Reprinted with the permission of the American Association of Individual Investors

Why is it that bright, educated people who come across stocks that could make them wealthy for life, so frequently fail to capitalize on golden opportunities—not enough brains or education?

No, not even close.

Two things are responsible: Beating ourselves, and a lack of knowledge. Beating ourselves is mainly emotions, meaning too much fear or greed. Normally those things take control when investors lack knowledge—they do not know what they own and why they own them in enough depth.

Investing is actually common sense along with a focus on the key factors that drive the greatest stocks.

In fact, investors need focus on only four factors that seem to be common, identifying traits of the greatest companies and stocks, in my experience. I have termed these four factors BASM:

• Business Model: How the company plans to grow, be profitable and protect itself from competitors.
• Assumptions: The key assumptions the company makes about their markets upon which they then develop the business model.
• Strategy: This is simply the plan the company develops to implement the business model.
• Management: These are the actual people who create the great business models, assumptions, execution and all the rest. Great management is also needed, over time, to adjust business models for competitive situations.

One item not mentioned here is earnings. So, what about earnings, you ask?

Earnings are part of the metrics you use in evaluating a company—gross margin, net margin after taxes, and return on capital are just some examples of other metrics. These tell you a lot about the competitive position and how well the company is managed. But these are report-card issues. While you do learn something about management from them, the report card does not tell you about vision and fixing problems.

In short, earnings are the golden eggs that drive stock prices, but BASM is the golden goose that lays those golden eggs—it is the engine of earnings.

The Business Model

The business model is the core of how a successful company operates. But most investors cannot tell you much or anything about their best investments and the business models. So let’s start here—on the first big element in BASM.

A good company normally describes and discusses their business model in several places including what they file with the Securities and Exchange Commission when they go public or have successive stock offerings, and the annual reports, all of which are easy to access from the company and the Internet. Here are the three elements of a strong business model:

1) The company describes how they are going to make a lot of money (or why they already are). If they are young and embryonic, they describe the specific path to get to great profitability.

2) The company describes how they will grow for a long time in the future, and how they will retain great profit margins and overall profit growth.

3) The company describes how it will protect itself from the competitors that want to get a piece of their markets and profits. They must talk about competition and how they will compete, protect and win—in other words, how the first two things in the business model will stay that way and not fall prey to strong competitor companies that may come along.

That’s it, and as simple as this is, it is amazing how many companies overly complicate it or write a poor business model and show us that they may not be going great places.

Thus, if an investor does not see anything of a clear, straightforward business model in filings or the annual report, he or she will have spent five minutes wisely, but then can move on and not bother with anything else.

One of the best examples of a great business model is Home Depot. When Home Depot came public, many people said it was just another big discount retailer. Many others challenged Bernie Marcus’ (co-founder) plans to pay workers in his stores more and spend more than competitors on training. Bernie understood that discount retailing was going to be dog-eat-dog competitively, and yet there could be ways other than price to differentiate between companies.

The big thing for Home Depot was a business model that was designed to attract customers on the basis of customer service while being price competitive. Low prices often meant that people felt adrift and could not get enough help to purchase anywhere near what their potential might be.

Well, paying help more than the minimum wage and the extra spending on training as part of the do-it-yourself business model concept of Home Depot did bring them the customers, and that eventually was reflected in the stock price.

Assumptions

Any strategy that a company settles upon to achieve its business plan is built on a set of assumptions, or projections, about how big a market is for a company or a product. Assumptions also must be made concerning anticipated competition and demand over the next year or three years. The assumptions part of BASM is best illustrated with an example.

Bill Gates came into the software spreadsheet market facing skeptics who told him that, since Lotus Development had 70% of the spreadsheet market, he could do nothing, and it was already “game over.” (“Game over” is one of the great syndromes of ordinary investing that ignores the elements of BASM.) So Lotus ran the hot product race without any real worries about Microsoft.

But Gates made huge assumptions about the way people and companies would buy and use software.

His biggest assumption was that customers would have a critical need for standard software—in other words, consumers were looking for uniformity and continuity in software so they would not have to relearn everything from ground zero when new products came out.

Gates also assumed that consumers would stay with one company’s products cycle after cycle if those products met their needs and were competitive in new technologies.

Setting standards and achieving early domination flowed from those assumptions as the core company strategy was formulated.

Eventually, Lotus lost, and Microsoft (need I add?) won. Now it really is “game over.”

Strategy

Management may have a great business model, but it has to have a strategy to execute the details of its plans.

Operational differentiation and excellence are concepts that apply to many great companies.

For instance, Intel has excelled over the years by continually coming out with the best new microprocessor chips to serve as the brains for personal computers. But aside from great product research and development, Intel spends a fortune on research and development in production methods and systems.

To reach back a bit further, McDonald’s is one of the truly great companies. And it is clear the core secret to McDonald’s great management success was operations. In fact, the McDonald’s business model went into great detail about how consistency and quality would flow from great operations management, and those factors would bring in the customers and control costs—and it did work, just as the company said.

