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THE SAFARIMAN’S GUIDE TO INVESTING

By

Alfred J. Lockwood, CPA, CFA

September 2008

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Alligator Investing’s Mission

Alligator Investing’s mission is to provide investors with a basic, common-sense

knowledge to approach investing in stocks, and to enable them to acquire long-term

wealth at a controlled level of risk.

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INTRODUCTION

For over the past two decades, I have spent my career analyzing businesses. I started as

an auditor in public accounting, spending a good deal of time picking apart many types of

businesses. Some were successful; others were not. It was interesting seeing different

companies and gaining an understanding of not just business, but why some companies

thrived while others failed. I also gained a further appreciation of accounting, not just as

a reporting mechanism, but also as a tool used by a company’s management to assist

them in evaluating business decisions and in measuring the success of those decisions. It

was also a valuable experience to interact with the various company management teams.

How well did they understand their markets? How focused were they on exploiting their

opportunities? How responsive were they to changes in the business climate? How good

were they at deploying company resources in order to maximize their profit potential?

Generally, the better the management team was at addressing those questions, the more

success the company achieved.

I left public accounting to pursue a career in investing, spending the last fifteen years

analyzing stocks and managing equity portfolios. Portfolio management further

enhanced my understanding and appreciation of accounting, finance and economics, and

how they are invaluable tools to the wealth building endeavor of investing. While that

may not seem like a long period, the past fifteen years have been quite dynamic. During

this period, the stock market experienced the greatest bull market since the roaring

twenties, and the largest bear market since the great depression. The market had to cope

with fears of both inflation and deflation, a rising and falling U.S. dollar, a war on

terrorism, as well as the inflating and bursting of the technology bubble that triggered at

business recession. This period also witnessed the collapse of Long-Term Capital

Management, a hedge fund run by Nobel Prize winning economists. The market was

shaken by some of the largest corporate frauds and scandals ever seen, including Enron,

Tyco, and WorldCom. Once formerly respected moguls of business were sent to prison

for longer terms than many murderers receive. Now the United States is sorting through

a housing bubble and a subprime debt and banking credit crisis; the worst debt crisis

since the junk bond debacle of the 1980’s. The jury is still out on how these problems

will be resolved, but rest assured that they will.

The U.S. stock market has survived two world wars, the Great Depression, the 1970’s oil

embargo, multiple recessions, and it will continue to survive anything the world can

throw at it. Not only has it survived, the stock market has thrived. Over the twentieth

century, the U.S. stock market returned 10.3 % to investors. One thousand dollars

invested in 1900 would have grown to over eighteen million dollars by the turn of the

twenty-first century. Despite getting off to a slow start, this century should be equally

rewarding.

The investor’s job is to participate in the stock market and to maximize opportunities

without taking unreasonable risks. Investors don’t need to be certified public

accountants, financial analysts or have a masters degree in mathematics, but they do need

some basic math skills (six grade math is sufficient), common sense, and some guidelines

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to follow. They also need to spend some time monitoring their investments and

investment programs. Ultimately, every individual is responsible for his/her retirement

savings. If you are one of the lucky few to have a corporate or government sponsored

pension, that’s great! But that still may not be enough. Should anyone strictly rely on a

corporate pension? Look what happened to the unfortunate flight attendants when the

airlines filed for bankruptcy, or to the partners at Arthur Anderson & Company who lost

everything when a lawsuit put them out of business, or the employees at Enron who had

all their savings in Enron stock, just to see it disappear. Investing is a certainly not a

riskless proposition, but by spending just a little time, anyone can make sound investment

decisions. If you prefer to use an advisor to handle your retirement program, effort is still

required to assure you are getting good advice. Use a policy of “Trust with Verification.”

Not all advisors have their client’s best interest in mind. Many advisors are pushing

overpriced products that they are told to sell by their employers. If you are not getting

value for your money, then you are losing not only the fees you are paying, but also the

lost returns from being in an inferior investment program. Chapter 3 illustrates how just

small changes in annual returns have huge impacts on future savings.

Investors today have a big advantage over those of 100 years ago. That advantage is

access. It has only been in the last few decades that stock investing has become more

accessible by the general public. Over a hundred years ago, the stock market was

considered primarily for the privileged and wealthy. Information was not readily

available on public companies. Indeed, regular quarterly and annual public financial

filings were not even required until the Securities Act of 1934. Brokers were people who

barely qualified as professionals and were not necessarily considered the trust worthiest

people. Commission rates were exorbitant and kept small investors out of the market as

the trading costs were prohibitive. Regulation of the industry was also in its infancy and

risk controls were inadequate. Mutual funds were invented in the early 1920’s and were

embraced by middle-class families even back then, but it wasn’t until the Investment

Company Act of 1940 that disclosure rules and requirements were better defined.

The age of technology brought investing to the masses. The automation of formerly

manual processes reduced the cost of investing. Additionally as technology prices

continued to decline and computing power steadily improved, the cost of investing

declined in lock step. The reduction in costs means that investors get to keep more of

their money versus paying it to brokerage firms for commissions and account fees. Prior

to 1990, it was not uncommon for brokers to charge rates of 50 cents a share or more,

plus minimum trade charges of $75 or more if they couldn’t trade enough shares. Not

only that, you had to talk to a broker! Charles Schwab was one of the original discount

brokerage pioneers who recognized that many (if not most) brokers were nothing more

than order takers and added little value (if any) to their client’s investment needs. With

that in mind, he used technology as a platform to offer discounted brokerage to the

general public. Although advice is not a commodity, trading is. And to charge extra for

mere trade execution made no sense to him. The public agreed, and today Charles

Schwab and Co. remains one of the premier discount brokerage firms.

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Today, the individual investor can trade 1,000 shares or more at a time for less than ten

dollars per trade. Ten dollars may not seem like much, but it adds up to a small fortune

over time. Assume the average investor makes two trades a month … one buy and one

sell. Assuming the commission savings per trade is fifty dollars, that would amount to

$1,200 per year. Investing that $1,200 into the stock market over twenty years at an

average return of ten percent would compound to $68,730. Thank technological

advancement for making these savings possible.

The other main benefit that technology has brought is access to information. This rapidly

accelerated with the spread of the Internet. Prior to the Securities Act of 1934,

companies whose stock traded in the public market were not required to make annual 10-

K and quarterly 10-Q filings. Even after this requirement, the individual investor had to

call the company to request a copy of the filings. Other news could be obtained from

reading the daily newspaper, magazines, or other traditional sources most of which

required a subscription. The Internet has changed the landscape dramatically.

Information today is vastly more abundant and only a mouse click away. Not only are

the required regulatory filings available online, recent news and events are available and

sorted by company. Sifting through the Wall Street Journal or other publications to find

information is no longer necessary. Simply go online and search for company news at

one of many financial websites. Much of the information the individual investor had to

pay for can now be obtained for free, such as earnings estimates and changes in

estimates. The passing of fair disclosure requirements by Congress in 2002 also means

that public companies who host quarterly earnings conference calls and investor days for

professional analysts must make these events available to the general public. For the

price of a broadband Internet connection, anyone can now participate from the privacy of

their own home. If a person can’t listen live because they are busy at work, on vacation,

or otherwise occupied, don’t worry. Most of these calls are available for replay at the

investor’s convenience. Thanks to technology, it has never been so easy to get

investment information, and the situation is more than likely to keep improving.

Although mutual funds and ETF’s (exchanged traded funds) have been around for

decades, technology has also greatly benefited these investment instruments. Again, the

processing and trading costs involved to manage mutual funds has declined. These lower

costs get passed down to investors in the form of lower fees. In the case of index funds

(funds that simply mirror popular indexes such as the Standard & Poor’s 500 Index),

costs are even lower because an index fund does not have to pay the expensive research

staff salaries and bonuses that actively managed funds pay. Not only that, but most

actively managed funds perform worse than the index they are trying to beat. That brings

us back to the information benefit. Today an investor who wants to know how their

actively managed mutual fund is performing can simply go online and compare the

fund’s performance to the benchmark index and a group of funds that are similar in style.

The investor can also keep track of changes in portfolio managers, get updates on current

holdings and changes in holdings, as well as other important information on the fund.

So what is the point of Alligator Investing? It is simply that investing should not be a

mystery or an unwanted chore, but an everyday part of life. It is a common sense

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approach to investing for the long-term that is rooted in sound principals and concepts.

Its objective is to help the individual investor increase real wealth over time. Keep in

mind that stocks will periodically decline as part of the normal investing cycle; but as

time progresses, the risk of losing money diminishes. Alligator Investing can be applied

to investing in individual stocks, mutual funds and ETFs. The chapters that follow will

detail the fundamentals of Alligator Investing and their application to investment

programs.

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CHAPTER 1: THE WAY OF THE ALLIGATOR

What do alligators have to with investing in public companies? Stepping back and

comparing alligators with companies helps discover that they actually have quite a bit in

common. Both alligators and companies have to function within their environments. For

alligators it is the swamp; and for companies, it is the economy. Both are fighting for

survival as they struggle to dominate their territories. They compete against others for

resources. Alligators are competing with other alligators as well as competing against

other species for food, water, shelter and the right to mate. Companies are competing

with direct competitors and other unrelated businesses for customers, suppliers, raw

materials, labor, manufacturing and office space, distribution capabilities and other vital

resources to sustain themselves; and also the right to mate … or in this cage merge in

order to broaden their business base and capabilities.

The business environment also has commonality with the swamp. Both are fertile

ecosystems providing the necessary elements for survival. But they also provide

challenges. Changes in the weather, drought, disease, predators and other perils must be

overcome as the alligator struggles to become dominant in the territory. The business

climate is also volatile. A rising company must navigate through recessions which

reduce the available resources needed to thrive. It must fight off competition, regulation,

labor shortages, and countless other issues on its way to dominating its industry niche.

In a capitalistic business system, companies are predators, just as alligators are predators

of the swamp. It’s Darwin at its best, as only the strongest and the fittest will survive and

become the “alpha males” of their respective territories. But the struggle for survival and

dominance will be ongoing, because there will always be the threat of a new emerging

alligator with the ambition to take over the swamp.

The Alligator Lifecycle

Companies follow a lifecycle that is similar to that of alligators. Prior to birth, alligators

start in the nest where many eggs have been gently placed and provided the nutrients and

protection to hatch as baby alligators. These eggs are analogous to venture capital

backed businesses. These businesses start with an idea and very few resources. Venture

capital or “Angel” financiers provide the nutrients and shelter to fledging companies.

The fledglings will emerge from the nest as small capitalization (“small-cap”) companies.

This book will not be concerned with venture capital backed companies because they are

typically privately held and not traded in the public market. Our journey through the

swamp begins with the infant alligator … the small-cap company.

Baby alligators are numerous when they hatch from the nest. However, the hatchlings

are not the dominant predators that they will eventually become. At this stage in their

lives, they are quite fragile and may fall victim to a host of troubles. Some will starve.

Others will contract diseases and perish. Still others will become food for birds, snakes

and other larger alligators. While infant alligators are fast growing as they journey

towards adolescence, it is a rough road and many of them will not survive.

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It is the same situation for small-cap companies. They are abundant in number. As of

year-end 2007, about 300 U.S. companies with market capitalizations over $15 billion (a

reasonable cut-off for large-caps) traded in the public markets, but over 4,500 companies

were available to trade with market caps below $1.5 billion, the small-cap breakpoint.

The small-cap arena is where many fast-growing, emerging companies can be found. But

it is also where most companies fail. Small-cap is a risky stage in a company’s life.

They have yet to acquire a base of business that will carry them through recession.

Companies fail as a result of gross mismanagement. Stronger competition takes note of

the emerging company and crushes it through predatory pricing or other tactics. Many

small-cap companies are not yet profitable and will fail due to lack of sustainable

financing. Many potentially innovative products don’t gain consumer support and fade

away. In fact, 14 percent of the companies traded today in the Russell 2000 Small-cap

index were unprofitable, a key indication that they are not yet self-sustaining. To put it

another away, about one out of every seven small-cap stocks is a sick or starving baby

alligator.

Adolescent alligators have one main thing in common with baby alligators, and one main

difference. The main consistency between adolescents and infants is that they are both

growing fast. Infants can easily grow more quickly because they are growing from a very

small size, and for a certain period of time can live off their fat reserves. During

adolescence the alligator still grows quickly due to its gain in stature and ability to more

readily fend for itself. That leads us to the main difference between infants and

adolescence. At adolescence, the alligator has now become more of a predator versus

prey. Its increased size has made it a more formidable animal to be reckoned with. The

adolescent alligator has gained in experience and become an expert hunter, established its

shelter, and learned to avoid many of the swamp’s hazards. Although it must still

compete against the adults in the territory, the adolescent alligator’s survival is practically

assured at this point.

Midcap sized companies are the business world’s adolescents. Ranging in size from $1.5

billion to $15 billion, there are just over 1,000 in number to choose from. These are the

companies that have emerged from the small-cap stage and now have their sites on

becoming industry dominators. Like small-cap companies, midcaps are fast growing.

Using the Standard & Poor’s Small-cap and Midcap indexes for comparison, the earnings

growth for stocks in these indexes for the past 15 years was about 14 percent and 13 ½

percent, respectively. Midcap companies continue to emerge after building a solid base

of business from which to grow. At this stage, they have the resources to bring in more

experienced management teams who know how to exploit large market opportunities.

Midcaps can invest more in sales and marketing, research and development,

manufacturing and distribution infrastructure. Their products and services are becoming

more recognized by potential customers. This often results in an acceleration of the

demand curve company’s offerings. The small-cap stage is where “early adopters” test

new products such as cellular phones, satellite television, new cholesterol drugs,

innovative athletic shoes, etc. But it is in the midcap space where products go

mainstream and really take off.

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Like the alligator, midcap companies also are more resilient and much less prone to

failure. Only 4 percent of companies in the Russell Midcap index were unprofitable in

2007 … meaning 1 of 25 were in jeopardy, making midcaps one-third the risk versus

small-caps. This is because midcap companies have built up a sufficient base of business

to carry them through tough economic times when they occur. Their management teams

are seasoned professionals who are experienced in effectively deploying the business’

capital resources. Midcaps have successfully fended off the competition from both their

peers and against larger companies in their industries. At this stage, their survival is also

practically assured.

This brings us to the adult alligator. The adult alligator is master of his territory. He

dominates in stature and has very few, if any, predatory threats. He may still grow, but

growth will be slower because he is now mature. His biggest day-to-day challenge is

finding enough to eat in order to sustain himself. His biggest threat to survival is not

from other alligators, but rather from habitat destruction. If the swamp dries up, he will

perish unless he moves to more fertile ground. Large-cap companies are just like adult

alligators. They are fewer in number and dominate market share within their industry

niche. Large-caps grow slower than small and midcap size companies. They have fewer

competitive threats, and the primary reason for their downfall is typically the decline of

their industry.

Let’s examine large-cap characteristics a little deeper. There are only about 300 large-

cap companies in the United States compared to thousands of smaller companies. There

is a logical reason for this. First of all, there are only so many large industry

opportunities. What do people use and need in everyday living? … Housing,

automobiles, telephones, computers, clothing, food, gasoline, air travel, movies, etc.

When you break it down into major components, there are only so many big product and

service categories that people need. Within each of those needs, one common theme

exists. Everyone wants to get the highest possible quality at the lowest possible cost! Or

in the case of luxury items, everyone wants exclusivity and will pay handsomely for that

special privilege. Because of this, industries consolidate down from many participants to

just a few leaders. After all, there can only be one “low-cost-producer” or “premium

brand.” At the infancy stage of the automobile industry, dozens of manufactures were

vying for market share. Only a handful survive today. When the computer industry was

emerging, hundreds of small computer assemblers and manufactures existed. Only a

handful survive today. It is the same case in the oil industry, the beverage industry, the

household appliance industry, the athletic shoe industry, and so on. Natural evolution

dictates for all industries that they will consolidate down to a few leaders.

What causes some companies to become dominant while others struggle to survive? The

key differentiator is management. Sure the industry leader has the lowest cost

production, the best distribution, a formidable sales force, and a solid capability in

research and development. Much of this is taken for granted, but it is a monumental task

for a company to obtain these advantages, let alone continue to build upon them. Why is

Intel able to dominate everybody else in the microprocessor business? Why are Coke

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Cola and Pepsi basically the only two brands of cola that people commonly recognize?

How did it come about that Exxon, Proctor & Gamble, Boeing, Microsoft, Nike, Toyota,

Johnson & Johnson, Kellogg, Wal-Mart, Starbucks, Nokia, and other industry leaders

beat out their rivals? The simple reason is because they had the better management teams

who knew how and where to focus company resources. The leaders effectively invested

in infrastructure … not just physical but also in human talent infrastructure. They

nourished cultures for success and were careful not to become complacent and allow

another hungrier competitor to take away their customers. Focused managements who

are motivated and remain hungry for success is a key characteristic in all today’s industry

leading companies.

