Common Sense Investing

Common Sense investing

Clint Vogus

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Contents Chapter Introduction

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1

Invest with Good Fund Managers

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2

Always Focus on Value

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3

Steady Results

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4

Don’t Sit on the Sidelines

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5

Develop Patience

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6

Markets are not Rational

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7

Think Beyond U.S. Stocks and Bonds

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8

Be Where Markets Are

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9

Don’t Follow the Crowd

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10

Have an Investment Plan and Stick to It

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Issues and Outlook for U.S. Economy

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Outlook for U.S. Stocks

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Investment Strategy

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Investment Opportunities

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Introduction This book is written for the individual investor who seeks a better life by saving and investing. In presenting my investment approach, I hope that you gain a better understanding of investing, take control of your investments and make better-informed investment decisions. Since this book is written for the individual investor, all the investments discussed are easily accessible to all investors and do not require large amounts of money. I refer to my investing approach as Common Sense Investing. It is based on a set of clearly defined investment principles, and an understanding of global economic issues that affect investments. Common Sense Investing focuses on being in the right markets at the right time, and also helps avoid being in the wrong markets. Twenty years of experience has taught me that being in the right place at the right time pays off. Being in the wrong place at the wrong time often causes losses. The challenge is to determine where the right place is. That is why my approach to investing requires an ongoing understanding of global economic issues and trends, and how they might affect specific investments. The technology market bubble that burst in early 2000 reminds us of the risks of being in the right place at the wrong time. From March 2000 through October 2002 the Dow Jones Industrial Average dropped 31%, the S & P 500 47%, and the NASDAQ 78%. In hindsight, this was a market to be out of during that period of time. There were other markets, however, that did well, such as small cap value stocks and bond funds. Both had positive returns. This book presents an approach to investing that has evolved from twenty years of personal investing experience and studying some of the best minds and many successful investors. Common Sense Investing 3

Common Sense Investing consists of ten principles that are used to guide investment decisions and an investment strategy, based on current global economic issues and trends. The investment strategy answers the question what markets to be in or where to invest based on the economic environment and trends. The investment principles define how to invest to take advantage of the environment. As an example, a market is technology stocks and a how to invest, is a technology mutual fund. As the global environment changes, investment threats and opportunities change. Investments therefore, need to be changed to take advantage of the new environment and avoid potential losses. A global issue that affects investment strategy in 2005 is the decline in the value of the U.S. dollar relative to other major world currencies. In this economic environment it would be appropriate to consider investments in global stocks and bonds that are unhedged to get the advantage of both foreign asset appreciation, and appreciation of the foreign currency. This would not have been a good investment strategy in the mid 1990’s when the dollar was gaining strength against foreign currencies. One of the lessons I have learned is that every market has a season. Common Sense Investing helps guide me to the right investment for the right season and avoid what is out of season. Investment Experts Interest in the markets during the boom of 1982-2000 brought a lot of new research and many books about different approaches to investing. This research gives us insight into how different investment approaches have performed under various market conditions. Several Nobel prizes have been awarded for investment research that led to a better understanding of market dynamics. I have read a number of investment books and publications, and 4

have spent much time trying to better understand what works in investing and what does not and why. In this pursuit I have studied some of the brightest and most successful investors. They range from Ben Graham, the father of value investing to George Soros, one of the most successful hedge fund managers, and many others with different approaches. Some of the experts that I have studied include, but are not limited to the following. Ben Graham and David Dodd, wrote Security Analysis, first published in 1934. It laid the foundation for value investing and was one of the earliest books to present a systematic approach to investing in stocks. Their approach was to buy stocks of companies when they were selling below what they defined as their intrinsic value, and hold them until they reached their full value. This was a conservative approach to investing and provided a margin of safety against general market downturns. Many individual investors and mutual fund managers use this value investing approach today. In 1984, as the great bull market in U.S. stocks was beginning, Ken Fisher wrote Super Stocks. He started with the value investing principles of Graham and Dodd and added some additional valuation measures to identify companies that had great growth potential but whose stocks were selling at prices that were low. Ken referred to these companies as “super companies” and predicted that they could increase in value 3 to 10 times in three to five years. Many did during the long bull market that followed. Jeremy Siegel, a professor of finance at the Wharton School of the University of Pennsylvania in his 1993 book Stocks for the Long Run, presented historical research from 1802 to the present to support his thesis that U.S. stocks are the best and safest long-term investment. The market performance for the 5

period from 1994 up to March of 2000 supported his research conclusions well. John Bogle, the founder of the Vanguard Group and an advocate for the individual investor, in his book Common Sense on Mutual Funds, helped investors to better understand the mutual fund industry. He presented data on the returns and costs of managed mutual funds compared to index funds. His book concluded that investing in index funds was a lower cost alternative to investing in managed mutual funds, and in many cases yielded better returns. The index method of investing became very popular in the 1990’s and Vanguard had the largest index mutual fund. It grew to about $100 billion in assets before the market downturn of 2000, and is still the largest mutual fund today. Harry Dent, Jr., has been one of the leaders in research on the relationship between demographics and market returns. He wrote his first book in 1993 titled The Great Boom Ahead. He predicted the stock market boom that we experienced in the late 1990’s. He presented many insights into the relationship between demographics and investment returns. In his latest book, The Next Great Bubble Boom written in 2004, Harry presents further demographic trend data that predicts the final boom in the U.S. stock market before a downturn, beginning at the end of this decade. He demonstrated, through his research, that the investment environment and specific opportunities change over time and are driven by demographic and technology cycles. Charles Ellis published the first edition of Winning the Losers Game in 1975. In this book he presented reasons why most individual investors do not make money in investing. He demonstrates that with a sound personal investment policy, and an understanding of the markets and discipline, investors can change from losers to winners. Since his early work there has been much research on the psychology of the individual investor. The new field of Behavioral Finance attempts to understand why investors make more irrational or emotional decisions than rational ones, when it comes to investing. 6

In The Essential Buffet Robert Hagstrom presents the principles that Warren Buffet uses to make investment decisions. Warren’s principles include investing in a business not a stock, demanding a margin of safety to minimize risk, and focusing on a few outstanding companies. Warren has been investing since 1956 through his company, Berkshire Hathaway, and has the best long-term record of any investor. He invests for the long term and rarely sells any of the companies that he invests in. Soros, The Life, Times and Trading Secrets of the World’s Greatest Investor, written by Robert Slater, traces the life of George Soros from his beginnings as an immigrant from Budapest, Hungry to the most successful hedge fund manager. Many of Soro’s investment successes resulted from making large bets on the outcome of world economic or political events. His ability to understand world macro-economic and political events, their impact on investment markets, and to predict how they will turn out, has been a key to his investment success. Peter Lynch, one of the most successful mutual fund managers during his career with Fidelity, describes his approach to investing in Beating the Street. During his thirteen years, 1977 to 1990 as manager of the Fidelity Magellan Fund, the fund earned a compound annual return of 29.2%. Lynch believes in order to make the best investment decisions you have to understand a company’s products, management, and business. He traveled thousands of miles each year to visit companies and meet with management to assess their growth prospects before making a major investment. He focused on commonly known products that everyone was buying as they represented the best opportunities for growth. Some of his best investment ideas came from his wife. She would suggest companies that were producing products that she liked. Identifying high growth companies that had good management with good products contributed significantly to Lynch’s success. 7

William O’Neil, founder of Investors Business Daily, in his book 24 Lessons for Investment Success, explains his approach of investing in stocks that have strong earnings growth and strong price appreciation. His daily newspaper is dedicated to helping investors follow his momentum investing system. He recommends buying stocks that have the highest levels of market activity and strong current price, volume, and earnings trends. Many investors, through his daily newspaper, follow this strategy. The late Al Frank’s book The Prudent Speculator, details his value approach to investing, which has earned him one of the highest and most consistent portfolio returns of most all other investment newsletters as rated by Hulbert Financial Digest. He follows many of the value principles of Graham and Dodd but adds additional valuation measures and the use of margin to enhance returns. There are now several mutual funds that use his system. John Mauldin, an expert on hedge funds and alternative investments, has written a recent book Bull’s Eye Investing. In it he outlines his views on where various investment markets are heading and makes recommendations to align investments to protect assets and take advantage of evolving trends. He sees what he calls ‘new economic realities’ as the drivers for alternative investments. His book provides a road map to help avoid investment pitfalls in what he predicts to be a very turbulent investment environment for the next eight to twelve years. This brief summary of some investment experts that I have studied demonstrates that there are a variety of different and successful approaches to investing. They include value investing, momentum investing, index fund investing, buy and hold, large growth stocks investing, demographic trend following, betting on the outcome of economic and political events, and alternative hedge fund investing based on macro-economic trends. There are also a number of others such as day trading, technical analysis and using puts and calls, just to mention a few. My Investment Approach 8

All successful investment professionals have an approach to investing which defines how they will invest, where they will invest, what they will invest in, and when they will buy and sell. It’s these investment principles that guide their decisions. As we have described, they are very different. They all have been successful over periods of time and under various market conditions. There does not appear to be one best approach to investing nor one that necessarily works all the time. With over twenty years of personal investing and managing investment trusts, I have had the opportunity to experience a number of different market environments. They range from the 1972-1974 market downturn, when the Dow dropped 39.6%, to the 1982-2000 technology driven bull market, the 1987 crash, the 1994-1995 downturn, the 2000-2002 technology crash, the 2003 recovery, and now the 2004-2005 seemingly directionless market. I have learned from my mistakes, such as buying U.S. bond funds in the late 1970’s when interest rates were rising, buying gold at its peak in 1980, buying potential acquisition candidates in the late 1980’s, chasing the technology boom to its peak in March 2000, and trying some market timing approaches. My learning has often been painful, but they say that is how we really learn. This accumulated investment experience, as well as the knowledge gained by studying many investment experts has lead to the development of Common Sense Investing. Common Sense Investing consists of a set of principles, which define how I will invest. It also requires an understanding of the current global environment to help define which markets I will invest in. The investment principles, together with the current investment environment, results in an investment strategy. The strategy defines what specific investment I will make. Since the global investment environment changes over time, which changes market opportunities, I review investments 9

twice per year and make adjustments as conditions change. I change my investments as necessary to take advantage of the changes and avoid losses. In order to be an effective investor under a variety of different market conditions, every investor needs to develop an approach to investing based on the following: Develop a set of investment principles that fit who you are as a person and as an investor. Both your personality and your investment principles need to be compatible so you can be comfortable with your investment decisions and sleep at night. Follow your own principles or adopt someone else’s that are consistent with who you are, and don’t waver from them. As an example, if you are a conservative person, you should not have a principle that says that you will invest in high-risk investments. Gain an understanding of the current global environment in which you are investing. Look at what is going on both in the U.S. and around the world and how it affects the long-term outlook for specific types of investments. Some of the environmental factors to consider include, demographic trends, the state of the U.S. economy, current budget status, interest rate trends, valuation of the U.S. dollar against other currencies and direction, inflation rates, consumer spending, consumer debt, and balance of trade. Knowing these factors helps define what markets to invest in and which ones to avoid. It is important to separate long-term trends from short-term conditions, as it is the long-term trends that are most important in making investment decisions. Using this assessment of the global environment and understanding how it affects various investments, develop an investment strategy that is based on 10