Management

The best management demonstrates that it can envision a great future for the company and articulate a cohesive and logical strategy for getting there. The strategy cannot be pie in the sky—it has to be based on resources—human, financial, technological—within the grasp of the company.

Management also has to show it can execute the details, so you must watch carefully.

Great managers make promises and projections to you, the stockholder, that they can deliver on. They are driven to stay ahead of the pack and understand how to lead. While they truly want to win, they are realists in terms of the goals they can execute.

Lastly, great managers admit mistakes early and move aggressively to fix them.

Investing for the Big Money

Most investors spend too much time chasing the wrong information.

Focus is the key, and the simplicity and focus of BASM really has worked to develop some of the greatest all-time investment records and wealth for many people. They do not always call it BASM, but they concentrate on what the golden goose is that creates the golden eggs of earnings.

Great Business Model Descriptions: eBay vs. Google

How does eBay differ from Google?

They are both the darlings of our time, very successful, and both household words.

But eBay has a great business model in which—instead of concentrating on the powerful technology that was making them the best—they concentrated on a way to build true community and bring in all the customers and retain them. That was all spelled out in the prospectus they printed when going public. Google, on the other hand, was fuzzy about their business model. We know it was a great buy on the technology lead and popularity. However, they are now experimenting with so many things at once, and yet still derive almost all of their revenues from search engines that will be further assaulted by competition.

These differences could be seen by investors who scrutinized the public offering documents. eBay had great business model descriptions when it went public; Google did not.

Here is how eBay described their strategy at the time of the initial public offering (IPO):

“The Company’s objective is to build upon its position as the world’s leading online person-to-person trading community. The key elements of eBay’s strategy are:

“GROW THE EBAY COMMUNITY AND THE EBAY BRAND. The Company believes that building greater awareness of the eBay brand within and beyond the eBay community is critical to expanding its user base and to maintaining the vitality of the eBay community.

“Although the Company’s historical growth has been largely attributable to word-of-mouth, the Company intends to build its user base and its brand name aggressively…

“BROADEN THE EBAY TRADING PLATFORM. The Company intends to pursue a multi-pronged strategy for growing the eBay platform within existing product categories, across new product categories and internationally. The Company will target key vertical markets in its user programs and marketing activities.”

There are many more details and components of the business plan, but the key thing was that they all held together logically. They described in straightforward terms how they would grow and make money, and they presented something of a roadmap for both the company and its investors. This is what you want to find.

Google, in contrast, seems to have a good model for generating advertising revenues on its search pages, and it is very profitable. Moreover, the marketing and mind share aspect of its ubiquity, such that people use “Google” both as a verb and a noun—“googling” is a part of the language these days––means that Google has some major assets as it strives to become a dominant leader.

So, Google does have the first part of a good business model, the profitability. But it lacks the second and third parts of a great business model—a plan for growing the profits into the future and protecting them from competition. On these parts there is a blank slate.

Interestingly enough, the filings from its 2004 public offering contain language that concedes that Microsoft will be a competitor to contend with. But also very important is that those filings—unlike eBay’s filings—have very little in them about competitive strategy and the details of the business plan.

Even in late 2005, Google was still adding to what their core service had been. This only makes it a bit tougher for management to define their ultimate strategy and business plan.

The stock has done well, but the jury is out—and based on the BASM yardsticks, the clarity of strategy when they went public is lacking.

Fred Kobrick managed mutual funds for Wellington Management and State Street Research & Management before founding his own firm in 1998. Under his management, the State Street Research Capital Fund was ranked by USA Today as one of the top five performing funds over a 15-year period. He currently provides investment advice to nonprofit institutions and lives in Sudbury, Massachusetts. His book, “The Big Money” (Simon & Schuster, 2006), provides case histories, written to teach the simple guiding principles from which his investment record was generated.

Reprinted with the permission of:

American Association of Individual Investors (AAII)
625 N. Michigan Ave.
Chicago, IL 60611
(800) 428-2244
(312) 280-0170
(312) 280-9883 fax

www.aaii.com

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

Reprinted with the permission of the American Association of Individual Investors

What can you learn from three decades of monitoring investment newsletter performance?

Plenty.

It was nearly three decades ago that the Hulbert Financial Digest (HFD) began independently monitoring the performance of investment advisory newsletters. I’m devoting this column to a couple of the most important investment lessons that emerge from the list of newsletters that dominate the rankings of top performers.

The investment world today couldn’t be more different than the world that existed when the HFD set out to track newsletters, in mid-1980, at least on the surface. Back then, for example:

• The Dow Jones industrial average stood below 900—lower than where it had stood in 1966, 14 years earlier;
• Gold bullion, on the other hand, was just coming off a high of just under $900 per ounce—a record level that remains unbroken today, more than 27 years later (though gold is getting close);
• Inflation was in the double digits, as was the interest rate on long-term government bonds.