Large companies grow slower than small and midcap companies. Over the past fifteen

years, companies in the S&P 500 index grew their earnings at a 10% annual rate, over

three percent slower than the small and midcap indexes. The natural progression is that

growth slows during a company’s adult stage. As a company grows, it becomes a bigger

part of its industry, making market share gains more difficult. In adolescence, a company

may only have a 15 percent market share, leaving an 85 percent opportunity for further

market share gain. But as an adult and having achieved a market share of 50 percent or

more, the company has less opportunity than before to grow at the expense of its

competitors. The large-cap leader becomes more dependent upon industry growth to

sustain its own growth trajectory. Forty years ago, Nike was a new entrant in the athletic

footwear industry with barely a single point of market share. For years, it grew rapidly as

its products became more popular with consumers. Today Nike is the industry leader

with the dominant market share. Further market share gains are more difficult because

Reebok, Adidas (the former leader) and others have become better run companies in

order to compete against Nike. Today, Nike’s growth is slower than before and more in

line with industry growth. To keep growing, Nike has entered adjacent industries like

apparel and sports equipment. Today, Nike is an adult alligator in search of enough to eat

to sustain what little growth it can.

The second reason that growth is slower for large companies is because industry growth

itself slows over time. Industries begin with “early adopters” purchasing their product or

service. If the product gains broad appeal, prices generally decline making it affordable

for the masses. As it penetrates into the masses, industry growth accelerates. Often this

accompanies the adolescent phase of companies participating within that particular

industry. Eventually, over half of the people who eventually want the product have it,

and the industry enters its maturity stage accompanied with slower growth. A hundred

years ago, automobiles were a luxury item and status symbol. Despite the fact that they

still had to travel mainly on dirt roads, people wanted them and could see this was the

future of transportation. Henry Ford brought the automobile to the masses and the

automobile industry flourished for decades as the number of households with a car in the

garage continued to increase. Today, just about everyone in the United States has a car

and the bulk of industry sales are mainly to replace older worn-out cars.

It is not easy to destroy an industry dominator. The most common cause is that its

business becomes obsolete (habitat destruction) due to some newer innovation taking its

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place. The automobile killed off the horse-drawn carriage. The typewriter was replaced

by the personal computer. One-hour photo shops and digital photography did away with

Polaroid. Gross mismanagement is the other main cause for the demise of large

corporations. Every once in a while, a company gets too big for its britches and

management overreaches their capabilities. They become overconfident due to past

successes and begins to make a series of poor decisions as they try to maintain an

unsustainable level of growth. Recent examples of overreaching include Enron

Corporation and WorldCom. But large business failures are the exception, not the rule.

In general, after a company becomes dominant in its industry, it tends to grow more

slowly and merge with other competitors, making itself even more dominant than before.

And so goes the alligator’s lifecycle. Rapid growth during infancy accompanied with a

high survival risk. Continued rapid growth throughout adolescence at a lower level of

survival risk; followed by slower growth during adulthood when it achieves dominance.

Keep in mind that all adult alligators and all large-cap dominant mature companies have

one thing in common: They all had to pass through adolescence.

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CHAPTER 2: WHY STOCKS MOVE

History has shown that stocks rise over the long-term, but what causes stocks to rise and

fall? Simply put, the primary reason stocks rise and fall is because of the change in their

earnings-per-share. If earnings-per-share are rising and the expectation is for earnings-

per-share to continue rising, then stocks will go higher. If earnings-per-share are

declining and future earnings-per-share are expected to continue to decline, then stocks

will go lower. There is a strong link between the direction of earnings and stocks over

long periods of time.

Over short periods of time stocks are more volatile. In any given year, stocks may rally,

suffer a correction, and then rally again despite the earnings path remaining stable. That

is because investors as a group are an emotional bunch. And when money is involved,

emotions are heightened. The powers of greed and fear take over. For example, earnings

are rising. Companies are beating estimates. The economy is good and jobs are plentiful.

Stocks are going up and people don’t want to miss out. After all, it is fun to make

money. So they buy and they keep buying. The hot stocks get more buying attention.

Everyone wants to be winner and share his or her success stories at cocktail hour. It is at

these times that stocks approach the high end of their valuation ranges. Investors as a

group have become greedy and more willing to accept more risk. Don’t forget … stocks

are risky business.

And then it happens. Maybe a leading company gave a poor outlook. The job market is

not as robust. Inflation is coming back. Maybe earnings weren’t good enough to beat

Wall Street’s infamous “whisper number.” The Federal Reserve raised interest rates.

Whatever the problem is, stocks aren’t going up anymore. Even worse is that they are

going down! People who bought at the top want to cut their losses, so they are selling.

People want to pocket their gains before they disappear, so they are selling. You don’t

want to be broke at cocktail hour. It is not as good a story to tell. On top of that, it’s no

fun losing money … so people are selling. Fear has overtaken greed. It is at these times

that stocks approach the lower end of their valuation ranges, setting the stock market up

for the next rally.

The battle between greed and fear will rage on, but that is a short-term issue. Over the

long-term, it is earnings-per-share that matters; and more specifically, it is the direction

of earnings-per-share that matters. Line up any stock index against its earnings-per-share

and you will see that stock prices and earnings are closely correlated. Figure 1

graphically illustrates the relationship between price and earnings for the S&P 500 index

over the past 50 years. You can see that the S&P 500 has risen in value along with the

growth in its earnings. A regression analysis between the S&P 500’s price and earnings

since inception shows that earnings per share has explained over 90 percent of the S&P

500’s price action over the long-term.

But over shorter periods of time the relationship between price and earnings can break

down. During much of the 1970s and 1980s, the S&P 500 traded below its earnings trend

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line due to high interest rate levels and ongoing concerns over inflation, recession and the

United States’ competitiveness (or lack thereof) in the global economy. During the late

1980’s and 1990s, a combination of declining interest rates and euphoria about the

resurgence of the U.S. economy, and a new era of technology drove the S&P 500 far

above its earnings trend line to unsustainable valuation levels. During the first part of

this decade, stocks returned to more normalized valuations when the technology bubble

burst. At that point, fear became the overriding emotion and returned the S&P 500 back

to its earnings trend line.

Figure 1. S&P 500 Price and Earnings Over Time

S&P 500 Price vs. Earnings

$0$100$200$300$400$500$600$700$800$900

$1,000$1,100$1,200$1,300$1,400$1,500$1,600

1957 1967 1977 1987 1997 2007

$0.00

$10.00

$20.00

$30.00

$40.00

$50.00

$60.00

$70.00

$80.00

$90.00

$100.00

Price

EPS

Although earnings explain over 90 percent of stock price movements over time, it

becomes less of an influence over shorter time horizons. For example, earnings on

average explain 80 percent of price movements over 30-year time horizons, 70 percent

over 20 years, and just 50 percent over 10-year time periods.

Clearly other forces come into play that influence the short-term direction of stock prices.

These forces include political turmoil, currency fluctuations, weather, employment,

business sentiment surveys, and a host of other variables that factor into what investors

think about the current and future investment environment. But perhaps the most

powerful force impacting stock prices, apart from earnings, is interest rates, and the

expectation of inflation or deflation.

The overall level of interest rates, and the expectation of future changes in interest rates

are important to stock prices. Because all investment vehicles (stocks, cash, bonds, real

estate, etc.) are in competition against one another within an investor’s asset allocation,

interest rates set a benchmark for the required level of return that investors demand on

their capital. In order to keep up with inflation, interest rates generally must be greater

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than the rate of inflation. Otherwise a decline in real wealth is suffered. People buy

stocks because they expect the return on investment will compensate them for the risks

taken. The Capital Asset Pricing Model (CAPM) is a tool used by professions to value

stocks. The CAPM states that the required return on investment includes the “risk free

interest rate” plus a risk premium. The risk free interest rate is essentially the U.S.

government ten-year bond yield. When interest rates are rising, the required rate of

return on stocks is driven higher. The higher required rate of return puts downward

pressure on stock prices because essentially represent the future earnings and cash flows

that the company will produce. These cash flows are discounted to present value at the

required rate of return based on the CAPM. When interest rates rise, the required rate of

return rises and the present value (which is the stock price) goes down. When interest

rates fall, stock prices receive a tail wind.

The risk premium is the additional return (or additional interest rate) that investors

demand for investing in stocks as a group or individually. On average, the historical risk

premium for the entire stock market has been about three percent, but it can vary greatly

for individual stocks depending upon factors such as earnings volatility, trading liquidity,

and other variables. Another factor that impacts the risk premium is simply investors’

willingness to accept risk. If investors as a group are fearful or cautious, the risk

premium will be higher, making stocks more attractively valued (“cheaper”). But when

investors largely ignore the risks and become greedy, the risk premium declines and

price/earnings ratios increase. In the very short-term it is extremely difficult to measure

the risk premium due to all the factors involved. However, because stocks tend to trade

within a band around the price/earnings ratio (typically 14 to 18 times earnings for the

S&P 500 in a normal interest rate environment), it’s not too difficult to get a feel as to

whether stock valuations are overly depressed or excessive.

Two distinct periods help demonstrate the impact that interest rates have on the stock

market. The first is from 1954 to 1981. During that period the ten-year treasury bond

yield rose from 2.5 to 13.7 percent, and the rate of inflation grew from 0.3 to 10.4

percent. Earnings on the S&P 500 during that period grew from $2.77 to $15.36,

compounding at just over 6.5 percent. The price of the S&P 500 rose from $35.98 to

$122.55, but that only represents a 4.6% rate of compounding, almost two full percentage

points less than the earnings growth rate. The difference is due to the headwind created

by rising interest rates and rising inflation, which took the price/earnings ratio for the

S&P 500 from 13.0 times in 1954 to 8.0 times in 1981. It is not by coincidence that the

decline in the price/earnings ratio represents an annual negative return of just below 2%.

The period from 1981 through 2006 illustrates the impact from declining interest rates.

Treasure bond yields fell from 13.7 to 4.6 percent and inflation fell from 10.4 to 3.2

percent. S&P 500 earnings grew from $15.36 to $88.26 and its price increased from

$122.55 to $1,418.55. During that period the S&P 500’s price compounded at 10.3

percent, 3 percent faster than the earnings growth rate. The decline in interest rates and

inflation made the difference, resulting in an expansion of the S&P 500’s value from 8

times earnings in 1981 to 16 times at the close of 2006. The combination of rising

15

earnings and falling interest rates is clearly the best possible investment environment for

stocks.

During both of the above periods, earnings growth was the predominant factor in driving

stock prices higher, but it is clear that major changes interest rates and inflation can have

substantial impacts on stock valuations.

That covers inflation, but what about deflation? Deflation is bad. It stifles both

consumption and investment. A deflationary environment is one where the prices of

goods and services are generally declining. In a deflationary environment, people reduce

their consumption because they know their money will be worth more in the future just

by sitting on it. Deflation is the only environment where “stuffing money under the

mattress” is a sound policy. During deflation, people hold on to their money like it was

money! Why buy today what you can buy tomorrow cheaper? Business investment also

declines for the same reason. Businesses invest in capital equipment in order to earn a

return on that investment. But if the future dollars that investment earns are worth less

than today’s, businesses will hold their capital rather than invest it. That stifles growth.

If you don’t believe deflation is bad, just look at the Japanese stock market. It declined 90

percent from its peak when deflation took hold. Not convinced? The Great Depression

during the 1920s also experienced a deflationary spiral, which coincided with the U.S.

stock market declining 85 percent from its peak.

As far as growth is concerned, the faster the better. No matter what the interest rate

environment, faster growing companies have generally provided the greatest returns to

shareholders. But fast growth by itself is not enough. Growth must also be sustainable

over several years. The big money has been made in companies that are on a growth

track and stay on that track for long periods of time. As previously explained, it’s easier

for companies to sustain rapid growth in their infant and adolescent stages than in their

mature adult phase. To illustrate the power of earnings growth, Table 1 compares

earnings-per-share growth rates against stock price appreciation for various large U.S.

corporations. Large companies were selected because they had long enough operating

histories to make meaningful comparisons. Additionally Large-cap stocks have better

coverage by professional analysts, which makes it more difficult for investors to exploit

information that is not already in the stock’s price. The top half of the table shows

companies with above average growth rates. The lower table includes below average

growth-rate companies. Table 1 clearly shows that faster growing companies reward

investors more handsomely.

It is also evident that the company’s business or industry doesn’t really matter. A fast

growing financial services company will perform just as well as a fast growing

technology company, and a slow growing technology company will perform just as

poorly as a slow growing chemical company. If you are interested in seeing a stock’s

price move higher, you should care more about the earnings growth rate and its

sustainability, and care less about what industry the company participates in. However,

you should care that the industry opportunity is large and provides ample room for

growth. After all, a healthy swamp provides for healthy alligators.

16

Table 1. Earnings and Stock Price Comparisons

Earnings Per Share Growth vs. Stock Price Appreciation 1986 to 2006

% Change Annual Stock

Company Name Industry EPS Price Return

Proctor & Gamble Consumer Products 12% 14%

Merrill Lynch Financial Services 23% 20%

Johnson & Johnson Healthcare 14% 15%

Wal-Mart Retail 17% 15%

Caterpillar Inc. Industrial Equipment 14% 12%

Microsoft Technology 28% 26%

Kellogg Co. Consumer Products 6% 7%

DuPont Chemicals 5% 7%

IBM Technology 6% 7%

AT&T Telecommunications 5% 8%

General Motors Automobiles -2% 1%

Eastman Kodak Consumer Products -9% -2%

Figures 2 through 13 are graphic illustrations comparing earnings-per-share and price for

each of the above companies. These charts are identical in nature to the Figure 1, except

they are for individual stocks rather than the broad stock market; and the time period is

shorter. But the relationship still holds. Earnings-per-share and stock prices are linked.

There is no getting away from it.

Figures 2 – 13. Individual Stock Price and Earnings Comparisons Over Time

Proctor & Gamble Price vs. EPS

$0$10$20$30$40$50$60$70$80

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

$0.00

$0.50

$1.00

$1.50

$2.00

$2.50

$3.00

$3.50

Price

EPS

17

Merrill Lynch Price vs. EPS

$0

$20

$40

$60

$80

$100

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

($1.00)

$1.00

$3.00

$5.00

$7.00

$9.00

Price

EPS

Johnson & Johnson Price vs. EPS

$0

$10

$20

$30

$40

$50

$60

$70

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

$0.00

$0.50

$1.00

$1.50

$2.00

$2.50

$3.00

$3.50

$4.00

Price

EPS

Wal-Mart Price vs. EPS

$0

$10

$20

$30

$40

$50

$60

$70

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

$0.00

$0.50

$1.00

$1.50

$2.00

$2.50

$3.00

$3.50

$4.00

Price

EPS

18

Microsoft Price vs. EPS

$0

$10

$20

$30

$40

$50

$60

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

$0.00

$0.50

$1.00

$1.50

$2.00

$2.50

$3.00

Price

EPS

Caterpilar Price vs. EPS

$0

$10

$20

$30

$40

$50

$60

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

($1.00)

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

Price

EPS

Kellogg Co. Price vs. EPS

$0$10$20$30$40$50$60$70$80

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

$0.00

$0.50

$1.00

$1.50

$2.00

$2.50

$3.00

$3.50

Price

EPS

19

DuPont Price vs. EPS

$0$10$20$30$40$50$60$70$80

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

$0.00

$0.50

$1.00

$1.50

$2.00

$2.50

$3.00

$3.50

Price

EPS

IBM Price vs. EPS

$0

$20

$40

$60

$80

$100

$120

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

($1.00)$0.00$1.00$2.00$3.00$4.00$5.00$6.00$7.00

Price

EPS

AT&T Price vs. EPS

$0

$10

$20

$30

$40

$50

$60

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

$0.00

$0.50

$1.00

$1.50

$2.00

$2.50

$3.00

Price

EPS

20

General Motors Price vs. EPS

$0

$10

$20

$30

$40

$50

$60

$70

$80

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

($10.00)

($5.00)

$0.00

$5.00

$10.00

$15.00

Price

EPS

Eastman Kodak Price vs. EPS

$0

$10

$20

$30

$40

$50

$60

$70

$80

$90

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

Price

EPS

There are a couple more observations between the overall stock market and the individual

stocks. During the late 1990s, the stock market experienced a bubble when a frenzy of

buying in growth stocks drove valuations to historically high levels. But by looking at

the individual stocks charts, you see that not all stocks were treated equally. The low-

growth companies did not experience the same frenzy and were largely ignored, while the

high-growth stocks received a disproportionate share of the buying interest and rocketed

to unsustainable levels. It further illustrates the power of growth on stock prices. The

bubble ultimately burst, and rightly so. The excessive valuations were brought back to

normal levels. Investors who were smart enough (most people weren’t) to sell at the top

made a killing. But even if they didn’t sell at the top, and just held those stocks through

the entire period, investors still did better than if they had invested in low-growth

companies.