your principles and consistent with current trends. Strategy defines what specific investments to make. As an example, if current interest rates are high, and the Federal Reserve is taking action to lower them down, to take advantage of this trend, a U.S. bond mutual fund would be an appropriate investment. This assumes that one of your investment principles is to invest through managed no-load mutual funds. Always make your investment choices based on your investment principles and within the current investment environment. Review your investments twice during each year. The reviews should include a look at how each investment has performed since the last review and your assumptions about the current environment. If the reasons you made the investment are still true, then even if the investment has not performed as you had expected, continue to hold it. If the environment has changed, then it may be time to sell the investment and purchase one that is consistent with the current environment. Not doing reviews twice per year can put your portfolio at risk of potential loss as the environment may have changed and your current investments may not be appropriate for the new environment. There are appropriate investment strategies for every environment. Buying high-growth technology stocks may have been an appropriate strategy during the late 1990’s, but perhaps not an appropriate one for 2001or 2002. Buying long-term U.S. bond funds is a good investment strategy when interest rates are declining, but not appropriate in a rising interest rate environment. There is a right season for most investment strategies. Since we have no ability to change the investment environment, our challenge is to understand what it is and invest accordingly. 11

Common Sense Investing consists of my personal investment principles, and a current investment strategy based on my assessment of the investment environment and trends that I see. The principles will not change for me, but my investment strategy will, based on my periodic review and update of the investment environment. As the world changes, the specific investments that work best also change. Before I present my investment principles, let me give a little background on myself, which will help in understanding them. I came from a midwestern family of nine where we all worked as soon as we could get a job to help support the family. We learned early in life the value of money and the importance of saving. I had the opportunity to get both an engineering and a business education. I have always had an interest in mathematics and how things worked, both mechanical and electrical as well as complex systems. I was also fascinated by how businesses worked. During much of my career I worked in manufacturing companies in a variety of different industries and a number of management positions. This taught me the importance of costs, cost reductions, competition, business growth, strategy and profitability. I have had a lifetime passion for economics, world events, investments and learning in general. My hobbies include reading fiction and non-fiction, writing, running, tennis, cycling, traveling, and motorcycles. As shown by my investment principles, I am frugal, and always try to get the best value for each dollar. I am quite conservative when it comes to taking investment risks. My principles are a good example of a set of principles for investing based on personal values. I have no trouble sleeping at night with my investment decisions. My overriding principle in investing is to protect assets from major loss. This is not always possible when there is an abrupt and unexpected change in the investment climate that causes 12

the market to drop suddenly. Then the goal is to minimize losses and move on to the next investment opportunity. Common Sense Investment Principles 1. Invest With Good Fund Managers Invest in mutual funds rather than individual stocks to gain access to professional stock pickers and reduce the risk of owning a few individual stocks. 2. Always Focus on Value Never pay more for an investment than you should. Value never goes out of fashion. Value provides a margin of safety when markets turn down as well as an opportunity for additional returns when markets boom. Even good growth stocks go on sale. 3.

Steady Results As in baseball, always swinging for home runs can result in a lot of strikeouts. There are very few home run hitters who also bat 0.350. Waiting for the right pitch and sticking with the game plan is important to winning in both baseball and investing. Steady day in and day out small gains is the best way to accumulate good investment returns.

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Don’t Sit on the Sidelines You must be in the market to win, not on the sidelines. In any market whether up, down or sideways, there are opportunities for positive returns. Market timing is a loser’s game. Being fully invested in the right investment at the right time is a key to successful investing.

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Patience Good sound investing is boring as there is not a lot of activity. Trading is not investing. Investing well requires research, good judgment and then a lot of

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patience to wait for results. As in farming, give investments time to germinate, grow and then be harvested. 6.

Markets are not Rational Today’s price of a specific stock may have little to do with reason, logic or value. Ben Graham, the father of value investing, described it best. ”Mr. Market, in the short term, is a voting machine not a weighing machine.” The price of a stock on a given day has more to do with popularity than with worth. Don’t spend a lot of time trying to figure out why the market is where it is and where it might go next. The markets are not rational and therefore cannot be predicted.

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Think Beyond Traditional Stocks and Bonds U.S. stocks and bonds are not the only investment options available nor are they always the best. Consider foreign stocks and bonds, precious metals, natural resources, energy, real estate, and commodities. Since all markets move in cycles and not all together, all investment options need to be considered in an investment strategy, as there is a season for every investment.

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Be Where Markets Are A buy and hold investment strategy does not provide the best long-term results, as markets shift over time. Moving investments to where opportunities are is necessary to gain the best results. Traditional asset allocation models for investing do not maximize the advantage of major shifts in markets.

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Don’t Follow the Crowd It has been demonstrated through research that the consensus of the majority is generally wrong. Doing the opposite has a better track record. Do your homework and then follow your convictions, not the crowd.

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Have a Plan and Stick to It Good investing takes a plan and discipline. A set of principles, an investment strategy and the discipline to follow them separates the winners from the losers. Develop a plan and stick with it. Don’t be swayed.

Having independent outside guidance helps to keep you on track and assures that your principles are sound and your strategy is consistent with the current environment. The next chapters will explain each of these principles in more detail.

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Chapter 1

Invest with Good Fund Managers There are a number of different ways to invest in the market. The more common include individual stocks and bonds, managed mutual funds, index funds, and exchange-traded funds. Exchange traded funds or ETF’s are similar to index funds but are traded directly on the major stock exchanges. They have become popular in the past several years, and both the number and variety offered have increased. Additional information on ETF’s can be obtained at reuters.com, iShares.com, or etfconnect.com. By investing in individual stocks, I learned that it required both knowledge and time. Knowledge of industries and companies is required to find good stocks. Time is required for research, to follow daily price changes, and determine the right time to buy and to sell. I often bought and sold at the wrong times and wanted to hold on to my favorite stocks. Many individual investors have not done well with investing in individual stocks as they did not have the time nor did they develop effective buying and selling criteria. Many ended up with a buy and hold strategy that may have worked well in the 1990’s when almost every stock went up, but has not worked since the market downturn in 2000. Managed mutual funds offer management necessary to be successful.

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professional

One of the advantages of managed mutual funds over index funds or ETF’s is that they have the flexibility to change investments, as detailed in the fund’s investment prospectus. An index fund or an ETF must always be 100% invested in stocks and must continue to buy as new money comes into the fund. Index funds or ETF’s only sell when investors want to redeem shares, which might not be the best time to sell. They must also buy an equal proportion of all stocks represented by the specific index that they are mirroring. 16

Managed mutual fund managers decide what to buy, when to buy, and when to sell. Fees are higher for managed mutual funds compared to index funds or ETF’s, but it is worth paying for a good investment manager. Buying individual stocks can also be an effective method for investing if one has the time and technical background required to analyze stocks, and the discipline for buying and selling. Individual stock investing limits investments to primarily U.S. stocks. It is difficult and expensive for individual investors to buy most foreign stocks. There are a number of newsletters and services available that recommend individual stocks for those who are interested in taking this route. The rapid growth of the mutual fund industry in 1990’s brought some opportunists that may not have had interests of their investors as their first priority. Some fashioned self-serving greed crept into the industry during period.

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Thanks to the efforts of New York Attorney General, Elliot Spitzer, the Securities and Exchange Commission, and other regulatory and law enforcement agencies, some of these mutual fund firms and fund managers have been dealt with. A number of these firms have been fined and forced to make restitution to shareholders. Several fund managers and executives have been barred from the industry. Further regulation and oversight of the industry is being put in place to prevent these problems from reoccurring. The mutual fund industry is now much healthier and more focused on shareholder interests. During the 1990’s, with the rapid growth in the number of mutual funds there was also a lack of experienced investment managers. When the technology bubble burst in March of 2000, many fund managers did not know how to react. Some thought the drop was temporary and that stocks would recover quickly so they held on to their positions longer than perhaps they should have. This period, however, did produce some good fund managers. 17

I have found a number of mutual fund managers who share my investment principles, and have long track records of consistent performance under a variety of different market environments. They also have their shareholder’s interest as their number one priority. Some of the fund managers that I trust with my money include: Stock Fund Managers Mason Hawkins and Stanley Cates who have been managing at Longleaf Partners Mutual Funds for many years. Bill Nygren of the Oakmark Funds family. Chuck Royce founder of the Royce Funds over twenty-five years ago. James Gipson who has managed the Clipper Fund since 1980. John Montgomery, president of Bridgeway Funds. John Rodgers, manager of Ariel Funds. Harry Hagey who manages Dodge & Cox Funds, which was founded in 1930. Richard Aster, Jr. manager at Meridian Funds. Ron Muhlenkamp who has managed his Muhlenkamp Fund since 1988. Marty Whitman who founded Third Avenue Mutual Funds over twenty- five years ago. Wally Weitz who has managed the Weitz Funds since their founding in the 1980’s.

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Christopher Brown and John Spears who have been managing funds for Tweedy Browne, one of the oldest and most successful mutual fund firms, established in 1920. John Buckingham, who was an understudy of Al Frank for a number of years, and now manages the Al Frank Funds. Bond Fund Managers Bill Gross, who is the one of the world’s most respected experts on bonds, directs the management of many of the bond funds offered by PIMCO. Dan Fuss of Loomis & Sayles manages a number of their bond funds. None of the mutual funds or fund families mentioned above charges a sales load or sales fee.. I believe in putting all my money to work without having to pay a sales commission. I have found very few mutual funds, which both charge a sales fee and out perform the best no-load mutual funds over long periods of time. I have had the opportunity to meet with some of the above fund managers and have invested with all of them. What separates them from the thousands of others are: 1. They have investment experience in a variety of different market cycles and understand various market forces. 2. They are long-term investors and are not reactive to temporary market fluctuations. 3. They are patience in both their buying and selling. They have a strong bias towards value, and research companies before they buy. 4. They have most of their personal wealth invested in their own funds. 19

5. They are disciplined and have a set of investment principles, which they follow under all market conditions. None of these fund managers or fund families has the best performing fund each year. They have, over long periods of time, delivered consistently higher returns than their peers and often with less risk. My list of good mutual fund managers is not all-inclusive; there are others that are in the same league. As an investor it is important to understand who your mutual fund manager is, what his experience is in both good and bad markets, what decision making process he uses to buy and to sell stocks or bonds, and what his long-term performance record is compared to others in the same category. Most importantly, where does he invest his own money? Investing with the best fund managers increases your odds of protecting your assets during market downturns and getting consistent long-term results. Before buying any mutual fund, do your due diligence to fully understand who you are investing your money with and how they invest it.