Given this stark contrast, it would seem that caution should be exercised in drawing any investment lessons based on which newsletters have performed the best since 1980. Why should anyone think that strategies appropriate to the investment world in 1980 would be appropriate today?

But I would argue that a closer look shows that, on average, the period encompassing the nearly 30 years since 1980 is not really all that different than what came before.

Down Memory Lane

Imagine, if you will, that you have traveled back in time to the early 1980s, and you are perusing the data in the 1980 Ibbotson Associates yearbook. This firm was created in 1977 by Professor Roger Ibbotson, and its yearbooks of historical data have become a must-have for financial planners and advisers. Those yearbooks, of course, contain the year-by-year performances back to 1926 of stocks, bonds and Treasury bills, and inflation rates.

What conclusions would you have reached? Here are two:

• Over the period of 1926 through 1979 (the period that would have been covered in the 1980 yearbook), stocks provided a handsome return, in both nominal and inflation-adjusted term;
• In addition, there was a healthy equity premium—that is, stocks outperformed bonds, compensating investors for the additional risk associated with investing in stocks.

But these same conclusions hold for the period since 1980, as is illustrated in Table 1.

To be sure, stocks in recent decades have produced higher returns (both in nominal and inflation-adjusted terms) than the returns they produced before 1980. But the real difference is not stock performance but rather bond performance—bonds did much better after 1980 than they did before. Because of this, the equity premium since 1980 has actually been less than the longer-term average, despite stocks themselves providing better overall returns.

This stock/bond relative performance difference between these two long-term time periods indicates, to me, that any “lessons learned” from the list of long-term top performers would have questionable relevance to the future if any of those top performers were highly ranked because they were heavily invested in bonds.

However, this is not the case—none of the newsletters at the top of the HFD’s rankings for performance since 1980 (see Table 2) derived a significant portion of their investment earnings from bonds.

All of which leads me to be fairly confident in drawing the following lessons.

Lesson 1: Long-term investors need not lose sleep over the markets’ short-term gyrations because the markets’ long-term patterns will eventually assert themselves.

To be sure, I am under no illusions that my drawing of this lesson will change many investors’ behaviors. For whatever psychological reasons, many are obsessed about the short-term and therefore can’t imagine not paying it the closest of attention.

What my data show, however, is that investors need not focus on the very short term to perform very well over the long term, thank you.

Consider The Prudent Speculator, the newsletter in first place on the HFD’s ranking for performance since mid-1980. Of any of the newsletters I monitor, this service has been the most buffeted by short-term market gyrations. And yet, none surpasses it in its willingness to either ignore or tolerate those gyrations.

Consider what happened to it in the crash of 1987, which just celebrated its 20th anniversary. On that day, according to the HFD’s calculations, the newsletter’s model portfolio lost 57%. And yet, far from panicking, Al Frank (the newsletter’s editor at the time) maintained his fully invested (and heavily margined) posture, patiently faithful that the stock market’s long-term uptrend would eventually win out. The newsletter’s long-term top ranking is a testament to that faith.

Lesson 2: Worrying about the short term can work against you.

Another lesson that emerges from my tracking of investment newsletters is related to the first: Constantly monitoring your investment performance can cause you to unnecessarily reduce the amount of risk you are willing to incur, causing your long-term performance to suffer.

According to behavioral finance researchers, constantly looking at how your portfolio is performing is not a benign act. It leads you to focus more of your attention on the short term than you would otherwise, leading you in turn to miss the veritable forest for the trees.

One researcher who has extensively studied this behavioral pattern, Richard Thaler of the University of Chicago, calls it “myopic risk aversion.” He hypothesizes that the more frequency with which an investor re-evaluates how he is doing, the more frequently he will experience loss, since any risky asset will not infrequently be exhibiting a short-term losing streak. No investor (except the occasional masochist) enjoys the experience of loss, and most investors prefer to avoid losses; therefore, this greater frequency of re-evaluation will tend to cause investors to own less risky assets and avoid stocks.

To test this hypothesis, Professor Thaler and fellow researchers several years ago constructed an elaborate simulation that imitated the many decisions that investors make over their lifetimes. One group was able to look at how they were doing every month, another group every year, and the third group got to take a look just once every five years. Just as Professor Thaler hypothesized, the investors who re-evaluated their portfolio every month had the lowest average equity exposure.

So, why does my own newsletter that reports investment newsletter performance come out monthly?

It’s a good question. The problem, of course, is that I wouldn’t be in business if I had a subscription product that came out infrequently. But the tension exists nonetheless.

One way I try to resolve this tension is by focusing my monthly newsletter on long-term performance. For example, none of the performance rankings in my monthly newsletter cover periods of less than five years. And most of my scoreboards cover much longer periods.

My hope is that, in the very act of responding to investors’ desire for constant re-evaluation, I can get them to focus on the long term. After all, a ranking covering performance over the last five years, or especially the last 10 or 20 years, doesn’t change that much from month to month.

Conclusion

If investors nevertheless want to obsess about the short term, they can be my guest.

