back first before it looks for- ward. Take the last five-year high and low P/E of the stock, and multiply both by next year’s earnings per share (EPS). So if your target company’s low P/E was 10 and high was 17 in the past five years, and next year’s earnings estimate is $2 per share, then you have a target range of $20 to $34. If today the stock price is $20, you are near the low end of the range and, therefore, theoretically, this is a low-risk price. If the stock price is $10, the stock may be a bargain. This method makes some reasonable assumptions such as if the stock has traded in a certain range of P/E in the past, why would it not continue to do so? Also, because we are using next year’s EPS, we are projecting the future target price based on the past P/Es. Therefore, there are problems with this method, and in fact, both of these methods are imperfect because we are using future earnings estimates. The future earning estimate changes constantly; so to keep your estimates current, you need to update your calculations constantly. Also, this P/E range method doesn’t really give you a tar- get price, it gives you a range and that range can get very wide, depending on the stock’s previous trading pattern.

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That range can become too wide to be useful. When that range is too wide, you need to use common sense and con- sider applying another method.

Recession Method

The third method of trying to place a price target on a stock has it own unique problems, the least of which is that it doesn’t really give you a target price. This third method measures the relationship between sales to the market cap- italization of the target stock. This method is good to use at all times, but is most useful when the economy is in a recession or when assessing risk for very large companies. The stock market’s best performance occurs when the economy is exiting a recession. The most recent example was in 2003. After two solid years of dismal performance after the Internet bubble burst—taking all segments of the market with it, the economy finally bottomed. Mind you, the economy did not suffer nearly as much as the market. The U.S. economy fell into a mild, short recession, and it was the lowering of interest rates by the Fed that re- liquefied the economy. In a recession, earnings for corporate America collapse, in some sectors more painfully than others. It is during these periods when earnings are going down—with sales leading the charge—that the Quick-and-Dirty Method of stock valu- ation won’t work at all and the Past-and-Future Method tends to work. But in recessions, this third method works best. On average, we like to see the market capitalization of no more than two times the annual sales of a corporation. Recessions often bring slowing sales and shrinking or absent earnings. However, there are always sales, especially for the very large companies, and this Recession Method examines the price of


What to Buy. What to Avoid and Why

the stock in relationship to sales. Some companies’ sales, those that are generally termed defensive, slow much less than their stock prices collapse. Because the market cap is derived by multiplying the stock price times the number of shares out- standing, it is reliant on the price of the stock. In recessions or just before recessions start, stock prices generally collapse. Therefore, at the bottom of a market correction or the bottom of the recession, the P/S ratio looks the best. But what does that mean? During these times, there will be many companies with a P/S of less than 2. On which of these stocks or sectors should you concentrate? There is no exact science. You will often see ratios much lower than 1—some of them at a fraction of 1. Even in strong bull markets, there will be those sectors or stocks that are below 1, though there won’t be many. The solution is to look for an overall market that is underpriced by the P/S method. If the S&P 500 is below 4, it is a good sign of value. If it falls below 2, you are at an extreme for the market. In those cases, the stock is apt to strongly rally. When it is at 2 or less, everyone will be panicked, and if you can be sensible, you can be the lone reasonable person buying everything you can. You should mortgage the farm and buy stocks when that happens. If history is any guide, most people will be running from the stock market instead of running to it. A side note: I don’t mean you should literally mortgage the farm. I am a big proponent of paying off your personal mortgage and of eliminating your debt. But when everyone is running from the stock market, you should put all the money that you have earmarked for long-term investments in the stock market. Remember this final point about the P/S ratio: My num- ber of 2 or less is very conservative. Other experts believe that 4 or less is fine. Ken Fisher has written extensively

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on this ratio, and he is very firm about buying stocks with low price-to-sales ratios. That isn’t the only way he deter- mines value, but I have spoken with him several times and he favors this ratio. Since his company, Fisher Investments, is one of the most successful independent investment firms and he is a very smart man, I tend to listen when he speaks. Trust me, there are many successful mutual funds and investment companies that do not have a good track record of investing, but they have a great track record in market- ing. Mutual funds and brokers are very good at blurring the definition of performance. I listen to people like Ken Fisher who actually manage money and who can point to consistent performance. They are the ones to trust. I’ve provided the three easiest ways for the average investor to establish a target stock price. There are many more methods and each one is fraught with problems and has numerous shortcomings. No one method should be a conclusive factor in buying stocks, but before you consider buying any company, you must have an idea of the com- pany’s value. If you are not going to use the methods I have just described, then come up with your own. If you don’t, you are ignoring the professionals, because professionals will determine a company’s value before buying stock and they react to those changing values. They will buy a stock when it’s undervalued and sell it when it’s overvalued. The stock market is the only market place where an average per- son will buy something and not care or know if he is buying something that is worth the price. We need to change that. You need to change that if you choose to compete with me in the stock market. Once you have established a value, then you must focus your attention on growth.


What to Buy. What to Avoid and Why

Buy Stocks with Value and Growth

What is the difference between value and growth stocks, and why do I want you to buy a combination of both? Value stocks only consider the current stock price and its underly- ing value. Investors use today’s price of that stock and its future value to establish a stock’s relative value and that rela- tive value compares the current price of the stock with its future value. This is very simple and straightforward. I have received far too many calls on the radio show that equate the value of a stock exclusively with its price (you can hear calls live on my web site, www.investtalk.com or on one of our broadcast radio stations). Many amateur investors con- sider $1 per share to be a cheap stock price, but it’s not neces- sarily! A stock’s price tells you nothing about its value. The value of a stock shifts constantly; it becomes overvalued and undervalued as investors favor one or another sector or the stock of the moment. Google is a good example of the current stock of the moment. It is being pushed to new highs on the strength of its growth and profitability. Why do I recommend against buying it whenever someone asks me? Because of its relative value. Yes, I have been wrong about Google since it went IPO a couple of years ago, but it was overvalued then and it’s overvalued now. Someday—just like Cisco in the late 1990s, when it was also overvalued—it will fall to a reason- able number or maybe it will just stop going up as the earnings catch up with the price. Either method will bring the stock into a proper relative value relationship. This means that, if we follow the advice in this book, you and I will both miss some of the best performing stocks. We are trying to think rationally and to buy stock using a common sense method of investing. We will miss out sometimes because sometimes the stock mar- ket does crazy things and unexpected stocks jump up. Just try to ignore it and be confident in your method.

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Once you discover a stock that is cheap or undervalued, you have completed the first step. Growth is equally impor-

tant. Let me go back to Google and Cisco. It was their growth that caught the attention of the traders. Both these compa- nies had spectacular growth prospects in their day. They far outgrew their contemporaries, and because of that growth, they became the stars of the market. Microsoft experienced

a similar growth pattern as it grew from a startup in the

1980s. Many stocks throughout history have, for a time, been the market’s “favored son.” Even the U.S. car compa-

nies had their day in the sun many, many years ago. There is

a lesson to be learned from these most favored stocks. And

that lesson comes from growth. Use it like a mantra: buy growth, buy growth, buy growth, buy growth. That doesn’t mean that you can never buy other types of stocks. Sometimes large companies go on sale, and you should buy them when they do, but remember that growth and the rate of growth are what attract traders, mutual funds and indi- vidual investors to a stock. These investors buy growth and their actions bid up stock prices. Your stock can be the best, cheap- est, most undervalued company in the world, but it will not appreciate in value until it attracts attention. Usually, the stocks

that get the most attention are the stocks that have great growth prospects. A stock will get attention when mutual funds and other institutions begin buying it, and you want and need those individuals and institutions to move the stock price. There are some stocks out there that are growing but are dramatically overpriced. You want growth at a reasonable price.

It can be challenging to find those stocks, and when you do,

your patience could be tested because even when you find

one of them, you should still pause and consider it carefully.

If it’s a great growth stock and it’s not overpriced, you need

to know why other investors aren’t buying it. They could be right! They could also be wrong—and they often are!


What to Buy. What to Avoid and Why

When you disagree with the crowd, you are taking a lonely path. Many investors aren’t comfortable on that path, and still others do not want to do the work involved in strik- ing out on their own path. They’d rather follow the crowd. I never was much for following the herd. I have found that those who strike out on their own are more likely to strike it rich than those who keep their place in the herd. Do not mistake taking a different path with being lazy. It takes a lot more work to be different, to think ahead, to say that every- one else has mispriced this stock, but that you know better. Who are you? I will tell you that it is possible and desirable but very difficult to ignore the crowd. They are loud and they are all going in one direction, so if you strain directly against their path, you may well be wrong. If the market is moving up, it is moving up, and you have to be with the crowd to some degree, but at some point, you must be able to think for yourself. The crowd, after all, ran the market up for almost all of the 1990s, and then that same crowd caused the collapse. We left the crowd in 2000, but we were with them in the 1990s. Jerry Klein in our firm flowed with the tech boom—though we didn’t have any dot com stocks, and it was due to his insight that we were able to avoid much of the market bloodbath of 2001 and 2002. Truly successful investors are insightful. Those investors can fully embrace that concept of Creative Destruction. I have dis- cussed this method of investing in previous parts of this book. It is a method of thinking intelligently about your investments and not just following the herd; it advises investors to think ahead and to let go of the past. Don’t invest in a company that makes buggy whips when the new fangled motorized vehicle comes along. Don’t invest in companies that are tied to land telephone lines when you could embrace cellular technologly. Perhaps consider dumping any stock in stereo or CD music systems when Apple Computers developed the iPod.

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You need to find a balance between thinking for yourself and not ignoring the power of the crowd to move the mar- kets. In other words, be flexible when necessary and stub- born when required. I realize the challenge in that piece of advice and can only admit that the stock market is never the same, never predictable and will always be perverse. You have to be crazy to invest in it. However, it is also the best way to make money over any length of time.

Buy the Next Generation of Companies

It is easy to look back and pick out the truly innovative companies or periods in our economic history. The train, the car, the telephone or the cotton mill—these were the next generation companies in their day. The assembly line, mass marketing, and consumer loans were the next genera- tion of business methods. If you could have recognized them for what they were at the time, you would be ultra-rich, passing down your wealth to future generations. Today’s generation of companies focuses on the cell phone, alternative fuels, emerging global consumerism, medical technology and the continued evolution of a conflu- ence of Internet, entertainment and wireless technologies. How do you stay ahead or even identify the future winners from the losers? Creative Destruction discusses this issue. It provides answers, and that advice is just what it sounds like. New companies are constantly being created, and as a result, others are constantly being destroyed. Pick the wrong side, and you will lose money in the stock market. Therefore, look for those next generation companies. That sometimes means taking a chance on new companies, but more often than not, it also means finding those com- panies that are embracing the new at the expense of the


What to Buy. What to Avoid and Why

old. AT&T comes to mind. We own this company. It was an old generation company—one that we would normally never consider. It has a great brand name and 100 years of solid history, but their main business was landline telephony. Landline! Making phone calls over a wire in the ground is a dead business; it will be extinct someday soon. We decided to buy this company when they announced their purchase of one of the largest Bell systems, which owned one of the largest cell phone networks. Wireless is the future. In addi- tion, AT&T also has a cable company and has partnered with another firm to produce the convergence of VOIP (voice over Internet protocol) business. This old wire line company is remaking itself into a powerhouse wireless, Internet, and entertainment company. We saw these steps as leading to the next generation of companies. The creative side of wire- less technology was destroying wired telephone calls. You can play this game in almost every industry. Even the old steel mills use either very expensive methods of pro- ducing steel or the new high-output, low-cost methods. Any old, necessary industrial process can be viewed through the lens of creative destruction. New technologies in industry output mean either cheaper labor or cheaper methods or a combination of both. Using this philosophy to choose stocks will sometimes lead you to choose stocks outside the United States because the U.S. cannot offer cheap labor. Why would you buy a company in the United States, in an old industrial sector, if they are not on the cutting edge of processing their product? They need to have an edge: new factories with robotics, a distinction in product line. Some kind of cata- lyst must spark growth to increase earnings and increase the price of the stock. There are many U.S. companies doing just that, but they better have newer, faster and cheaper fac- tories outside the U.S. Even if they’ve been around forever, your focus should not be on old-line industrial companies.