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Chapter 2

Always Focus on Value Stocks seem to be the only thing that we buy without much regard for their value. This was taken to an extreme during the 1990’s technology stock boom. We were willing to pay very high prices for shares of stock in companies that had never earned a profit, and had no near term prospects of profitability. During this period, many companies focused on how much cash they could spend. Everything else that we buy, from food and clothing to cars and houses, we shop around to make sure we are getting the best possible value. In our professional business dealings we look for the best sources of supply, and negotiate for the best prices on everything from office supplies and airline tickets to raw materials and equipment. We are not hesitant to change suppliers for a few percent in savings. The reason we often ignore the price of an individual stock in relation to its value, is rooted in human nature and the psychology of investing. We experienced this in 1999, when the NASDAQ gained 85.6%, driven by many of the dot-COM startup companies. During this boom there was a lot of momentum that was driving up stock prices. We did not want to miss out on the action. If we could buy a stock today for $15 a share and tomorrow someone was willing to pay $16, we bought it now. This worked until there were no new buyers who were willing to pay more. Those who bought early wanted to sell, and the prices came tumbling down. Over the next two years, the NASDAQ lost 67.2% of its value. This type of momentum investing is similar to a chain letter. It works as long as the next person is willing to pay more than you did for the stock. When the chain is broken, panic often sets in, there are more sellers than buyers, and the stock price can go into free-fall, taking your paper profits with it. 21

In order to assure that you are paying a fair price for a stock when you buy it, you need some criteria for determining what a fair value is. Ben Graham, in his work on value investing, developed a valuation method he called ‘intrinsic value’. His approach looks at the value of all the assets that a company has on a per share basis and compares it to the current stock price. If the stock price was 30-40% below its’ per share net asset value, then Ben felt the stock was selling at a bargain price. If other factors were positive for the company, the stock was purchased. Graham felt that if stocks could be purchased for less than their ‘intrinsic’ or net asset value, then that discount would provide a margin of safety in the event the stock market went down or if the company did not perform as anticipated. Since Ben Graham’s work, others have refined and expanded his evaluation criteria. Additional valuation criteria used today include; price earnings ratio, price-to-sales ratio, price-to-book value, and price-to-growth rate. In value investing when a stock reaches full valuation it is generally sold. This selling strategy can avoid holding overvalued stocks that could suddenly drop significantly in price. Unless you are an excellent stock trader and can predict when a high-flying overpriced stock is about to turn down, value investing is a safer alternative. Value investing has historically out performed growth investing as defined by paying a premium for stocks that are experiencing greater than market rates of growth. Jeremy Siegel in his book Stocks for the Long Run sites one analysis that compared returns of large cap growth stocks to value stocks for the period from July 1963 to December 1996. Over this period the value stocks gained a compound annual return of 13.1%, and the growth stocks gained a compound annual return of 10.3%. James O’Shaughnessy, in What Works on Wall Street, presents the results of a number of studies, which showed that 22

stocks purchased at low valuations relative to the general market have outperformed both higher valued stocks and the general market. For the period of December 31, 1951 through December 31, 1994 all stocks had an annual compound return of 12.81% and the top 50 P/E ratio stocks returned 8.87%. In another study during the same period, the 50 stocks each year with the lowest price-to-book valuation returned 14.66% compound annual return compared to 12.81% for all stocks. That means that $10,000 invested in the general stock market at the end of 1951 would be worth $1,782,174. $10,000 invested in the lowest price-to-book stocks for each year would be worth $3,591,446 at the end of 1994. Quite a difference. Buying stocks with low valuations does not result in the best returns every year, as in 1998 when large cap growth stocks returned 42.15% and large cap value stocks returned 14.68%. Over the long run value stocks have produced higher returns than the stock market in general, and than higher priced stocks. Past returns are not necessarily an indication of future returns, but when given a choice, I will always pay less rather than more and look for good quality companies selling temporarily at bargain prices. Value managers, in their stock selection criteria and discipline, do not over pay. During the second half of 2004, when there were few bargain stocks, value stock fund managers held onto cash and waited for stock prices to become reasonable.

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Chapter 3

Steady Results Growing up in Illinois I played a lot of baseball. It was always exciting to swing for the fences and pop one over for a home run. However it did not happen very often and my attempts resulted in a lot of strikeouts. I was not a Babe Ruth, Hank Aaron or Barry Bonds who can hit home runs and maintain high batting averages. In investing, swinging for the fences is like hunting for the next Microsoft, Dell Computer, or Harley Davidson. Investing in an IPO or buying that dot-COM company that should double in six months are also examples. It’s exciting when you get the home run, but there are many more strikeouts. In the mid 1980’s mergers and acquisitions were popular. I researched to find smaller companies that might be acquired and potentially gain 30-50% in price quickly. I learned it was difficult to find potential acquisition candidates and buy them before the pending acquisition became common knowledge. Sometimes even when acquisitions were announced, they were not completed due to regulatory or other issues. The idea sounded good and some investors did make money buying acquisition candidates, but they seemed to have information that was not available to me until the stock price was already high. Another example of swinging for the fences is buying the best performing mutual funds each year. Many of the best performing funds each year are sector funds, some of which are leveraged to give returns that are higher than market returns. In the technology stock boom of the late 1990’s, there were a number of technology mutual funds that had over 100% returns in a year. But like all things that go up rapidly, they can also come down rapidly. Many of these funds in the following years were amongst the worst performing. This has been 24

repeated in recent years with energy funds, biotech funds, emerging market funds, China funds and others. When an investment idea becomes popular, prices become overvalued and it is time to consider alternatives as you are most likely too late to take advantage of further gains, and the risk of loss increases. It is human nature to want instant results in everything we do and no different with investing. We would like 20% plus returns every year as we experienced during the 1990’s. That period was unusual and only occurred one other time in the last century, which was in the early 1920’s before the 1929 stock market crash. During both the 1920’s and the 1990’s, stocks increased in value not because of great increases in company profits, but because investors were willing to pay more than the stocks were worth. P/E ratios expanded greatly. The demand for stocks was increasing at a rate greater than the supply and therefore, prices kept rising. Then one day buyers decided they were paying too much and it was time to sell. Unfortunately they all wanted to sell at the same time, and there were not enough buyers willing to pay the price. What often appears to be an instant result is a high-risk game that goes on as long as there are more buyers willing to pay more. When the buying stops our paper gains turn into real losses. Steady results seem to be a better long-term investing alternative. A steady performing mutual fund that I have owned for a number of years is the Ariel Fund, a small cap value fund. As reported in their June 30, 2004 quarterly report, 1-year annualized returns were +28.90%; 3-year +12.90%; 5-year +13.09% and 10-year +15.44%. During these same periods, the S & P 500 Index annualized returns were 1-year +19.11%; 3year -0.69%; 5-year -2.21%; and 10-year +11.69%. The Ariel Fund has never won the prize for being the best performing mutual fund in any given year, but has delivered steady results year after year. Their company slogan is ‘Slow and Steady Wins the Race’. Past performance is not an 25

indication of future results, but it helps us understand how various approaches to investing have performed over time. One of the characteristics of a slow and steady mutual fund manager is their analysis of a company’s stock before they purchase it. Before they buy they make sure that the company has strong financials, good management, good products and market position, and is not overpriced relative to its future earnings potential. Research is necessary as the steady performing mutual fund managers buy stocks in companies with the intent to hold them for long periods of time. Holding periods are years not weeks or months. If a mutual fund has turnover of more than 50%, that manager is more likely to be chasing stocks that are moving up rather than investing in good companies for the long term. My number one principle in investing is to preserve assets so there is something to grow. I no longer swing for the fences or try to catch that occasional stock or mutual fund that may return 50 or 100% in a year. I have watched a few go by and have often been tempted. I focus on steady returns over longer periods of time. It is not as exciting to win a baseball game with singles, doubles and an occasional stolen base compared to a grand slam home run in the ninth inning, but the win still counts and more games are won that way. This is the same in investing. “Slow and steady wins the race”.

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Chapter 4

Don’t Sit on the Sidelines The subject of market timing has interested both professional investors and academics. Many research studies have been conducted and computer-based models developed to help predict the future direction of the market. The question that market timing attempts to answer is when to be in the market to take advantage of the periods of maximum gains, and when to be out of the market to avoid periods of major losses? If answer to these questions could be found with a high degree of consistency, then overall gains could be significantly improved. If we could have avoided being in the market on Monday October 19, 1987 we would have missed the 508-point or 22.6% drop. If we were out of the market during the 1973-1974 downturn we would have avoided losses of 55.1%. If we had sold our technology stocks before March 2000 we would have avoided losses of 47%. If we had been out of the market during the 1990 sell-of and reinvested in 1991, we would have avoided the 1990 decline of 13.8% and gained 39.8% in 1991. These are some examples of why market timing has attracted the interest of so many. The history of market returns over long periods of time shows the market does not move in a straight line, but in cycles and spurts. If we could catch the right waves and avoid the storms, we could have better returns. A study quoted by Charles Ellis in his book Winning the Losers Game, presents the risk of getting the timing wrong. This study by Cambridge Associates points out that both major gains and losses in the market occur in very short periods of time, in many cases a day, such as occurred on October 19, 1987 when the market dropped 508 points. This study by Cambridge Associates reviewed the stock market’s daily movements from 1982 through 1997. The study found that if you were out of the market for the ten best days during that sixteen-year period, the annualized return for the 27

entire period would be 16.1%, compared to 19.6% if you stayed invested everyday for the entire period. If you were out of the market for the twenty best days, the annualized return would have fallen to 13.9%, and out for the best thirty days, the return would have fallen to 11.9%. Looking at a longer period of time, Ellis points out that during the period from 1926 to 1996, including the 1929 market crash, almost all the market returns for that seventy year period occurred in only sixty of the months or seven percent of the time. Missing just a few of the short upward movements in the market would significantly reduce your returns. Based on this and other historical studies, it appears as if the risks of not being in the market outweigh the risks of trying to time when to be in and when to be out. Once you have missed a rising market opportunity, it is gone. There are a number of professional investors who practice various forms of market timing, and I do follow several market timers to get their perspective on the overall dynamics of the market. There are a number of technical analysts who have developed market indicators to help them assess the general trend and direction of the market. Most are based on looking at historical data and then developing models that have some correlation with historical market movements. They use this data to forecast how the market should move. If we believe that history repeats itself in predictable ways, then some of the market timing models may be beneficial. Not many, if any, have stood the forward test of time. One of the current writings on market timing is a 2003 book by Ben Stein and Phil DeMuth titled Yes, You Can Time the Market! In this book the authors look at stock market returns for the one hundred years from 1902 through 2001 in relationship to several valuation criteria. One of their conclusions is that when the market is overvalued relative to its most recent fifteen-year valuation trend, future returns over the next five-year period tend to be negative most of the time. 28