But these short-term traders shouldn’t fool themselves into thinking that this obsession is necessary to build long-term health. On the contrary, it is probably standing in their way.

Mark Hulbert is editor of the Hulbert Financial Digest, a newsletter that ranks the performance of investment advisory newsletters. It is published monthly and is located at 5051B Backlick Rd., Annandale, Va. 22003; 703/750-9060; www.hulbertdigest.com. This column appears quarterly and is copyrighted by HFD and AAII.

Reprinted with the permission of:

American Association of Individual Investors (AAII)
625 N. Michigan Ave.
Chicago, IL 60611
(800) 428-2244
(312) 280-0170
(312) 280-9883 fax

www.aaii.com

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

Reprinted with the permission of the American Association of Individual Investors (AAII)

If you’ve ever been to the track, you know that big winnings come from betting against the crowd.

Bet on the favorites and you may cash in a couple of small winning tickets; but scope out an underdog the crowd doesn’t believe can win and you collect a big payoff. There simply isn’t much reward in betting with the consensus.

The same holds true in the investing universe. To be consistently successful, you must adopt a contrarian’s mentality and bet against the crowd. There are a host of good businesses out there-even a lot of great businesses-you might invest in, but if you want substantial returns, you have to place less emphasis on the prospects for the business, and more on the prospects for the investment.

Investors commonly confuse a good business with a good investment. Many good businesses have expectations embedded in their stock prices that are just too high. The reason is that investors tend to extrapolate events forward in a linear fashion-that is, they believe a company doing well will continue to do well and if performing poorly, will continue to perform poorly.

Cisco Systems (CSCO) and Microsoft (MSFT) are highly successful companies, but their stock-implied growth expectations in the late 1990s would have translated into sales in excess of the U.S. gross domestic product. As an investor, you face the task of recognizing whether current expectations are overly optimistic or overly pessimistic. Changes in expectations-not earnings growth-move stock prices.

The advantage lies in being able to determine whether the deficiencies in current expectations are too optimistic or too pessimistic.

Good Companies

What makes a business a “good” business?

There are certain characteristics inherent in all good businesses. In particular, good businesses are not only profitable, but they also generate free cash flow net of capital reinvestment (capital expenditure).

Good businesses also generate a return on their invested capital over and above their cost of capital. They continue to grow their business-reinvesting in new assets-for as long as their return on their invested capital exceeds their cost of capital.

Good businesses are able to sustain or increase their rate of return on their invested capital. A fading return on invested capital indicates the business is becoming average and no longer special; a choppy return on their invested capital indicates a cyclical business model.

Investors should prefer businesses with revenue growth, operating margins and asset turnovers that are above average relative to others in their industry, since these drivers are the financial impetus behind return on invested capital. Accelerating dividend payments are also preferable, since they are a sign that the company’s management is interested in paying shareholders income while maintaining sufficient cash flow to run operations.

What Makes a Good Business vs. a Good Investment

Good Business Cash flow is positive Profitability Return on invested capital is greater than the cost of capital Return on invested capital is stable or trending upward Has the ability to reinvest cash flows back into the business, which allows for asset growth Sales growth continuing Operating margins improving and better than peers Asset turnover improving and better than peers Good Investment Stock-implied expectations about future cash flows are overly pessimistic Market price differs substantially from warranted price

Good Investments

While there are many factors that constitute a good business, there is one primary consideration when it comes to a good investment: expectations.

A business is worth the present value of its existing assets plus the net present value of its future investments. So the current price of a stock is based on what investors collectively (”the market”) expect the business’ future to be.

Of course, no one can predict the future, so when analyzing a stock’s price you are left with two choices.

One is to take a crack at forecasting a company’s future performance, translate that into annual cash flows and calculate the firm’s “warranted price.”

As an alternative, one can analyze stock-implied expectations (the cash flow expectations embedded in a stock’s current price), back out the cash flows, and determine whether the market’s assessment of the future seems reasonable (see below ). This helps determine whether the consensus view is sensible, and whether the company will meet, beat or miss expectations.

Since changes in expectations drive stock prices, it only makes sense to start out by investigating what those expectations are.

Divergent Opinion Rules

Just because a company happens to run a good business, doesn’t mean investing in it will be profitable. Remember, as an investor, you aren’t rewarded for betting with the consensus. You need a divergent opinion, cultivated by an informational or analytical advantage. More often then not, it is information combined with common sense that contributes to outwitting the consensus. Here are two examples:

• Dell Inc. (DELL) has consistently operated a great business, generating returns on invested capital in excess of 20% per year since 1996. Given the track record, investors focusing on the economics of the business instead of the embedded expectations would have thought this a prime candidate for investment. But if they had put their money into Dell in 2005, they would have lost over 30% of their capital-despite the fact that return on invested capital increased to a near all-time-high level-because stock-implied expectations were calling for returns to be much higher.
• Century Aluminum Co. (CENX), another great business, has enjoyed an upward return trend since 1999-indicating an improving business-and generated returns nearly twice their cost of capital for the past three years. Investors have earned over 50% year-to-date 2006 because previous stock-implied expectations calling for the business to generate cost of capital returns have since been readjusted upward.