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You need to keep an eye out for the newest, latest, next great thing. What is that? What could it be? My company found a small publicly traded company that came up with

a new seismic method of finding oil deep in the ground or

under the ocean. It uses old technology, seismic waves, in

a new way—to find oil. That looked like next generation

thinking to us. We also found several companies in a huge emerging market in India. In India, the middle class is going to double in a few years and is already larger than the United States’ middle class. This is the next generation of markets. China also fits this category. Apple came up with the iPod, Nokia with the flip phone, and I am not sure who invented the flat panel, high-definition television, but it certainly will either force all companies producing the old TV tubes to go out of business or change. That new thing does not always have to be a new invention or a new company. It just has to be on the leading edge of something. Find those companies that have the new thing that is growing its sales and whose stock is not overpriced. Then make sure it fits most of our rules. That’s it. You are rich. It is simple. Now go and make millions with my blessing. Then why am I still writing? If nothing else, you will learn from this book that nothing is

easy in the stock market. Let me give you another way to find stocks with good value.

Buy Companies That Have Been Unfairly Punished

I really like buying companies that look forward, those on the new horizon of products or services, but that does not mean I ignore the old companies when they are on sale. The difficulty lies in determining when a company is on sale and when it will never recover because its products or services are obsolete.


What to Buy. What to Avoid and Why

Microsoft was the leader and still is when it comes to the computer operating system, but as a growth company, it is old. They have already conquered the world market for their main product. Since Microsoft packaged their soft- ware system into all the computers, no one could compete. So Microsoft grew and became old, and its growth slowed to the high single- or very low double-digit percentages. However, we bought Microsoft and kept buying it in the low $20 range in 2006. It was stuck in a trading range of the low to the high $20 range for several years. Remember our dis- cussion on value? Here was a company that was still making huge profits with huge profit margins. It was trying to find the next big thing and had billions of dollars in the bank to develop the next big thing. And, this big company was still growing 10% per year, but the price of the stock was stuck. We thought that at some point, everyone else was going to wake up and see that Microsoft was not a dinosaur. Investors would someday take a look at Microsoft’s cash horde and its ability to keep growing. When the light bulb came on, the stock price was going to break out of the range. Until then, we bought the stock in the low $20s with a plan to sell back two-thirds of our position when it rose to its old highs. It finally broke out in November in 2006. This was a classic stock; you had to buy it when it was on sale. In Microsoft’s case, it was being punished unfairly because of its size. It was changing from a growth company to a value company, but traders didn’t seem to want to reward it for its value. It is the lonely cow that strays from the herd, but I like fresh grass every so often, so straying from the herd for the right reason is good—and green grass tastes mighty sweet to an old cow. How do you know if a stock is being unfairly punished? What are the characteristics? First, I suggest you stay with the big stocks—ones with a market cap of $10 billion or more.

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When looking for stocks that have been beaten down, you must ensure staying power. Big companies have resources that little companies just do not have, and that usually means money or access to money. A candidate that is being unfairly punished must have a low P/S ratio, a high EY and a low P/E ratio. It does not have to have growth, although that would be a plus because as it grows it becomes a cheaper stock in relationship to that growth if the stock price remains the same. Growth will make up for a lot of ills. When looking for the unfairly punished stock, you must be careful. Stocks get beaten up for a reason, so there will be a very sound, solid cause behind why the traders do not like the company. The best kind of cause in my mind is because the company is no longer growing as fast as it was and is moving from a growth company to a value company, like Microsoft. Another one is Wal-Mart. Both these companies slowed in their growth, but that was not the only reason they were punished. Both ran into political trouble: Microsoft for its monopolistic characteristics and Wal-Mart because of its political incorrectness. It remains a mystery to me why we, in the United States, attack our most successful companies. We are the only nation in the world that does that. So both companies were and to some extent still are in the news for their supposed faults. Another company we should discuss is Altria, the old Phillip Morris, the tobacco maker. It too was big, making lots of money and was unfairly punished. However, I would not buy Altria, but would and did buy Wal-Mart and Microsoft. Why, you might ask? Since you asked, here’s the reason and why you should carefully consider the reasons behind why a company has been unfairly punished. The difference is a shrinking industry versus a stable or growing industry. Smoking cigarettes is a shrinking busi- ness. Altria’s litigation fees have never been specifically


What to Buy. What to Avoid and Why

defined, though I think those lawsuits are absurd at this point. At this point, everyone surely knows that smoking

is bad for your health. So when you look at Wal-Mart, you

see a company that is expanding, though not by much in the

U.S. since it has already penetrated almost everywhere, but

it is still expanding. In other parts of the world, it is growing fast. Microsoft has come out with its new operating system and several new gadgets that may or may not spark better growth. These two companies have solid prospects for the future, whereas smoking is a shrinking industry. How do you spark more smokers? The government won’t allow com- panies to advertise, they can’t target kids anymore (although they denied ever doing that) and they constantly and will forever be sued until every last smoker has either won all the money or died. People are quitting in droves. Why would anyone want to be in that business? Besides, I hate smoking, and to be honest, that also factored into my decision. Look for big companies that make money and have some growth prospects. Separate their problems into short-term issues and long-term systemic problems with the business. Look for problems that companies can put behind them. If

a quarter or two of earnings fall short, make sure its tem-

porary. You do not want a company that is being destroyed by a new competitor with a newer, faster, cheaper widget. Your unfairly beaten up prospect has to still have the best widget. In Wal-Mart’s case, their superior delivery of low-

priced goods will eventually prevail, and for Microsoft, it

is the current and continuing dominance of their computer

operating system. Neither of these situations will change in the foreseeable future. Some day, yes, but not for years. Once you have found your target company, you have to make decisions about its stock price. Remember, you need

a low P/S, a high EY and a low P/E. That seems straight-

forward, but to be unfairly punished, these numbers have

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to be exaggerated. The best way to do that is compare the numbers with their industry. They should be the lowest P/S numbers, the highest EY and lowest P/E, in comparison to their peers. Remember, these stocks should be depressed in price, and the reason needs to be temporary—thus unjusti- fied. Before you buy, look at a chart. This unfairly priced stock should have put in a solid bottom on a long-term chart. The stock should be bouncing off that bottom before you buy. No one knows how low is low.

Don’t Buy Penny Stocks

I have talked about what to buy throughout most of this book, but other than story stocks, I haven’t really discussed what not to buy. You should also never buy a penny stock. This is a stock that is usually selling for under $5 per share and often for less than a dollar. Most of these stocks are also story stocks, but some actually have earnings. The main rea- son I hate penny stocks is that they usually go out of business. They are usually pumped to the public as a “can’t miss,” get in on the ground floor before others discover it, the next Microsoft or Exxon Mobil or Merck, it will just keep going up in value by a multiple of 10 or 100 or even 1,000. Anyone telling you this about these types of stocks is “pumping” the stock to you. It’s a sales job, and they are selling you. If you buy these stocks after one of those pitches, you are not making an independent decision; you are letting these sales- people have control of your stock portfolio. That is a mistake because they lie. The company that is sending you that e-mail or fax or calling you directly is getting paid in shares of the company they are pushing or already own large portions of the shares. This company and/or the backer of the stock, whoever that


What to Buy. What to Avoid and Why

might be, need buyers to “pump” up the stock price so that they can sell or “dump” their shares, usually to you, and

realize their profits. It is not illegal as long as they are tell- ing the truth, and there is often a grain or even a large part of the truth in the story they tell. This method of selling is called “pump and dump.” Don’t believe the “truth,” the “half truth” or the out-and-out lies they are selling. You cannot accurately separate fact from fiction, and since there is just too much fiction floating around, penny stocks are not worth the risks. Stay away from them. There are legitimate stocks selling for under $5. We already talked about Lucent; for several years, it was available for less than $5 per share, but I bet you never received any e-mails, faxes or a phone calls asking you to buy Lucent or trying to convince you that it was going to be the next Microsoft. That doesn’t happen with legitimate companies. That is the realm of the “pump and dumpers.” Stay out of that realm!

I know I will receive letters and e-mails telling me about

how this person or that person made a fortune on penny stocks. I also know that someone has to win the lottery every now and then, but the odds aren’t good that it will be you or me. If you are going to put money in a penny stock, you might as well play the lottery or, if you want better odds, go

to Las Vegas and put it all on black on the roulette wheel. At least you have a 50/50 chance of doubling your money in that bet. This book is dedicated to making reasonable choices and managing the risks that you take in buying stocks, and I am telling you right now that the risks involved in story stocks and penny stocks are just too high.

I will tell you one story about a pump and dump deal

offered to me years ago. At that time, I was fat, dumb and happy. (Now I am just fat and happy.) I was sitting in my office in New York in the late 1970s, right around the time of the big up market for gold. One of my colleagues came across

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this great investment. I could throw some money in with him and invest in a gold mine. Of course I was interested! Gold was going up every day. After I expressed interest, he brought in a salesperson for the mining company. Actually, she said she was the wife of the original gold mine owner. She brought a video tape with her for us to watch and a bag of dirt. It was an actual big bag of dirt, and it was heavy. It was one of those banker’s bags, and it had a bank’s name on the outside, printed in nice stenciling. It made an impression on me. Don’t think less of me; remember, I was young and impressionable at the time. We went into the conference room and we watched a twenty-minute film about this new mining method to make huge sums of money in gold. When it was over, I wasn’t impressed, even at my young age. What this lady was trying to sell us was a huge pile of dirt from this gold mine. There were any number of piles of dirt, and they showed you the dirt piles in the film. For only $2,000, I could buy a specific pile of dirt. Then they would process the dirt and remove the gold. The pile could have ten times $2,000 dollars in gold, or it could have very little gold—or it could have no gold at all, that was the risk you were taking. However, even if there was only a little gold, it didn’t matter because gold was rising so fast that all you have to do is hold off in pro- cessing your pile or buy several piles of dirt and sell them to another investor (another sucker) for a higher price. Her final push to sell me a pile of dirt was to show me the bag of dirt she brought and a much smaller bag with the actual gold produced from this big bag. Now I know I was from California working in my first big-city job in New York, but I didn’t realize I looked that dumb. While her pitch was not exactly a pump-and-dump scheme or penny stocks, her process was the same. She was selling a scam. She was trying to convince us of the fortunes


What to Buy. What to Avoid and Why

we were going to make if we bought her dirt. The whole scam was a crock of—to be polite—manure. My friend actually bought a pile of dirt. He never saw even a faction of an ounce of gold and then gold prices col- lapsed. Why didn’t I buy? Because I was convinced that any pile of dirt I bought would not have gold in it because, if it did, they would exchange my pile for another one. How could I ever be certain of which pile was actually mine? I want to keep you from being sold this same pile of dirt in the form of penny and story stocks.

The Seasonality of Stocks

Earlier we touched on the large secular bull and bear mar- ket cycles and the smaller cyclical moves inside those cycles, but there are other tendencies in the market that might help you when buying and selling stocks. In any calendar year from January to December, there are annual trends in the move- ment of stock prices. Broadly speaking, the first and last three months of the year are the best times to be in the market. It is not a guess or a feeling. It is true; the statistics don’t lie. Since 1970, from October through March, the average return has been 6.92%. From April to September, the average is 3.45%. This pattern has held up for many years. The weakest month has been August, followed closely by September. You would think that you could use this to time the market, and to a degree, you would be correct. However, in the past 15 years, August has been up 8 of those years and down only 7. It is just that the down years outweigh the up years, and a couple of those years were way down. Timing the market has never been a good idea, but learning the trends will help you decide when to be aggressive and when to just sit back and relax. Black Mondays will also

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occur randomly. On October 19 th , 1987, the stock market fell 508 points. That does not seem like much with the Dow trading at or near 8,000, but back then the Dow fell to 1,738– a 22.6% decline in just one day. You don’t get that kind of collapse very often. How many of you would look at that and not panic? In the long run, timing the mar- ket is not a successful strategy. If you would have followed the annual trend, you would have been in the market fully in October 1987. There is a lesson to be learned by Black Monday. Tuesday, the day after the crash, was the absolute best day to invest in the market for the next 20-something years. This is one of our rules: Buy stocks when everyone else hates them. The headlines on the front page of The Wall Street Journal read: “Stocks Plummet 508 Amid Panicky Selling,” “The Market Debacle Rouses Worst Fears of Little Investors,” and “A Repeat of ’29? Depression in ’87 Is Not Expected.” The Wall Street Journal, a respected business newspaper, was telling you that there was panic in the street—on Wall Street. If the Journal’s dire head- lines were depressing, what do you think the mainstream television news and other papers were saying? They fed on the panic and made it seem worse than it was. Yet, the day these headlines came out was the best time to invest. Mind you, there were those who said to buy. Leo Fields, a member of the Zale family, was quoted as saying he was gathering a list of buys in that same paper, but most oth- ers were talking doomsday. You have to be able to think for yourself. Do not listen to others and always remember that sometimes it is best to ignore the crowd. In my weekly newsletter, I sometimes warn investors to be careful and sometimes advise them to invest all the money they have, but even when I warn of a market slump that might be coming our way, I rarely tell my readers to


What to Buy. What to Avoid and Why

sell all their positions. No one, and I mean no one, knows which direction the market will take. You can play the odds and understand the cycles, trying to get an edge on the next guy, but timing the market is far too difficult. I have tried it, and maybe I am just stupid, but I could not make it work. Thank goodness I am not alone in that opinion. Maybe you are like me and don’t believe it won’t work. You want to give it a try? If you do, please do it with just a little of your money, or better yet, use some- one else’s money. I wish I would have done that. Actually, you will find it is more stressful losing other people’s money than it is to lose your own. It is for me.

