Market Watch - February 2005

Can We Make Money In This Market?

In order to look ahead, let’s review the past. And let’s bear in mind the prophetic quote of General Douglas MacArthur that “The economic history of the world will be written in the Far East the next 100 years”.

Yes! But we have to be very disciplined in our investment approach, and we have to be aware of 4 simple principles. We also have to be aware that there are only two types of investors: those who buy value priced investments, and everybody else. The value-oriented investors will adhere to these simple rules:

1)		Never risk principal.
2)		Don’t be greedy.
3)		Respect the time value of money.
4)		Limit your choices.

Never risk principal- Principal is hard to come by, so it should be invested conservatively. High yield, low risk investments in A rated stocks and bonds provide opportunities to both preserve your capital and make a few bucks. Always buy dividend-paying stocks. Investments in high risk, non-dividend paying securities should be limited to a small percentage of an investor’s portfolio. Investments in A rated stocks that have low price earnings ratios (14 or below), that pay a good yield (above 4%), insure a nice stream of dividend income in the event the stock does not appreciate quickly. Over the long-term, however, not only do dividends tend to increase in companies that are committed to sharing their earnings with investors, but those stocks usually increase in price. To some extent, dividend paying stocks have a floor, below which they will not sell, simply because the yield (dividend) will tend to keep the stock at price levels close to market yields on bonds and other money market instruments. Companies that have a history of increasing dividends over time tend to do well over a long period of time. Almost 50% of return on stocks over our lifetime has been from dividends.

Don’t be greedy- Greed is one of the seven deadly sins that we participate in without realizing what we are doing. It is normal to want to make a killing in the market. On the other hand, if we are disciplined and purchase A rated, high dividend paying stocks, and if we are patient, those stocks, bought correctly, over a period of time will out perform the non-dividend paying, or low dividend paying, high price earnings ratio stocks. If our broker is saying that 20% annual returns are de rigueur, it’s unlikely we will obtain that 20% unless we are buying stocks at value prices. Otherwise, other smart investors would gobble up all available 20% returns. That increase in demand for those stocks would increase the price of the security to the point where 20% returns would no longer be possible. It’s instructional to remember that the long-term historical return on stocks in this country is just under 11% annually, and that’s including dividends.

Respect the time value of money- Look at the chart that shows what a compounded investment of $10,000 will yield in terms of total value at different interest rates.

COMPOUNDING TABLES
($10,000 INVESTMENT COMPOUNDED ANNUALLY)(dollars)

The 10% column represents the average investor (which means many people fall below and above the 10 %), and the 20% column represents Warren Buffet type returns. If one needs income, one cannot compound. But if one does not need income, compounding is, indeed, the road to riches. $10,000 invested in the Dow Jones 30 Industrials 50 years ago would be worth more than $350,000 today. The dividend yield on that investment would have grown from $390 a year to more than $7,500 annually today.

Limit your choices- Stay away from illiquid investments, limited partnerships, commodities, straddles, puts and calls, options and hedge funds. Options can be used to lock in profits, and from that point of view can be useful. However, most options go unexercised.

What aids are there to help us in our decision making process?

We could break services available to investors into two different categories: (1) those
services that are available from, and/or influenced by, stock brokerage firms and (2) those services that are completely independent of the influence of brokerage firms and financial institutions who benefit from the purchase or sale of stocks and bonds. Mainstream publications like the Wall Street Journal, Fortune Magazine, Business Week, and so forth, including CNBC, and programs like that, are all financed by and beholden to brokers or other financial institutions whose advice is mostly designed to make money for those institutions. While most of them are honest, they all have paid huge fines the last few years, pointing out that even honest institutions allow self interest to interfere with sound investment advice. On the other hand, there is a cadre of publications available for interested investors. Dow Theory Letters (www.dowtheroryletters.com) provides a daily market summery and a newsletter every 3 weeks that is an excellent analyses of market conditions. Dow Theory Letters is the oldest, most independent review of the market available today. Value oriented investors can use a publication called IQ Trends (www.iqtrends.com). IQ Trends is also an independent, old publication started by Geraldine Weiss whose theory is DIVIDENDS DON’T LIE. Mrs. Weiss follows 350 of the best-capitalized, most secure stocks in the US. She has broken stock analysis into undervalued stocks (buying area), rising stocks (still a value but getting to be less so), and overvalued stocks (do not buy). This service is available twice a month, either online or through the mail. Those two publications will provide investors with much of what they need to know to cut their risk and make money in the stock market. If ordering IQ Trends, be sure to get the complimentary book published by Mrs. Weiss that points out why dividends are so important entitled The Dividend Prescription.

While the above two publications will provide entree into other things to read, there are other bedrock publications which are independent and can help us in understanding the macroeconomics of investments in today’s rapidly changing economic climate. The American Institute for Economic Research (www.aier.org) publishes an “Economic Education Bulletin” every month. It’s excellent and only $25 a year. Adrian Van Eck has several monthly publications, but only one is a monthly economic publication, Money-Forecast Letter (1-800-542-5018). One classic book stands out written by deceased Columbia Professor Benjamin Graham called The Intelligent Investor. The authors’ website, www.gwrauch.com, has posted several articles that can answer investment questions common to all of us. Finally, Value Line has a service (www.valueline.com) called Value Line Investment Survey 3.0 that is free for 30 days and follows all of the major listed U.S. companies.

Remember that over a period of time, the average dividend yield of the Dow Jones 30 Industrials is 4.3% which means that $4.30 is paid out for every $100 invested. The average price earnings ratio from 1920 to the present is 14.4 times earnings. If we discipline ourselves to buy only A rated stocks that are at or below 14.4 times earnings and that provide a minimum yield of 4.3%, the odds of making money in this market increase dramatically.

The stock market has a high and low annual variance in excess of 20%. During each year, stocks have their own patterns of high and low prices. Buy them using the above formula when they are selling at their lows. Hold them and collect dividends (or choose the dividend reinvestment plan, which is compounding) and just hang on. If they have a favorable price move, and they obtain pricing far in excess of historic price earnings ratios, then they will be selling at a yield of less then 4.3%. The more active investor might consider selling that stock and finding a new one. Other investors, who are compounding their dividends by reinvesting them in that same stock, may choose to simply hold on. Either method works. Both methods are at the heart of the philosophy of investing hero Warren Buffet.

Conclusion

In summary, this is not a market that will rise with the tide. In fact, the market is way over priced to the point where historic information indicates that money will not be made in the stock market over the next ten years.

Therefore, while the odds are against us, there’s a glimmer of hope, and always an opportunity, in every market. These opportunities will not be brought to you by most stockbrokers. You must rely upon yourself and your own research, which you could double-check with your broker, and their research department. Any method of investing in these markets that is not highly structured and disciplined, however, puts the investor in position to lose money.

Always remember, though, that there is nothing wrong with cash. That measly 3% to 5% return on cash beats losing money in this overpriced market.

Caveat Emptor!
George Rauch
February 1, 2005