A Different Kind of Risk

Market forecasters must accurately predict future cash flows and discount rates and then determine a fair market price.

Expectations analysts take the current market price and back out market implied cash flows, asset growth rates (reinvestment rates), and return on invested capital.

While somewhat complicated, this can be done repeatedly with surprising accuracy. The reliability of the conclusions drawn from expectations analysis is also based on the ability to assess the market’s expectations as reasonable or unreasonable, which determines the direction of market error- either too optimistic or too pessimistic. The approach forgoes the exceedingly high level of accuracy required in market forecasting in favor of a more philosophical look at the investment’s prospective future (i.e., will margins expand or contract, will revenues grow faster or slower, etc.).

The level of risk can be further reduced by limiting the companies to those that trade at or below cash and book value.

For example, if you choose to buy a stock with market expectations for negative future cash flow because you think the business will generate positive cash flow, and the stock trades slightly above cash, your downside risk is limited because if you are wrong, the stock will fall only to cash value (unless management spends that cash).

Calculating Implied Expectations

Expectations analysis involves taking the current market price and backing out market implied expectations. How is this accomplished?

The foundation for the pricing equation is that the value of a firm today is the value of its stream of expected cash flows over its life, discounted back at a specific rate of return. So you need to do the same kind of analysis as you would for any cash flow valuation method. The key components are the firm’s current asset base, the return on investments the firm generates on its assets, the firm’s future asset growth rates (reinvestment rates) and the degree to which these returns change as the company’s life cycle matures.

But by reverse engineering the calculation, you can determine the stock-implied expectations based upon current stock price, as well as put in your own assumptions to better understand what the stock should be trading at in the future. You can also compare these assumptions to those embedded in a company’s peers, as well as against a company’s own historical performance, to better understand where the most uncertain assumptions lie.

Of course, there are many factors that can affect a firm’s cash flows, and institutional investors like our firm use sophisticated (and expensive) software that can crunch a wide variety of factors into consideration to determine the implied expectations.

For individual investors performing expectations analysis on a stock, the analysis can be performed using spreadsheet software and the equation:

where is the sum of all future cash flows. [The on-line encyclopedia Wikipedia has a longer mathematical explanation of this under “discounted cash flow” at http://www.wikipedia.org/]. So if you know the price and the discount rate, you can back out the firm’s expected future cash flows. Once done, you have only to determine whether or not you believe those cash flows will be realized, missed or exceeded.SummaryIt is important to understand and correctly interpret the expectations embedded in current stock prices when making investment decisions. Changes in expectations alone will cause changes in stock prices.Being a good business-or even a great business-isn’t enough because the market doesn’t reward you for investing with the consensus.Successful investing on a consistent basis is the result of developing a correct contrarian thesis and acting on it.

To Find a Good Investment, Ask the Right Questions

One very important aspect of evaluating stocks lies in asking the right questions. Perhaps that sounds rather obvious, but investors tend to ask the wrong questions, or ask questions not to get objective information but rather to secure support for opinions they have already formed.Today, with so many sources of investment data, opinions and analyses, investors can easily find support for any hypothesis. Whether they think a particular stock will rise or fall, there is ample data to back up their judgment.For example, satellite radio companies XM (XMSR) and Sirius (SIRI) get a lot of play. Investors who like them as a buy will cite their triple-digit revenue growth as validation. In contrast, investors who think the companies have peaked and are ready for a fall can point to their negative margins and inability to generate more than 10 cents on the asset dollar in sales for reassurance. There is ample support for both viewpoints.Investors who can suspend judgment for as long as possible tend to be better investors, allowing the big picture to materialize before one or two data points steer them in the wrong direction.Active investing also means challenging market opinion, and asking what performance is expected of the company in order for it to merely achieve the level of valuation suggested by its current stock price. Inherent is the discipline to resist trying to prove you are right about a stock, but rather to question where the market’s collective intelligence about a stock’s price suggests the market is wrong. The subtlety of this insight can make a big difference.The quality of any investment process depends on the rigor and tenacity of the framework used. Here are some key questions that can help reveal where reality may be contrary to the market’s view.What Is the Context of the “Good” Information?The context of information can be just as important as the information itself.Over the last few years, valuation levels of JetBlue (JBLU) have essentially “priced in” cash returns at their cost of capital. That’s about the same level the company achieved in 2002 and 2003. (The spread between returns and the firm’s cost of capital were essentially zero during those years.)The problem here is that there’s no value to growing a business that only achieves its cost of capital. If the firm is paying 6% for its capital and only generates a 6% return, it hasn’t created any value.It’s only when it can achieve returns in excess of its cost of capital that value is created for shareholders.How Good Does the Story Have to Be?It’s easy to get caught up in a great story. New products or newly launched businesses are frequently accompanied by breathless press releases suggesting a rosy future for the stock.It’s easy to see if the company’s sales are strong, but understanding the expectations in the stock price helps frame the correct question: “Just how good does the story have to be?”Everyone knows the exciting Google (GOOG) story, but what has the collective market priced-in at its recent $425 per share? Assuming Google’s economic profitability remains stable, what level of revenue growth is necessary to support that price?Within five years, Google needs to achieve revenues 2.5 times current levels. And that’s just to support its current price. For it to be considered as a worthy long-term position, one would have to believe that the market has underestimated Google’s potential by at least 20% or more.This is not to question or denigrate the incredible performance of GOOG in the past, but rather to arrive at the correct investment question, which is, “How much better can GOOG get?” What Will Be the Catalyst to Market Efficiency? In the case of undervalued stocks, what will be the catalyst that sends the market a signal that a correction is needed? Without that event, these stocks may never realize their potential. For example, in 2003, Motorola (MOT) returns had fallen to 20-year lows (nearly zero) and the stock price dropped in six of the previous seven years to an incredibly low $8 per share. At that level, the stock price implied virtually zero growth and little chance for improved returns. The depressed price and performance expectation might have continued were it not for one salient event: CEO Chris Galvin stepped down. That catalyst was enough to attract a crowd of investors who otherwise would likely have ignored MOT’s prospects. Combined with an expected change in business strategy, MOT’s stock climbed over 30% in a matter of weeks and doubled over subsequent months. In addition to management change, earnings surprises and other corporate actions can drive performance. For some stocks, the key question to act on might simply be, “Is management change imminent?” Amazing investment opportunities may follow.