Eight: How to Find Stocks

A Way of Thinking

This is a much more pleasant topic. Finding stocks to buy is exciting. It’s what stock pickers live for, and they work hard to choose stocks to make as much money as possible. It is a contest really, a contest of skill, of overcoming the other investor who decided to sell you their stock. Every time you buy a stock, someone else sold it. If the stock goes up, you were right and they were wrong. Buying and selling stocks is a deadly serious competition. You are competing with everyone else.

What a great game!

Finding stocks to buy is not hard; however, there are pit- falls to avoid and it takes careful, time-consuming work to do it right. I am going to go over the things my office does to find stocks or get ideas. However, I would like to first discuss some of the common traps that seem to snare everyone at one time or another.


How to Find Stocks

Number one is to avoid buying stocks based on a tip from

a friend, a knowledgeable stranger, or even your mother. You must do your own homework. Doing your own homework requires reading. If you plan on managing your own funds, you need to enjoy reading financial magazines, newspapers and company financial statements. You do not have to be an accountant, but you do need to understand how to read

a balance sheet and an income statement. Don’t panic. It’s

not that hard. If you buy stocks on tips from others without doing your own homework, you will be subject to failure. I assure you that you will fail if you buy based on stock tips. Many times these tips trickle down to you after everyone else knows about them. So don’t be impressed if the stock price of these tips has risen sharply, that’s when tips are spread, but you will often be the last one in line to hear about it. So the smart money is selling to you since other investors already rode the stock price up. The best way to find stocks is to do some independent thinking. For example, I have been reading a lot about the economy of India and other emerging markets for several years, but it wasn’t until I looked closely at India that I got excited. They had been growing their economy by about

7% to 8% per year for some time, but when I discovered that most of their population was very young, educated and English speaking and that their population exceeded 1.2 bil- lion people when, in the United States, we have only 300 million, I began to seriously consider buying some Indian stocks. When I looked at their low per capita income and the very low number of cars per 1,000 people, and the fact that they are an old, stable democracy dedicated to the rule of law, I decided to take the plunge and buy. My thought process was backed by sound reasoning and basic research. You have to start the process of buying a stock with independent thought. It is not as hard as it sounds. Look

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around you. Is there something going on in your life that may lead to a stock? If you have children, what is the new hot thing they just have to have? Or, for that matter, is there something that you have to have or need that others also have to have and need? Something in the news may spark a stock idea. For instance, recently the Democrats took back the Presidency. What changes might that bring in spending? My first thought was less on military and more on domestic. I will stay away from companies supplying our military. The slowing in spending won’t happen overnight, but the prospects have changed. If the Democrats are going to spend more on domestic issues, who will prosper? Will more money be spent either through the government or private industry for homeland defense here in the States? What companies might benefit? Security companies might benefit, companies that make bomb detection devices like x-ray machines or tech companies that check fingerprints or track people and equipment in some way. Or, increased spending might appear in social programs and the top of the list might be medical coverage. On the other hand, will the government try to control costs, and if so, what effect will that have on earnings for medical corporations? It is a thought process. What will change with Democrats in control? It is not easy, but let your mind explore these types of thoughts.

I like Peter Lynch’s suggestion to buy things you know

about. If you work for a veterinarian, you know what is hap- pening in that industry. Do they have new products, services or devices that will change the way vets do business? Or if you’re a policeman, what new type of protection or detection

devices are being used or invented to either safeguard society or find criminals? Keep your mind open to all possibilities.

I have 35 nieces and nephews. Every so often, I take a

few of them to the mall and let them shop. I encourage them


How to Find Stocks

to talk about what is new or what it is that they want. True Religion jeans were a hot new item at one time, and I actu- ally bought the stock—knowing full well it was a fad. I could not believe that paying $500 for a pair of jeans would last, but for a while, the stock price rose sharply. I got out quickly to the disappointment of my niece. The important thing was the idea. Where do you come up with ideas? The most plentiful place for me is in reading. In our office we get The Economist, my favorite magazine, and Forbes, two premium business magazines. We also receive The Wall Street Journal, The Financial Times, Investor’s Business Daily and a half dozen different newsletters. We also buy databases of all the stocks traded on any exchanges in the United States. You can- not compete with professionals when it comes to information. However, all that information does not lead to success. It does, however, provide a fruitful playing ground for stock ideas. Before you go out and buy a bunch of publications, let me give you another lesson on what not to do. Do not buy stocks based on any publication’s top 10 or top 100 list of best stock performers. In fact, you can expand this lesson to never buy a stock that is on everyone’s lips or at the tip of their pen. That means stocks that are on television, on the radio, or in newspapers or magazines. That is coming from a guy who hosts a call-in radio show that discusses stocks. Usually, once a stock is in the news or makes a top 10 list, it is too late. It has already made a run, and you are the last in line to hear about it. Do not chase performance. It is a loser’s game. If you want to be successful, you must have original ideas. You have to develop a method of finding ideas and expand- ing those ideas. You do not have to get those ideas from a business publication; they can come from anywhere. Other than knowing when to sell a stock, this is probably the most difficult task to learn.

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Once you have some ideas, however, do not go out and plunk your dollars down on those stocks. Later on, we will discuss managing a portfolio of stocks and diversification, but for the time being, take your idea and chew on it a bit. Having an idea and turning it into an actual buy of a stock is a process. Don’t rush into it. If your idea is based on a theme rather than on an indi- vidual stock you discovered, then you need a way to find the stocks that fit that theme. For instance, when I began thinking about investing in some Indian companies, I had no idea what companies I should buy. All I had was an idea and some basic research on the economics and demographic of the country. What’s next? The Web is a massive free tool available to everyone. If you do not have a computer with high-speed Web access, I suggest you avoid investing in the stock market. This pursuit requires too much research for you to accomplish it success- fully with low-speed or intermittent access. Staying with the Indian theme, I needed to find all the stocks available to purchase that were either Indian stocks or would benefit from Indian growth prospects. I went to ETFcenter.com. To start my search, I also went to Marketwatch.com, Yahoofinancial.com, and MSNmoney. com. You could also type “Indian stocks” into any search engine and search for them, but it will cost you a significant amount of time doing research that way. For me, it was sim- pler to just start with the ETF center. What is an ETF? They are a hybrid cross between a mutual fund and a stock. They are baskets of stocks that shave the market into many differ- ent slices, based on almost anything. I found two ETFs that were actually closed-in funds dedicated to Indian stocks that were trading on our exchange. The symbols are IIF and IFN. These two ETFs had a basket of stocks of companies in India. They listed the stocks. That was the beginning of my effort


How to Find Stocks

to buy. From there, I went to the web to find out everything I could about those companies. What industry were they in? How big were they? Were they making money? Did they have any new products coming out? Who were their competitors? Once I had answers to those questions and I had applied all our earlier lessons on EY, GPE and P/S ratios, I had a good list of stocks that qualified. It was a process that required me to take the data available and conduct my own research. Once you start a process like this, which, by the way, can take days or weeks to complete, sometimes it leads to another theme or way of thinking. For instance, in researching India, there were a lot of comparisons to China. In that comparison, there were repeated references to both countries’ need for raw materials to continue their growth in the future. Raw materials mean commodities:

oil, steel, gold, food, fertilizer, paper, plastics, natural gas and more. After revisiting the number of people in both of these countries and the potential for a consumer boom, my research led me to look into buying large, international commodity stocks. You never know where your research will take you. Keep an open mind and think critically about what you read. It is not like watching television, you have to exercise your mind. You will be surprised at the different ideas you will develop. Pursue them! Before you get too excited, let me give you another bit of advice: Do not over-analyze. Jerry, my mentor, calls it paralysis by analysis. At some point, you need to make deci- sions. The Internet is a great place to do your research, but at some point, you have to stop reviewing your options and decide. On the radio show, I get many calls that begin with, “I have been watching this stock…” and they have usually been watching a stock that just continues to go up. They have done all their research, they like the company, it’s growing its sales and earnings, but there was something that was not

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right. The P/E was too high, or they missed their numbers in the last reporting period, or that sector may have something going wrong, so they are watching it. They are watching it and waiting until all the stars are aligned just right, and then they plan to buy. The stars will never align perfectly. They are paralyzed by too much analysis! Nothing will ever be perfect. You can always do more work, more research, but you will never be a good investor unless you learn to pull the trigger. The best way to combat this anxiety is have a get-out strategy in case you are wrong. You do not have to buy a stock and live with it forever. The great thing about the market is that it is liquid. You can buy and sell any stock any day. Once you have completed your work on the stock and find that it meets most of our rules, then take the plunge. Let me revise that: Finish this book first, but then take the plunge.

Making Decisions and Charting Them

Buying a stock is easy. Anyone can buy any stock at any price. Buying is an act that is positive, full of hope and promise and way too easy. In fact, it has gotten easier with the advent of online trading discount brokers, deal- ers with very low trading costs. The problem is not buy- ing a stock but buying a stock at the right price. The “right price” is a nebulous term, one that is hard to define. The average investor could buy a stock and have it move up in price, but he often mistakes his luck for skill. That was the hallmark of traders in the late 1990s. At that time, anyone could buy almost any stock—underpriced or not, because all stocks rose until the beginning of 2000. There is nothing wrong with being lucky on occasion, but you should not trust luck to help you with the stock market.


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You should learn to be skillful in choosing your stocks. Then, if a little luck comes your way, you will know how to capitalize on it. The hardest part about making money in the stock market is not buying stocks, it is selling them. Selling is not a posi- tive act. It is a negative act. Either you are selling because you made lots of money and are taking profits, or you are selling because the stock has gone down and you are trying not to lose your shirt. It is always hard to sell a stock. The physical act of selling is just as easy as buying, but the emo- tions involved make it a lot harder. If a stock is moving up and it’s one of your winners, how do you know when to sell? Are you saying you will never sell? That’s Warren Buffet’s philosophy, and I have heard investors tell me that they are never going to sell their win- ners. It’s going up—why would anyone sell? I have seen those same investors sell those same stocks at a loss, finally giving up after they lost all their profits. Everyone has a sell point, even Warren Buffet. If a stock you bought immediately goes down, where do you sell? Did you make that decision before you bought the stock. You should have. Before you buy a stock, you should always establish your sell points, both on the upside and downside. They may change with time, but always have them in place before you buy. One solid method is to sell stocks when they become overvalued. The problem with that strategy is that if you sell too early, even if it is overvalued, you could lose a lot of profit. There are ways to hold those overvalued stocks and sell them at better prices than those stocks that are at value. Google is a prime example. That stock was overvalued the day it went public, so where do you sell it? Using our rules, you would never have bought the stock, but there will be times that stocks you did buy that were below value, have

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gone up and are now overvalued. Do not automatically sell them. Using charts will help you determine when to buy and sell stocks.

When to Buy

Once you’ve done all the research and found a stock to buy, your job is not done. Do not drop everything and go out and buy the stock. If you’re trying to buy stocks at the very best price and sell them at the highest price possible, your cause will be greatly enhanced if you learn to read charts. Before we go any further, let me state very clearly and emphatically:

Chart reading is not a science; it is an art.