The second observation is that can be seen more clearly is the impact on a stock’s price

when earnings decline. A broad market index like the S&P 500 includes many

companies in many industries. Except during recessions, companies and industries that

21

are suffering declines are generally more than offset by those that are experiencing

growth. That is the main benefit of diversification with an index. You don’t have to

worry about which companies are going to lead the charge. You will own the winners

and the losers, but overtime, the winners will more than offset the impact from the losers.

But when buy individual stocks as opposed to investing in mutual funds or index funds, it

is important that to spend the time identifying the current and emerging leaders. Buying

a second rate company in an industry just because it is cheaper than the leader is a loser’s

strategy!

If you don’t have the time or inclination to properly research individual stocks, then stick

with mutual funds. If you don’t have the time or inclination to properly research actively

managed mutual funds, stick to index funds.

Some investors like to look at growth in a company’s book value or growth in dividends

when they invest. By doing this, they are missing one huge point. A company can’t

grow its book value long-term without generating earnings, and if the company’s

earnings aren’t growing, it means the company has most likely become mature or

stagnant, and its best days have most likely past. The same argument can be made for

dividends. Dividends are paid out of the earnings and cash flows that a company

generates. If earnings won’t grow, neither will the dividends. Not only that, but

companies that are in rapid growth modes are generally reinvesting their cash back into

the business and not yet paying dividends. If your objective for investing in stocks is to

achieve capital gains and build real wealth, then stick with earnings growth as your

primary focus.

It should be clear now that why earnings growth is the primary determinant to stock

prices, and how changes in interest rates can have a secondary effect. As of today (late

2008), interest rates are at the lower end of their historical ranges, and inflation pressures

may also be increasing given the amount of money that governments are putting into the

global economies. Given that, investors in the U.S. stock market today should not expect

the kind of returns seen over the past twenty-five years because there is not likely to be a

tailwind from declining interest rates. This means that from today, earnings growth will

be as important as ever.

22

CHAPTER 3: THE JOYS OF ADOLESCENCE

Chapter 1 described the way of the alligator. Infant and adolescent alligators are fast

growing, and adults grow slowly. Infant alligators are high risk, and adolescents and

adults are lower risk. Chapter 2, laid out that long-term stock price appreciation is

primarily driven by growth in earnings-per-share. There should be no surprise at this

point where this is leading. Midcap stocks, the adolescents of the stock market, represent

the best opportunity for long-term capital appreciation and wealth creation without taking

on an excessive amount of risk.

Figure 14. Compounding of a Dollar Over Time

Growth of a Dollar 30 Years Ended 2007

$-

$10.00

$20.00

$30.00

$40.00

$50.00

$60.00

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

Large Cap

Mid Cap

Small Cap

Figure 14 shows the growth of a dollar invested for the past 30 years in small, mid, and

large-cap stocks. When investors move down in market capitalization, they are taking on

additional risk. To compensate for the additional risk, they expect to earn higher returns.

In general, that has been the case. Investors in small and midcap stocks did achieve

higher returns relative to large-cap stocks. A dollar invested in large-cap stocks 30 years

ago would be worth about $34 dollars at the end of 2007, while a dollar invested in small

and midcap stocks would be worth $51 and $60, respectively.

However, it appears that by moving too far down in size, additional compensation is no

longer being rewarded for the additional risk. After all, midcap stocks generated higher

returns than small-cap stocks. The primary reason for this is the survivorship risk in the

small-cap area of the market. Remember that fourteen percent of the companies in the

Russell 2000 small-cap index are unprofitable versus only four percent in the Russell

Midcap index. So although an individual small-cap company may be fast growing, as a

group they don’t grow any faster because the survivors have to more than offset the

declines generated by the unprofitable and unhealthy infants who are also included in the

small-cap index. Midcap companies fight a lesser headwind in that regard.

23

Another reason that midcaps have beaten small-caps is that there are a limited number of

large industry opportunities to exploit. As a result, many small companies are limited in

their ultimate size because the industry in which they operate is also small. A company

may be the dominant shirt button manufacturer, but the shirt button industry will always

be a small swamp incapable of supporting a real giant.

Finally, the small-cap area of the market has in recent years become a source of public

venture capital. Typically, the riskiest companies seek start-up capital from the private

capital industry. In the private capital stage, they further develop their business models

and work to achieve enough support to become profitable and self-sustaining. After

achieving this, the company lists itself on the public market by filing an Initial Public

Offering, the main purpose of which is to raise funds to pay back the private investors

and to raise additional growth capital for the company. However, as investors’ risk

appetite has increased over time, more companies are leaving the nest before being fully

incubated. Riskier companies are going public earlier. For evidence of this, look no

further than at all the unprofitable technology companies that went public in late 1990’s.

When unprofitable companies go public, they join the ranks of the unhealthy 14 percent

of the small-cap index. Many of these companies will ultimately expire.

Figure 15.

Growth of a Dollar 25 Years Ended 2007

$-

$5.00

$10.00

$15.00

$20.00

$25.00

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

Large $18.80

Mid $24.50

Small $15.00

To see the picture more clearly, take a peek at figure 15, which shows the growth of a

dollar over the past twenty-five years invested in small, mid, and large-cap stocks. You

can see that midcap stocks again were the winners. But what also jumps out is not only

did small-cap stocks return less than midcaps, but they also returned less than large-cap

stocks! Most individual investors today do not understand the degree of risk they are

taking in the small-cap arena. Many are told by financial advisors that in order to

enhance long-term returns and to distribute risk, they need to diversify their assets across

24

all categories, including small-cap. Investors certainly need to diversify, but not blindly.

Adding small-cap stocks (especially small-cap growth stocks) to the mix of assets not

only reduced long-term returns, but increased risk. That is a poor trade off. Adding

midcap stocks to the investment portfolio however served to both raise returns and lower

risk.

Table 2 displays the annualized rates of return and standard deviations for small, mid, and

large-cap stocks for both the past twenty-five and thirty years. The standard deviation is

a measure of risk, and in this case measures the volatility of past returns. Stocks with

annual returns that experience large swings from year to year will have a larger standard

deviation and are considered more risky. The data show that midcaps have not only

provided larger returns than large and small-caps, but that midcap returns have actually

been less volatile than both large and small caps.

Given that midcaps at face value should be more risky than large-caps, it seems unusual

that midcaps would have a lower standard deviation. This lower risk is a statistical

aberration caused by the bursting of the 1999 stock market bubble. Prior to 1999,

midcaps did experience a higher standard deviation accompanied with higher returns.

But the bull market of the late 1990s was focused primarily on large-cap stocks and

technology. During the five-year period ended 1999 large-caps had annual returns higher

than midcaps in each year, outpacing midcaps by over six percent annually. When the

bubble burst, it hit large-caps harder than midcaps since the midcaps did not experience

the same kind of extreme valuations that were created in the large-cap area of the market.

During the subsequent five years ended December 31, 2004 large-caps lagged midcaps in

each year, and by over nine percent annualized. That ten-year period of higher volatility

for large-caps was uncharacteristic of how stocks normally act across a cycle. Typically

in bear markets, smaller capitalization stocks decline more than large caps due to a “flight

to safety” by investors as they attempt to reduce risk. They sell the small-caps due to

their inherently higher risk, and seek refuge in the security of large-caps who provide

more resilient businesses. The lower trading liquidity of smaller caps makes selling more

difficult in a bear market resulting in more pronounced price declines.

Table 2. Long-Term Index Comparisons

Annualized Average Returns Large Cap Mid Cap Small Cap

30 years ending 2007 12.8% 14.5% 13.4%

Std Dev 30 yrs ending 2007 15.3 14.9 17.8

25 years ending 2007 12.5% 13.6% 11.4%

Std Dev 25 yrs ending 2007 15.8 15.3 17.6

But even in more “normal” markets, midcaps will generally provide better risk-adjusted

returns versus both large-cap and small-cap stocks. It appears that midcaps and

adolescence is the stage where the process of creative destruction gains momentum.

Much has been written about the process of creative destruction in the field of economics.

Creative destruction is the process whereby existing established industries become

25

obsolete and replaced by newer emerging technologies. Younger entrepreneurial

companies typically own the newer technologies. These companies in turn achieve their

greatest shareholder returns in the midcap stage as their products and services enter the

mass adoption phase by consumers. Monster Worldwide, a leader in online recruitment

advertising, has changed the way prospective job seekers and employers connect.

Recruitment advertising was once the domain of the daily newspaper and is now rapidly

moving to the Internet. Apple’s iPod has led the charge in changing the way people buy

and listen to music. Apple has virtually eliminated the Sony Walkman as well as several

music retailing stores. History provides several examples of creative destruction, which

ultimately improves standards of living by eliminating established inefficient processes,

thereby freeing up resources to be redeployed into more productive efforts.

Illustrated above is that midcap stocks have provided the best path to enhancing long-

term returns without accepting an unreasonable level of risk. But how do midcaps

measure up against large and small-caps over shorter time horizons? Table 3 details the

rolling five and ten-year annual returns for all three categories for the past twenty-five

years. Midcaps have beaten large-caps in seventeen of the past twenty-five rolling five-

year periods, 68 percent of the time. Over ten-year rolling return periods, midcaps beat

large-caps 70 percent of the time. During the times that midcaps lagged large-caps over

ten years, the average shortfall was only three-quarters of one percent, with the worst

shortfall being 2.3 percent. This shortfall occurred during the large-cap stock market

bubble in the late nineties and was a period where midcaps still returned almost seventeen

percent during that ten-year period. However, the average beat by midcaps during the

rolling ten-year periods was two and three-quarters percent, 3.7 times greater than the

percentage shortfall. For the past three, five, ten, twenty-five and thirty years, midcaps

have been the best place to invest in U.S. equities.

Is there a case for small-caps? Not really. Small-caps beat large-caps less than 50

percent of the time in both rolling five and rolling ten-year periods. But in many of the

periods that small-caps posted higher returns than large-caps, small-caps were beaten by

midcaps anyway. There has not been a strong argument for investing in small-caps for

the past twenty years. The main drag on small-caps has ironically been due to “growth”

stocks. Small-cap value has actually been a good place to invest, but midcaps have done

just as well in the value category (adolescence still rules). This will be explained in more

detail in Chapter 8. In summary the data show that an investor’s portfolio should include

both large and midcap stocks. The longer the investor’s time horizon, the larger the

allocation should be to midcaps in order to take advantage of their higher appreciation

potential.

26

Table 3. Rolling Five and Ten Year Return Comparisons by Market Cap

Rolling Annualized 5 Year Returns Rolling Annualized 10 Year Returns

Large Cap Mid Cap Small Cap Large Cap Mid Cap Small Cap

1982 14.3% 19.2% 24.0% 6.2% 11.9% 15.7%

1983 17.6% 22.2% 26.7% 10.0% 17.6% 23.3%

1984 14.0% 16.0% 16.1% 14.1% 21.2% 25.8%

1985 14.1% 15.9% 14.8% 14.0% 18.9% 23.2%

1986 19.1% 19.3% 15.7% 13.6% 17.0% 19.0%

1987 15.5% 14.4% 12.5% 14.9% 16.8% 18.1%

1988 14.6% 13.7% 11.8% 16.1% 17.9% 19.0%

1989 19.7% 18.9% 17.0% 16.8% 17.4% 16.6%

1990 12.2% 9.7% 6.1% 13.1% 12.8% 10.4%

1991 14.9% 13.8% 13.2% 17.0% 16.5% 14.4%

1992 16.2% 17.2% 15.1% 15.9% 15.8% 13.8%

1993 14.8% 16.1% 14.0% 14.7% 14.9% 12.9%

1994 9.0% 10.3% 10.2% 14.2% 14.5% 13.5%

1995 17.2% 19.9% 21.0% 14.7% 14.7% 13.3%

1996 15.3% 15.8% 15.7% 15.1% 14.8% 14.4%

1997 19.9% 18.2% 16.4% 18.1% 17.7% 15.8%

1998 23.4% 17.3% 11.9% 19.0% 16.7% 12.9%

1999 28.0% 21.9% 16.7% 18.1% 15.9% 13.4%

2000 18.2% 16.7% 10.3% 17.7% 18.3% 15.5%

2001 10.5% 11.4% 7.6% 12.8% 13.6% 11.5%

2002 -0.6% 2.2% -1.3% 9.2% 9.9% 7.2%

2003 -0.2% 7.2% 7.1% 11.0% 12.2% 9.5%

2004 -1.8% 7.6% 6.6% 12.1% 14.5% 11.6%

2005 1.1% 8.5% 8.2% 9.3% 12.5% 9.3%

2006 6.8% 12.9% 11.4% 8.6% 12.1% 9.5%

2007 12.4% 16.9% 15.4% 5.7% 9.3% 6.7%

The Adolescent Investor

For the moment, let’s spend a little time on adolescent humans, not alligators. Young

investors have one huge advantage over the middle-aged in saving for their retirements.

That advantage is time. By investing early in life, the power of compounding can work

to its fullest benefit. If you are a teenager or young adult reading this book,

congratulations! You are already thinking about your future financial security and have

plenty of time to build a financial fortress. If you are older, you should still be proud of

yourself for focusing on your future. Hopefully you started the saving process earlier, but

it is never too late to start. It is also never too late to teach your children or grandchildren

about saving and its importance to long-term financial health.

The power of compounding can indeed be formidable. To demonstrate its effect, let’s

assume Joe is 22 years of age and just graduated college. He just starting in his new

career and although he knows he needs to save for the future, he can’t save a lot because

he needs to pay for rent, food, transportation, dating and other essentials. But Joe needs

to save some, so he puts away $200 a month, either in an IRA or in his employer-

27

sponsored 401k plan. As his career progresses he starts to earn more and can save more.

He saves $300 a month in his thirties and then $400 in his forties and $500 a month after

turning 50 until age 60. Let’s also assume Joe invested it all in a large-cap index fund

since that is a smart choice to avoid high fees which eat into investment returns; and that

Joe’s investments on average earned 9 percent per year (the average rate of return for the

stock market over the last century was 10%). Based on the above, by age 65 Joe’s

retirement account would be worth over 1.5 million dollars. His total contributions (cash

out of pocket) into the account from age 22 through 60 were only $165,600. By saving

early, Joe made over nine times his original investment. That’s the power of

compounding.

But saving is boring. Why not take that extra cash and get a slightly nicer car, or some

extra clothes? Carpe Diem after all! Fair enough. Nobody likes a killjoy. So Joe starts

saving at age 30, instead of 22, and everything else stays the same. It shouldn’t make that

big of a difference since he only contributed $21,600 during his twenties, right? Wrong!

By waiting until he turned thirty, Joe’s savings at age 65 shrink to about $950,000. That

delay of $21,600 cost him over a half million dollars at age 65! In order to make up for

skipping saving in his twenties, Joe now needs to save $600 per month starting at age

thirty through age 60. An extra $50,000 in total contributions is required. If he waits

until he is 40, Joe’s monthly savings requirement jumps to $1,600. That’s $218,000 more

in contributions that needs to be paid out of pocket! Delaying retirement savings places a

disproportionately higher burden on future contribution requirements. That is why it is

important to start a retirement savings program early and to stick with it. Life is full of

choices. In the case of retirement savings, the choice is between starting now versus

working harder and longer later.

Because every individual’s saving and retirement requirements are unique, it is

worthwhile to spend a little time on your own plan. This will help determine if you are

on track and what kind of retirement savings you can reasonably expect to have in the

future. If you are proficient at using spreadsheet software, it will be easy to create a

worksheet to run various simulations for retirement planning. But if you are not a

spreadsheet wizard, there a lot of good tools available on the Internet to help understand

the retirement savings requirement. These may be found on your employer’s retirement

plan site or at your on-line broker/mutual fund family’s website. A simple tool to use is

the retirement plan calculator on Yahoo Finance. Just visit http://finance.yahoo.com and

click on the “Personal Investing” tab. Yahoo Finance multiple calculator tools to assist

individuals in planning their retirement.

Parents can do two major things for their children to make their futures more promising.