Following their valuation market timing criteria, you would have been out of the market for the entire period beginning in 1986, through the greatest market boom in our lifetime. You would also, however, have avoided the 2000 bubble bursting losses. Their fundamental thesis is to buy into the market when prices are low relative to historical levels and to be out of the market during periods when valuations are high. We have seen in the 1990’s that stocks can remain overpriced for long periods of time and yet the market continues to go up. If we were out of the market for only valuation reasons, we may miss large market increases. As with all market timing models, we will not know whether or not they improve overall investment returns until many years from now, after we have experienced a number of market cycles. By then it is a bit late if in fact the market-timing model was wrong. I have found that in both up, down and sideways markets; there are always some sectors that perform well. As an example, in 2004 the S & P 500 gained 8.99%, the Dow 3.5% and the NASDAQ 8.59%. Market sectors such as natural resources gained 28.4%, and real estate gained 28.7%. Mid-cap Value stocks gained 12% and Small Cap Value stocks gained 21%. During the bear market of 2001 and 2002 the overall market was down each year by double digits but small cap value stocks were up each year by about 20%. Since the best investment minds have not demonstrated over long periods of time that any market timing model consistently predicts stock market behavior, and we have only one lifetime to invest, my choice is to be fully invested at all times in the right market sectors. My investment decisions will continue to be based on my investment principles and on the investment environment. I do not want to miss the surges in the market, which historically have accounted for most of the long-term gains. I am not going to be sitting on the sidelines waiting for the precise moment to play the game and risk missing the season.

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Chapter 5

Patience Many successful investors have demonstrated with their long-term returns that investing is not a game with a lot of daily activity. As a young teenager I worked for my father in his small manufacturing business. He would always remind me that visible activity, or what he referred to as ‘asses and elbows’, was a sign that you were being productive. If there was not a lot of activity then you were not productive. Thinking and planning did not count as productive activity in his world. That may be true in a production business, but it has not been proven to be true in the investment business. Investment results are not necessarily a function of the number of stocks that are bought and sold in a given year, but rather buying the right stocks at the right price and selling them when they reach their full market value. A lot of trading activity may be a sign of poor stock selection, as the value of a stock normally does not change significantly in short periods of time. The more trading activity, the higher the transaction costs, which also lowers returns. Frequent trading activity is appropriate if you are a stock trader, momentum investor or dealing in commodities, but not appropriate if you are a long-term investor. In today’s fast-paced, instant results and information overload world, it is easy to understand why it is difficult to have patience with investing. There is excitement in buying and selling stocks and watching them go up and down on a daily basis. There is not a lot of excitement in spending time analyzing the financial performance of a company, meeting with it’s management, talking to their suppliers, customers and competitors to determine if their stock is a good long-term investment. This takes time and patience. It is also not very exciting to buy a good stock that has been recently discounted by Wall Street and waiting several 30

years until it reaches its full market value. This is what good long-term investors do. The portfolio turnover of many of the best long-term performing mutual funds ranges from 20-25% per year. This means that their average holding period for a stock is four to five years. The average portfolio turnover of all mutual funds ranges from 50-80% and in some cases is 100% per year. Patient investing does pay off. The Longleaf Partners Fund, a mid-cap value fund, is a good example. They reported in their June 30, 2004 semi-annual report that they were having difficulty finding any stocks that were selling at low valuations. For the first six months of the year their total activity was to add no new holdings and sell two stocks that had reached full market value. The fund’s performance for the past twelve months was 20.33%, for the past five years 7.38%, and for the past ten years 14.65%. The S & P 500 lost 2.2% per year during the same fiveyear period. The Oakmark Select fund, managed by Bill Nygren and Henry Berghoef, reported in the September 30, 2004 Annual Report, that no new stock positions were added and no holdings were eliminated during the past quarter. They reported a 13.64% return for the past year, 14.29% for the past 5 years and 20.21% per year since the fund was started in November 1996. I like the returns from boring patient investing. Peter Lynch reported in his book Beating the Street, that during the last market boom individual investors, on average, gained one third or less of the market returns due to excess trading. Many sold their good performing mutual funds or stocks when they suffered a temporary downturn and bought others as they hit their peaks and then headed down. A further example of the importance of patience is shown in a study published in 1992 by Tweedy, Browne Company, LL.C. The firm has managed individual investments and mutual funds since 1920. In their work titled What Has Worked in Investing: Studies of Investment Approaches and Characteristics Associated with Exceptional Returns, they use the returns of individual stocks from 1968 through 1990 to compare relative performance for different holding periods.

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One example they site is the market drop of 27.9% in 1974. If you had held a group of low price-to-book value stocks, the return after one year would have been 5.0% better than the market, after 3 years 62.2% better, and after 5 years 172.6% better. This is pretty strong evidence that doing the proper research on companies before buying, buying at the right price, and holding for a long period of time is an effective strategy for achieving superior market returns. It’s boring but effective. Being a patient investor takes discipline and courage to stay the course, particularly during temporary storms, day-to-day market movements, and the barrage of news. If thorough research is done before buying a stock, fluctuations in the market should be ignored, as they occur everyday and for a variety of different reasons, most of the time unrelated to the underlying value of the stock. Stocks should be sold when they reach full market value or if the fundamentals of the company change in a way that reduces their long-term potential. Patient investing is boring but historically has gotten more consistent results in the long run when compared to many other investing approaches.

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Chapter 6

Markets Are Not Rational Every day the major market indexes such as the Dow Jones Industrial Average, the S & P 500 or the NASDAQ go up or down as a reflection of how investors feel about stocks. If investors are positive, they are buying, and the averages go up. If they are negative, they are selling and the averages go down. The daily buying and selling of stocks does not appear to be a rational process but rather one based more on the emotions of fear and greed. If investors fear that stocks may go down, they sell. If they see opportunities for the market to go up they buy, as they do not want to miss out. To demonstrate how this works let’s look at a few typical days in the market. On Monday December 6, 2004 the Dow Jones Industrial Average went down by 45.15 points or 0.43%. After the markets closed on Monday it was reported in the financial press that the market on Tuesday, December 8, 2004 should go higher as reports that oil prices continued to decline, productivity in the U.S. was higher than expected, and holiday shopping looked stronger than anticipated. What actually happened on Tuesday was that the Dow dropped 106.5 points for a loss of 1.01%. It was interesting to read one of the technical market analysts on Wednesday morning explain why the market declined on Tuesday. He reported that the weak jobs report released the prior week now had traders questioning just how strong the economy was and they therefore had difficulty pushing stocks higher on Tuesday. Overnight we went from a view that stocks were worth more and the market should go up, to the view that perhaps they were overpriced. This pattern is repeated each day in the stock market where in excess of one billion shares of stock are traded daily on just the New York Stock Exchange. This process does not seem to me to be very rational. It does not appear that investors are looking at the valuation of 33

each company’s stock price based on the fundamentals of the company before they buy or sell. Perhaps that is why buying and selling of stocks on a daily basis is referred to as trading rather than investing. One of the classic examples of irrationality in the stock market is Monday, October 27, 1987. On that one day the Dow dropped 508 points or 22.7%. What happened that day to make the value of the thirty biggest and best companies in the U.S worth billions of dollars less than they were just twenty-four hours earlier? It was fear, which led to panic selling. Fear that some of the domestic and global issues that we were facing at the time might lead to a major slow down in the economy. There was no logical reason or fundamental factors that changed the value of these companies in one day. They were doing what they were doing the day before when they were valued on average 22.7% higher. As we experience the daily ups and downs of the market, the financial press and market analysts report reasons for the changes. When the market goes up, the headlines in the Wall Street Journal might read ‘strong jobs report fuels market’ or ‘better than expected profit report from Intel pushes market up’ or ‘market analysts upgrade of G.E. spurs market rally’. When the market goes down, the headlines might read ‘inflation fears spooks market’ or ‘factory utilization for March drops by 1% causing concerns on Wall Street’; or ‘terrorists attack in Spain sparks sell off’. There are always reasons presented by the market experts that try to explain why the market acted the way it did. Many times they sound very convincing. The reality is that each day the market reacts to what is perceived either as good or bad for stock investing. Ben Graham expressed it best when he said that ‘Mr. Market’, the stock market, in the short term is a voting machine and not a weighing machine. He meant that everyday, investors, traders and professional money managers, decide by their buying and selling of stocks, which ones are the most popular. The most popular, or hottest stocks are the ones that are being bought and therefore their price goes up. The stocks that are not 34

very popular are being sold and therefore go down in price. In the short term stocks are often valued based on popularity. For example, on December 6, 2004 a share of Caterpillar stock dropped in value by $0.35, from $90.92 per share to $90.57 per share. This represented a reduction in value of 0.4%. When multiplied by the total number of shares outstanding, Caterpillar’s value dropped by millions of dollars in one day. What happened within the Caterpillar organization in less than twenty-four hours to cause it loose millions of dollars in market value? The answer is most likely nothing. The company most likely ran on Monday December 7, 2004, as it had the previous day. They got orders, produced and shipped products and made money just like they had been doing when their company was valued at $90.92 per share the day before. On Tuesday, December 7, 2004 Caterpillar stock closed at $90.82, up $0.25 per share from Monday or 0.3%. It is hard to imagine what happened in less that twenty-four hours to make Caterpillar more valuable than the day before. Perhaps the buyers and sellers on Monday made a mistake when they sold shares for less and changed their minds on Tuesday. In any event, Caterpillar went on making and selling equipment and services around the world and making money, just like every other day. There are times when something does change to reduce the value of a specific company’s stock, such as the loss of leadership or a scandal, but this happens infrequently compared to the daily changes in a stock’s price. That is what Ben Graham meant when he referred to Mr. Market as a voting machine. Every day the most popular stocks get more votes and the price of their shares go up. The unpopular stocks get the boot and their price goes down Historical research has taught us that the daily price fluctuations of stocks are primarily reactionary and driven by fear and greed. Because of the somewhat irrational approach to the daily changes in stock prices, there is an opportunity for the astute 35

investor to gain an advantage. When a stock is selling at a price below its intrinsic value, the market presents a good buying opportunity. When a stock becomes priced at or above it’s fair market value, it is a good opportunity to sell and harvest profits. Since the market does not consistently price stocks at their true value, the patient and analytical investor can capitalize. This approach to buying stocks when they are undervalued and selling when they reach full value is referred to as value investing. I have grown to accept that today’s price for a particular stock or today’s level for the Dow, S & P 500, or NASDAQ may have little to do with the value of that company or the value of the overall market. Even though the investment professionals and the press have reasons as to why the market did what it did, the reality is that the psychology of the traders and institutional investors who control most of the daily transactions in the market, were either a bit fearful that day or a bit greedy. When someone asks me where the Dow will be next month or next year, I say I have no idea. If they ask me where it might be in five or ten years, I say most likely higher. Historically, over long periods of time, stocks have always increased in value, but never in a straight line. Use the ups and downs along the way to your advantage. Capitalize on the mis-pricing in the market to buy if under priced, and sell if overpriced. Don’t spend time trying to predict where the markets are going to be in the short term, unless you are good at predicting irrational behavior. Markets do not behave rationally much of the time.