When you study charts and look for patterns, essentially all you are doing is looking backward at history. That history is the actions of traders as they push the stock up or down in price. The chart knows nothing about the fundamentals, and it knows nothing about the stock itself. A chart is com- prised of only two elements: the stock price and the number of shares traded. All the other studies, and there are many, have to use these two components. I am not going to explain all the techniques involved in reading charts. This book is an effort to make you a better investor, and to do that, you have to have an understand- ing of both the fundamentals and the technical details; therefore, I am going to give you the basics of chart read- ing. There are some very good books on charting. The best is Technical Analysis of Stock Trends, 8 th Edition. This is the definitive work on technical analysis. If you want to be a student of chart reading, you need to buy and study this book.


How to Find Stocks

I will be giving you samples of charts, these will be real charts from real companies. Advanced Get from E-Signal is the charting program being used, and it is one we use in our office. There are other charting programs and free charts available on the Internet. At this time, I like StockCharts. com or BigCharts.com. They have good interactive charting systems, and everything I will discuss about charting can be done and seen on these charts. All the charts I will be using will be bar charts. There are other kinds of chart structures (candlestick, line, and point and figure), but the bar charts are often the easiest to grasp. It is often better to keep it simple than to learn all the differ- ent ways to study charts. Who has that kind of time?

Buying Trends

Charting Rule #1:

Buy stocks that are in up trends.

Like all good rules, it sounds easy but is harder than you think. You do not want to be in a stock that is down and has gone down over weeks or months, but to decide when the trend has changed and the stock is moving up can be difficult because of the second rule:

Charting Rule #2:

Do not guess at the bottom.

So how long should a stock move up before you decide it is in an up trend and that it has established a bottom? If you have ever bought and sold stocks over any length of time, you understand this dilemma. Let’s look at a couple of charts.

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Above Average Investing 114 1 Source: eSignal, Advanced GET This is a one-year bar chart of

Source: eSignal, Advanced GET

This is a one-year bar chart of daily stock price movement for Microsoft. To keep it simple, I took out everything except the actual price movement. Each vertical bar repre- sents the movement of the stock price over one day. For the first half of the chart, you see sideways movement, where the stock stays in a channel before it collapses, “gapping” down to a low in the middle of the chart. It hit its bot- tom after that and then moves up, only to come back to “retest” that bottom price before breaking up to march to new highs on the extreme right hand part of the chart. That retest of a bottom will come up again very shortly, so remember that term. If you apply the first rule, you would not buy this stock until it hit the bottom and bounced upward, but tell me, where did the upward trend start? When would you buy? Remember, when you buy the stock, you do not get to see the future, so what do you use to tell you that a new upward trend has started? At the very bottom and for a few days to a couple weeks after that, the stock price moved up, only to fall back down again. You can see how difficult the task is.


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Because of this difficulty, analysts have developed tools to help you decide where and when stocks change direction. Now look at this same chart with a few of these tools added.


Source: eSignal, Advanced GET

I drew trend lines and placed another chart below the price chart. This one tracks the “On Balance Volume.” Remember, we are trying to decide when a stock has changed its trend; therefore, look at the downward stroke of a single down trend line from top on the left to the bottom on right starting in early May—right in the middle of this chart. When the stock price broke up through that trend line, it signaled a trend change. The problem is that in the case of Microsoft, as soon as it broke up through the trend line, indicating a trend change, the stock almost immediately broke back down. However, if you were looking to buy Microsoft, you should have bought this stock as the price broke up beyond the trend line. Then, a week or two later, it would have broken down again; so what should you have done then? This is what makes chart reading

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so difficult. In this case, you would have done nothing because this latest move down was only a retest of the bottom and a successful retest at that.

Support and Resistance

Charting Rule #3: Watch for support and resistance points and do not react until the stock breaks them.

Support and resistance in a chart are those places the stock price has been before and not broken up and down from those places. In this chart, the support is at the very bottom of the chart. The price of Microsoft collapsed and made a bottom. When the stock bounced up from that bottom, that bottom became a support. All we are doing is observing the movement of stock prices as traders push them up and down. The trad- ers pushed Microsoft to a yearly low; once it bounced up from that low, we had a support on the chart. The price of the stock moved up and broke the trend. As it did that, we had a buy signal, so we bought the stock. The up trend was in place. Then the stock moved right back down to test the original bottom. The traders reacted by buying before it actually reached the bot- tom, moving the stock back up. This is considered a “double bottom.” It’s not a perfect double bottom, because it did not go to the exact same price of the previous low. They are rarely per- fect. If a stock successfully retests the bottom three times, that is a “triple bottom.” The more bottoms that are tested and the more the stock moves up each time, the stronger the bottom or support is, and the more confidently you should be buying. Therefore, since this stock price did not break down through the old bottom, you would not have sold this stock,


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even though it briefly fell out of trend. Simple, isn’t it? If you think this is complex, hold on. We haven’t even scratched the surface of charting. There are dozens of chart studies, and we have only looked at trend lines. As the stock price moved up from its successful retesting of the bottoms, you will note I drew in three trend lines called a “channel.” A trend line is drawn using at least two or three high or low points in a stock price. Look closely at the trend lines. The line is drawn at the tops and bottoms of stock prices. You are connecting two, three or more stock price tops or bottoms with your drawn line. As long as the stock is in a trend, you never have to worry about selling and, as advised by Charting Rule #1, you want to buy stocks when they are in an upward trend.


Charting Rule #4:

Do not buy over-extended stocks.

Again we will use Microsoft’s 1-year chart as the example:


Source: eSignal, Advanced GET

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This time, I drew a resistance line straight across the old tops connecting three places on this chart. The first top was in November, the next in late January and the third in March. I drew that line all the way across my yearly chart; note where it intersected the stock price. You should rec- ognize this line as resistance as the stock price moves up to meet it. When a stock moves up to previous old highs,

those highs act as resistance for the stock price just as an old low acts like support. The new line connected a triple top, meaning it was a strong resistance point since the stock met it three times and failed to break through. This shows that the stock price movement hesitated when it hit that area for

a fourth time. It looked like it would break through and, in

fact, did but traded sideways for two weeks before finally “breaking out.” Break-outs are very important so try to remember what they look like on a chart. After this stock has broken out, is this chart depicting an overextended stock? If it does, then we do not want to buy it. Generally, we want to sell it, but rule number three is not easy to apply. Many overextended stocks possess some characteristics of value. In this case, is Microsoft over-valued at its current price of $30 per share? To figure that out, we

have to go back to our rules about valuing a stock. You should already know what its value is before you bought the stock, so if you owned Microsoft, you would already know your

target price. In this case, at this time, I have a value of about $40 per share for Microsoft. So from a value standpoint, it is not overextended, but the art of chart reading may help you re-evaluate your value judgment. How you answer these three questions will help you determine the stock’s overex- tention though its value is fine. Remember overextention is

a chart pattern and has nothing to do with the fundamentals of the company itself:


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1. Has the stock broken all resistance on a one-year chart? This one has.

2. Is the stock price movement on a 1-year chart steeper than a 45-degree angle? Microsoft’s is.

3. Has the On Balance Volume started to break down? On this chart, it has not.

What is On Balance Volume? I will get to that. So Microsoft has broken above all resistance—that’s very good, but it has done so with a very steep chart pattern—and that suggests danger. Many times, if a stock moves up at a greater than 45% angle, there will be a pullback, and often, up to half of the move up will be relinquished before it starts up again. That is not a certainty, but just based on observation of past events in thousands upon thousands of charts. Based on that experience, I would conclude that this chart is overextended with justification because of the value of the stock. I feel that Microsoft was overextended on the down side, and the yearly chart of Microsoft below proves my point:


Source: eSignal, Advanced GET

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In 2006, you will see a strong down stroke on the chart.

If you use the support and resistance technique, you see that

Microsoft has strong support at about $20, where the chart traded at its lows in the recession of 2000 to 2002. It fell sharply in the first part of 2006, and I would say that was an overextended drop in price, especially at a time when Microsoft was making billions of dollars and had billions of dollars in the bank. The drop was more than 45% and unwar- ranted. All it did was rebound from that drop, continuing its move upward from the low made in 2003. For a real test, can

you see the resistance on Microsoft in this 5-year chart? It will be about $33 per share. That is the old high made in 2001. That will be the next test area as Microsoft moves up. Let’s talk about On Balance Volume since I mentioned it

a way to spot stocks that are overextended. It is more than just a tool for this purpose. We at KPP use it extensively. We think it is useful for more than just looking at plain old volume. Volume refers to the number of shares traded over



specific time frame. When the volume of traded stocks


high for a day or week in relation to its normal volume,


usually suggests that the buyers or sellers are in control.

However, On Balance Volume looks at the type of volume. Is

it up volume or down volume? When a stock trade is made,

a stock’s price either rises in price, falls or stays the same.

When it rises in price, that volume of shares is added, and when it falls, it is subtracted from the total number of shares traded. This way, if more buyers are accumulating the stock on up ticks, you know that traders are willing to bid that stock up at higher and higher prices. They continue to want to own the company as prices rise. The opposite is true for sellers. These buying or selling trends result in a line chart we call On Balance Volume or OBV. The only time the OBV line is important is when its movement is divergent from the movement of the stock price


How to Find Stocks

chart. In my Microsoft example, study the OBV line and compare it to the stock price movement. The OBV line is moving in conjunction with the stock price chart. It means nothing when it is going in the same direction. However, it doesn’t always look that way. Let me show you an example of divergence where the OBV line is moving up and the stock price is not. In that case, the stock price eventually caught up with the OBV.


case, the stock price eventually caught up with the OBV. 5 Source: eSignal, Advanced GET Note

Source: eSignal, Advanced GET

Note the price of this stock in August and the correspond- ing OBV line below it. The stock price gapped down in one day, then recovered the next day, but look at the OBV line. It too spiked down, but look at the strong move upward. The stock price only recovered to the $45 price level, but the OBV moved up much higher than the previous OBV line. The OBV spiked upward, but the stock price did not. That is divergence and that OBV line was a buy signal. Even on the

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next move down of the stock price in September and again in October, the OBV line never moved down again. More buyers than sellers were willing to buy the stock at lower prices. Those were buy signals. This assumes this stock was worth buying, which you would know if you did your work on valuation. We do not buy stocks that do not meet the five stock-specific rules, even if they go up. This is a good time to review those Buying rules:

1. Buy relatively low P/E stocks.

2. Buy stocks with an EY of 150% or more of the yield earned on a 10-year government bond.

3. Buy stocks with GPEs of 2 or higher.

4. Buy stocks with a P/S ratio of 2 or less.

5. Buy stocks with at least a 17% ROE and/or ROA.

We might as well review those seven Investing Rules too:

1. Experts are wrong.

2. When everyone knows something, it’s worthless.

3. Always buy stocks when everyone hates them.

4. There is no crystal ball.

5. Sell when everyone else loves stocks.

6. Always buy stocks that are making money.

7. Don’t buy story stocks.

If you see the OBV line moving in one direction and the stock price not moving in that same direction, it is impor- tant because you have divergence. If the OBV is going up and the stock price is not or it is moving down, that is a buy signal. If the OBV is moving down and the stock price is moving up, get out of that stock. Remember, the OBV is saying that more buyers are leaving or coming into the stock on up or down ticks. So if buyers are willing to buy


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more and more shares as the stock is moving down, and you can see this in the OBV line, then eventually the buyers will exhaust the sellers and the stock will move up. Use the OBV to observe and react to the divergence between the OBV and stock price movement. There is a lot more we can discuss about OBV and there are many ways to compute it, but this book is not about gen- erating your own chart; it’s about reading charts.

Double and Triple Bottoms

The next kind of buy signal that I like a lot is when a stock hits a double or triple bottom. Finding a stock’s bottom as it comes down is very difficult, and I am not suggesting you become a “bottom fisher.” That is someone constantly try- ing to guess at a stock’s bottom before buying. A strong buy signal occurs after a stock has fallen to a low level, bounced up from that low level and then has retested that low level again. If that retest is successful and creates a double bot- tom, it is a strong buy signal. If it does it again, creating a triple bottom, and bounces up again, buy more. You have to be able to see a successful retest of a bottom on a chart before you can call it a bottom. Bottom fishers do not wait for that successful retest, they buy when they perceive that stock has gone down far enough, but they often don’t wait long enough. I do not like guessing where a bottom is; I want to verify that bottom on a chart.