The first is to encourage them to obtain advanced learning and acquire skills needed for

higher paying jobs. That doesn’t necessarily mean a college degree, although that surely

helps. There are some fairly poor accounting majors and fairly wealthy plumbers. Both

professions require specific learning. The learning may come from a trade school rather

than be provided by an Ivy League college. The main point is to acquire skills that are

demanded in the market place. The second major thing parents can do is to open a

savings account for their child (or children) and to invest money into the stock market for

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them. There may be no better way to teach someone, especially a child, than through

example. At age five, start putting away $50 per month for the child until she (or he) is

18. Talk to her about saving and its importance to her future. At nine percent, her

savings account will be worth over $15,600 at age 18. She will be witnessing first-hand

the power of compounding. Explain to her that even if she never adds another nickel to

the account, at age 65 the power of compounding will turn that $15,600 into almost

$900,000. This assumes an average return of nine percent with no taxes, but if you invest

in an index fund, a great deal of the return will indeed be tax-free. For a total cost of

$8,400, you can teach your children an invaluable life lesson, and perhaps send them on

their way to becoming a future millionaire.

All of the above examples were based on a 9 percent rate of return, a little less than the

average return of the U.S. large-cap stock market over the last century. This rate was

used to be conservative and to demonstrate that astronomical rates of return are not

required in order to build long-term wealth. But if history is a guide, rates of return can

be increased by adding some tasty adolescent alligators into the mix. Assuming a 50/50

blend of large-caps and midcaps increases the rate of return to 9 ¾ percent. That is

reasonable given historic results. Using the above example of Joe’s savings program

starting at age 22, the additional ¾ percent increased the expected value at age 65 by

$360,000 to almost $1.9 million. In the extreme case of investing Joe’s assets entirely in

midcap stocks (an imprudent investment decision which is not recommend), and

assuming a 10.5 percent rate of return (not unrealistic), the value at age 65 jumps to over

$2.3 million.

Adding the power of adolescence and midcaps to an investment program greatly

enhances the ability to achieve long-term wealth objectives without taking unwarranted

risk. Table 2 above shows the 30-year rates of returns and standard deviations separately

for large-cap and midcap stocks. By combining these results using a 50/50 mix between

large and midcaps and rebalancing annually, an annualized return 13.7 percent is

realized; but the combined standard deviation actually drops to 14.5. Adding midcaps to

the asset mix not only increased the annual rate of return above that of large-caps, it

actually lowered the risk of the overall portfolio by increasing the stability of returns.

This is how diversification is supposed to work. Clearly any good long-term investment

program should include midcap stocks in the allocation.

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CHAPTER 4: ALLIGATOR ANATOMY

Each individual alligator is unique with its own individual characteristics, including

color, size, distinguishing scars, or other attributes. However at the core, all alligators are

the same. They are flesh and blood. They all have powerful jaws, four legs, a tail, and a

thick hide. Their biology is the same, each having a stomach, lungs, heart, liver etc.

They all spend their lives doing essentially the same thing … feeding, fighting and

breeding as they struggle to survive.

It is the same situation for companies. Each individual company is unique, with its own

set of products and services, facilities, and other attributes. Colgate sells toothpaste and

household products. Disney manages theme parks and produces other entertainment

services. Wells Fargo provides loans and other financial services. Starbucks sells coffee.

Exxon extracts oil and sells gasoline, diesel fuel and other refined products. Each

business is unique with its own set of challenges in its struggle to survive. However at

the core, all companies are the same. When you break it down, all companies do

essentially the same thing … money comes in and money goes out. They are all money

machines, and the companies that provide the greatest returns to shareholders will be the

ones that make the most money in the form of earnings-per-share.

Money comes into a company primarily from revenue generating activities, mainly by

selling products or services to its customers. Sure a company can raise money by issuing

debt (borrowing) or stock (selling an ownership interest in itself), but if a company is to

grow and be self-sustaining, it needs to generate revenues in excess of its internal

survival needs. A company that isn’t selling enough to pay its bills is dependent on

external sources of funds to survive. It is not in as much control of its destiny as a

company that generates free cash flow. If the banks become unwilling to lend, or if the

company cannot sell a piece of itself to an outside investor, it will perish.

Money goes out of a company to support the expense structure. This includes the cost of

goods sold, selling expenses, general and administrative costs, research and development

expenses, taxes and other costs. A company has to spend money on materials, inventory,

employees, buildings, equipment, insurance, accountants, lawyers, and the other

necessary expenditures to support its business. All businesses have this in common. If

money is left over after paying the necessary expenses, the company can reinvest the

extra money in growth initiatives to create new products, expand into new territories, or

make strategic acquisitions. The company may choose to return the excess cash to

shareholders in the form of dividends or corporate share repurchases. Corporate share

repurchases increase shareholder value because by repurchasing shares, earnings-per-

share is increased by spreading earnings across a reduced number of shares. For

example, if a company generates ninety dollars in earnings and has ten shares

outstanding, earnings-per-share is nine dollars. If the company buys back one of those

shares, earnings-per-share increases to ten dollars (ninety divided by nine). While

earnings remained flat, earnings-per-share increased due to a corporate share repurchase.

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This may seem elementary, but it should be obvious that all companies sell products and

services, and they all have to pay their expenses. The point is that no one should really

care how a company makes its money. One man’s trash is another man’s treasure.

Money is money. Earnings-per-share is earnings-per-share. Try to avoid value

judgments about a company’s business until after looking under the hood to determine

what kind of excess cash flow it throws off. Ross Stores is a retailer that focuses on

selling to customers with an average household income of $45,000. Ross Stores

specializes in buying apparel manufactures’ discards in the form of past season’s fashion

and other closeout or excess merchandise, and then selling it to consumers at a discount.

Their tag line is “dress for less.” Ross is not at the leading edge of fashion or a luxury

retailer by any stretch of the imagination, but it satisfies a basic need (clothing) with a

good product at an affordable price. Tiffany is at the other end of the spectrum. It sells

diamonds, jewelry, and is famous for its “blue box.” Not only does their inventory not go

out of fashion or spoil, it increases in value while just sitting on the shelves. It is not

uncommon for a Tiffany customer to spend on one purchase more than what the average

Ross Store’s customer makes in a year. Tiffany’s quality is impeccable, and its stores are

located in the most prestigious markets. Tiffany must be a better business than Ross

Stores. However, the stock price and the business fundamentals tell a different story.

Figured 16. Ross Stores Versus Tiffany & Co.

Ross Stores Vs. Tiffany & Co.

Stock Price Appreciation

$0

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Over the years, Ross Stores has substantially rewarded its shareholders. Ross’s stock

price compounded at a 21 percent rate in the twenty years ended 2007, while Tiffany

returned 18 percent. During that period, Ross Stores grew its earnings at a 20 percent

rate versus 12 percent for Tiffany. Although Ross sells past fashion and closeout

merchandise, it does it very effectively. Its gross and operating margins are below

Tiffany’s, but Ross makes up for this in velocity, turning its inventories four times faster

than Tiffany. This results in a return-on-equity that is almost fifty percent higher than

Tiffany’s with Ross actually carrying less debt. By not tying up cash in inventory, Ross

Stores generates significant free cash flow, which it uses to expand its store base, pay

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dividends and repurchase shares. In recent years, Ross Stores has stumbled a bit. The

implementation of a new information system did not go smoothly and caused some

business disruption that lowered their operating margins. If Ross Store’s management

works through these issues, operating margins should expand and Ross should re-emerge

as a leader in retailing.

In just a few simple steps, the financial health of any company of interest can be checked

fairly quickly. The Internet has made accessing financial information on companies

extremely quick and easy. Summary financial information can be found on Yahoo

Finance. Just enter the ticker symbol for the stock of the company being researched, and

in the tabs of the internet pate will be listed options for balance sheet, income statement,

and cash flow statement summary information for the past three years. For more detailed

information, go directly to the company’s website and click through to their investor

relations section. Almost every company will have available their most recent annual

reports and a tab to click directly to their required public SEC (securities and exchange

commission) filings. The filings you should be most concerned with are the annual 10K

filings, quarterly 10Q filings, and proxy statements (Schedule 14A).

Most companies these days are doing a good job of providing information on their

websites that use to be available mainly to professional investors. These include webcast

replays of presentations that companies have given at investor conferences, and replays

of their quarterly earnings conference calls. If these are available, they can be valuable in

gaining additional insights into the company’s growth strategy, current opportunities they

are exploiting and potential challenges they are facing. Not only can individual investors

get an outlook update directly from the company’s management, they can hear Wall

Street analysts’ questions and concerns along with the company’s response to those

issues. For those who have the time to spend reviewing these calls, it’s well worth the

time. If those who don’t, they probably shouldn’t be investing directly in stocks and

should stick with funds and indexes.

At a minimum, the serious investor should read the annual report. Companies (should)

put a lot of time and thought into preparing their annual report and Form 10K. This is not

only their progress report to shareholders, but also one of their main shareholder

marketing pieces. The annual report is where a company can lay out its long-term

strategy, execution plan and business opportunity. Make sure to read the Chairman’s

letter and other information summarizing the company’s business segments. The annual

report many times gives a sense of the company’s culture and focus, which are critical to

its success. Form 10K (the required annual SEC filing) includes a lot of information.

Not only does it include the financial statements, but also the business description

including a list of potential risks. It details key management personnel along with their

backgrounds. If not included in the 10K, this information may be included in the

company’s annual proxy statement. The proxy also shows the level of management

ownership in the company and its executive compensation schedules.

Here are the eight simple checks to perform on any company that is a potential

investment.

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Step 1. Is the company profitable? This information can be found by looking at the

company’s income statement, either in the annual report or Form 10K. Look at the net

income line. The company should demonstrate that it is consistently generating a

positive net income from operations. Alligator investors are not interested in unprofitable

or any other kind of unhealthy business.

Step 2. Is the company really profitable, or is it just accounting gimmickry? Too many

investors just look only at a company’s income statement to evaluate its profitability.

That is a huge mistake. Companies can generate paper profits for short periods of time (a

few years even) by manipulating accounting rules. If profits aren’t supported by real

cash flow, there is a good chance that the company is a house of cards waiting to

implode. This was the problem with Enron Corporation, HealthSouth Corporation,

Krispy Kreme Donuts, and many other high-profile corporate frauds. To validate the

quality of income statement earnings, turn to the cash flow statement. The cash flow

statement separates a company’s cash flows into operating activities, investing activities

and financing activities. Take total cash flows from operations and subtract capital

expenditures. Capital expenditures can be found in the investing activities section of the

cash flow segment. Operating cash flow less capital expenditures is called “free cash

flow.” If cash flows from operations minus capital expenditures are consistently positive,

then the company is healthy and income statement earnings are more reliable and

potentially sustainable. Operating cash flows don’t have to exceed capital expenditures

in each individual year, but over time the company should be generating more operating

cash flow than its capital expenditure requirements. It should be generating free cash

flow.

If a company is consistently spending more on capital expenditures than it is generating

from internal operations, that means it is reliant on external sources of cash to fund its

growth. It must either borrow or sell additional shares, which dilutes the existing

shareholders’ interests. It means the company is not self-sustaining and most likely

should be avoided. In some hyper-growth situations, capital expenditures may exceed

operating cash flow because the company wants to take advantage of its growth

opportunity before too many competitors come in and spoil the market. This was the

case with Starbucks and other retail/restaurant concepts in their earlier stages, and is the

case today in many of the solar industry companies. Ultimately Starbucks and the other

successful business plans achieved consistent free cash flow. However, the landscape is

littered with companies that were long on promise and short on results. When investing

in high growth companies that are not yet generating free cash flow, it is important to

have a good grip on the company’s long-term plan and its ultimate path to real economic

profits. If that level of confidence cannot be obtained, it may be prudent to wait for the

company to prove itself by generating free cash flow, and then invest at that point.

Step 3. Is profitability improving? Companies that are experiencing improving

profitability benefit not only from rising sales but also from higher profitability on those

sales. The combination of rising sales combined with improving profitability is a

powerful driver to earnings growth and generally results in attracting money into a stock.

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Stocks with improving sales and profitability tend to experience higher returns than the

market in general. Key figures to look at in evaluating profitability are the operating

margin and the return-on-capital. The operating margin can be calculated from the

income statement, and represents operating income (earnings before interest and taxes)

divided by net revenues. Operating margin represents the percentage of each revenue

dollar that accrues back to the company. If operating margin improves from seven to

nine percent, that means that for every $100 in revenue, the company keeps an extra two

dollars before taxes. Return-on-capital measures how profitable the company is for each

dollar of capital invested in the business. It is a measure of how efficiently the company

deploys capital. Capital includes both equity and long-term debt (including the current

portion of long-term debt). To calculate the return on capital, divide net operating profit

after tax by the average capital for the year. A quick and dirty way to get to net operating

profit after tax is to take operating profit from the income statement and multiply it by

one minus the company’s income tax rate. To calculate average capital, add equity and

long-term debt at the beginning and end of the year and then divide by two. If the

company has no debt, you can simply use return on equity as a close enough

approximation for return-on-capital. Even if the company does have debt, if the amount

of leverage (the debt-to-equity ratio) employed in the business is fairly constant, you can

still use the change in return-on-equity as a rough guide to tell if profitability (in the form

of capital efficiency) is improving or deteriorating.

It is preferable to own stocks that are experiencing rising operating margins and

improving returns-on-capital (or returns-on-equity). These are indications that business

is strong and the company is improving its position in the industry. A company can still

grow earnings while experiencing declining operating margins and returns-on-capital if

its revenue growth is fast enough to offset the decline in profitability. However, this is an

indication that the additional business the company is going after is not as good as its

existing business base, and that growth will be slowing and may perhaps flatten out or

decline. Generally, stocks that are experiencing declining profitability have a harder time

beating the broader stock market and should only be purchased at steep discounts to their

fair value.

Step 4. Is the company financially solid? Again, investors should avoid sick alligators.

A financially solid company has a strong business model that can weather recessions and

other setbacks when they occur. One aspect of being financially solid is the generation of

free cash flow discussed above in step 2. The other aspect is the amount of financial

leverage in the company. In other words, how burdensome is the company’s debt load.

Companies use debt in their capital structures for various reasons. When purchasing

long-term assets like equipment or buildings, a company will finance a portion of the

purchase with debt, much the same way an individual borrows to purchase a home or a

car. The cash flow the company expects to generate from the use of the equipment and

building will go towards paying off the debt in the future. Debt financing may be

required for a strategic acquisition. A company may take on debt to repurchase shares

and lower its overall cost of capital. The cost of debt is the interest payments on the debt.

The interest cost of debt is typically less than the company’s cost of equity. If a company

has steady cash flow, it makes sense to hold some debt and reduce the number of shares

34

outstanding which results in a greater earnings-per-share for the remaining shareholders.

Additionally, interest is tax deductible, making the cost of debt lower still. To check a

company’s debt level, look at its balance sheet. Add long-term debt and the current

portion of long-term debt. Divide this by total shareholders’ equity. The lower the

number the better. A debt-to-equity ratio of 1 or less is preferable. Anything above one

is highly leveraged and should generally be avoided.

Step 5. Are earnings per share growing? Alligator investors want companies that are

growing earnings-per-share, the ultimate driver to stock price appreciation. It is easy to

find the earnings-per-share on the face of the income statement. In general, earnings

should be growing ten percent a year or better each and every year. On average, you

should want earnings to be growing in the mid-teens or better, but even the best

companies in the world will have a slower growth year every now and then, especially

during a recession. But when a company grows (at any rate) through a recession, it is

clearly showing its strength. An accelerating rate of earnings growth is preferable to a

declining rate of growth. For instance if two years ago, Company A grew earnings-per-

share 12 percent, and then grew in the last year by 14 percent, then earning growth is

accelerating. But how can it be determined if earnings are expected to accelerate in the

next year? Many websites and service providers sell earnings estimates and revisions.

Yahoo Finance even makes some basic earnings estimate information available for free

on http://finance.yahoo.com. Just type in the company’s ticker symbol and click on the

“Analyst Estimates” tab. In the “EPS Trends” box you will find the estimates for the

current and next fiscal years. Historical earnings per share can be found on the

company’s income statement in its 10K filing. Calculating the annual changes in

earnings per share will indicate if growth is accelerating or not. The EPS Trends box in

the Analyst Estimates tab also shows the trend in earnings estimates for the past ninety

days. A trend of increasing estimates is preferable to a trend of declining estimates. In

the “Growth Est” box of the Analyst Estimates page the forecasted five-year growth rate

in earnings is also indicated. While the five-year growth rate figure is helpful to

understanding the longer term outlook for a company, it is not as important as the current

and next year estimate changes and the revision trend in estimates (the indication that

estimates are rising or declining).