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Chapter 7

Think Beyond U.S. Stocks and Bonds U.S. stocks and bonds are not the only investments that are available to us today, nor are they always the best performing. Alternatives such as foreign stocks and bonds, commodities, energy, precious metals, natural resources and real estate are all available through mutual funds and ETF’s, and should be considered as part of an overall investment strategy. The U.S. stock market has had a long-term upward trend for the past two hundred years. There have, however, been periods when the U.S. market has gone down or has been flat. From 1965 to 1982 the U.S. market was flat for the entire eighteen-year period, with some ups and downs in between. From 1973 through 1974 the U.S. stock market was down by 27.2% in 1973 and 27.9% in 1974. In 1990 U.S. stocks sold off and ended up down 13.8% for the year. From 2000 through 2002 when the technology bubble burst, technology stocks lost 78% of their value. During these flat and down market periods, there were other markets that were up. In 1987 international stocks gained 24.63%. During the 1993-1994 U.S. market downturn, international stocks gained 32.56% in 1993 and 7.78% in 1994. During 2001 and 2002 when the U.S. stock market was still suffering from the technology bubble bursting, U.S. bonds gained 8.42% in 2001 and 10.27% in 2002. It is not always true that international stocks do well when U.S. stocks are down, as the U.S. economy has a great impact on other economies around the world. However in any year there is generally a market or market sector someplace in the world that is doing well. In 2004, which closed with the DOW up 3.5% and the S & P 500 up 8.99%, there were a number of international markets that performed much better. Overall international stocks were up 11.79%. Countries or regions that performed exceptionally well included Brazil up 23.3%, Europe up 15.98%, Mexico up 51.1%, Canada up 12.2%, and Australia up 22.9%. 37

In the twenty-one year period from 1982 through 2001, international stocks had better returns than U.S. large cap growth stocks in ten of the years, and were the best performing category above all U.S. stocks and bond in five of the years. This period included the technology boom during which large cap growth stocks led all markets for five years. With the development of the mutual fund industry it is easy to invest in both sector and broad based international stocks. There are a number of investment styles followed by international fund managers ranging from growth to value and from all cap to small cap and large cap. Some funds focus on emerging markets while others focus on developed countries. Some hedge against changes in the value of the U.S. dollar relative to foreign currencies, others are unhedged. When investing in foreign stock funds it is important to understand the fund manager’s investment approach as well as the unique risks associated with international investing, such as currency and political risks. Today, with the declining value of the U.S. dollar relative to other currencies, unhedged international funds provide the investor the additional gains from the currency appreciation. If the dollar begins to strengthen then this becomes a disadvantage. Some of the no-load international mutual funds that I have used include Artisan International Fund, Oakmark Global Fund, Third Avenue Value International Fund, Polaris Global Value Fund, Tweedy Browne Global Value Fund, and Dodge and Cox International Fund. Since my approach to investing has a bent towards value, most of these funds have a value approach to investing. There are a number of other good international funds as well. Foreign stocks are also available through index mutual funds and ETF’s. Both invest in a basket of international stocks that represent various international stock indexes. There is quite a variety available. Some represent all foreign stocks, others represent geographical regions such as Europe, and still others represent specific investment styles such as small cap value.

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Another international opportunity that is often overlooked by U.S. investors is the international bond market. As we have become a more global economy and as many counties have developed more stable currencies and financial institutions, this has become a viable investment option. Interest rates and currency values change over time based on the economic conditions of a particular country or region. Normally interest rates in developing countries such as China, India or South Korea are higher than in developed countries such as Germany, Canada or the United States. Political risk also increases a country’s interest rates. Interest rates in Russia or Venezuela would be higher than in the United States due to differences in political risks. When interest rates in the U.S. are at the bottom of a cycle and beginning to rise, investing in foreign bonds could be a way to gain better-fixed income investment returns. As with investing in international stocks, there are additional risks with foreign bond investing, such as rising interest rates, political risk, foreign currency risk as well as higher investment costs. These additional risks need to be considered before making foreign investments. Buying a mutual fund whose management has experience and presence in the foreign market can help minimize risks. Some of the no-load foreign bond funds that I have used include Loomis & Sayles Global Bond Fund, PIMCO Emerging International Bond Fund and American Century International Bond Fund. There are a number of other good international bond funds as well. As an example of recent performance, over the past three years Loomis & Sayles Global Bond Fund returned 52.2%, PIMCO Emerging Market Bond Fund 78.1%, and American Century International Bond Fund 66.9%. Past performance is never an indication of future performance. During this same three-year period the U.S. stock market had a negative return. A few other areas of investment outside of traditional U.S. stocks and bonds include commodities, energy, precious metals, natural resources and real estate. These investment 39

sectors present different but unique opportunities due to longterm world trends. Gold has done nothing but lose value since it peaked at over $800 an ounce in 1980. It dropped to as low as $250 an ounce, and then over the past three years rose to the $425-$450 range. Still a long way from the $800 an ounce I paid in 1981. A buy and hold gold investor has lost a lot of purchasing power since 1980. What has been driving gold up recently has been fear. Fear of terrorist’s activity and political instability around the world. Fear of a worldwide recession. Fear of the high budget and trade deficits in the U.S. Fear of the impact of the declining value of the U.S. dollar. Fear of inflation. Very little of the rise in the price of gold in the past few years has been due to an increase in the demand for gold. Some foreign central banks have taken the opportunity of gold’s rising price and have sold some of their holdings. As long as the high level of uncertainty exists in the world around economic and political stability, the price of gold will continue to rise. When the uncertainties are resolved in positive ways, the price of gold will revert to more historical values. If they are resolved in negative ways, such as a recession, then gold may continue its upward trend until the economy recovers. Gold is a short-term investment opportunity but brings with it a lot of risk and needs to be followed very closely for changes in the world outlook. Other precious metals such as silver and platinum are priced more on actual demand rather than as a hedge against political or economic stability. I would be cautious with investments in the gold and precious metals area. Both gold and precious metals can be purchased through no-load managed mutual funds, index funds or ETF’s, some of which hold gold bullion and others invest in gold or precious metal producing companies.

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Commodities, energy, and natural resources present an interesting longer-term investment opportunity. There is a worldwide long-term shortage of energy including oil, natural gas, and coal. There are also shortages of commodities such as timber, steel, and copper. With the industrialization of China and other emerging countries, we are more rapidly depleting our natural resources. In 2004, China consumed 25% of the world’s cooper, 32% of the world’s coal production, 25% of the world’s aluminum, 50% of the world’s cement, and 40% of the world’s steel. As many of these resources are not renewable and others take a long time to replace, costs will continue to rise until substitute products are found or additional capacity added. This upward trend in prices may be interrupted by a temporary recession. Besides China, countries like India and others are also accelerating their rates of industrialization. Commodities and natural resources should be considered in an investment strategy with a full understanding of both the opportunity as well as the risk. Some of the no-load mutual funds that I use that specialize in these sectors include; RS Natural Resources, U.S. Global Resources, PIMCO Commodity Real Return, ICON Energy, and Excelsior Energy & Natural Resources. There are also index funds as well as ETF’s to consider. Real estate has been one of the best performing sectors in the U.S. for the past one, three and five years. In 2004 it was the best performing of all sectors returning 28.7%. Many now think since U.S. real estate has done so well over the past five years, that a bubble has been formed and will burst within the next several years. This is difficult to judge but real estate investments through no-load mutual funds are also worth consideration. When putting together your investment strategy consider other investments besides U.S. stocks and bonds. Consider foreign stocks and bonds, precious metals, commodities, energy, natural resources and real estate as they at times present unique 41

investment opportunities. Consider the associated with each one before investing.

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additional

risks

Chapter 8

Be Where Markets Are Over the past 200 years the U.S. stock market has gone through various cycles. Some were short, such as the 19731974 market downturn. Some were long such as the 1982-2000 technology market boom. Some were positive with good market gains; others were negative with severe losses, such as the 2000-2002 technology bubble burst, where technology stocks lost over 70% of their value. If we stayed invested in technology stocks through the entire downturn, it will be many years and perhaps my next lifetime before we would regain our losses. If we had invested in an index fund representing the Dow and held it for the period from 1965 through 1982, we would have had no net gain. For this entire eighteen-year period the Dow ended at about the same level in 1982 as where it started in 1965. In terms of the purchasing power, our money would have lost value, as the inflation rate during this period averaged 3.5% per year. Within each down market cycle there are opportunities to avoid losses and make positive gains, if we understand where that markets are and what the trend is. Often we try to either hang on during a down cycle in the hope that the cycle will reverse soon, or bail out of the market all together and miss opportunities. During the 2000-2002 downturn, the market suffered a 47% loss and technology stocks dropped by 78%. Some hung on and are still trying to recover their losses. Others accepted the reality that technology stocks had gotten extremely overpriced. They took some losses and then looked for investment opportunities in other markets. We found that many small cap stocks were undervalued relative to large cap and technology stocks, and that this appeared to be a good area for investment during the recovery period. In 2000 small cap value stocks gained a 22.83% return 43

and in 2001 they gained 14.03% when the NASDAQ lost 39.2% and 21.0%. During this period the Federal Reserve was reducing interest rates to stimulate the economy. Therefore U.S. bond funds were a good place to invest as they appreciated in value as interest rates went down. In 2000 U.S. bond funds went up 11.6%, in 2001 they went up 8.4% and in 2002 they went up 10.3 %. Another example of the risk of buying and holding through a long down cycle was the market crash of 1929. If an investor had stayed invested through the 1929 crash, it would have taken 65 years to recover the losses. Based on an analysis of the history of market returns over a long period of time, stocks are the best long-term investment when compared to alternatives such as bonds. To demonstrate this, Jeremy Siegel in Stocks for the Long Run presents the historical returns of the market for the past two hundred years. This analysis assumes that we all have a very long time horizon in which to stay fully invested in the market to recover from inevitable down market periods. As history has shown, down markets can last for a long time and be quite devastating. The long-term returns of the market have averaged about 10-12% per year; however there have been many years when returns have been negative. There have also been years when they have been in excess of 20%, such as the late 1990’s. The range of market returns from the period of 1952 through 1994 has been -27.9%, and +55.9%. If we had about fifty years before retirement, we could invest in market index funds, ride out the up and down cycles, and expect by our 70th birthday to have earned on average 1012% per year. The only risk is that we retire at seventy when the market is in an up cycle and not a down cycle. The reality is that most of us are not 30, or 40 or 50 years from needing some of our retirement funds. 44