Charting Rule #5: Buy stocks that have suc- cessfully tested double or triple bottoms.

The chart below tracks our company’s recent stock pur- chase of KBH. This stock is a home builder, and at this time

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in history, the home industry is in a lot of trouble. All the builders have been severely punished. I smell an opportu- nity. This will not be a long-term hold, but rather, a trade, and my signals come from this chart:


Source: eSignal, Advanced GET

Can you see the strong bottom this stock put in? In June, July and September, there were three bottoms. One more came in November, but that bottom was not as low as the others. We at KPP bought this stock shortly after that fourth bot- tom. The real trick will be getting out of this stock in time. It is much harder to sell than to buy. In the next chapter, we will focus on sell signals. (We sold this stock not long after the purchase because of the weakening housing market.) Many stocks put in bottoms, but that doesn’t mean that you should buy all of them. You still must always check the stock’s value by researching it, and the bottom has to be clear and distinct to qualify as a double or triple bottom. In other


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words, the bottom has to be at very near the same price each time it tests the bottom. It can’t be all over the place.


it tests the bottom. It can’t be all over the place. 7 Source: eSignal, Advanced GET

Source: eSignal, Advanced GET

There are easily determined bottoms in this chart: one in October, one in June and July, and the last one to the right in October again, but there are no double or triple bottoms anywhere. You can argue that the June and July lows might qualify because they were close in price on the close of the day. In charting, there is a strong desire to find the patterns you seek. You could argue this was a double bottom, but in my opinion, it was not. You could also argue that the low in October on the right was a retest of the double bottom in June and July. You would be trying to squeeze this chart into a preconceived idea. Be careful! After studying about 10,000 charts, you will get the hang of it.

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Moving Averages

In the last few charts, you might have noticed long lines moving through the year on the price chart. These are mov- ing averages of the stock price. I am sure you know what an average is, but you might not know what a moving average is when discussing stock prices. I like to have four moving averages on my charts: a 20-day, 50-day, 100-day and 200- day. These moving averages tend to act as support and resis- tant points. In calculating an average, take the last number of days—if we are using a 20-day moving average, you take 20 days of stock prices—add them together, and divide by 20. This gives you the average price for those 20 days. To make it a moving average, drop the oldest day price and add the new- est price on each new day. That maintains the 20-day aver- age. You plot yesterday’s 20-day moving average and today’s 20-day moving average. Tomorrow, you drop the oldest day again and add tomorrow’s price. You keep moving forward by dropping and adding days everyday, and you build a mov- ing average line that represents the 20-day moving average of the stock’s price. Using the average helps smooth out the stock’s daily movement. Once you have the concept, you’ll see how easy it is to calculate any moving average. Once you have the moving averages and can plot them, what do you do with that information? What do those aver- ages mean to you? How can you use them to buy or sell stocks? Let’s focus on buying first. A 20-day moving average is considered a short-term average. It represents about one month of trading, since the market is not open on weekends. Even a 50-day moving average is considered short term. The 100- and 200-day moving averages are long term. We use these moving averages because everyone else uses them. I know that sounds stupid, but its true. The 200-day moving average is basically one year’s worth of stock data.


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Generally, when the stock price is above all the moving averages, it is in an up trend and that is a buy signal. In a market that is in a long-term bull or bear phase, this method works well. It does not work well when a market is trading sideways. I won’t make this into a rule because using moving averages as triggers for buying and selling fall into rule num- ber one concerning trends. An old investment saying is: The trend is your friend. Stay with the trends. Moving averages help you determine when you are in a trend.

Professionals use some of the following signals:

When the stock breaks up penetrating the 200-day mov- ing average, it is in a strong upward trend.

When a stock breaks up through the 20- and 50-day mov- ing average, a trend reversal is in place.

When the short-term 20-day moving average breaks up through the 50-day moving average, the stock is in an up trend and you should buy it.

When a stock comes down to one of the moving averages and bounces up again, it is a buy signal.

These are the basics in using moving averages. Again, just as in all chart reading techniques, these patterns tend to be true but are not always true. When you can use the signals on a chart and your fundamentals together, you have the best chance of buying a stock at the right price.


What is a gap? You can easily see them on a chart, and they can appear as either a gap up or a gap down. They are neither a buy nor a sell signal per se. A gap occurs when a stock

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price opens at the first trade of the day at a sharp difference than it closed the night before. For example, if a stock closed yesterday at $20 per share, and this morning its first trade was at $25 per share, the stock gapped up $5 per share. To demonstrate, let’s look at Google’s 1-year chart:


To demonstrate, let’s look at Google’s 1-year chart: 8 Source: eSignal, Advanced GET There are a

Source: eSignal, Advanced GET

There are a number of gaps both up and down on this chart. The first gap up was in the middle of October to the extreme left of the chart. It’s very clear on the chart that it closed one day at one price and opened the next day at a higher price. There is a gap down in late January, a gap up in late March and another one in the middle of April. The last one is in October on the right where it gapped up again. There are also a number of minor gaps as well. If there is a gap up, it generally means that the stock is moving up and will continue to do so. Again, in chart reading, these things tend to be true but are not always. For example, look at the gap up in April on Google’s chart, right after that


How to Find Stocks

the stock sold off. That sell off went right to the 200-day mov- ing average and bounced up, so the 200-day moving average was a support. It came back down to the 200-day moving average in August and tested the support line of the 200-day moving average before it bounced up again. That was a buy signal. The price of the stock at the end of the chart was about $500 per share. At that point, is it extended? I feel it might be because it is so far above the 200-day moving average line and because the value of the stock is much less. I would not buy this stock until it comes down and retests the 200-day moving average where it will likely find strong support. The OBV line in this chart concerns me. That is the line below the price chart. Note the OBV high at the extreme left of the chart is not as high as it was at the beginning of 2006. I do not feel comfortable with that kind of pattern. If the current stock price is higher now than at the begin- ning of the year, then the OBV should also be higher. Is that divergence? I think it is and it is not good in this case. Time will tell us if the stock will fall. There is a rule that says: Gaps always get filled. Besides watching for gaps and understanding that a gap up is bullish and a gap down is bearish, be aware that gaps leave holes in the stock chart. Those holes need to be filled, meaning that the stock price needs go up to the top or down to the bottom to continue its primary trend up or down. When a stock price gaps from $20 to $25, that gap gets filled by the stock price coming back down to $20 and then continuing back up. The $20 price acts as support when the stock comes back down. This is a nice rule about filling gaps, but it has one major flaw. Gaps do indeed tend to be filled, but the time it takes to fill a gap could be measured in days, week, months or some- times years. Do not use gaps as a sole indicator of what to do. Always look at trend lines, moving averages and especially the OBV when studying gaps on a chart.

Nine: The Hardest Part of Being in the Stock Market

When to Sell

I have primarily discussed chart patterns that indicate when to buy. Buy at support, buy when a stock breaks out, buy when it moves above its moving averages and buy when you see double and triple bottoms. We can turn those indi- cators around and sell when stocks break down below sup- port, sell when they fall under all the moving averages, or sell when they fail at double and triple tops or break below double and triple bottoms, but selling is not that easy. You can use these signals, and you would not be wrong to do so, but you need to put more thought into the process. Buying is fun. It is a positive activity full of hope and prom- ise. It is also the easy part of trading. The far more difficult task is knowing when to sell. Using charting is one way to sell stocks, and it is a skill that will help you tremendously when determining when to sell and when to hold. But there are other ways to sell stocks, and we are going to explore them. An honest discussion about selling stocks has to include the philosophy of never selling. There are those who advocate


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holding stocks forever; Warren Buffet is one of them. If you do not know who he is, then you are not a serious investor yet. He

is history’s most successful and famous stock picker. He would say he is a picker of businesses, not stocks. When he buys

a company, his time horizon is forever. Exceptions do occur

when he does sell, but they do not occur very often. Since

he is the greatest investor of all time, you can’t dismiss this philosophy. His method is valid. The problem with that is that we are not all Warren Buffet. He has a deep understanding of what companies to buy that will work for the long run. I found

it interesting that he did not buy one tech company, ever. He

says he doesn’t understand them. I think he does understand them he just doesn’t like that technology changes so fast that you could hold the best company today and ten years from now, it will be out of business. There is a lot to sticking with companies and businesses you know and understand. In that situation, being a buy-and-hold investor will work. In fact, over any ten-year period, the stock market has always been higher, so if you buy an index of stocks, not indi- vidual stocks, you can hold the index and eventually make money. It’s a fact. It also might mean you could be long dead before you make money. For example, if you have a portfolio

comprised mostly of high tech, NASDAQ stocks that you bought at the peak of the market in early 2000, by the start of 2008, you are still 50% below the peak, and it looks like

it is going to take many more years to retrace that collapse. If

you buy individual stocks, the story could be very different; in six years, the Dow has climbed to new highs. Large stocks far outperformed the small stocks in that period, but even in the Dow, which is only 30 stocks, only about half of them made the move to drive the Dow to new highs. The others did not do nearly as well. Odds are that you are not going to be Warren Buffet. You are going to want to sell at some point. None of this helps

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you know when to sell, but it does demonstrate that stock picking and buying at the right price is important. However, it is less important than selling. Proper selling techniques are critical, and if you do not have them, I say again, just buy an index in the S&P 500 and hold it forever. You will do fine. For the rest of you, I want to lay down some sell rules. After all, even Warren Buffet sells stocks sometimes. We will have two kinds of rules for selling. One will be selling for basic reasons and one will be for charting reasons. We have already established one basic reason for selling stocks in the Investing Rules. It doubles here as a Selling Rule.

Selling Rule #1:

Sell when everyone else loves the stock.

You can even broaden it to include times when everyone loves the entire stock market. The problem is that we don’t know when that love is at a point where we should implement the rule. This is where charting will help you stay with the market or your winning stocks as long as possible and trend lines and moving averages on a chart will tell you when the love has gone out of the stock or the market. Later, I will show you some more charts that will help you interpret the signals sent off by that lack of ardor. First, let’s go over some of the basic reasons for selling stocks. Some of the signs that the market has turned ugly and it is time to leave are economic in nature and other signs are observational. For example, if you observe that the stocks that make up the stock market are reporting fewer stocks reaching new highs and more stocks falling to new lows, then love for the market is on the wane. If up volume is less than down volume and that trend has been in place for a few weeks to a few months, it confirms that the love is


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gone. At that time, you will notice fewer IPO (initial public offerings) being made. Merger and acquisition activity will fall off. Less money will be coming into mutual funds, and foreigners will be net sellers of our stocks. All these signs are difficult to quantify, but they are observable. If you pay attention, you will see the changes. However, to make your life easier (though still not exactly easy), you should apply rule number two in combination with rule number one.

Selling Rule #2:

Sell when a recession is on the horizon.