Steven Holt Abernathy is principal and chairman and Brian Luster is a senior analyst and portfolio co-manager at The Abernathy Group in New York, NY. The firm specializes in asset protection and wealth management. You can contact the authors at 800-342-0956, info@abernathyfinancial.com or at http://www.abernathyfinancial.com/.

Reprinted with the permission of:

American Association of Individual Investors (AAII)
625 N. Michigan Ave.
Chicago, IL 60611
(800) 428-2244
(312) 280-0170
(312) 280-9883 fax

www.AAII.com

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

I thought this was a finance 101 topic but based upon what I read in the financial press maybe it’s not. For some reason people like dividends. Even I have fallen prey to the siren song of dividends, as the fact that Bank of America (BAC) now has a 5.2% dividend yield with a P/E ratio of 9.84 excites me. My perverse logic works something like this: the stock can’t go much lower and you’re practically guaranteed a 5.4% return on your money, which management wouldn’t be paying out if they didn’t think they could support it – so it must be a good investment. But the reality is that I was making this argument when the stock was at 55 and today it closed at 48.59. That’s a 12% drop. Nevertheless, over the last 5 years Bank of America has been a pretty good investment – but not necessarily because they have a high dividend.

From talking to people I get the impression that there are several misconceptions out there that need to be cleared up. First, let’s be clear that dividends are not a free lunch. Every time a stock goes ex-dividend the price of that stock goes down by a corresponding amount. The reason is simple: the company’s value has gone down by the amount of the dividend payment. It has less cash in the bank. Second, and related to the first point, higher dividends do not necessarily translate into a higher total stock return. When companies pay out dividends either 1) they are making a conscious decision to trade off future growth for a return of capital or 2) they are raising additional funds from one group of investors to transfer funds to another group of investors. In principle, all a company can do is tweak the balance between dividend return and capital gain return.

If you don’t find these arguments convincing you can review the academic work that has been done on this topic. Perhaps the best-known study was the 1961 paper by Miller and Modigliani [1]. Their mathematical proof, which is now generally accepted as correct, basically demonstrates the assertions made above. In addition, a 1974 Black and Scholes study proved empirically that high dividend stocks produced no better total return than lower dividend paying stocks [2]. The bottom line is that dividends just don’t matter – one way or the other.

Although there are a number of arguments in favor of paying dividends…

• Signaling effect – because a company is very reluctant to lower a dividend (it’s a really bad sign) they are equally cautious in raising a dividend. They only raise the dividend if they truly believe that the business has bright prospects.
• Desire for current income – some people, for example retired people, like to receive current income to fund their living expenses. (I never have understood this since for a few dollars they can sell some of their investments to generate cash for living expenses.)
• Clientele effect – some investors like dividends and do not suffer negative tax consequences from receiving them – e.g. pension funds, IRAs, endowments. By paying dividends a company is appealing to this target group.

…there are other arguments against high payouts that are even more compelling:

• Tax issues – it used to be the case, and in all likelihood it will soon be the case again, that dividends were taxed at a higher rate than capital gains. Therefore, by paying a dividend a company is forcing their investors to pay taxes.
• Creates a reinvestment burden – now that I have this dividend what do I do with it?
• Calls into question the company’s prospects for growth. The assumption is that if a company is paying a dividend they must not have very good investment opportunities. Typically, high growth companies don’t pay dividends because they have better uses for the capital.
• If a company has excess cash they can repurchase shares instead of paying dividends. This will drive up the price of the stock and return cash only to those shareholders that want it.