We have recently experienced the greatest bull market in our lifetimes. It is unlikely that many of us will experience another one of similar length and magnitude. This leaves most of us with the necessity of following the market cycles, and structuring our investment strategy to take advantage of them. To maximize our potential returns and avoid major losses, we need to keep abreast of the changing global environment and move our investments as the environment and the markets change. When large cap growth stocks are overpriced, don’t hold large cap growth stocks. When small cap value stocks are under priced, buy good small cap stocks. When interest rates are in a period of long-term decline, consider buying U.S. bond funds. When the world economy is growing rapidly, consider commodities and natural resources. Sticking with an investment for a long period of time through down market cycles is a risky strategy when your time horizon to recover losses is limited. It is always easier to row with the tide than against it. Portfolio changes should be made very thoughtfully and based on long-term trends, not on a reaction to today’s drop in the Dow or the S & P 500. Most major trend changes in the economy or the world environment occur over periods of months or years, not days or weeks. Make sure the change represents a trend that has developed or is developing. As Charles Ellis puts it in Winning the Losers Game, “As an investor you must adapt to the market. The market won’t adapt to you.” Be where the market is, not where it was or where you would like it to be. This approach should increase your odds of avoiding major losses and getting positive gains.

45

Chapter 9

Don’t Follow the Crowd Robert Shiller in Irrational Exuberance explains how investors get caught up in the mass psychology of the markets and abandon rational thinking. We are reminded of this when we examine how investment decisions were made during the technology boom. As Shiller points out, investor’s behavior then was no different than in the early 1920’s before the 1929 market crash. As we look back at the 1990’s technology boom, it is hard to understand why we paid over 100 times projected earnings per share for companies that had only been in business a year or two. It is also hard to understand why we paid everincreasing amounts for shares of start-up Internet companies that had no earnings. Many new technology and Internet companies bragged about how fast they could spend cash. The executives of these companies would report not on profits but on how much they were spending on marketing and promotion. A new term ‘burn rate’ came into being as a measure of how much cash a company was spending. In Internet companies a measure of business success was how many sets of eyeballs a website could attract per day. During this time the belief was that profits did not matter anymore. This was a new era for business, or so we were led to believe as we followed the crowd. Ken Fisher, an investment manager and author has a favored expression that captures the essence of following the crowd. He says, “When everyone knows or believes something, it generally is not true”. This certainly turned out to be the case during the technology boom. Many of the things that we came to believe about technology companies and the new business era turned out not to be true. We experienced this in March of 2000 when the bubble began to burst. Ken demonstrates his point about common knowledge and crowd following by reviewing the annual forecasts of investment managers. Each year he gathers data on what 46

investment professionals around the country think the markets will do in the next year. If the majority of the investment professionals forecast that the market will go up by 6-8%, Ken believes that there is a likelihood that the market will either go down or go up much higher. Ken looks either at the minority view or at what the experts did not forecast to get the best indication of what the market will do during the next year. Ken’s track record in using this approach to predict how the market will perform has been quite good. In the majority of the years, the consensus of the professional investors has been wrong. Yet this is what most of us follow. Following the crowd is easy, as everyone is agreeing. Going against the crowd takes courage and there is often little support. Robert Shiller further explains that as mass hysteria builds, as it did in the early 1920’s, again it the late 1950’s, and in the 1990’s, business writers and analysts try to help us justify our beliefs and keep the momentum going. Do you recall all of the articles and broadcasts about the era of the 1990’s being a new and different time? During the 1990’s, there was a lot of talk about the impact the baby boom generation would have on the continued growth of the economy. This time we believed we had a new economy and had licked the business cycle. Technology was going to contribute to unprecedented growth in productivity; and our declining interest rates would continue to stimulate both personal and business spending. We even heard that profits did not matter any more. The technology boom and its benefits were changing forever the economy of the U.S. Anyone that did not invest in it would lose out. Many technology companies were forecasting growth rates of 60, 70, and 80% to continue for many years. During the technology boom, the number of families investing in the stock market grew from about 40% to about 65%. There was no way we thought that any technology investment was a bad bet. We did not want to miss out so we dove in and drove stock prices even higher. 47

Reality hit in March of 2000 when the house of cards began to fall. During this time, most of us abandoned rational thinking as we got caught up in the momentum of the crowd. We were tempted by the rewards of instant gains and feared being left out. We did not take time to analyze what was happening to the valuations of stocks we were buying. There were a few investment professionals who were saying in 1998 and 1999 that the market was over priced, the free-for-all spending could not go on forever, companies had to make a profit if they were going to survive, and the market always returns to historical valuations. A few got out of the market in 1998 and 1999 only to be severely criticized as the market continued to rise. In March of 2000 they became instant geniuses as the market began its decline. The few lone wolves in the crowd were right as rationality began to return to the market. The lesson learned from this experience is to understand what makes sense, what is rational, and what is not. Even though the market reacts somewhat irrationally every day, means that its valuation may have little to do with reality. Don’t get caught up in the hysteria of the crowd. Stick with investment fundamentals. Make your own assessment based on your investment principles and your view of the current economic environment. In the long run the fundamentals of a company and the health of the U.S. economy determine what a fair value is for a company’s stock and for the entire market. When these values get out of touch with reality, as they have for periods of time, they have always returned to fair value and reality.

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Chapter 10

Have a Plan and Stick to It As we reviewed in the introduction, there are many different ways to invest. They range from momentum investing, such as the CANSLIM system that William O’Neil developed, to index investing, asset allocation, value investing, hedge funds and many others. One common characteristic of all successful investment approaches is they have a set of rules or principles, which define how they will invest, what they will invest in, and under what conditions. William O’Neil in his book 24 Essential Lessons for Investment Success outlines the specific conditions under which a stock should be purchased and when it should be sold. When the system is followed, in certain market environments, good investment returns can be achieved, as many followers of his system have demonstrated. Ben Graham and David Dodd, in Security Analysis, present a method for determining the intrinsic value of a company, which they believe is the price at which the stock should be purchased. The fair market value then defines at what price to sell. Their method of value investing clearly defines how they invest, what they invest in, and under what conditions. Proponents of traditional asset allocation have developed models that define how an investment portfolio should be structured so that assets are invested in all the major sectors of the market, and rebalanced each year to maintain prescribed allocations. Technical analysts have built computer models that track both short-term changes in stock prices and long-term price trends. These models are used to take advantage of small changes in the price of a stock as well as determine when to be invested in the market, and when to be on the sidelines. Warren Buffet, the most successful long-term investor of our time has a strict set of criteria, which define under what 49

conditions he will buy a company for his portfolio. Often he waits years until the conditions are right. These and other approaches have worked because the investor also has an understanding of how markets act. They understand that markets are influenced by both economic trends, and irrational reactions. To effectively follow any system of investing, a good understanding of the markets, the economics of business, global trends, as well as the psychology of the market are required. The most important reason many systems of investing have worked is that they have a defined process and set of decision rules. They are documented and always followed. This unemotional and disciplined following of sound investment decision rules separates the successful investors from the rest. The investment model for decision-making might be right but if not followed all the time, the results will not be consistent. If the model is flawed, then the results will also be inconsistent. I have found approaches to investing that did not pass the test of time as they were based on specific market conditions. When the conditions changed, the system no longer delivered results. Every investment system may not be effective under all market conditions. As we have shown earlier, investing in sector stocks such as technology may have been an effective investment model to follow during the 1990’s. It has been a very poor investment model so far in the 2000’s. Changing this model to a broader sector rotation model may be a good alternative as other market sectors such as energy, transportation, and natural resources have been strong in the early 2000’s. This change might broaden the model so that it works in all markets. The model used for making investment decisions must be one that is good for all seasons and must pass the test of a number of different markets cycles. My model for investing consists of investing with good mutual fund managers, to be fully invested at all times in the appropriate investments based on the world economic and 50

political trends, to consider not only U.S. stocks and bonds but also foreign and specialty investments, to be where the markets are, to make my own informed investment decisions and not follow the crowd, and to re-evaluate the market environment and make gradual changes to my portfolio to reflect any changes in long-term trends. This is not the only way to invest. As I have shown, there are many other investment approaches. What is important is to find a defined investment process that has worked under a variety of market conditions. Make sure that it is consistent with your own individual values and stick with it all the time, not just when it seems to be working. Your individual approach to investing needs to fit who you are or you will not stick with it. I am somewhat conservative and could not be a momentum investor since I focus more on paying the right price than following a stock’s price up beyond its fair value. I also could not invest by following an event driven hedge fund strategy, as I am not a big gambler. George Soros and Julian Robertson have done extremely well using this strategy. They have often taken what appeared to me as great risks and have gotten great rewards much of the time. Develop an investment plan and stick with it. Good investing takes knowledge of the markets, discipline, patience and often courage. If you do not have an investment plan, find an independent investment advisor who has an investment approach that you can understand and are comfortable with. He will make sure that you stick with the plan and help prevent you from making emotional investment decisions or following the crowd. It may be difficult to find independent investment advisors, as many are associated with selling a particular investment product, which can color their view and limit your investment options. Remember that every investment approach must define how you will make investment decisions, what you will invest in, and under what conditions.