The Fed and Interest Rates

How do you recognize when a recession is coming? We al- ready discussed government statistics, and I suggest you re- visit the discussion on leading economic indicators, but those will not tell you when to sell. They will provide a sense of economic direction and that is what we are looking for when determining when to apply rule number two. The problem with those government statistics is that they are always being revised, so when the initial report on unemployment data comes out, you can bet it will be wrong. It is not unusual for it to be off by 50%. Still, you have to use what you have, and if everyone else is reacting to these statistics, you need to understand what they are doing and why. In general, when looking at an economic cycle, keep an eye on the direction of interest rates. At the top of a strong, growing economy, the Federal Reserve begins to increase interest rates. That is the first round of cannon fire across the bow of the economic ship. The Fed usually raises rates slowly and in increments. They usually issue four rate increases in a row. When the Fed starts the process of raising rates, they are

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trying to put the breaks on an overheating economy to fight inflation. By the time the fourth rate hike hits the economy, there is usually still no sign of damage. Those cannonballs of interest rate increases take about 12 months to show any dam- age in our economy. When the Fed begins shooting those rate increases, the stock market will start to get very nervous. The stock market hates rising interest rates, and the Fed almost

always raises interest rates too far, sinking the ship and causing

a recession. Therefore, in general, when the Fed starts rais-

ing rates, an economic slump is on the horizon. When that happens, the stock market will weaken. It is not a definitive

reason to sell, but it is a good reason to be very careful, and

it should make you feel, as an investor, more open to selling

stocks. After you sell, you might want to sit on the cash for

a while. You do not always have to be fully invested in the

market. Cash is also an investment at times. Since it takes a very long time from the first interest rate increase to affect the economy, economic health indicators will still look very good for a while. Earnings, growth and employment will be healthy. However, investors always look ahead, and they react to what they think they see. They too can be wrong, but that won’t stop them from trying to deci- pher the future, and it certainly won’t stop them from driv- ing stock prices downward. The corollary to the Fed raising rates is the inflation news. If the Fed is raising rates, you need to watch for signs of inflation. The Fed uses inflation as the excuse for raising rates. When the Fed stops raising rates, or pauses, they may explain their pause by claiming that inflation is moderating. That may or may not be true. The Fed has two mandates. They are to keep a steady economy growing, and they are to control inflation. The actual law that governs the Fed does not say that, but that is how the law has been interpreted. The Fed has several blunt


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instruments it uses to implement that mandate and the most obvious and most effective tool on hand is the lowering and raising of the interest rate on money they lend to banks. If they say they are raising rates to control inflation, they also may want to reduce economic growth. If they say they need to slow the economy, they may really be fighting inflation. These two things are attached at the hip. You cannot sepa- rate one from the other. In normal economic cycles, this is relatively straightfor- ward, but once in a while we experience economic “stagfla- tion.” That means that we experience no economic growth but inflation still rises. Which way does the Fed move in that situation? We had stagflation in the 1970s, and it was painful. Another economic malaise that we have not seen in the United States since the Great Depression is “deflation.” Japan suffered under this sickness for all the 1990s. That’s when everything becomes less costly every month. You, as a consumer, may think that is great, but it isn’t good for the economy. If you know things are going to be cheaper next month than this month, what do you do? You avoid spend- ing, and in doing so, you stop the economy. Jobs are lost and this goes on and on until the consumer decides that he needs to spend money or that goods won’t get any cheaper. It is a spiral that feeds on itself, and for an economy, it is very dif- ficult to combat. As a consumer, you may like the cheaper prices, but even cheaper prices won’t help if you lose your job. I would rather have inflation and a job. Inflation is the norm, and the Fed telegraphs a pos- sible recession to investors by increasing interest rates. The increases take time to filter into the economy, and the time it takes is why the Fed usually raises the rates too high and actually pushes us into a recession. The “soft landing” or “Goldilocks scenario” is where the Fed raises rates just enough to stop inflation and only slows the economy. The

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odds that the Fed can successfully engineer this kind finesse are remote but possible. I have one final point on the topic of how the Fed raises and lowers interest rates. I mentioned that the Fed controls the interest rates of money loaned to banks. Our banks, the ones that hold our checking and savings accounts and the ones that hold our mortgages, are the banks receiving those higher-rate loans from the Fed. The interest rate that the Fed charges these banks is the Fed’s fund rate. So when you hear that the Federal Reserve raised or lowered rates today, they are talking about the overnight rate of interest they charge banks. The banks take that money and lend it to you, me and other commercial entities. They might borrow money at 4%, lend it to you on a mortgage at 7%, and keep the dif- ference. Being a bank is very profitable. Remember, they get to borrow someone else’s money and make money on that money. It’s a nice little system. When the Fed raises rates, it tends to slow the economy because banks don’t want to borrow as much money at the higher interest rates. It takes time for the economy to sense that fiscal reticence. The Fed can only guess at how high to make the interest rate before banks are more reluctant.

Selling Rule #3: Sell when the reason you bought the stock is no longer valid.

Selling Rule #4: Sell when the competition changes the game or when your company can no longer compete.

Selling a stock because the reasons you bought it no lon- ger exists or when that company can no longer compete are easy rules to apply. Remembering why you bought the stock


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in the first place assumes that you have a great memory for stocks or you wrote those reasons down before you bought the stock. I strongly recommend you write down your rea- sons because memory is not always entirely reliable. Even though it seems like an easy one, I want to explore some examples of these rules. The turn of last century was a great time to buy railroad stocks. They were money-making machines as they knitted the country together, moving goods and people much faster than horse and wagon. Therefore, as an investor, you owned railroad stock. Then came the automobile. At first, it looked like a great big boondoggle. It was very noisy and unreliable, but that changed quickly. Soon the car could go anywhere there was a road and even some places where there weren’t roads. Still, the railroad could move large quantities of goods and people over great distances much cheaper and more reliably than a vehicle. It was very difficult to see that change in transportation com- ing. It took years. The bottom line is that the reason those investors bought the railroad stock changed. Not only were the reasons you, as an investor, bought and owned that stock no longer valid, but the railroad could not compete with the automobile any longer. Another example is the telephone. AT&T was the only game in town for many decades until the break up. But let’s focus on the business model. AT&T was the long distance carrier for almost all voice transmissions. That began to change in the 1980s with the advent of wireless cell phones. At first, everyone felt that the technology was unreliable and dropped calls and bad reception areas were common. Those problems have been largely overcome and the land line, that hard copper wire in the ground, was becoming obso- lete. AT&T could no longer compete. If you bought AT&T because they had a monopoly years ago, that reason to own the stock disappeared when it was broken up into the Bell

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regional telephone companies. If you bought AT&T because they had control of all long distance calling, that reason dis- appeared a few years ago with the popularity of cell phones and their flat monthly fee for any call anywhere. Finally, I will give you a newer example. Where do you think any business that makes television or computer CRTs (Cathode Ray Tubes) are going to be in ten years? They will be all out of business unless they can change to flat panel screens. This was obvious several years ago. Or, what will happen to the music CD business with the advent of iPod devices? Will we still need our big music systems? These are clear examples of Creative Destruction in the making—new businesses destroying old ones. These are fairly easy to see and avoid. However, not all of them are obvious, and in fact, most changes are hard to see. In these examples, both selling rule 3 and 4 applied, but when only rule 4 applies, it is much more difficult to discover that your company can no longer compete, and decide to sell. In a current example, a technology company, TIVO, has changed the game and pioneered a new business. This is pre- cisely why Warren Buffet stays out of the tech stocks. TIVO invented a system that records video from the television and then plays them back whenever the viewer wants. It is a simple business, although the technology was, at the time, very dif- ficult to develop. TIVO became so popular that it evolved into a pop culture verb: “TIVOing it” meant you recorded a televi- sion show as in, “I’ll watch the game tomorrow; I TIVOed it.” The same thing happened when “Xerox” became the verb used to describe making copies because Xerox was the first company to make copy machines, and Kleenex has come to describe any facial tissues. But TIVO will also go the way of Xerox. Cable and satellite companies can now copy the tech- nology, and they control the signal to the TV. Cable and satel- lite companies must agree to let TIVO use their system. They


The Hardest Part of Being in the Stock Market

won’t because they see the profits to be made by offering their own DVR machines that do the same thing. TIVO is toast. One more before we go to charting. We all saw the suc- cess of Blockbuster Video. Customers rented movies from Blockbuster and brought them home to watch. The process was a long one. You had to get in your car and pick out the movie, pay to rent it for a day or two, come home and make sure you watch it within the time frame, and then take it back in time to avoid the penalty. Then came Netflix, a new business model where customers paid a monthly fee and chose several movies at a time. Netflix overnighted the CDs to their patrons and those customers kept them as long as they liked. There was no cost to mail them back and no late fees. As long as the customer paid the monthly subscription fee, they could get as many as five videos at a time, send them back and get more. This business model helped destroy Blockbuster Video’s policy on late fees and significantly dam- aged the movie company’s business. Netflix, however, is doomed. Their business model, though excellent for its time, will eventually be destroyed by the DVR put out by the cable and satellite companies. These DVRs have storage capacity. The cable companies can beam signals into them. If you put them together, as some cable companies are figuring out with their Movies On Demand services, you have downloadable movies that you can store on your DVR and play them anytime you want. The system is in place now, but the business is not yet booming. All the cable companies have to do is negotiate fees with the movie studios and then copy the Netflix model of downloading so many movies a month for a flat fee. That will be the end of Netflix. My brother-in-law helped put the company together. He is going to be looking for a job. These basic reasons for selling a stock are much more speculative and subjective than charting reasons. However, I

Above Average Investing


believe they are better reasons to sell than any you could come up with by following a chart. Remember, charting is not a science, it is an art. Never confuse charting with fundamen- tal, independent thinking, and the basic rules for selling are all about the fundamentals of a company. Will your company make money in the future? Can it grow its earnings? That is what drives stock prices earnings and growth of earnings. Always buy companies that make money and that will make more money in the future. From that point of view, it’s easy. Implementing it can be very difficult. Human nature gets in the way every time. We are emotional creatures. I am almost crying right know because I smell my wife’s Christmas cook- ies baking and I know she will not let me have one. Charting helps take emotion out of the equation. It is something you can point to and see; the basic rules are harder to see and prove. Human nature wants to make things simple and charting does that. Just don’t fall in love with charting. If you do, you will eventually see the flaws in charting and fall out of love with it. Save yourself the trouble and use charts as a tool to help you make decisions—not the sole answer to the mysteries of buying and selling stock. Use independent thinking, a funda- mental understanding of the market and business, and charts in combination to make sound choices.

Using Charts to Sell

Selling Rule #5: Sell when a stock price breaks below its upward-sloping trend line.

I like to apply this rule when a stock has become overval- ued, meaning that if I value a stock at $20, and it has moved up to $30, I get nervous. I want to capture as much profit as I can, and applying the trend line break rule is what we call in the


The Hardest Part of Being in the Stock Market

industry a tight stop out. These “stops” are established sell or- ders to take us out of stocks. Let’s look at this one-year chart.


us out of stocks. Let’s look at this one-year chart. 9 Source: eSignal, Advanced GET There

Source: eSignal, Advanced GET

There are several trend lines drawn. The downward trend, starting at the beginning of May and pointing down- ward, shows you a buy signal when the stock price broke above the trend line. That happened in late June. If this is a stock that you were watching because all the fundamental reasons for owning a stock were in place and you were look- ing for a good buy point, this downward slopping trend line would have given you the signal to buy. That signal is when the stock reverses, breaking up through a downward trend represented by the trend line. You now own the stock as it continues to rise. Note the three parallel lines going up following the stock price. Those are upward-sloping trend lines. If this stock is overvalued, you could use these trend lines as your get out point when the stock breaks down. What you are

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looking for is a breakdown in price where the price of the stock falls below the bottom trend line. If it does that, you would sell this stock. Trend lines are very simple to follow, and in many ways, too simple to use. They work best in trending stocks. Stocks that trade sideways or are very erratic are not suited for trading using this method. Can you guess what company this price chart represents? It’s Microsoft again. Selling when a stock price breaks below its upward slop-

ing trend line is a very tight out point—what we would call

a tight stop. You only use this technique when the stock

becomes overvalued or you think any of the earlier selling rules or investing rules also apply. If you see too much love for a stock or if the economy is

headed into a recession, tight stops might be in order. What

is too much love? Study the chart. If the angle of the price

chart is steeper than 45%, that tells me that the price has gone up too fast because too many people love the stock. Placing a tight stop out using trend lines is a good course of action in that case. If I feel selling rules 3 and 4 are in play, I will also use a tight stop out. The difference is that if there is too much love

in the stock price, I am willing to buy the stock back when the profit takers shake out some of the love. As long as the fundamentals do not change, buying back a stock is not only acceptable but smart. On this same Microsoft chart, I have drawn a line straight across connecting tops in November, January and March. These tops were resistance levels as the stock price rose, and if you remember our lesson on resistance points, stocks tend to stop going up at their resistance points. Now that the stock price

has risen above the resistance point, this line becomes support. Support is the point where the stock tends to stop going down.

A price break below support levels is a sell signal.


The Hardest Part of Being in the Stock Market

Selling Rule #6:

Sell stocks that break below support levels.