Steps 1 through 5 are the primary checks that should be performed on every stock. If the

potential investment passes those tests, steps 6 through 8 can provide further insight into

the company.

Step 6. Is the company a leader and gaining market share? A leader is a company with a

top-three market position in its industry niche. It is preferable to own the number one or

two players, but in highly fragmented industries the number three position can still be

okay if it is gaining market share. A leader for alligator investment purposes is also a

company that is growing its sales and earnings faster than its competitors. In fact, it is

more important that a leader be outpacing its competitors than being the largest. In the

1990’s Dell was the leading personal computer company. Its direct selling distribution

model gave it a low cost advantage over competitors. Dell exploited this advantage to

gain market share and create a dominant company. But Dell’s competitors then

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responded, especially Hewlett Packard. Hewlett Packard always maintained a reputation

for quality products, but its cost structure was not competitive. Under new management,

Hewlett got its cost structure under control and reinvigorated its sales and marketing

efforts. It not only stopped its market share losses, but started to regain share and has

been the new leading stock in this industry for the past few years. Sticking with the

leaders is important, but it is also important to monitor their progress to ensure that they

remain leaders. The best check for this is to determine that their sales and earnings

growth is faster than their direct competitors.

Step 7. Is management focused on building shareholder wealth? You want management

to be on your side and to be motivated to prudently grow the company’s earnings.

Charlie Munger, Chairman of Wesco Financial Corp. (an 80% owned subsidiary of

Berkshire Hathaway) and long-time partner with Warren Buffet, has spoken repeatedly

about the power of incentives in motivating human behavior. The second half of “Poor

Charlie’s Almanac” contains a compilation of speeches that Mr. Munger made during his

illustrious career, and is highly recommended for investors and business professionals.

Reviewing a company’s annual proxy statement gives a feel for management’s incentive

structure. The proxy statement includes tables detailing executive managements' salaries,

bonuses and equity (stock options and/or restricted stock) compensation for the past three

years. It also includes a discussion of how annual cash bonus and equity compensation

awards are made. Most of the time, the discussions are vague, but occasionally some

good detail is given. Finally, the proxy statement lists executive officers and their total

insider ownership in the company. There is no set rule for how much executive officers

should be paid in cash and stock. What is relevant is the overall reasonableness of the

policies, and that policies appear to be fair in motivating executives and not be excessive.

If the company had a poor earnings growth for the past three years, a steep drop in the

annual bonus awards should be expected. If that is not observed, that means incentives

are misaligned.

With regards to equity compensation, it is preferable that management receive stock

options, not restricted stock. Restricted stock awards became more popular after the

bursting of the technology bubble at the turn of the century. It was partly a backlash

response to the excessive stock option granting practices by high-technology companies,

which were creating overnight millionaires in businesses that had no real long-term

sustainability. Switching to restricted stock was a clever way for managements of mature

companies to reward themselves more handsomely while appearing to be concerned with

shareholder interests. Most of the supporters for restricted stock came from large mature

companies who had entered in their slow growth phases and had seen the majority of

their shareholder value creation long past. More support came from compensation

consultants who could latch on to the public’s negative sentiment caused by scandals

including Global Crossing and WorldCom; or jealous accountants who have lately

become more concerned with creating complex financial reporting rules rather than

making financial statements more meaningful to shareholders.

Why should investors prefer management receive stock options instead of restricted

stock? Because unless the company’s stock price goes higher, the options that

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management receives will expire worthless. If management is unable to deliver real

shareholder value in the form of a higher stock price, then the stock options they receive

will pay them precisely the right amount for that lack of service … nothing! However, if

management was paid in restricted stock, they get to keep the value of the stock received

even if they don’t grow shareholder wealth. Restricted stock in most cases is just a gift to

executives. The vast majority of restricted stock grants have no requirements for

management to achieve business performance metrics. If executives avoid being fired,

the restricted stock grants will accrue to them free and clear. It does not matter if they

built shareholder wealth. Frankly, that is not much of an incentive!

Options on the other hand are worth something only if management can grow the firm’s

value. While stock options provide a better incentive for management than restricted

stock, excessive option granting at the expense of existing shareholders is not condoned.

Excessive stock option grants create the wrong kind of incentive in the form of short-

sited thinking to drive a stock price artificially high, providing for a quick cash-out by the

option holder. It gets management thinking more about how they will make themselves

rich rather than rewarding all of the company’s stakeholders; including public

shareholders, employees, customers, suppliers and others. As a management focuses

more on short-term performance, it can inadvertently destroy the long-term opportunity.

An example of short-sightedness would be to make a series of acquisitions to boost

earnings-per-share, but paying too much for them. As a general guideline, it is preferable

to see option grants limited to 10 percent of a company’s earnings growth rate. For

example, if XYZ Company’s objective is to grow its earnings-per-share at a 15 percent

long-term rate (and if that is reasonable assumption), then stock option grants should be

limited to 1.5 percent of Company XYZ’s current outstanding stock. If XYZ Company

has 50 million shares outstanding, then stock option grants in any year should be limited

to 750,000 options.

Small and midcap size companies tend to grant options in the range of 2 to 3 percent

annually. That should be expected. Smaller companies tend to be faster growing and can

afford to grant more options in order to attract executive talent. Additionally, executives

and other employees joining smaller, riskier companies need a proper incentive to be

lured away from their existing employment. But as a company grows in size, its growth

rate will naturally slow. As it slows, so should the level of stock option grants. It is only

logical that people are not taking the same level of risk by joining an organization when it

is larger and more established, and they should not receive the same proportion of equity

compensation as those employees who joined in the infancy and adolescent stage. If a

company is consistently granting more than 3 percent of the shares outstanding to

employees every year, it is an insight into its management’s culture as to how they think

about themselves versus shareholders.

Step 8. Are there accounting shenanigans? A company’s financial statements should be

fairly straight forward and simple to understand, especially for smaller companies which

typically are focused on only one business as opposed to conglomerates like General

Electric which are a collection of multiple businesses and highly complex. The United

States has the best regulatory and most transparent accounting practices in the world.

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This means that investors in U.S. companies get a clearer look at just how a company has

performed. A company’s financial statements can give you some insights not just into

the business results, but also into how management thinks and whether they are

conservative straight-forward people, or if they are aggressive and overly risky with

shareholder capital. Financial statements can also give clues about management trying to

hide information about the company by placing it in the footnotes rather than on the face

of the financial statements.

One of the most important tests for accounting shenanigans is simply checking the “cash

flow from operations” versus net income, and a company’s ability to generate free cash

flow. This was covered above in Step 2 separately. In performing this step, keep a

watchful eye for sudden increases in accounts receivable or inventories that are

disproportionately larger than the increase in sales. A sudden spike in receivables may

indicate management is offering easier credit terms to customers in order to drive short-

term sales. It could be an indication of “stuffing the channel,” a practice used by

companies to make short-term sales goals in the hope that demand will pick-up later to

clear inventory forced down to its customers. Spikes in inventory may indicate that

management has overestimated demand for its products and may have to take future

write-offs and markdowns in order to clear inventory.

Read (or at least scan) the footnotes in the financial statements for joint ventures and

other forms of off-balance sheet financing. Aggressive managements will often try to

hide losing or less profitable ventures from the face of the financial statements. They do

this by setting up joint ventures in which they have a minority ownership. Often times

the majority owners of the joint venture are in some way related to the company. By

doing this, a company can inflate its reported results. Take the example of a Research &

Development joint venture (“R&DJV”). The R&DJV performs research for the benefit

of the company to develop a new technology. Because the company only owns a

minority interest in the R&DJV, it does not have to show the full cost of the research on

the income statement, which effectively overstates earnings-per-share. If the research is

successful, the company will often have an option to buy out the majority shareholders of

the R&DJV at a determined “fair value.” You can be sure that value will be fair to the

R&DJV majority interest-holders, but it is probably less fair to you as a shareholder of

the company. If the research is not a success, the company is most likely guaranteeing

the obligations of the R&DJV, and ultimately you (as a shareholder in the company) end

up footing the bill anyway.

Joint ventures are also used to move debt off the balance sheet in order for the company

to give the appearance that it has a more sound financial position than economic reality.

Essentially, debt is loaded on to the minority-owned joint venture, but the company

ultimately guarantees the debt. It’s nothing more than smoke and mirrors. Aggressive

managements will always try to find ways around accounting rules. When financial

statements include footnotes about joint ventures, debt guarantees and off-balance sheet

financings, it should raise a red flag … especially if these also involve transactions with

related parties. These are indications that management is more interested in making

themselves money at the expense of the public shareholder.

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Other footnotes in the financial statements that should be read are the “commitments and

contingencies” footnote, and footnotes related to pensions and other post-employment

retirement benefits (OPEBs). The commitments and contingencies footnote is where a

company lists lawsuits, guarantees, purchase obligations and other issues that impact

claims on future cash flows. This should be a short footnote … maybe just a couple of

paragraphs. If it starts to run more than one page, be wary! With regards to pensions and

OPEBs, keep in mind that these represent future liabilities for the company. If the

company is not taking proper actions to fund obligations today, they could be a burden on

the future cash flows and earnings. Look at all the trouble the automobile manufactures

and airlines companies ran into because of the burden placed on them by their under-

funded pension obligations.

Finally try and avoid companies with complicated capital structures. If the company

makes extensive use of convertible debt, multiple classes of stock, option strategies

(warrants, puts and calls) on its own stock in managing the capital structure; then

investing in that company should generally be avoided. Management should be focused

on running the business, not on playing with clever financing structures. Convertible

debt by itself is not enough to avoid a company. In many ways, it is an excellent way for

a company to raise capital at a cost-effective rate. What investors need to be wary of a

company that seems to be serially hooked on complicated financing structures and

potentially gaming its own stock. Recently, SLM Corporation (more commonly known

as Sallie Mae) had to raise capital because it lost over two billion dollars of shareholders’

money when it bet the wrong way on future exchange contracts involving its own stock!

SLM Corporation is in the business of lending to students working on advanced degrees,

not managing shareholder capital through hedge fund-type activities. Monkeying around

like that with shareholder capital is nothing more than shenanigans, and should be

avoided.

In summary, investing in a company should not be overly complicated. By sticking with

reputable managements that are running straight forward, profitable businesses, growing

their earnings-per-share that are backed up with real cash flow; the alligator investor will

be well down the path to successful investing. Appendix A includes a list of fundamental

research questions that can be used to help evaluate most companies.

39

CHAPTER 5: WHERE TO HUNT ALLIGATORS

Before going alligator hunting, investors should understand something. Investing is not a

task taken lightly. Like cooking, it takes care, diligence and nurturing. You wouldn’t try

to learn how to cook by eating, would you? Most aspiring chefs would probably get a

recipe book and some good cooking utensils. They would make sure their cooking

appliances were in good working order. They would purchase quality ingredients to

ensure the resulting meal had its best chance to be tasty. And then they would start

cooking and practicing. Their first few meals might not turn out good enough to be

served at a four star restaurant, but they probably would not be too bad either because of

the care taken to prepare them. But with more practice the chef’s skills improve, and

after a period of time, a culinary master may blossom.

But that’s cooking. Investing is not as easy. There is no recipe or magic formula to

follow which produces a great investment every time. When hunting alligators, you need

to be able to navigate through the swamp. Plenty of alligators will be seen, but the astute

hunter is only interested in seeking out the emerging adolescents. You’ll have to be

careful not to jump at every opportunity you see. Be patient. Stalk your prey and

observe it for a period of time so that by the time you take your shot, you’ve set yourself

up to be in an advantageous position with a better than average chance for success (define

success as making money). Keep in mind that even when being care and diligent, you

will still take some bad shots. That’s okay. Even the professionals don’t succeed every

time. Besides, you can protect against bad investments by selling them before too much

damage is done. After all no one wants to be around a wounded alligator when it is angry

and defensive. The point here is that following sound disciplines and performing proper

steps will increase the odds for investment success, but will not guarantee it. Like

cooking, with time and practice, investment skills will improve. Investing is a

challenging endeavor that can be extremely rewarding for the patient and diligent hunter.

Index Funds

If analysis isn’t your bailiwick, or you don’t have the time nor the inclination to spend on

researching individual stocks, the benefits of investing in midcap stocks can still be

obtained. Keep in mind that midcaps are the best equity securities category for

enhancing long-term wealth appreciation at an acceptable risk level. Rather than trying

to pick which alligator will emerge as dominant, simply own all of them by purchasing

the entire swamp in the form of a midcap index fund. By owning a midcap index fund,

you will own all the emerging leaders. You will also own a lot of company’s who plod

along in the corporate game of survival, but the gains achieved by the leaders will more

than offset the performance of the laggards. Not only that, but as the indexes rebalance

over time (meaning they remove the laggards and put in new potential leaders), investors

continue to participate in new emerging opportunities. Lastly, using index funds is a low-

cost solution to investing. Index funds are funds that replicate a segment of the stock

market by investing in all the stocks within that market segment in the same proportion

that they are represented by that segment. Index funds don’t try and “beat the market” by

overweighting or underweighting individual companies. By merely replicating the

40

market, the funds do not have to invest in expensive analyst teams and “star” portfolio

managers who may or may not be successful in providing returns greater than the stock

market. This keeps index fund fees low, often less than one-fourth of a percent. That

compares to actively managed mutual funds that often charge fees of a full percentage

point or more. Paying lower fees means the investor keeps more of his money. Not only

that, but there is no guarantee that paying the additional fees for an actively managed

mutual fund will result in earning higher returns. In fact, the odds of beating the market

for an actively managed fund are less than fifty/fifty. More on that later.

Hopefully by now it is apparent that having a portion of an investment portfolio in

midcap index funds makes sense. There are two primary providers of index fund data to

investment groups, Standard & Poor’s and Russell Investments. Each takes a slightly

different approach to creating their midcap market indexes, but both have captured the

essence of the midcap market and have provided comparable returns over time. Standard

& Poor’s manages its indexes through its S&P Index Committee, which is comprised of

various Standard & Poor’s economists and industry analysts. The committee’s purpose is

to determine which U.S. stocks are eligible to be included in the S&P MidCap 400 index.

Companies must meet specific criteria for size, financial viability, trading liquidity,

industry sector representation, and other metrics for inclusion in the index. Specific

details of the guidelines are available on www.indices.standardandpoors.com. The S&P

MidCap 400 index is essentially a managed index by the Standard & Poor’s organization,

which makes an attempt to select 400 stocks which they believe are representative of

United States mid-sized companies that together reflect the characteristics of the broad

midcap market. Changes to companies in the index are dictated by the S&P Index

committee which monitors the indexes composition on an ongoing basis. The advantage

to the S&P MidCap 400 index is that it has a selection process that attempts to weed out

nonviable companies and focus on a smaller group of potential emerging leaders. The

main disadvantage of the S&P MidCap index is that its committee management process

requires human intervention. In order for an emerging company to be included in the

index, it must not only be recognized by the S&P Index Committee as such, but must also

be actively placed into the index by the committee. The decision to add a name to the

index also requires the decision to remove a name. Because of the general resistance of

the organization to “over manage” the index, it is possible that the S&P MidCap index

could entirely miss out on participating in emerging leaders in new industries. This lost

opportunity risk is offset by S&P’s avoidance of nonviable companies that may be

popularized in the market for short periods of time, subsequently falling back to earth as

the investment fad fades. The recent rise and fall of Internet stocks are a good example

of this.

Russell Investments takes a much different approach to creating its midcap index. Rather

than selecting component stocks to be included in the index, Russell merely defines how

to segment the market by size and then lets the stock market determine which stocks will

be included in the particular index. No committee is used determine which stocks will be

included or excluded. By taking this approach, Russell removes the element of human

judgment and opinion as to what is a proper midcap stock and what is not. Russell

Investments rebalances its indexes annually. By doing this, it automatically adds to the

41

index any new emerging leaders that have risen to their adolescence stage and removes

companies that have matured to adulthood, or have declined due to be coming sick.

Russell does not try to define what is a good business and what is a bad business. Rather,

it lets the stock market be the ultimate arbiter of companies that get included the Russell

Midcap Index. To learn more about Russell Investments’ methodology on index

construction, you can visit their website at www.russell.com/Indexes/. The following is

an excerpt from Russell’s website. “The Russell Midcap Index offers investors access to

the midcap segment of the U.S. equity universe. The Russell Midcap Index is

constructed to provide a comprehensive and unbiased barometer for the midcap segment

and is completely reconstituted annually to ensure larger stocks do not distort the

performance and characteristics of the true midcap opportunity set. The Russell Midcap

Index includes the smallest 800 securities in the Russell 1000 (index).” To clarify this,

the Russell Midcap Index basically includes the 800 next largest U.S. incorporated stocks

below the largest 200. The main advantage of the Russell Midcap Index is that because

of its automatic annual rebalancing procedure, it is more likely to pick up all the

emerging leaders. It does not try to weed-out nonviable businesses and lets the market

ultimately decide which businesses are viable and which are not. The main disadvantage

is that nonviable businesses that become popular in the short term can be included in the

index and will ultimately be a drag on future performance when they fall from grace.