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Chapter 11

Issues and Outlook for U.S. Economy As part of my investment process I review each year the major issues and trends facing the U.S. and the world, and access how they might affect the investment environment over the next few years. I believe that long-term investment returns are impacted by major world economic and political trends. A review of the investment environment is like looking at a long-range weather forecast. They both help prepare us for the upcoming season. I see a number of major issues facing the U.S. as well as trends in the world that should be considered when making investment decisions. I will cover some of the significant ones that might influence investment decisions for 2005 through 2008. Aging Population and Declining Workforce Harry Dent, in The Next Great Bubble Boom, presents projections for the retirement age population and the number of entrants into the work force. In 2005 there will be 3.5 million Americans reaching retirement age. This compares to an average of 2.6 to 3.25 million per year for the period 1988-1995. This increase is occurring at a time when the number of new entrants into the work force is declining. During the 1980’s there were 2.5 million new entrants to the work force each year. In 2005 there will be 2.0 million. Over the next twenty years the projections are:

2005 2009 2015 2020

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Reaching Retirement Age (Per Year)

New Work Force Entrants (Per Year)

3.5 million 4.25 million 4.5 million 5.0 million

2.0 million 1.0 million 750,000 350,000

By the year 2050, 26% of the U.S. population will be over the age of 65, compared to 16.3% in 2004. Japan’s retirement aged population will increase from 23.9% in 2004 to 44.7% by 2040, Germany’s from 23.5% to 37.4%, and Canada’s from 17.0% to 33.3%. In 1950 there were 16 wage earners for each social security recipient. In 2003 that dropped to 3.3, and by 2033 it is projected to drop to only two workers per retiree. In the entire developed world in 2004 there were 100 workers for every 30 retirees. In 2040 it is projected to be 70. In the U.S. by 2030 28% of the GDP will be required to support retiree benefits, and by 2050 46%. In all of Europe the percent of GDP spent on elderly benefits will go from 15% in 2004 to 30% in 2040. These demographic trends will limit the investment opportunities in most developed countries as a higher percentage of each country’s GDP will be required to support elderly benefits. Fewer financial resources will be available for business development and other investments. Of particular concern in the U.S. is consumers generate 65-70% of GDP. If there is less for consumers to spend, then growth opportunities will be limited. This trend could limit potential investment opportunities in the U.S. stock market. In developing countries the trends are the opposite. In China, 69% of the population is under 40. In South Korea 65%, and in Indonesia 74%. These counties will not only be growing their work forces over the next 20-30 years, but they will also be growing their internal markets. Developing countries could present future investment opportunities as their economies grow and their political and banking systems stabilize. Growing Federal Budget Deficit In the fourth quarter of 2004 the U.S. Congress authorized an increase in the budget deficit of $800 billion, increasing it to a record $8.2 trillion dollars. In 2004 the $568 billion dollar budget deficit represented 4.2% of GDP. This 53

means our U.S. government spent $1.9 billion more than it took in each day. There were a number of reasons for the deficit in 2004, including funding the wars in Iraq and Afghanistan, fighting the war on terror, and an earlier tax cut to stimulate the economy. One of the current risks of a high government budget deficit is that foreign governments and foreign investors are financing it. In 2004 foreign individuals, foreign financial institutions, and foreign governments held 43% of all U. S. Treasuries. If foreign investors found other investments that were more attractive, it could cause a sell-off of U.S. Treasuries, forcing interest rates higher. This has been of particular concern in the past few years when the U.S. dollar has been declining in value against major world currencies. Continuing high government budget deficits can have harmful effects on the economy. During the 1920’s excessive government debt from funding the First World War coupled with excess consumer and corporate debt, contributed to the market crash in 1929 and the recession that followed. It also led to a devaluation of the U.S. dollar in 1933. If we do not get our governmental financial house in order and continue to overspend, our economy will suffer, and we need to be aware of this in our investment decisions. Increasing Personal Debt The U.S. has changed from a nation of savers in the 1960’s and 1970’s to a nation of spenders in the 1980’s and 1990s, to a nation of super spenders and borrowers in the 2000’s. In 1962 the personal savings rate was 8% of income. In 2004 it was 0.2%. In the 1960s total savings represented 7.5% of GDP. Since 2000 it has been 1-2% and declining each year. In 2004 U.S. household debt, which is the total debt of all households, hit $9.7 trillion dollars, up 39% from 2000. 54

During the ten year period from 1993-2003 consumer debt grew by 140%, while GDP grew by 70%. Since 2000 mortgage debt increased by $2.65 trillion or 42%. Fortunately during much of this period interest rates were decreasing to their lowest level in 50 years. With the lack of individual savings, money is not being reinvested in the economy to provide business growth for the future, limiting growth potential for many U.S. companies. As interest rates increase, as they have recently, consumers will be forced to spend more of their income on servicing their debt and have less income for other purchases. During 2003 and 2004 record numbers of homeowners refinanced with adjustable rate mortgages. Their monthly mortgage payments will begin to increase as interest rates rise. Overspending by the consumer can continue for a long time, as it has already, but not indefinitely. Consumers cannot spend all their income on debt interest. In 2004 it took 14% of personal income just to pay debt interest. At some point consumer debt may cause the economy to slow, and therefore limit investment opportunities. Growing Foreign Trade Imbalances Not only are consumers spending more than they earn each year, but more of what they buy comes from foreign countries. Our appetite for low cost foreign goods is causing an ever-increasing foreign trade deficit. In 2004 the foreign trade deficit was about 6% of GDP. This is double what it was in 1986, the last peak before the revaluation of the U.S. dollar. Individual foreign investors, foreign central banks and foreign governments are increasingly financing a higher percentage of our total debt and our balance of trade deficit. In 2004 with China and Japan alone, our trade deficit was in excess of $500 billion. If our current rates of consumption continue, the balance of trade deficit could reach $825 billion by 2006.

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In 2004, foreign investors held 43% of all U.S. Treasuries, 25% of all corporate debt, and 12% of all U.S. equities. Balance of trade deficits and budget deficits are putting a higher and higher percentage of total world savings in the U.S. It now takes about 80% of the world’s total savings to finance the balance of payments deficit. This severely limits the ability of the U.S. to continue to increase its net imports without a corresponding increase in exports. In 1980 the U.S. was the largest creditor nation in the world, with a $360 billion trade surplus. In 2004 our total foreign account deficit was $2.7 trillion. Over the past several years U.S. exports have remained steady at 5% of total GDP while imports have increased to 15%. This puts increasing pressure on interest rates in the U.S. as foreign investors seek to maximize their investment returns. If foreign governments and investors would decide to reduce their total investment in the U.S., this could drive up U.S. interest rates and slow the U.S. economy. Declining Value of the U.S. Dollar In the past few years, as our balance of payments deficit increased, the U.S. dollar has lost value relative to other world currencies. From 2002 through 2004 the dollar declined by about 30% relative to world currencies. The last time the U.S. faced severe trade imbalances and budget deficits was in 1984. As a result, by 1987 the U.S. dollar had lost about 50% of its value. As the U.S. dollar loses value against foreign currencies, U.S. investments become less attractive to foreign countries, and we as Americans loose much of our purchasing power when buying foreign goods. This can lead to higher costs for imported goods and inflation. Until the U.S. can reduce its trade deficit, the U.S. economy is at risk of higher interest rates, higher costs of foreign goods, lower foreign investments, and inflation. Increasing Cost Inflation 56

Since the mid 1980’s inflation in the U.S. has ranged from 1.5-2.5% per year. 2004 brought some concerning signs that future inflation rates might be higher. The cost of health care continues to increase each year at rates much greater than general inflation. Energy costs, led by the cost of crude oil, is a long-term threat as the world’s demand is growing and supply declining. Demand is now accelerating by the industrialization of China. China is now a net importer of oil, and in 2004 consumed 5% of the world’s supply. China also consumes over one-third of the world’s coal. Many commodity prices also saw sharp increases in 2004, as supplies are outstripping demand. This is also being fueled by increased worldwide industrialization. China now consumes 25.5% of the world’s aluminum, 40% of the world’s steel, 30% of the world’s iron, 32% of the world’s coal, and 50% of the world’s cement. As China continues to grow at 8-10% a year, costs for major industrial commodities will continue to rise and shortages will continue. In 2004 the price of copper increased by 78.5%, natural gas by 10.2%, and platinum by 38.4%. Since the 2003 economic recovery, costs of services in the U.S. have also begun to increase. If the dollar continues to decrease in value, many of the imported products that we have come to rely on in the U.S. will also increase. Increasing interest rates will also put pressure on costs. These are some of the forces that are putting pressure on rising costs. Higher inflation rates will change the investment environment, and need to be watched over the next several years. Rising Interest Rates 57

The current Federal Reserve policy to increase interest rates, started in June 2004, could slow the economy as the cost of borrowing increases for government, business, and the consumer. The balance of trades deficit and the decline in the value of the U.S. dollar puts pressure on the U.S. to increase interest rates to continue to attract foreign investment. Slowing Corporate Profit Growth Corporate profits have grown at double-digit rates since the third quarter of 2003. This helped to fuel the recovery in the market in 2003 and 2004. During the second half of 2004, profit growth began to slow and is projected to slow further during 2005. U.S. corporate profit growth will decrease from 15% in the fourth quarter of 2004 to about 8% during the first half of 2005. In real dollar terms, total corporate profits peaked in 1997 at $508.4 billion and were expected to be at $448.8 billion in 2004. The long-term trend for total corporate profits has been down to flat since the recession of 2000. The growth in 2003 and 2004 is primarily a result of the recovery from the 2000-2002 recession. With increasing cost pressures, rising interest rates, the falling value of the U.S. dollar, and higher consumer debt, it is unlikely that double-digit rates of corporate profit growth will continue. There has also been a decline in capital investments in the U.S. This may reduce the rate of productivity increase we experienced in the 1990’s, further limiting corporate profit growth. Collectively, these factors will have a dampening effect on the growth of U.S. profits over the next several years and therefore, limit opportunities in the U.S. stock market. Slowing Growth and Stagnant Economy

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Since consumers drive 65-70% of the U.S. economy, if consumers are not increasing their purchases each year, the economy’s growth is limited. Over the next several years the consumer may not be in a good position to fuel the economy to exceptional growth. Consumer debt is at an all time high, and debt service is becoming an increasing percentage of consumer disposable income. Interest rates are on the rise. 35% of the mortgages are adjustable rate. As interest rates increase, monthly mortgage payments also increase for many homeowners. Growth in wages is still somewhat depressed. Costs of energy, healthcare, and other necessities are increasing at rates greater than income growth. If the value of the U.S. dollar continues to decline, the costs of imported foreign goods could increase significantly. Job creation remains below levels required to both employ new work force entrants and reduce the level of unemployment. With the federal government deficit building, it is unlikely that any new fiscal stimulus will be forthcoming. These issues in aggregate suggest that the U.S. economy will struggle to grow at any significant rate over the next several years, thus limiting the opportunity for U.S. companies to grow in sales and profitability. Overvalued U.S. Stock Market The valuation of the U.S. stock market, as measured by the P/E ratio of all the companies in the S & P 500 at the end of 2004, was 19.8. This compares to 26.7 at the end of 2003. The improvement during 2004 was the result of profit growth for the year in excess of 20%, much of which occurred in the first two quarters. During 2004 the S & P 500 increased by 9%, which helped the P/E ratio valuation improve. During 2004 the U.S. stock market moved towards becoming more fairly valued. Even though the aggregate price to earnings ratio declined in 2004, it is still at the upper end of historical ranges. Looking at the historical data over the past 100 years, the average P/E ratio has been 15. The upper end of the range has 59

been 21-22, which has only been exceeded twice, once prior to the 1929 crash and in 2000 before the bursting of the technology bubble. The low end of the range has been 8-11. Historically most bull market cycles started when the market P/E ratio was at or near the low end of the range when the P/E ratio reaches the high end of the range it generally corrects through several downturns, as it did in 1929 and through the 1930’s, to the low end of the range. As we are still at the high end of the range, and the prospects for significant growth in corporate profits is unlikely, the risk is that the market may continue to correct to the range of more historical valuations, over the next several years. There may, therefore, be less opportunity for growth stocks in the U.S. and low valuation stocks may be a bit more difficult to find. Summary As we have seen from above discussion of the major issues facing both the U.S. and the world, the overall environment over the near terms is not one that is conducive to high growth for U.S. stocks. Until some of these issues are resolved in a positive way it will be difficult for most U.S. companies to grow at rates that would support strong growth in the U.S. stock market. It will also be difficult to find many currently under priced stocks. Caution should, therefore, be exercised when making investment decisions in U.S. stocks. With the current interest rate environment in the U.S., and the unfavorable balance of trade, it will also be risky to invest in U.S. bonds. Over the next several years, investment opportunities appear to be better in both foreign markets and alternative investments.