Support and resistance are buy and sell signals and terms commonly used by professional traders. If you study charts for any length of time, you will begin to see a pattern of

support and resistance. There are many kinds of support and resistance. The terms are used constantly to describe what

is happening with the movement of stock prices. Trend lines

can provide support and resistance just as moving averages, double and triple tops and bottoms and many other chart signals can. Get used to the terms support and resistance because if you plan on using charts, you will have to become

a master at discovering support and resistance areas. You will note on the Microsoft chart that the current price of the stock is about $30 per share and that the support level, represented by my straight line drawn across previous highs, is about $28.25. The percentage loss from its current price to a break of support is about 10%. That brings me to the next rule.

Selling Rule #7: Sell a stock when it breaks down 8-10% from its most recent high.

This too can be considered a tight stop out of a stock. It would be easier just to say sell at 10% or 8% from the high, but some stocks are a lot more volatile than others. If your stock tends to move up and down 2–4% a day, then you want to give it more room. Large cap stocks usually move slower, whereas the small ones can be very volatile. You are going to have to make a decision as you observe your stocks. When and if you make that decision to sell at a percentage

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fall in price, make sure you write it down and commit to following it before the actual event happens. I have warned you about falling in love with your stock, and writing sell points down will help you remain objective about a stock. I know it sounds silly because you are sure you will apply the rules objectively, but I cannot tell you how many people I have talked to who were convinced they would get out at a certain point, but just didn’t do it. Why? Because they fell in love with their stock. If you write it all down and don’t follow your own rules, then there is no help for you. You are a hopeless romantic. Remember, our goal is not to fall in love but to make money. When has falling in love ever made you money? And that is from me, a hopeless romantic in all things except money. These selling rules that use charts are a lot easier to apply than the investing rules, but keep in mind that charts are only a tool. They are a good tool, but they do not tell the future. They are not perfect. Every trader out there is doing the same thing when it comes to chart reading, so how are you going to get the edge on those traders? The simple truth is that you can’t. However, if you use all my rules consistently, your odds of beating the competi- tion increase. And you are competing, don’t forget that. Every time you buy or sell a stock, someone else is on the other end of the trade. That person has made the opposite decision. Who will be right? They are betting against you. That is the sad but complex truth. Do not be naive; when it comes to making money in the stock market, everyone is trying to get the edge on you. Sometimes that draws in criminal activity like the pump and dump artists or people who try to convince you to buy a worthless penny stock. Be smart and be careful. Let’s discuss selling at the break of moving averages. These are very good triggers for exiting a stock. You can use


The Hardest Part of Being in the Stock Market

long-term or short-term moving averages. If you are going to use a short-term moving average, I would suggest the 20-day exponential moving average. This would be considered very short, and you would use it in the same situations in which you would use the trend line as an out point. I need to explain a little about how an exponential mov- ing average differs from a simple moving average. To com- pile a moving average, you add the stock prices together over the number of days of the average you are studying and divide by those days. That gives you an average. To make it a moving average, all you have to do is add the next day drop-off the furthest day back, and re-compute the number. Each time you do that, plot it, and soon you

are building a line of dots. That is the moving average. This line is a simple moving average. However, to build an expo- nential moving average, you have to weigh the importance of some days over others. The most recent days are given more weight or importance than older days when comput- ing the exponential moving average. It is a mathematical construct, nothing more. Most charting programs, includ- ing the free ones on the Internet, let you choose between

a SMA (Simple Moving Average) or an EMA (Exponential

Moving Average). In using the 20-day moving average, I like the EMA. I also like using the EMA for the 50-day moving average and the SMA for the 100- and 200-day moving averages. There are a lot of different ways to ana-

lyze the numbers and you will need to play with them to see what types of information they provide. Long-term investors use the 200-day moving average. It

is a moving average for a year’s worth of stock trading, so it

shows the average price of stocks for the long haul and many investors use it for that purpose. Calculating a stop out point for stocks based on the 200-day moving average would be considered very loose.

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Selling Rule #8: Sell when the long-term 200-day moving average is broken on the down side.


200-day moving average is broken on the down side. 10 Source: eSignal, Advanced GET Here is

Source: eSignal, Advanced GET

Here is a chart of Goldman Sachs. You will see four moving average lines and three drawn trend lines. When looking at this chart, the lower moving average line is the 200-day moving average. These moving average lines are smooth, running along the daily price chart of the stock. The smoother they are, generally the longer the moving av- erage. The line up from the 200-day moving average is the 100-day, the next line up is the 50-day and the top line is the 20-day moving average. In a long-term, up-sloping chart where the stock price moves up in a fairly constant manner for a year, this is how the lines look. It will get confusing on a chart with a stock price that moves up and down a lot in a year. On those types of charts, the moving averages weave in and out of each other as they keep pace. Don’t worry, you


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will get used to it. After a while, you will be able to tell at a glance which trend line is which on any chart. In May, June and July on the above chart, the stock price tested the 200-day moving average and bounced up each time it did so. There was no sell signal, though you would have been close. We like to refine the 200-day moving aver- age rule by using 97% of the moving average price on a close as a sell signal. That means that we wait until the price of the stock closes at the end of the day at 97% of the 200-day moving average price. We do this because so many traders pull the trigger right at the 200-day, and often a day or two later, the stock recovers after all the “weak hands” sold it off. It doesn’t get any easier, does it? If you remember our lessons on how to buy a stock, you could have bought this stock at several points. When it came down and successfully tested the bottom for the second time in June (double bottom), that was a buy signal. It did it two more times: once in July and again in August. Those moments were buy signals for this stock. It would be nice if all stock charts looked like this and the signals were so clear, but they are not. The Wal-Mart chart below is a puzzler.


Source: eSignal, Advanced GET

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It is hard to pick out the moving averages, but with prac- tice, it will be obvious. The stock price on the extreme right hand side of the chart just broke the 200-day moving average as the stock price fell. Normally, that would be a sell signal. However, if you look back over the year and see how often Wal-Mart’s stock price has moved up and down through that average, you might agree that it would be a hard signal to use to buy and sell this stock. Sometimes the yearly chart doesn’t tell the whole story. Take a look at a weekly chart going back to 2001.

12 Source: eSignal, Advanced GET
Source: eSignal, Advanced GET

The story becomes clearer. On the extreme right hand side of the chart, the top line of the moving averages is the 200-week moving average. Note the change of scale from days to weeks for the moving averages. It is clear that this stock is moving sideways from the middle of 2005 to early 2007 within a trading range of $42 to $50 per share after falling from a range of $45 to $60. These are approximates using the price scale on the extreme right side of the chart.


The Hardest Part of Being in the Stock Market

As you look at this multi-year chart of Wal-Mart, you should immediately notice that its stock price does not gen- erally fall much below $45. On closer inspection, Wal-Mart double bottomed in late 2005 and mid 2006 at $42 per share. That is your buy signal. If Wal-Mart retests that bottom and bounces, buy the stock. That is also your sell signal. If it fails at that level, get out. As this example demonstrates, it can sometimes be use- ful to take a look at weekly charts with weekly averages. If a stock is moving straight down or up for an entire year, then go to the longer-term charts to determine support and resistance. There is no hard and fast rule for using weekly or monthly charts. If the daily chart is not telling you a story, then expand your search. Every stock has a story (not to be confused with “story stocks”…) and if you look at enough data, you can find it—even if the story is that the stock has no support or resistance. There are many other ways to use moving averages as both buy and sell signals. You could use “crossover,” a situ- ation where a short-term moving average crosses a longer- term moving average as a signal. However, I never liked that method. When charting moving averages, I like to keep it simple, even though you might not think using the 20-, 50-, 100- and 200-day moving averages is simple. Master these averages before you move on to more complicated chart- reading techniques such as parabolics, oscillators, MACD, stochastics, Bollinger bands and many others. I have been showing you how to read bar charts, but there are also line charts and candlesticks and a completely different charting method called point and figure. I would strongly suggest you master the basics before moving on. You will make the most successful decisions using information and methods you can thoroughly understand and use. I like staying with the basics and using On Balance Volume as a confirming indicator for

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stock direction. I also like the Relative Strength Indicator, but that may be just me. It took a long time for me to ferret out the techniques I am most comfortable with. I also have acquaintances in the business who swear by the point and figure method of charting. It’s good and I like it, but I can’t strongly recommend it.

Managing a Group of Stocks

Using fundamental and technical analysis to buy and sell individual stocks is the foundation to successful invest- ing, but that is only part of the answer to earning consistent returns. I know that doesn’t sound like it makes sense, but let me give you an example of what I mean and one that hap- pened to a client who gave up trying to manage his portfolio himself. It wasn’t that he couldn’t pick good stocks that gen- erally made money. That wasn’t his problem. The problem wasn’t in his selling technique either. The problem was in his portfolio management. He tended to buy large amounts of some stocks and small amounts of others. At one point, his portfolio was full of Canadian Oil Trusts that were paying him very substantial dividends, averaging about 10%. Oil was high and going higher, demand was increasing world- wide and Canada had huge deposits of the black gold. His reasoning was very sound, and his stock picks and buy prices using fundamentals and technical details were excellent. However, his portfolio management skills were lacking. When the Canadian government announced that, for the first time, they would be taxing oil trusts, changing the law, each one of his picks sank immediately—dropping 20–30% in a few days. All the fundamental and technical analysis in the world will not save or protect your portfolio from severe loss due to an unexpected event. Proper portfolio management


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will save you though. It doesn’t just protect you against unex- pected governmental action, but remember when 9/11 shut down our market for a week? That was very painful. In 1987, the market crashed, taking stocks down by 30% in just one day. Even proper portfolio management can’t save you from everything, but it does offer you some protection. When you buy stocks, you are taking risks. The measure of that risk is something that is very difficult to quantify. The rules suggested in this book help you reduce your risk and the use of charts can help you wring out some of the risks involved in buying and selling stocks. However, stocks are still risky. Therefore, to mitigate that risk further we need to employ some techniques that spread the risk over different factors. I am not talking about buying bonds or real estate, although those are very good ways to help mitigate your risk. By investing in those things, you are reducing your wealth’s overall exposure to disaster. The reward gained from hold- ing stocks far outweighs the risks, in my opinion, but I want to assume as little risk as possible while, at the same time, maximizing my potential for gain. Not only do you have the best opportunity to make the most money from the stock market, but the market is also very liquid so you can get to your money when you need it. Bonds may be a good risk avoidance tool, but historically, the returns from bonds pale in comparison to stocks. Real estate is a very good long-term investment, and if bought correctly, the return can compete nicely with stocks, but you have to be willing and able to tie up your wealth for years at a time. There are a lot of people willing, but they are not always able to obtain the financial backing to sup- port an investment in real estate. Do you have the ability to forego rent for several months or to replace carpeting, walls or plumbing, if need be? Can you hold onto the property through recessions where tenants are hard to find and still

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not be forced to sell the property at the worst time? Overall, stocks are much better, and with REITs, you can buy real estate and still have the advantage of liquidity. I will discuss REITs later. I want to fully explore how to mitigate risk with a portfolio of stocks. The first and easiest way to minimize risk is to avoid buying too much of any one stock or sector. Generally buy no more than 3% of any one stock and no more than 10% of any one sector. Yes, you can buy 5% and 15%, but as you move up in ownership percentages, you increase your risk. Can you buy less? Yes, but then you run the risk of being overly diversified, and in that case, you might as well buy an index fund. There is a balance. I like to own between 25 and 40 different stocks. Sometimes I will own slightly more or less, depending on the market and my stock selec- tion, but if I am fully invested that is my range. I will also usually have a spread of 10 to 15 sectors. If an industry such as oil or tech is the flavor of the day and that is the industry that is moving, I may have two sectors or even three in that industry. Tech, for instance, could mean telephone, soft- ware or hardware. I might own three stocks in each, being fully aware they are related and that I have just increased my risk. In that case, when I am fully aware of the increased risks I have assumed, I will have some tight stops in place to get me out of an overweighted situation. The important factor here is to be aware of the risk you are taking and to spread it out. Other factors that make me more cautious in my weightings would be the economic and stock market cycles. Are they pointing to a stronger market? Are we in a bull trend or bear cycle? Is it a secular bull or bear environment? The backdrop of the market and economy is very important and should make you more or less cautious. Your portfolio should reflect that level of caution.


The Hardest Part of Being in the Stock Market

Regardless of market conditions, I strongly advise you to stay within the 3% and 10% range.