Like the S&P MidCap 400 index, these advantages and disadvantages are largely

offsetting.

Figure 17. Growth of Dollar 1995 through 2007

Growth of a Dollar

1.00

2.00

3.00

4.00

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

1.00

2.00

3.00

4.00

S&P 500

Russell Midcap

S&P MidCap 400

Figure 17 compares the price performance of the S&P 500, the S&P MidCap 400 and the

Russell Midcap indexes from 1995 to 2007. This time period was used because 1995 was

the year that these midcap indexes were originally available for exchange traded funds

and mutual funds to be created around these indexes. Although index funds were

popularized for the S&P 500 in the early nineteen-eighties, it wasn’t until 1995 that index

funds became readily available for the midcap segment of the stock market. This

42

analysis excludes dividends, but since the yields on each midcap index are comparable,

the outcome is the same.

You can see from figure 17 that investing in either the S&P MidCap 400 or the Russell

Midcap index would have resulted in returns far exceeding that of the large-cap S&P 500

index. Standard & Poor’s approach of having their Index Committee select the

component stocks resulted in a 12.1 percent annualized return during the twelve-year

period (excluding dividends) versus the Russell Midcap index return of 10.4 percent.

Both indexes beat the S&P 500 index price return of 7.5 percent. Although Standard &

Poor’s approach surpassed Russell’s over the time period, it did not beat Russell every

year. In four of the twelve years the Russell Midcap index performed better than the

S&P MidCap 400, and there is no guarantee that the S&P MidCap 400 index will

perform better than the Russell Midcap index in the future. In fact, for the five years

ended in 2007, the Russell MidCap index beat the S&P MidCap 400. The purpose here is

to show that there is more than one way to participate in the midcap segment of the

market, and if history is any guide, both are acceptable ways to enhance portfolio returns

for the long-term.

Knowing the description of the indexes is nice, but it would be nicer still to know how to

invest in them. Let’s cut to the chase. To invest in the S&P MidCap 400 index exchange

traded fund, buy ticker symbol MDY or IJH. They can be purchased the same way an

investor buys any stock in a brokerage account. MDY is the MidCap SPDRs Trust and

IJH is the iShares S&P MidCap 400 Index. The MDY and IJH exchange traded funds are

virtually identical except that the SPDRs are managed by State Street Global Advisors

while the iShares are managed by Barclays Global Investors. Both are respectable

professional organizations and your money will be safe with either institution. To clarify,

it is not necessary to have an account with State Street or Barclays. They merely manage

the funds. MDY and IJH can be purchased in any brokerage account, whether it be at

Charles Schwab, TD Ameritrade, eTrade, Wells Fargo, or wherever. ETFs can even be

bought at Merrill Lynch, Morgan Stanley or any of the big brokerage firms, but alligator

investors have preference for the discount brokerage firms, which provide low

commission costs with excellent customer service. To invest in the Russell Midcap

index, buy ticker symbol IWR which is the iShares Russell Midcap Index exchange

traded fund.

To invest in a traditional index mutual fund, there are several reputable fund families

available including Fidelity and T. Rowe Price. Many astute investors prefer the

Vanguard Group, Inc. Vanguard pioneered the popularization of index funds in the early

nineteen-eighties with the launch of the Vanguard Index 500 Fund. Most professional

investment managers dismissed the fund during its initial launch wondering why people

would settle for just market returns, when they could potentially earn more by investing

in actively managed mutual funds. Over two decades later with most actively managed

mutual funds providing sub-par returns, the Vanguard 500 Index is now one of the largest

mutual funds in the United States with over sixty billion dollars in assets under

management. The Vanguard Group is also one of the largest and most respected mutual

fund groups in the industry with a focus on providing investors with quality investment

43

solutions at low cost. Vanguard understands that by keeping their costs low, individuals

keep more of their money. Chapter 6 discusses the impact of fees and taxes on future

returns. Vanguard offers the Vanguard MidCap Index Fund, ticker symbol VIMSX. The

Vanguard MidCap Index Fund mirrors the stocks in the MSCI US MidCap 450 Index.

This is yet another midcap index, but it has performed similarly to both Standard &

Poor’s and Russell’s. Again, the important thing to remember is to invest in the midcap

segment of the market, the best area of the U.S. stock market to enhance long-term

returns at an appropriate risk level. In order to invest in the Vanguard MidCap Index

Fund, open an account directly with Vanguard. This can be done by visiting their

website at www.vanguard.com. Vanguard offers more than just index mutual fund

investing. They also offer actively managed funds, traditional brokerage account

services, as well as several other investment and retirement planning services. You can

learn more about Vanguards services as you progress through your investing career. But

for now, at least get started by investing in some good index funds.

Actively Managed Mutual Funds

For the general investing public, index funds are preferred over actively managed mutual

funds. Index funds essentially guarantee that investors earn the market rate of return

minus a very modest fee. Index fund investors won’t do better than the market, but they

won’t do worse either.

The vast majority of funds across the landscape of mutual funds are actively managed

funds. Actively managed funds (“active” funds) are managed by professional portfolio

managers supported by teams of securities analysts. These people are no dummies either.

Most hold a masters degree in business or mathematics, are chartered financial analysts,

and have access to the most advanced research tools available in the industry. Managers

of active funds try to beat the market by applying their knowledge and skill. They

believe that by doing this, they will outsmart the herd, and that their efforts will reap

rewards for their investor clients in the form of returns that exceed the market averages.

There must be some truth in this. After all there are thousands of mutual funds available

today through dozens of fund families. Clearly people would not tolerate paying higher

fees for below market returns. That would just be throwing good money after bad.

But the fact is that most mutual fund investors do not earn above market rates of return,

and most active funds do not beat the market averages over time. How can an entire

industry survive based on such a poor overall track record? Several factors contribute to

the industry’s resilience including individual investors’ ignorance, misinformation and

aggressive marketing by the financial industry, and the inclination that people possess to

gamble for the chance at higher returns. Let’s face it. When it comes to investing, most

people are confused or mystified by the financial markets. Many individuals do not

necessarily understand the difference between stocks and bonds, let alone common

stocks, preferred stocks, calls, puts, convertible bonds, interest-only or principal-only

strips, credit default swaps, or other types of investable securities. Even with index

funds, investors still need to consider small-caps, midcaps, large-caps, growth stocks,

44

value stocks, international, emerging markets, industry sector funds, and different bond

classifications. No wonder people get confused!

There is a logical explanation why the average active mutual fund cannot beat the index.

The stock market consists of all participants, including institutions, individuals, fund

complexes, pensions and anyone else who invests in stocks. The indexes represent the

average performance of all these participants. Because the indexes represent the average,

index funds virtually guarantee their investors will receive average performance. But the

remaining active participants cannot all be above average. Half will be above average

and half will be below average. And that is before fees and expenses are taken out. Not

only do active funds have to perform better than the market, they have to be better by

more than their costs. After removing fees and expenses, far fewer than half active

mutual funds are above average. This will demonstrated this later is this chapter.

A study performed by Dalbar, Inc. examined mutual fund inflows and outflows over a

twenty year period to gauge how well individual mutual fund investors did versus if they

just held the S&P 500 index. During Dalbar’s twenty-year study period the S&P 500

returned almost thirteen percent annually, while the average mutual fund investor earned

only three and half percent. The difference was attributed to investors buying at market

tops (chasing gains) and selling at market bottoms out of fear, only to later repurchase

again at higher prices. Investors also had a tendency to buy funds that were recent top

performers. When the top performing funds started to lag the market averages, investors

would sell those funds and then buy the next most recent top performing funds.

Many households clearly need help with their retirement savings plans. People know

they need to save for retirement, but they are not quite exactly sure how to do it. They

search for a trusted advisor who can develop for them a savings plan and choose the

appropriate funds in which to invest. Novice investors generally start by asking family

and friends who they use. That type of referral makes up a good portion of the

investment management business. Maybe the investor received an unsolicited call from a

broker or financial planner who caught them at the right time to hear to a sales pitch. Or

maybe the barrage of television advertising from various brokerage, mutual fund, and

investment companies finally caused them to pick up the phone or walk into an office and

sign up. All of these methods have one thing in common … they all required little effort

on the part of the investor, the person buying the funds. What it comes down to is a lot of

folks are just plain lazy when it comes to managing their savings plans. It may be

because the subject is considered complicated, or maybe they just feel too busy to deal

with it, so they avoid spending time even learning the basics. Either way, it has left the

door wide open for the investment industry to prey upon the individual investor.

Here is how the game works. Investment companies know that in order for them to get

business, they need to offer investors products (funds) that have provided returns better

than the market averages. Investment companies constantly test and incubate new funds

that deploy various investment strategies in hopes that some of them will develop

saleable track records. The tests that fail are closed. Nobody ever hears about them. But

the tests with good performance are put into their marketing machines and sold to the

45

public as the new hot fund or the new emerging portfolio management team. Investment

companies are also constantly on the prowl for small funds with good track records that

are managed by professionals who lack marketing and distribution capabilities. The

investment company acquires the small fund and puts it into their marketing machine.

The brokers, financial planners, and advisors who work for the investment companies get

paid by those companies to sell their employer’s products. If their funds don’t beat the

indexes, the employer will incubate or acquire other funds to replace the poor performers.

Some advisors will do whatever they think it takes to keep your business and charge you

fees. If the company they work for fails to provide good product, the brokers and

advisors will take their book of business to a different company in hopes of getting better

fund offerings to sell. While it is their best interest to provide investors a quality service,

the discussions in the back office revolve around how to grow assets (and make more

money), how to get more clients (and make more money), how to increase “share of

wallet” (and make more money), what new specialty products can be offered (which

charge higher fees and make more money), and other topics which basically revolve

around how to make more money from everyone else’s money.

Most investment products are sold to investors, as opposed to investors researching

alternatives and making an educated choice. It is unfortunate, but a great many people

spend more time researching and evaluating the purchase of a car or piece of electronics

than they do researching and evaluating their investment options. This is the

environment that has allowed an entire industry to flourish despite its overall subpar

performance record.

An article by Thomas P. McGuigan, CFP in the February 2006 issue of the Journal of

Financial Planning studied the performance of large-cap and midcap active fund

performance over a twenty-year period ending in 2003. For large-cap domestic stock

funds his conclusions included the following. “The longer the investment time frame, the

more difficult it was for active managers to outperform the index fund. … The long-term

investor had a 10.59 to 24.71 percent chance of selecting an actively managed fund that

outperformed the index fund. … The cost of selecting the “wrong” manager was high. …

and predicting in advance which mutual funds would outperform was difficult.” For

midcap domestic stock funds, Mr. McGuigan reached a similar conclusion with emphasis

on the following points. “A long-term investor (10-20 years) had a 2.63 to 13.16 percent

chance of selecting an actively managed fund that outperformed the index fund. …

midcap funds performed worse against the index than did large-cap funds.”

To corroborate the conclusions above, this text performed a study of active mutual funds

for the ten-year period ending December 2007. All unique (only one fund class type per

fund) active funds that had at least a ten-year performance record were selected from the

Morningstar, Inc. mutual fund database as of December 31, 2007. Funds were first

segregated into market capitalization categories of large-cap, midcap, and small-cap, and

then categorized by style between blend, growth, and value. Results from evaluating the

midcap blend category are presented in this text, as the primary focus was to evaluate

whether or not using active midcap mutual funds is an effective way to capture the

46

opportunity available from investing in midcap stocks. The Russell Midcap index was

used as the benchmark index for comparing active fund performance.

At year-end 2007, there were eighty-six unique midcap blend funds in the Morningstar

database that had a performance record of at least 10 years. During that period, the

Russell Midcap index returned 9.9 percent annually. Subtracting 0.2 percent for fees (the

typical expense ratio for an efficiently run index fund) leaves an index fund return to the

investor of 9.7 percent. The median fund return after fees was used to evaluate mutual

fund performance. The median represents the mid-way point for the distribution of all

returns, where half of the funds returned better and half performed worse. Using the

median, the average midcap blend fund returned 9.75 percent. Forty-one, or roughly half,

of the midcap blend funds were able to beat the index over the ten-year period. In other

words, investors had basically a fifty/fifty chance of picking an active fund that beat the

index.

That doesn’t seem like bad odds, but that does not quite tell the whole story either.

Because the sample includes only funds that existed for the entire period, it excludes

funds that may have existed ten years ago, but didn’t survive through 2007. The funds

that did not stand the test of time most likely had poor performance and were closed

down. The impact on the test results is known as survivor bias, which results in

overstating the results of active funds. John C. Bogle, founder of the Vanguard Group,

Inc. referenced a study in the early 1990’s by Princeton Professor Burton Malkiel

estimating that the effect of survivor bias would be to reduce active fund performance by

over one percent annually. Other academic studies have since been performed that

further corroborate Professor Malkiel’s result. By including the survivor bias impact, the

average active fund return drops to 8.75 percent versus 9.7 percent for the index fund.

That is not too bad a shortfall against the index until you consider its impact over the ten-

year period. An investor who placed 10,000 dollars in the average active fund would

have seen it grow to 23,135 dollars at the end of the ten years, versus 25,140 dollars had

it been invested in the index fund. Although the annual difference was only one percent,

it resulted in the active fund investor incurring a shortfall of 2,015 dollars, 8.7 percent

less versus the index fund investor. Extend these returns to twenty-five years and the

shortfall grows to almost 20,000 dollars, a 24.3 percent difference in accumulated wealth.

That is over twice the initial 10,000 dollar investment!

How do investors go about selecting an active mutual fund in which to invest? From

personal observations over the years of individual investors, financial planners and

institutional consultants, the most common way that active funds are selected is based on

their past performance track records. Most commonly, the past five-years performance

record is used as a barometer for identifying active funds that should provide future

returns greater than the index. Other factors are considered such as investment

philosophy, tenure and experience of the portfolio management and research team,

stability of the business, trading turnover, style drift and other factors. But where the

rubber meets the road, it is past performance that becomes the final determinant that

causes people to invest in a particular fund. People want to invest with winners, not

47

losers. And the seemingly best way to apparently find a winner is to see who is currently

winning.

To test that theory the ten-year performance record for the above eighty-six midcap blend

funds was broken into two five-year periods. The first period measured annual returns

for the initial five years ending 2002. During the five years ending 2002, fifty-five of the

eighty-six funds had returns greater than the Russell Midcap index. These fifty-five

funds had demonstrated themselves as winners, worthy of attracting additional investors

seeking above market average returns. The return of these fifty-five funds was next

compared to the Russell Midcap index (minus 0.2 percent for fees) for the subsequent

five-year period ending 2007. The results are indeed illuminating. The funds that beat

the index for the first five years lagged the index fund return on average by 2.9 percent

annually in the following five years ending 2007. The average investor in the active

funds would have been almost 2,700 dollars wealthier by investing in the index fund

(based on a 10,000 initial investment). Only eight of the fifty-five funds that beat the

index during the initial five-year period beat the index over the next five-years ended

2007; meaning that the odds against the active fund investor beating the market were

about seven to one.

Rather than just focusing on funds that beat the market, you could make your selection

from the top quartile of funds for the five years ending 2002. Clearly in order to achieve

that level of performance, the fund manager must have some advanced skill.

Unfortunately the results are not encouraging. In fact the top quartile of funds on average

performed even worse, lagging the index by 3.7 percent annually in the five years ended

2007. Only two of the twenty-two funds from the top quartile in the initial five-year

period managed to beat the index during the subsequent five years. The odds against the

active fund investor beating the index fund jumped to ten to one. Table 4 summarizes the

results of the active midcap blend fund study.