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Chapter 12

Outlook for U.S. Stocks There are many interrelated factors that affect the U.S. market and what investors are willing to pay for stocks. Some factors are rational, such as the economy and world trends, and others are less rational such as investor sentiment. This is why it is so difficult to predict short-term changes in the market. Predictions can often be counter to what should happen based on facts and trends. On the rational side, we have identified several longterm economic trends and issues that will impact the U.S. economy, future corporate growth, and profits. In the long run, as history has shown, stock values and the value of the stock market as a whole are based on current profits, the outlook for future profits, investment risks, and a fair valuation. The U.S. stock market is currently overvalued. As pointed out in the previous chapter, high growth in corporate profits over the next several years is unlikely. Therefore, it is doubtful that profit growth alone will reduce current high P/E levels. Issues such as governmental, U.S. economic, demographic, and world, will limit potential growth. Major governmental issues include an increasing budget deficit, the costs of the war on terror, increasing social costs, increasing dependence on foreign energy, rising interest rates, an increasing trade deficit, and the declining value of the U.S. dollar. Major demographic issues include an aging population and shrinking work force. Coupled with increasing consumer debt, lack of savings, rising interest rates, and rising inflation, there may be limited opportunity for continued high consumer spending and limited resources for future business growth and development. Major world issues include the rise of terrorism, the industrialization of China and other countries, the increasing 61

demand for energy and other commodities, and the increasing level of U.S. debt held by foreign countries. Until we see positive progress on issues such as the budget deficit, consumer spending, and the unfavorable balance of trade, it would be difficult to argue that the U.S. economy will grow at rates required for significant market returns. As the daily stock market goes up and down based somewhat on emotional reactions, we may go through periods of optimism, which could drive the market higher in the near term. In the long run, however, as history reminds us, the price of stocks is based on rational fair market valuation. I therefore, see quite a bit of risk in the U.S. stock market for the next several years. The most likely trend for the market is a long-term secular bear market. It could last from eight to twelve years as some past bear markets have, but would likely include periods of bull market advances. In its mild form it could be similar to 1965-1982 when the market was flat from end to end, but had some ups and downs in between. It is also likely, given the U.S. and world issues; there could be a major market correction within the next several years. It is unlikely that a period such as 1982-2000, with double-digit returns, will reoccur for some time, as the market is currently overvalued and a high growth economy is unlikely. The major difference between today’s investment environment and the 1990’s is there is more risk and uncertainty. It is therefore, imperative to preserving and growing your financial assets that you pay continued close attention to the global environment. Be nimble and stick to your investment principles. Be vigilant to changes in the environment.

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Chapter 13

Investment Strategy Given the current investment environment with the issues facing both the U.S. and world, an appropriate investment strategy should include the following: 1. In the U.S., focus on undervalued stocks as the market is overvalued in aggregate, and growth opportunities appear limited. Value stocks provide a margin of safety that could minimize losses during a down market and offer some growth opportunity in an up market. Stock selection is extremely important in an overvalued and slow growth market, so pick the best mutual fund managers. 2. Look beyond U.S. stocks and bonds for investment opportunities. With the risk of continuing decline in the value of the U.S. dollar and the growth of developing economies in Asia, Eastern Europe and other areas around the world, both foreign stocks and bonds offer the potential for better returns. The offsetting risk is that many foreign economies are dependant on exports to the U.S. and a slow down in the U.S. economy could also affect other foreign economies. Selection of the country and the company are extremely important as well as keeping up to date on the developments in each country. Use seasoned foreign investment managers to minimize risks. 3. Include commodities and natural resources in your portfolio. With the industrialization of China, India and Eastern Europe, the world’s capacity and supply of oil, coal, natural gas, copper, timber, and other essential commodities is less than projected long-term demand.

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In 2004 there were significant price increases in a number of commodities, lead by energy. Until supply catches up with demand or alternatives are found, prices will continue their upward trend. If the world economy slows, commodity prices will decline but most likely only temporarily. 4. Minimize investment costs. In the next several years’ double-digit returns are unlikely. It is therefore important to minimize the cost of investing. Avoid high brokerage fees, and loads on mutual funds. Use low cost on-line brokerages. Every dollar of cost avoided in investment fees is another dollar invested. 5. Invest with the best fund managers within each investment category. Now is the time to count on the experienced mutual fund managers who have been successful in both up and down markets, and who have the investor’s interest above their own. 6. Be in the right markets at the right times to minimize risk of loss and maximize gains. This is not the time to buy and hold investments. To gain consistent positive returns pay closer attention to where the opportunities are and what areas to avoid. As these change, change your investments. During these times it is important to have an independent advisor that understands the markets and can guide you to the areas that offer the best promise. Now is not the time to entrust your financial assets to those who represent a financial product that may color their objectivity or limit investment options. There is a risk, given the current environment, that there may be a downturn in the U.S. stock market within the next several years so asset protection and risk avoidance should be in the forefront.

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Chapter 14

Investment Opportunities Given the environment for the U.S. stock market over the next several years, I see investment opportunities in the following areas: 1. U.S. small and mid-cap value stocks currently present the best opportunities for growth in what will likely be a sideways to down market over the next several years. In slow growth markets, small and mid-cap stocks have performed better than large caps. Smaller companies focused on specific markets can grow at rates greater than the general economy. Large companies tend to grow at the growth rate of the economy. In the current market environment, it is risky to pay high prices for stocks, as we are not in a growth environment and need the margin of safety as protection against downturns. A no-load small or madcap value fund, a small or madcap value index fund or a small or madcap ETF would be appropriate investment vehicles. 2. Commodities and natural resources present growth opportunities, as worldwide demand will outrun supply for some time. The risks are volatility, as they tend to go up and down in large moves. If the growth of the world economy slows for a time, as it might, there could be a sudden temporary drop in commodity prices. They need to be watched closely. Gold has been attractive in the past few years due to political unrest in the world and the decline in the value of the U.S. dollar. Gold and precious metals are high-risk investments as they often change course quickly and dramatically. Investments in any of these areas can be made through no-load mutual funds, index funds or ETF’s. 65

3. Real Return U.S. Bonds. With the threats of inflation and the rising interest rate environment, the best way to invest in U.S. bonds is through TIP’s or Treasury Inflation Protected Bonds, which pay the appropriate U.S. Treasury interest rate and are indexed for inflation. They are available through a number of no-load mutual funds or through direct purchase from the U.S. Government. 4. Foreign Stocks. With the declining value of the U.S. dollar relative to other currencies, and with higher growth rates in developing countries, foreign stocks appear to offer some opportunity for investment growth. Stocks of some foreign counties are selling for lower valuations than the U.S. A value approach should be taken in this area, as there are additional political and currency risks. Foreign emerging market countries such as Russia performed well in 2003 and 2004 and could provide future opportunity, but carry additional risk. A number of no-load mutual funds, index funds and ETF’s are available in this investment area. 5. Foreign Bonds. With higher interest rates offered by some countries, foreign bonds offer the potential of higher returns than U.S. bonds. The decline of the dollar helped returns in 2003 and 2004. Political and currency risks need to be considered. 6. Real Estate. Over the past five years real estate has been one of the few asset classes that has shown consistent double-digit returns. Some experts say that we now have a lot of overpriced real estate and the bubble will burst, sending prices down. This could occur with a downturn in the U.S. economy. However, commercial real estate could still provide an opportunity for gains. They can be invested in through either no-load mutual funds, real estate development company stocks, Real Estate Investment Trusts (REITs) or ETF’s. 66

Summary In this book I have shared with you an approach to investing that I have developed over the last twenty years both by trial and error, and by studying some of the brightest and most successful investors. There are many different approaches to investing. All have a set of principles and the discipline they stick with even when the market and outside pressures try to sway them in other directions. There are some approaches that are more effective in certain market environments than others. As an example, momentum investing is more effective in rising markets, and value investing is more effective in flat or declining markets. My approach to investing is based on value principles and considers major trends in the U.S. and world economies that may impact specific investments. I invest in those markets that offer the best current opportunities. With investment reviews twice per year, I keep my investments current with the changing environment. My investment principles define how I will invest, and the current environment defines what I will invest in and when. We are facing some very challenging times in the new century of the 2000’s. Consistent investment returns are going to be more difficult to achieve than in the 1990’s. It will take a disciplined approach as well as a continual awareness of the outside world to win. I have written this book for the individual investor and encourage each of you to either develop a set of investment principles and the discipline to follow them, or find someone that shares your investment philosophy that can help keep you on track. If there are any questions about investing that I can help answer, contact me through our website at thevogusgroup.com. We are here to help you in your journey through the treacherous waters of investing. I hope this book has been helpful. 67

Recommended Reading I would encourage you to explore different views on investing. Some of the books that I have found insightful include: Title

Author

Beating the Street

Peter Lynch

Common Sense on Mutual Funds

John Bogle

The Essential Buffet

Robert G. Hagstrom

What Works on Wall Street

James P. O’Shaughnessy

Irrational Exuberance

Robert J. Shiller

The Next Great Bubble Boom

Harry S. Dent, Jr.

Winning the Loser’s Game

Charles D. Ellis

Stocks for the Long Run

Jeremy J. Siegel

24 Essential Lessons for Investment Success

William J. O’Neil

Bull’s Eye Investing

John Mauldin

Security Analysis

Benjamin Graham and David Dodd

Financial Reckoning Day

William Bonner with Addison Wiggin

Soros – The Life, Times & Trading Secrets

Robert Slater

Prudent Speculator

Al Frank

Yes, You Can Time The Market!

Ben Stein and Phil DeMuth

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