Despite all the evidence that dividends don’t matter the financial community loves to flap their jaws about the virtues of dividends. S&P even maintains a list of “dividend aristocrats” which are stocks that have upped their dividends for 25 or more consecutive years. When Lowes declared a quarterly dividend of eight cents per share and an increase in their share repurchase on May 25, 2007 everyone pointed out that the dividend represented a 60% increase and that they had paid a cash dividend each quarter since going public in 1961. Lowe’s CEO made the statement: “The additional share repurchase authorization and dividend increase are an indication of Lowe’s financial strength, and reflect our commitment to return capital to shareholders.” Apparently the signaling value of dividend increases isn’t so obvious because CEOs always spell it out for us.

Then there was this June 13, 2007 article in Forbes that begins with:

 

“Wednesday was one of those days Caterpillar investors can use to take their wives out to dinner. They got a large dividend increase, as well as a message of confidence from the company.

 

The board of directors of Caterpillar (nyse: CAT - news - people ) voted Wednesday to increase the quarterly cash dividend by 20%, or 6 cents, to 36 cents per share.

 

“This increase reflects the board of directors’ continued confidence in Caterpillar’s long-term outlook,” said CEO Jim Owens

Investors responded by sending shares up $1.85, or 2.4%, to $79.93.”

I found the assumptions in this article strange to say the least: 1) All Caterpillar investors are men 2) I should spend a return of capital and 3) Caterpillar’s stock price responded to the dividend increase as opposed to “the directors’ continued confidence”.

Even more blatant dividend propaganda was forced upon us with the May 21, 2007 Barron’s cover story entitled “Still Too Stingy”, which called for a return to good old fashioned dividends as an alternative to share repurchases. The article laments the fact that dividend payouts are on the decline and points out that millions of baby boomers are nearing retirement and seeking higher yields. The article has several particularly annoying quotes from Edward von der Linde, the manager of the Lord Abbett Mid-Cap Value fund, “Shareholders own the company. The earnings are their cash. Give it back.” Regarding the potential for an increase in federal dividend taxes, he says “Since when is my tax status the business of management?” and he argues that share repurchases “give money to people who want to go away. Why not give the money to all shareholders equitably? The only way that the board of directors and management can directly affect shareholders is via the dividend.” [3]

I just don’t understand this point of view. I own a company’s stock because I want to be invested in that company. I don’t want them returning a portion of my investment on a periodic basis. When they do that I have to reinvest the money and they involuntarily trigger tax consequences, which company management should be concerned about. Let’s face it, one of America’s best-loved stocks, Berkshire Hathaway, has never paid a dividend and no one is complaining. Conversely, even the Barron’s article points out that initiating a dividend payment has not helped Microsoft’s stockholders.

I will concede one point to the dividend payment camp that was actually raised in the Barron’s article. There are several examples of companies buying back their shares at inflated market prices that are ultimately not sustained. To avoid this problem companies need to be judicious about when they buy back their stock. Of course, it’s hard to imagine a CEO announcing that they are going to discontinue their stock repurchase program because they believe that their stock is overvalued.

December 12, 2007 Addition

I just read another Barron’s article [4] about stock buybacks that further supported this last point with some very compelling data. In the graph to the left Standard & Poor did an analysis that showed that the more aggressive a company was in repurchasing their shares the worse their stock performance was. Aggressiveness was calculated as the percentage of a company’s market capitalization that was repurchased. Part of the problem is that the more aggressive companies borrowed heavily to support their repurchase programs. It’s possible that companies that used excess cash to execute these repurchases faired much better, but that was not discussed in the article.

[1] M. H. Miller and F. Modigliani, “Dividend Policy, Growth, and the Valuation of Shares”, Journal of Business, Volume 34, pp. 411 – 433, October, 1961
[2] F. Black and M. S. Scholes, “The Effects of Dividend Yield and Dividend Policy on Common Stock Prices and Returns”, Journal of Financial Economics, Volume 1, pp. 1 – 22, May, 1974
[3] Andrew Bary, “Still Too Stingy”, May 21, 2007, Barron’s
[4] J. R. Brandstrader, [$$]”Buybacks That Bite Back“, December 10, 2007, Barron’s

The opinions and views expressed in this article do not necessarily reflect the views of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

Breaking with tradition, I’ll give you the moral of the story first: “Slow and steady wins the race”. Like you didn’t know that? But do you really understand it? The Greeks were pretty sophisticated mathematicians so it’s entirely possible that the concept of compound interest was already well understood when “The Tortoise and The Hare” was written. However, had they been sophisticated marketers the famous Aesop’s fable would have been converted into a 60 second spot for the local bank because it serves as a great example of how perseverance and responsible behavior really pay off when it comes to investing. And apparently we all need a 60 second spot like this to remind us of something that, at one level, is intuitively obvious.