Table 4 Analysis of Active Midcap Blend Mutual Funds

Above Mkt Funds Top Quartile Funds Russell Midcap

Five year return ending 2002 6.70% 8.90% 2.00%

Five year return ending 2007 15.10% 14.30% 18.00%

Shortfall versus the index - 5 years 2007 -2.90% -3.70% N/A

Number of funds 55 22 N/A

Number of funds that beat the index 8 2 N/A

Percent of funds that beat the index 14.50% 9.10% N/A

5 year value of $10,000 investment $ 20,201 $ 19,508 $ 22,878

Examining the distribution of active fund results versus the index puts the risks of

investing in active funds into further perspective. Figure 18 shows the distribution of

relative performance for the five years ending 2007 for the fifty-five active midcap blend

funds that beat the index in the previous five years. Not only did the average fund did not

beat the index, but for the funds that did do better, it was not by much. Only two funds

beat the market by more than two percent, and the average additional gain for the funds

that did beat the market was only 1.8 percent. This 1.8 percent difference would have

48

resulted in an additional 1,800 dollar gain over the five years ended 2007 versus the index

fund. As mentioned above, investors had a 14.5 percent chance of picking one these

winning funds. But investors also had the same 14.5 percent chance of choosing one of

the eight worst performing funds. The average shortfall for worst performing funds was

8.5 percent, a shortfall of 7,100 dollars against the index fund. That results in over a

thirty percent shortfall to accumulated wealth versus the index fund after five years,

representing over seventy percent of the initial 10,000 dollar investment. In short,

investors had a fifty-fifty chance of gaining 1,800 or losing 7,100 dollars. Here is an

experiment to play with some friends. Flip a coin ten times. Each time it turns up heads,

pay your friend eighteen dollars. Each time it turns up tails, your friend pays you

seventy-one dollars. Most likely no one will want to play … or you have really dumb

friends.

Figure 18. Active Midcap Mutual Fund Relative Performance Distribution

Active Fund Relative Performace

21

76

20

11

6

2

0

5

10

15

20

25

-12 to -10 -10 to -8 -8 to -6 -6 to -4 -4 to -2 -2 to 0 0 to 2 2 to 5

Performance Vs. Index

# o

f fu

nd

s

Just a quick word on the active midcap growth and midcap value funds. Without going

through all the details, the results were basically the same. Active funds that beat the

index for the first five years typically did not beat the index over the next five years. The

penalty for picking the wrong fund was greater than the gain for picking the right fund.

There appears to be no clear way to determine the winners from the losers in advance.

The conclusion is that buying active funds is primarily a leap of faith. The active fund

industry to a certain degree caters to an investor’s urge to gamble in an attempt to beat

the odds that are stacked against him. To attract investors, fund complexes advertise their

past performance or their Morningstar ratings to convince you of their superior skill. But

the facts are the facts. Academe is littered with studies documenting the slim chance that

active funds have in outpacing index funds over time. Read the fine print or listen to the

disclaimer that is included in every active fund advertisement and prospectus … “Past

performance is no guarantee of future performance.” No kidding!

49

It is no surprise, given the above results and the numerous other studies showing the

advantages of index funds over active funds, that most mutual fund complexes and

brokerage firms now offer a menu of index funds for their customers. If you can’t beat

them, join them!

But if you are inclined to try to beat them, here are some guidelines to at least try and tilt

the odds to be more favorable (but still not positive). First, stick with low cost funds.

According to John C. Bogle, “A low expense ratio is the single most important reason

that a fund does well.” That makes good sense. Since most active funds do not beat the

index, charging lower fees to customers gives the manager a better chance of being able

to add value above those fees. Consider the example of playing poker at a casino. The

casino makes money by taking a rake (a fee) from every hand played. A skilled poker

player has to not only beat the other players at the table, but also win enough to cover the

casino’s rake before making money. The higher the rake, the better the poker player’s

skill must be. In the case of active mutual fund investing, the investment firm is the

casino and the portfolio manager is the poker player. The portfolio manager not only has

to beat the market, but also has to beat it by more than the investment firm’s fee (rake)

before shareholders can earn above average returns. Given that the long-term stock

market return is about ten percent, and the average active fund fee is over one percent, the

portfolio manager must perform over ten percent better than the stock market before

adding value for its active fund shareholders.

Choose funds with lower trading turnover. This also keeps costs down. Whenever a

fund makes a trade (either buying or selling a stock) it results in commissions to the fund

and also a market impact cost. Over the years commission costs have come down

dramatically. It is now common for institutional traders to pay as little as one cent per

share traded, versus ten cents or more over a decade ago. Spreads between the bid and

ask prices have also decreased over time, which has helped bring costs down. However,

these lower per unit trading costs may have partly contributed to the rising turnover rates

in active mutual funds. The average turnover for midcap blend funds in 2007 was 108

percent. That means the average fund bought and sold every stock in the portfolio at

least once during the year. Perhaps the biggest cost involved with trading today is market

impact, or the amount that a stock moves when a fund tries to buy or sell it. Buying a

stock puts upward pressure on a stock price, and selling vice-versa. Depending on the

stock’s liquidity (a measure of how easily it trades), the market impact on a stock could

easily be over 1 percent, especially for less liquid midcap stocks. A fund that is

constantly turning over will suffer a greater market impact cost, which again raises the

bar that the fund manager must clear when trying to beat the index. When holding

mutual funds in a taxable account, investors must also consider the impact of income

taxes eating into investment returns. Higher turnover funds result in higher taxes. It

makes almost absolutely no sense for an active mutual fund to be held in a taxable

account. Active funds, if used at all, should be restricted to tax-exempt IRA’s, 401(k)

plans, etc.

The tenure of the portfolio manager or managers should also be considered. If the

portfolio manager or managers on the fund have recently changed, the track record for

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that fund is no longer that manager’s record. Technically, the performance record for a

fund belongs to the fund and the fund complex. The fund could change the portfolio

manager every year and the track record would continue to be the record of the fund. It is

not uncommon for a fund with a good track record to have its portfolio manager leave to

pursue other more lucrative offers. When a new manager is put in place, the record is no

longer really relevant. And as was shown above, the past track record for a fund has no

predictive value in estimating future returns anyway.

Finally consider the size of the fund, especially for midcap funds. When a fund is small,

say only a few hundred million to a billion in assets under management, the portfolio

manager has greater maneuverability to execute on investment ideas. As a fund grows in

size, liquidity to execute becomes a bigger issue since the fund will be trading bigger

blocks of shares in any given company. The market impact to trading costs and

performance increases. But investment companies like their funds to grow in size

because it means more profit for the investment company. So in order to keep growing,

the fund may start owning more stocks; or groups of stocks within an industry rather than

just the best stocks in the industry. Performance starts to suffer as a result. Not only that,

but the portfolio manager has seen the fund grow and is now responsible for a large fund,

which he does not want to see revert back to being a small fund. So the portfolio

manager may start to manage the fund a little closer to the benchmark index. He built the

fund to a large size by taking calculated risks, but as the fund has grown, fewer risks are

being taken for the sake of job preservation. The portfolio manager has shifted from

playing an offensive strategy to a defensive strategy, and fund performance as a result

can suffer. When an active midcap fund has accumulated several billion in assets under

management, it just doesn’t have the flexibility and perhaps lacks the motivation that

smaller funds have.

Several screening tools are available on the Internet to identify funds in which to invest.

One of the better ones available for free is offered by Yahoo Finance at

http://finance.yahoo.com/funds, or choose the mutual fund option on the investing tab of

the Yahoo Finance home page. From there select Yahoo’s fund screening tool, which

allows for screening various criteria including category (small, mid, large, growth, value,

etc.), manager tenure, fees, risk, turnover, and other metrics. Morningstar, Inc. also

offers a basic fund screening tool on its morningstar.com website. Select the Fund tab on

its home page. Within its Tools menu, select the Fund Screener option. Basic screening

criteria are available for free. More advanced screens can be performed by subscribing to

Morningstar’s premium services at a current subscription price of under twenty dollars

per month. More screening tools are available on the Internet from brokerage firms,

other financial sites and directly from the active fund complexes. Keep in mind that none

of these screens can guarantee that the active funds selected will beat the market. Even

Morningstar, who perhaps has the most comprehensive mutual fund database available,

cannot demonstrate that its four and five star fund selections on average beat the stock

market indexes over time.

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Other prominent investors have given their opinions about the merits of investing in

index funds. To quote perhaps the greatest investor of our generation:

“Most investors, both institutional and individual, will find that the best way to own

common stocks is through an index fund that charges minimal fees.”

Warren E. Buffet, Chairman Berkshire Hathaway Corporation

For a more thorough discussion of index funds, Common Sense on Mutual Funds, New

Imperatives for the Intelligent Investor by John C. Bogle is recommended.

Common Stocks

As stated previously individuals who do not have the time or inclination to do analysis

should stick with index funds. For those who do have the time and the inclination,

keeping the vast majority of stock investments and all of your bond investments in index

funds is still recommended. The index funds chosen should be diversified across various

categories. See chapters 7, 8 and 9 for a discussion of diversification. For individual

stock investments, limiting exposure to a maximum 25 percent of total equity

investments is recommended.

Investing in individual stocks offers some advantages over active mutual funds. The first

is control. The investor will control which stocks are select, at what price to purchase

them, and at what price to sell them. She will be in a position to act on insights she may

have regarding a particular company and profit from those insights. Investing efforts can

be concentrated on just a handful of good ideas, as opposed to active funds which

typically hold from fifty to over a hundred stocks. The ability to concentrate holdings

allows investors to maintain focus and take appropriate action at the right time. Holding

too many stocks not only dilutes the contribution of each individual holding, but can also

damage overall performance as too many holdings could become unwieldy or distracting.

Individuals run the risk of getting lost in the trees and making bad knee-jerk decisions by

overreacting to stock price volatility caused by rumors or miss-reactions to short-term

issues. If a stock selection mistake is made, losses can be cut quickly.

When you are in control of investment trading, absolute risk on any stock can be limited

by selling before the loss becomes large. Better control also exists over taxable gain

recognition. With the average active midcap mutual fund turning over one hundred

percent annually, be assured that taxes are going to eat into returns. However, with

individual stocks, the individual controls the level and timing of turnover and the

resulting taxable gains. Investors should let winners run to take advantage of the tax-free

compounding that will occur over time. Selling winners too quickly is a mistake made by

many investors, as is holding on to losers in the hope that they rebound.

Another advantage stock investing has over active funds is that understanding the

situation in a stock investment is easier than in a fund. Active fund research is focused

on the qualifications of the portfolio manager and research team, the investment style and

philosophy, the diversification of the fund’s holdings, the past performance record,

52

account turnover and other factors. But even after going through that exercise, there is

still a great deal of uncertainty about exactly what the active fund has invested in. The

decision to invest in any particular active fund has a great deal to do with an investor

getting the “warm and fuzzies” as opposed to any real concrete evidence.

When investing in a stock however, there is a great deal more information that can be

evaluate in the decision to own or pass on a particular company. The size of the

addressable market opportunity for the company can be evaluated along with what

products or services it sells and to whom, its pricing strategy and ability to higher cost

through to customers. Investors can evaluate the company’s cost structure and estimate

where cost pressures exist and where the company can expand margins through

leveraging its infrastructure, what kind of capital expenditures are required not just to

sustain the business but also to invest in growth. If the company of interest is a retailer or

restaurant, visit the store locations and talk to the managers about how the business is

performing. If the company provides medical solutions, ask doctors about their

effectiveness. Required Securities and Exchange Commission filings (10Ks, 10Q’s and

proxies) are most likely available on the company’s website in the investor relations

section. Most companies today post replays of their public quarterly update calls to

analysts and shareholders to facilitate evaluating the company’s progress. Many

businesses also post replays of their annual analyst day meetings, where they lay out in

detail their long-term strategy and objectives. In short, there is a plethora of meaningful

information that is available to the diligent investor.

Individual investors have a size advantage over institutions. Remember from the

discussion above that a smaller size is an advantage to a mutual fund for trading liquidity

purposes. An individual investor has the same advantage. Assuming two hundred

thousand dollars is available to invest across twenty stocks, and that the average stock

price is thirty dollars, each stock position will consist of about three hundred shares.

Given that the average midcap stock trades over three-quarters of a million shares per day

and the average small-cap stock trades almost a half million, it’s safe to say that an

individual’s personal trading is unlikely to have any significant market impact on the

stocks you buy or sell (unless the individual is Bill Gates). Individual investors can

navigate the swamp virtually undetected as they hunt for the best investment

opportunities.

But being an individual investor is not without its disadvantages. First of all, most people

already have a full time job that takes the majority of their time. Having a family will

also cut into the amount of time available to research and invest in stocks. The vast

majority of time spent on a stock is when evaluating a new opportunity. Every new stock

investment requires an investment of time become familiar with the fundamental

opportunity that the company faces. At a minimum, several hours should be budgeted to

get familiar with the company’s growth story, understand management’s plans, review its

financial statements, and to develop a thesis as to why the company is a good investment

(if it indeed is). This is also the time to establish an exit strategy from the stock. If it

turns out the investment thesis is wrong, selling is required to conserve capital. If the

stock exceeds its fair valuation estimate, sell some or all of the holdings. Nobody ever

53

went broke taking a profit. Once familiar with the company, allow one hour per month

per stock to keep investment knowledge current. That should be enough time to check

for recent news, earnings updates, technical analysis (charts) or other required work.

Although access to information today has never been better for the individual investor,

investment professionals still have an information edge over individuals. Investment

professionals have the resources to invest in industry consultants and state of the art

research tools and systems. They can afford research staffs with analysts specifically

focused on each industry to ferret out the best ideas. The analysts and professional firms

have direct access to the senior executives of companies in which they invest. This gives

them direct feedback from management when performing their research1. Individual

investors generally cannot afford to invest as much into the research process that

professionals can. But do not be too disheartened by that. Even with all those resources,

most professional fund managers have failed to beat the market indexes over time.

There are probably more disadvantages to be mentioned, but the purpose here is to

encourage you to invest, not to scare you away from the hunt. In order to find potential

investment opportunities, a little money must be spent on one or two investment service

subscriptions to assist the stock screening and evaluation process. Keep in the mind that

whatever subscription services are chosen, their purpose is to assist in making better

investment decisions, not to offload the entire process. Ultimately, each individual

investor must accept full responsibility for each and every investment decision made.

Without accepting full responsibility, it is too easy to fall into the blame game. In the

blame game, rather than going back and reviewing why an investment decision was

incorrect, the loss (or selling a winner too soon) is blamed on someone or something else.

By accepting responsibility for bad investment decisions, the astute investor will be more

likely to examine what went wrong and learn from the mistake. This learning can help

avoid making similar mistakes in the future. The investment service subscriptions

selected should be geared towards stock selection and evaluation rather than general-

purpose business reading. While the Wall Street Journal, the Economist, Business Week,

Forbes and other periodicals are fine publications, they are not truly geared towards

helping the individual investor make better stock selections. Here are three subscriptions

considered helpful to the individual investor: Investor’s Business Daily; Morningstar,

Inc.’s premium services; and The Value Line Investment Survey.

Investor’s Business Daily (“IBD”) is arguably the best daily newspaper geared towards

helping the individual investor identify quality emerging stock opportunities. IBD was

founded by William J. O’Neil, one of today’s most seasoned and successful investment

professionals and also the founder of William O’Neil & Co., Inc., a leading institutional

investment organization. In Mr. O’Neil’s book How to Make Money in Stocks, A

1 Sometimes being close to management is a disadvantage. When a company is floundering, management

will at least try to put a positive spin on the situation. Management needs to save face protect their

reputation. They may acknowledge their company’s problems but may dismiss them as temporary and try

to convince investors that plans being implemented will turn a bad situation back to good. No management

will ever admit that the emperor has no clothes. In these situations being too close to management is akin

to dancing with the devil.

54

Winning System In Good Times Or Bad, he lays out his trademarked CAN SLIM

approach to investing in stocks and also provides guidance on how to better use IBD as a

tool for successful stock investing. IBD is currently separated into two sections. The

first part (A section) of IBD provides a briefing of headline news with varying features

about stocks, industries, mutual funds and other items of interest. The B section,

“Making Money,” gets to the meat of IBD, updating the stock market’s overall current

condition and identifying stocks and industries that are showing leadership. Charts are

included in B section for the overall market, leading stocks, sectors, and commodities.

Data and charts for the IBD 100, their top data graph rated stocks, are updated weekly.

IBD’s “Making Money” section also includes an “Investor Education” page that provides

ongoing training to help investors get the most utility from an IBD subscription.

IBD provides limited fundamental data on companies, mainly just the few metrics which

Mr. O’Neil’s CAN SLIM system considers important. CAN SLIM does not try to

forecast business fundamentals or determine a stock’s price target through discounted

cash flow or other stock valuation methodologies. In fact, the CAN SLIM approach

considers a company’s valuation secondary (if not completely irrelevant) to the factors of

the supply and demand for a company’s stock. IBD’s strength is identifying companies

that are currently exhibiting strong fundamental performance and using technical analysis

as an overlay to enhance the timing of purchases and sells in any given security. Given

IBD’s strength in screening for companies experiencing strong earnings growth and

favorable stock price momentum, it is a good resource for the individual investor seeking

to invest in new emerging companies. A subscription to IBD costs about three hundred

dollars per year, and also includes access to the investors.com website, an online version

of the newspaper with additional resources for screening and evaluating stocks.