Another way to reduce risk and manage a portfolio of stocks is to consider foreign equities. Foreign stocks traded on our ex- changes do not usually move in tandem with our market. This gives you a good hedge against our market’s swoons. To insure proper diversification, you can buy an ETF (Exchange Traded Fund) which can represent a foreign market’s index or a subset of foreign stocks. If you are not a fan of ETFs, then buy for- eign stocks traded on our exchanges called ADRs (American Depositary Receipts). These are stocks that comply with our general accounting principles, meaning that theoretically they are more transparent in their accounting methods and easier to analyze. I say “theoretically” because U.S.–based companies in recent years have, all following the general accounting rules, been less than honest in their numbers. But if you buy ADRs to have foreign exposure, at least they have to lie and steal using the same bookkeeping methods as our homegrown liars and cheaters. Doesn’t that comfort you? There are other ways to not be tied to the foibles of our market. Commodity-type stocks, though they are still tied to our market, often react independently from the average common stock. Gold, for example, has been one of the worst investments in the past 100 years while, at the same time, the stock market has constantly moved up. It is not tied to our market, so as a risk diversification investment, it would be good, but based on its absolute return, it’s terrible. There are better options out there. A good way to reduce risk is to use options, but that opens up a whole new can of worms and this book will not delve into that topic. It takes special training and a certain type of disciplined investor to be good at managing risk using options, and most investors do not understand it.

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Instead, let me describe an easier method that we often use—shorting! Once you understand what shorting is you will understand why it can be used to reduce risk. The SEC feels that shorting is more risky than buying stocks, and they are not entirely incorrect, but they are also ignoring how shorting can be employed to reduce risk. In their effort to try to protect the investor, sometimes the SEC does the investor a disservice. If you are not smart enough to protect yourself in the stock market, you shouldn’t be in it. Since when has government been the best guardian of your wealth anyway? In fact, the government’s talent lies in the destruc- tion of your wealth, not in protecting it. Take a look at your paycheck. Compare the gross pay with what you bring home. That income tax bill you pay was supposed to be a temporary tax. I guess it all depends on what “temporary” means. Also, when they first came up with the income tax, it was sold to the public as a very small tax to pay for a necessary war. Tax and war: two of the greatest destroyers of personal wealth! Don’t get me started. Back to selling short as a tool to reduce risk. When you “sell a stock short,” you are expecting the stock to go down, and if it does, you make money. You are actually borrowing someone else’s stock and selling it. Note: You are borrow- ing a stock; so, therefore, at some point, you have to give it back. This is the central concept to shorting. To exit a short position, you have to buy the stock back to return it to the original owner. It is always easier to understand most things with exam- ples. Let’s say I want to short Goldman Sachs stock. I intend to sell this stock I do not own, so I borrow it from someone who does own it, usually through my broker, who actually does the borrowing for me. Just by putting an order in to sell the stock short, my broker ensures that it is borrowable and that I can perform the trade. If not, they would tell me


The Hardest Part of Being in the Stock Market

that the stock is not shortable or borrowable. If it is bor- rowable, and I can short the stock, and I do it at $200 per share—the approximate cost of Goldman Sachs stock. I sell

it for $200. Remember, I never owned the stock in the first

place, so after I sold it, I am short the stock in my portfolio. I now have a short position in Goldman Sachs. It will show up in my portfolio as a negative for so many shares at such and such a price. In this case, the price is $200 per share. Now,

a month later, let’s say the stock fell to $180 per share. If I

want to exit my short position, I put in an order to my bro- ker dealer or online trading firm to buy the stock at $180. Remember, I borrowed someone else’s Goldman Sachs stock and I have to give it back to them at some point. To give it back, I have to buy it. When that trade goes through, I will be out of my short position with a $20 per share profit. Most of this borrowing and giving back activity is taken care of by the brokerage firm, you just have to make the decision to short and then to buy to cover the short position. “Buy to cover” is the term used to exit a short trade. You can see how this can reduce risk. If you have a group of stocks that you own “long,” meaning you bought them hop- ing they will increase in value, you can now offset those long positions with “short” positions. Put simply, you can short bad stocks and buy long good stocks. It’s not always that easy. Also, if you own stocks that you have made profits in, and for some reason you are uncomfortable with the market or the economy and you see a danger in owning stocks, you do not have to sell them to protect yourself. You could “short against the box.” If you own a 100 shares of Microsoft and you still want to own Microsoft because you do not want to pay capital gains tax on your profits, you could sell short 100 shares of Microsoft. If the stock moves up or down, you will make nothing, and you will lose nothing. Later, when you perceive the danger is over, you can get out of your short,

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never having to exit the long position on Microsoft. Frankly,

I don’t like to short against the box. I am in the stock market to make money, not to run in place.

A better idea is to hold on to Microsoft and sell short a

related company that has much worse fundamental and tech- nical characteristics. In that situation, I am hoping that even if the market turns ugly and I lose money on Microsoft, I will make more money in shorting a bad stock than I lose on a good one while, at the same time, I reduced my overall risk to the market by using shorts. So if shorting can reduce risk, why does the SEC state

clearly that shorting is very risky? Because in one sense, it is. If you buy a stock long, hoping it will go up, you are risking the amount of money you used to buy the stock. The worst thing that can happen is that you will lose all your money. In other words, the amount of money you can end up losing is finite. If that happened to you after you have read this book,

I have wasted my time and you have wasted your money both

in buying this book and buying a stock that you held until it went to zero.

If you short a stock, how much money are you risking?

You are risking an unlimited amount of loss. This is why the SEC says shorting is more risky than buying a stock. Let’s say you shorted Microsoft. How do you lose money on a short? The only way is for the stock to go up in price. As it goes up, you are losing more and more money. How far can it go up?

It can go up forever. Your losses are limitless. If you let that happen, you are dumber than a rock. Still, the SEC tries to protect those rocks, so they describe selling stocks short as more risky than buying stocks.

In using shorting as a method of reducing risk, make sure

you have get-out points just in case you are wrong and you didn’t need to protect your portfolio with some shorting activ- ity. Still, it is a very good way to reduce risk, just be careful.


The Hardest Part of Being in the Stock Market

Even when the bubble burst in the dot com collapse, my firm never shorted more than 25% of the portfolio assets. We kept the rest mostly in cash and held a few long positions. Why? Because shorting is betting that the market will go down, but

historically, it has a bias to go up on average 10% a year. Some years it does go down and some years it goes up, but the bias is to the up side, so when you are shorting, you are bucking the long-term trend. There are times to do that, but again, if we are talking about risk, and we are, then the odds of the market going down are not as good as for the market going up. Therefore, employ a shorting strategy gently. There are many other ways of reducing risk in a portfolio of stocks, but they become increasingly exotic. Stay away from them! The absolute best way to reduce risk in a stock portfolio is to invest in cash. Cash is an investment. You earn money when investing in cash. In a stock portfolio, most investors picked

a money market fund as the holder of any cash. Most people

do not remember that they did this since it was a box that they marked on an application when they opened the account, but that money market investment earns interest too. It is an investment. Sometimes the interest is fairly small, and if it falls below the inflation rate, you are actually losing money, so

there is risk in holding cash. You have to measure and under- stand the risks you are taking with each investment. The methods outlined in reducing risk are easy to describe, but knowing when to employ them is not. When

a market is overheating, start reducing your risk. When the

economy is faltering, reduce risk; when inflation is heating up, reduce risk; and finally, when the FED is raising rates, reduce risk. None of that helps you make day-to-day deci- sions. Exactly when is the economy overheating or inflation too high? To make those decisions, you need to become a student of economics and that brings me back to the begin- ning of this book when I told you that experts are always

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wrong. I do not call myself an expert. I am a student of the market just like you. If we call ourselves experts, then we are going to be wrong all the time. Learn the economic cycles and the causes of inflation. Track the economic data pouring out of the government each week that tries to decipher the complex beast of our economy. Watch and learn the world economic ebb and flow; the global economy is going to be increasingly impor- tant to earning money in the stock market. Above all, make sure you enjoy keeping current on world economics. If you do not enjoy it, you will not be successful. It will quickly become a burden, and you will lose interest. When that hap- pens, you cannot call yourself an investor—you will have become a gambler.

Ten: Putting It All Together

Buying, selling, and managing a group of stocks is always

a challenge, but it can be very rewarding both financially and

personally. There is nothing better than picking a stock that

doubles or triples. It gives you a sense of power, a vindication of your mental prowess, and it is certainly a fun way to make

a lot of money. My life has always been about making money.

I think it started from being hungry and eating pancakes for

dinner because flour, water and colored corn syrup were cheap ingredients. At twelve, I told my mother that I wanted to be a millionaire when I grew up, and I remember her saying that would be nice. I also remember her not believing me. I made my first million by age 33. I took my family to Las Vegas for a big dinner party where I announced that I had made my goal and wanted to share the accomplishment with everyone. My mother wasn’t very open about it, but I could tell she was proud by the way she talked about me to her friends. Making my mother proud was just as important to me as becoming a millionaire, although I didn’t realize it

when I was twelve. Making the money was hard work and keeping it is even harder. My second million was slow in coming. I thought I

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was smart, but I was actually too smart for my own good. I went into a series of money-losing ventures, so it took years for me to get the second million. Along the way, I learned a lot of traps to avoid, and one of the biggest was not to think or act irrationally. That means—do not try to get rich quickly; instead, focus on getting rich slowly but steadily. Not that there is anything wrong with winning the lottery, it is just that it is not going to happen to you or me. You can buy a mil- lion lottery tickets and likely you will end up winning some money, but you also will become poor. Buying those tickets because you want to get rich quickly is acting irrationally. The trick is not to get rich quickly, but to get rich. You can do it in many ways, but essentially, it will come down to one thing: Spend less money than you earn. This book is about getting rich rationally by investing in the stock mar- ket. If I would have followed the rules I have laid out in this book—learned from my partner, Jerry Klein, a seasoned market veteran, that first million would have turned into two million in a much shorter period of time. In implementing these rules, do not expect to be an instant millionaire. The rules are designed to be a common- sense method of investing, and they will make you wealthy. The better you apply them, the more money you will make. You will make mistakes, there will be disasters in your port- folio, and you will become frustrated when it seems like nothing is working. You also will be successful. How much money will you make over what period of time? I tell my clients that we at KPP will double your money every 7 to 10 years. That may not seem like much, but the power of com- pounding means that if you are able to do this on the low of 7 years and invest $100,000 at age 21, when you are 65, you will have made over $7,000,000. You would not have to save any more money—just let the $100,000 ride. This is a very doable figure—not some pie in the sky dream, not achieved


Putting it all Together

by gambling and certainly not achieved by taking any undue risks. Sound investing in stocks that make and grow their earnings and sales and learning to avoid the big draw-downs in your stock portfolio means you will get rich slowly, but you will get there. If you want to get there faster, save and invest more money. Stop buying the latest and greatest toys or a bigger

house just because you can. Don’t spend every raise you get, invest it. Always spend less than you earn. Separate needs from wants. You would be surprised how much you can save

if you just understand that you spend most of your money on

wants and not needs. You need a roof over your head, trans-

portation, clothes and food. Decide how much of the roof is

a want versus a need, the same for your transportation. Ask

yourself: How many times do you truly have to eat out? Stop whining about not being rich and become rich. I know many millionaires, and the one thing they all have in common is that they don’t seem like they are rich. They have nice homes and nice cars, but they could have much more if they wanted it. But they don’t. That’s why they are rich. Contrary to common belief, millionaires are millionaires because they don’t spend much, not for any other reason. They don’t have fabulous lives filled with extravagant spend- ing, trips, jewelry, cars and multiple homes. They lead much simpler lives than the general public believes. Don’t buy into the pulp on TV and in the rag magazines; that isn’t real life. How do you get started? What steps do you take? Begin by learning. Read some good basic books on investing. Peter Lynch has some very good books that are well written and simple. Graduate to the better books, and at some point, you must read Ben Graham’s book on value investing. There is none better. Pick up some magazines. Forbes, The Economist, Business Week, and Barron’s are all good investor magazines. Don’t get your stock ideas from the television. Always

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assume that once you hear about a stock to buy in the popu- lar press, it is too late. Think for yourself! If you have read this far into this book, then you can come up with your own ideas. If you don’t have any right now, don’t worry; the stock market is not going anywhere. There are always opportuni- ties; you just have to prepare yourself to take advantage of a few of them when they come along.