I guess I needed to be reminded as well. Despite my quantitative background and the fact that I know all the formulas for calculating compounding it wasn’t until I read a Wall Street Journal article a couple of years ago that I finally put two and two together and realized the simple implication of compounding for investors: Start saving early.

Since a picture is worth a thousand words let’s do a simple example involving twin brothers Tory and Harry. Tory is the responsible one that starts an IRA at the age of 22, squirreling away $2,000 per year while Harry waits 10 years, figuring that he will quickly catch up to his brother by saving $4,000 per year. After all, it can’t be that hard to catch up to someone who only has a $20,000 lead, right?

So, to make the calculations easy let’s assume that the savings are invested at the beginning of each year and return 10% each year - reasonable assumptions. Here are the results over Tory and Harry’s lifetime:

Guess what? Harry never catches up - and for a simple reason. The income that Tory earns on his $20,000 head start exceeds the extra $2,000 that Harry is saving each year in perpetuity. By the time they both reach 65 Tory’s nest egg has grown to $1,435,810 while Harry’s account is a paltry $1,080,097. In fact, if Harry wants to have even a prayer of catching up he needs to start no later than 7 years after his twin brother. It’s no wonder that Albert Einstein referred to compound interest as “the greatest mathematical discovery of all time”.

I was lucky in that I instinctively saved everything I could from an early age despite not fully appreciating what I was doing. But suppose you have followed Harry’s strategy for most of your life and now you’re looking at this example and you’re thinking it’s too late? Well, you can’t do anything about the past but every minute that goes by without a mid-course correction is another minute wasted. Start saving as much as possible right now! You can start by cutting back on the Starbucks. That has to be worth at least $1,000 per year.

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that this document is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other financial instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.

Dollar cost averaging is an investment “strategy” that is credited with almost magical abilities by many investment advisers. The argument goes something like this: You can’t pick the highs and lows of the market so just invest a constant amount in regular intervals and you will buy more shares when the market is lower and fewer shares when the market is higher. Thus your average cost per share will be lower over time. Well, something has always bothered me about this argument but I could never quite put my finger on it. The idea of a mindless process producing better than average results over time just didn’t sit well - not to mention that this argument sounds vaguely like the crazy practice that some people engage in where they buy more of a stock that has moved down from their initial purchase price only because that will lower their average cost (like they still aren’t in the hole on the original purchase?).

Don’t get me wrong; there are clearly a few benefits to dollar cost averaging, not the least of which are psychological. First, with a disciplined investment strategy you won’t be tempted to time the market. Second, when prices drop the blow is softened by the belief, rational or not, that you now get to buy more shares at a lower price. But aside from the psychological benefits there is also a savings discipline that comes with dollar cost averaging. Your income is earned in a relatively steady stream and dollar cost averaging forces you to save it as it is earned.

But this notion of being economically better off simply by spreading out your investments over time just doesn’t hold water. All you really need to know to see the fallacy of this claim is that the market tends to move up over time - i.e. it has a positive expected return. Therefore, the faster you put your money in the faster it’s going to grow. So, if you’re sitting on a pile of money the smartest strategy is actually to invest it all as soon as possible in one big lump sum. Sure, it may go down shortly after you invest but it’s just as likely to go up. End of discussion.

Well, there are probably a lot of advisers out there that aren’t satisfied with this explanation and that’s why Dr. John Greenhut, an Associate Professor of Finance in the College of Business and Technology at Texas A&M University, wrote a rather comprehensive expose on Dollar Cost Averaging. His article, Mathematical Illusion: Why Dollar-Cost Averaging Does Not Work, appears in the October 2006 issue of The Journal of Financial Planning.

In his article Dr. Greenhut exposes the mathematical illusion that seems to produce stellar results from dollar cost averaging. As he points out, the apparent success of this technique often results from unfair or flawed assumptions about stock price movements that work in favor of dollar cost averaging - namely, that assumptions are often made that stock prices vary around a mean by constant dollar amounts when in fact the variation actually tends to occur in constant percentage terms. Dr. Greenhut provides ample illustration that these assumptions are flawed and he proves that lump sum investing is at least as good as dollar cost averaging. However, he then goes on to argue that since the market is always expected to drift upward lump sum investing is actually superior to dollar cost averaging and he cites the academic research that supports this conclusion. He even goes so far as to examine historical data on over 1600 companies and empirically demonstrates that dollar cost averaging is only superior if a stock is in a downtrend.

Since you don’t know ahead of time if the market or an individual stock is going to be in a downtrend and since your best guess at any point in time is that an investment will drift upward you might as well invest your money as fast as possible and forget about dollar cost averaging - unless of course you need a little psychological boost.

The opinions and views expressed in this document do not necessarily reflect the views or opinions of InvestingMinds. InvestingMinds did not prepare and does not endorse such content. Please note that it is intended for general circulation only and the recommendations contained herein do not take into account the specific investment objectives, financial situation or particular needs of any particular person. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy securities or other instruments. No part of this document may be reproduced in any manner without the written permission of InvestingMinds.