One of the best values today for quality fundamental research about companies is the

Morningstar, Inc. “Online Premium Services” subscription. For less than twenty dollars

per month, individuals get access to Morningstar’s research on over two thousand

companies. The stocks covered include leading global companies, but also many of the

emerging leaders that alligator investors are looking for. Screening tools allow users to

search through four hundred and fifty criteria to facilitate finding investment

opportunities. Morningstar’s strength is its research methodology, a bottom-up

fundamental approach to valuing and rating stocks. Morningstar states in its investment

approach “that purchasing shares of superior businesses at discounts to their intrinsic

value and allowing them to compound their value over long periods of time is the surest

way to create wealth in the stock market.” Each stock covered by Morningstar receives

an in depth analysis of its business opportunities and risks, the sustainability of its

competitive advantages, its growth opportunity and outlook, management quality and

stewardship over shareholder resources, and a fair value estimation based on a discounted

cash flow method, including a margin of safety analysis. Morningstar also provides a

great deal of fundamental information including ten years of historical financial

statements and ratios making it simple to see trends in a business’s results. Morningstar’s

emphasis is on identifying quality businesses and buying them at steep valuation

discounts to their estimated fair values.

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A comparison of the two approaches shows that Morningstar is similar to IBD in that

both methods seek to invest in quality companies. However Morningstar is different

from IBD in that Morningstar’s ranking system is based primarily on discounts to

estimated fair value, which makes it somewhat of a counter-momentum strategy versus

IBD, which actively seeks out stock price momentum. Customizable charts are available

from Morningstar, but they are not as good as IBD’s. Morningstar tries to control risk of

major stock losses by emphasizing buying quality businesses at deep discounts. Because

IBD’s CAN SLIM method is not valuation sensitive, it controls stock loss risk by

requiring investors to sell losers quickly before losses get out of hand. CAN SLIM is

primarily a quantitative and technical approach, while Morningstar is a more traditional

fundamental system. Both the Morningstar and CAN SLIM methods to investing in

individual stocks can be effective. Used together, IBD and Morningstar complement

each other well. Combining IBD’s momentum bias with Morningstar’s valuation

sensitivity can be a strong formula for investment success.

Which brings us to the Value Line Investment Survey. Value Line is one of the oldest and

most respected independent investment research organizations with over three-quarters of

a century of experience tracking, analyzing and ranking investments in a consistent

manner and methodology. Value Line states its mission is “… to provide investors with

the most accurate and independently created research information available, in any

format [investors] choose, and to teach them how to use it effectively to help meet their

financial objectives.” The Value Line Investment Survey (the “Survey”) is a weekly

publication covering 1,700 stocks across almost 100 industries in addition to commentary

on the overall stock market and economy. Companies included in the Survey are

prescreened for quality and trading liquidity by Value Line. The Survey includes most of

the global leaders, as well as many potential emerging companies with market

capitalizations over a half-billion dollars. For sixty dollars per month or less, you get

access to one of the best tools available assisting individuals in researching and

evaluating stocks. A subscription also includes access to the online version of the

Survey, which provides the ability to screen across the Value Line universe of stocks in

addition to other research tools.

Probably no other service provides as much quality information on one page about a

company than the Survey’s Ratings & Reports updates. On one page subscribers get a

brief description of a company’s business, an analyst’s update for the company’s outlook,

up to sixteen years of key fundamental statistical per share data, up to ten years of

historical financial information, a summary of past and expected future growth trends, a

chart summarizing up to thirteen years of historical price data with a graphical projected

price range, an independent forecast of both business fundamentals and projected stock

price objectives, and more. Most importantly, Value Line provides its proprietary

rankings for timeliness, safety, financial strength, stock price stability, price growth

persistence, and earnings predictability. Value Line sorts the Survey’s stocks by industry

and also includes a brief quarterly industry update. By sorting stocks by industry,

comparison of companies within an industry to identify the leading participants is made

easy. The Survey can assist with identifying investments that are suitable for investors

ranging from conservative to aggressive orientations.

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Perhaps the Survey’s most significant differentiator is Value Line’s timeliness rank. The

timeliness rank evaluates all stocks in the Survey for stock price momentum, earnings

momentum, earnings surprises, price volatility and other metrics. Stocks are given a rank

by Value Line from one to five. Companies ranked one and two are considered more

likely to have better relative stock price performance over the next six to twelve months

versus the average. Value Line has tracked the performance of its timelines rankings

since 1965, and has demonstrated that their top two timeliness ranks have added value to

investors above the average stock, and the against the S&P 500 index. Although Value

Line ranks stocks for safety and other metrics, it is the timelines rank that has stood out as

having an ability to increase shareholder returns.

Value Line takes education seriously and provides several resources on its website at

http://www.valueline.com to assist users in maximizing their utility of the available

resources. Visit the Value Line University for an extensive discussion of the Survey’s

method and approach. On their home page investors can find a tab for educational

videos, which briefly describe the Survey. It is worthwhile for individuals to spend two

hours watching these videos if they decide to subscribe to the Survey.

All three resources, Investors’ Business Daily, Morningstar’s Premium Online Services,

and the Value Line Investment Survey are good choices to assist alligator investors with

successful stock investment choices and decisions. But these services will require an

investment of resources. In order to make money, some must be spent. IBD and

Morningstar combined will cost about the same as Value Line alone, about six hundred

dollars a year or less if multi-year subscriptions are purchased. That amounts to 1.2

percent of fifty thousand dollars, assuming that is the amount available to invest in

individual stocks. One hundred thousand dollars to invest in stocks drops that expense

ratio to 0.6 percent. That expense ratio is cheaper than the average active midcap mutual

fund which charges 1.38 percent. Since that the average active fund does not beat the

stock market over time, money may be better spent on one or more of the above services

than on an active fund manager.

To summarize, investing in emerging midcap companies (the adolescent alligators) is a

prudent, risk-adjusted strategy to enhancing long-term investment results. If you don’t

have the time or inclination to select and manage your investments, stick with the midcap

index funds. If you want the chance to beat the midcap indexes but don’t want to select

individual stocks, buy active mutual funds. If you invest in active funds, understand that

the odds are stacked against you in trying to beat the index and that there are no proven

tools available today which have been shown to assist investors in picking winning active

funds. Finally if you believe you have the time and skills to beat the market, consider

investing in one or more of the above investment subscription resources. Additionally,

keep the majority of investments in index funds anyway until you prove that you indeed

can beat the indexes.

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CHAPTER 6: FEES AND TAXES – PARASITES ON RETURNS

Good planning, diligence and persistence are all essential to building a retirement war

chest. Not only should investors save as much as possible, but they also need to focus on

maximizing their saving’s return potential. That doesn’t mean imprudently increasing

exposure to high-risk ventures in the hopes of landing elephants. One of the best ways to

enhance investments return’s long-term potential is to minimize the expenses incurred for

investment services. The two biggest expense components are fees and income taxes.

A parasite is defined in biology as “an organism that grows, feeds, and is sheltered on or

in a different organism while contributing nothing to the survival of the host.” The

definition of parasite also includes “One who habitually takes advantage of the generosity

of others without making any useful return.” That sounds consistent with the hundreds of

active mutual funds and investment managers that charge high fees for sub-par returns

versus the index funds. It seems there are more than a few investment firms that have

grown large while contributing little if benefit in the form of useful returns (in excess of

the indexes) to their host clients. Not all investment counselors and fund managers are

bad people. A good investment counselor or financial planner helps its clients stay on a

proper long-term savings and investment path to achieve his or her retirement goals. And

there is the uncommon portfolio manager who will provide superior returns relative to the

index. But most of the time financial planners, registered investment advisors, brokers

and consultants are selling the products and services that are offered by the firms that

employ them. They are compensated based on how much they sell and the amount of

fees they generate for their employer. The higher the fees they generate, the more they

stand to make. They most likely do want to add value for their clients, but the nature of

the industry, its fee structures and its compensation plans make adding value a difficult

task. Many times, the financial advisor was either a friend or referred by a trusted

confidant. That ends up bringing emotional ties into the financial planning decision and

can cause investors to stick with poor long-term strategies.

Investing is not just a matter of earning high returns to build long-term wealth. It is also

about keeping as much of that wealth as possible. Paying out higher fees and taxes than

necessary puts a drag on returns. Even small percentage differences can have a huge

impact on a person’s ultimate retirement savings thirty years down the road. That is

because the amounts paid in fees and taxes are no longer available to benefit from the

Power of Compounding. Nobel prize winning physicist Albert Einstein has been credited

with saying, “Compound interest is the most powerful force in the universe.” Let’s begin

by separately addressing the impact that fees have on future savings.

Even though the previous chapter demonstrated that the odds are low for choosing an

active mutual fund that outperforms the index fund, assume that some lucky investors

actually picked a fund that performed the same as the index over the past twenty-five

years before fees. Also assume the future mid-cap index return will be twelve percent

annually. Currently the average fee charged by active mid-cap funds is 1.38 percent. An

efficient index fund charges 0.2 percent per year. Table 5 compares the results of

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compounding ten thousand dollars over the next twenty-five years for the index, the

index fund, and the active fund.

Table 5. Impact of Fees on Net Fund Performance

Index Index Fund Active Fund

Gross Return 12% 12% 12%

Fee None 0.20% 1.38%

Net Return 12% 11.80% 10.62%

Years Invested 25 25 25

Beginning Value $10,000 $10,000 $10,000

Ending Value $170,000 $162,572 $124,693

Shortfall vs. Index None 4.4% 26.7%

Table 5 clearly illustrates how small differences in fees can dramatically impact long-

term savings. The efficiency of the index fund allows it to charge just a nominal fee of

0.2 percent, which is less than two percent of the total gross return. After twenty-five

years, the impact of fees is minimized, taking away only 4.4 percent of the potential

wealth. With the index fund, investors kept over 95 percent of their money.

The active fund fee of 1.38 percent represents over eleven percent of the gross return.

The active fund must charge a higher fee to pay for an expensive research staff and its

“star” portfolio manager who may leave if not adequately compensated for his incredible

skill. Although the 1.38 percent fee may seem a small price to pay for earning over ten

percent a year, the impact it had on the ending savings amount was enormous. The active

fund charging the average active fee resulted in an ending balance that was only about

three-fourths of the return achieved by the index fund with the identical gross return. The

prior chapter showed that most active funds do not keep pace with the indexes.

Considering the fee penalty paid for active management on top of the performance

penalty, the index approach to investing in mid-cap stocks becomes even more attractive.

There is no question that index funds have a clear advantage in keeping fees low. Index

funds do not need expensive research departments and can leverage the continuously

declining cost of technology, passing along the efficiencies and savings to their

customers. Most fund complexes today offer index fund options in addition to their

active fund offerings. This is mainly because investors over the years have started to

notice that their active funds have been beaten by index funds and have demanded index

funds be made available. Reluctantly, the active fund complex provides them at a

reduced fee to their active fund fees.

However, it is still “buyer beware!” when it comes to choosing an index fund. Even

though all index funds merely track the index’s performance (which is all that is acquired

of them) they don’t all charge the same fee. They should though. Index funds are

commodities, just like gold, corn, gasoline, bottled water or any other commodity.

Because of this, investors should pay the lowest fee available in order to retain the

greatest portion of the index’s performance. An efficient midcap index fund should

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charge no more than twenty-five basis points (0.25%) per year. However, some index

funds are charging fifty basis points (0.5%) or more. The investor gets nothing in return

for paying the higher fee. In fact, all the investor gets is a lower net return. Applying the

additional 0.3% charge to the above table would have reduced the ending savings of the

index fund to $152,010, a shortfall over ten thousand dollars compared to the low-fee

index fund. Vanguard Group, Barclay’s iShares, and State Street’s SPDRs are

highlighted as being among the most efficient providers of index funds and ETFs. If you

are paying in fees more than what these institutions are charging, consider a change.

One last thing on fees. In this day and age, investors should never have to pay a “load”

or sales charge for investing in any mutual fund, especially an index fund. However,

many fund companies today charge “loads” either up front or in the form of a deferred

load. A deferred load is an inflated fee for the first few years of investing. Loads usually

cost around five percent and are charged by some investment companies to pay for their

sales force. Keep in mind that active funds are already charging fees that are over five

times more than index fund fees. How much more must people pay for below average

performance? In short, loads are highway robbery. Find a different investment company

if yours insists on charging them.

Now it’s time to discuss income taxes, a topic most people dread. According to Albert

Einstein, “The hardest thing in the world to understand is the income tax.” If investments

are held in individual retirement accounts (IRAs), employer sponsored 401(k) plans or

some other form of tax deferred vehicle, then do not worry about Uncle Sam and his

cousins (the state and local income taxing authorities) taking a cut from investment

returns. However many households today are doing additional saving outside their

employer sponsored savings plans and IRAs. If you thought the impact of fee’s impact

on investment returns was a lot, get a load of how the government is taking a bite out of

your hide!

Returns from stock investments come in two forms, dividends and capital gains. As a

company becomes more mature, it starts to generate more free cash flow from its

operations. When the company was younger, it invested the majority of its cash flow into

growth opportunities because it could identify many projects that would earn its

shareholders an attractive return on investment. Over time the company can no longer

find as many attractive projects and starts to generate more cash than is needed to run the

business. In other words, it is maturing from adolescence to adulthood. When a

company starts to generate significant free cash flow, it has several options. It can hoard

the cash on its balance sheet, make strategic acquisitions, repurchase the company’s

stock, or pay dividends to its shareholders. When a company pays dividends, it is

returning cash earned in the business back to its shareholders, letting investors decide

how to spend or reinvest it.

Dividends received by shareholders are taxable for federal and state income tax purposes.

States generally tax dividends at the same rate that they tax wages. However the Federal

government currently taxes dividends at a preferred rate of fifteen percent. This preferred

rate is currently set to expire in the year 2010, at which time dividends will return to

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being taxed at the ordinary income tax rate - the same income tax rate used on wages.

The argument that companies should not pay dividends is that it causes double taxation.

Corporate income (which becomes retained earnings) is already taxed by the government.

When a company distributes its retained earnings in the form of dividends, the dividends

are taxed yet again at the recipient level. To put it another way, individuals are paying

dividend taxes on earnings that were already charged corporate income taxes.

Many companies prefer to repurchase their own stock as a more tax efficient way to

return cash to shareholders since corporate share repurchases are not taxed. This avoids

the double taxation issue with dividends only to a certain extent. The theory behind

corporate share repurchases is that when a company buys back its own shares, earnings-

per-share increases because net income is spread across fewer shareholders. The higher

earnings-per-share ultimately should result in a higher stock price. However, this will

only be true if the company’s business performs as expected. Since the market sets stock

prices, the company could be repurchasing stock at artificially high prices. One would

hope that management would use proper judgment in evaluating at what prices they

should repurchase their stock, but because the company’s management is generally

optimistic about its prospects, their judgment is biased and often times wrong. Finally if

an investor needs cash from his investments, he or she will be required to sell stock in

order to raise the cash, which results in a taxable capital gain plus commission costs to

execute the trade. By paying dividends, the recipient can use their own judgment about

how to deploy the cash to its best utility. Paying dividends may result in some income

taxes, but it also keeps the company from making bad decisions with excess cash that is

potentially burning a hole in its pockets.

Dividends are taxed, but for now they at least are getting preferential treatment from the

federal government. They should receive this preference because it is in fact double

taxation of earnings. Dividends shouldn’t be taxed at all so long as corporations in the

United States are paying income taxes. Hopefully officials in Washington D.C. and the

state governments are reading this book and will amend this gross injustice perpetrated

against the investing public.

The other form of taxable income from stocks is realized capital gains. Capital gains are

realized when investments are sold. Sales of investments held for one year or less are

considered short-term capital gains. If investments are held for more than one year

before being sold, they are considered long-term capital gains. Short-term capital gains

are taxed at the ordinary income tax rate. Long-term capital gains are given a tax

preference by the federal government to encourage savings through long-term

investments. The current federal income tax rate on long-term capital gains is twenty

percent for investments held over one year, and fifteen percent for investments held over

eighteen months.

As just mentioned, capital gains are triggered by selling. With no selling, capital gains

are never realized and investments will receive the maximum benefit from compounding

over time. For a quick demonstration of this, take the case of an investment of ten

thousand dollars that earns ten percent over the course of a year. If no taxes are owed,

61

then the investment will be worth eleven thousand dollars at the end of the year, a gain of

one thousand dollars. But if the investment is sold before the end of the year and triggers

a realized short-term gain, federal and state income taxes will be owed. Assuming a

combined Federal and state ordinary income tax rate of thirty-five percent, the gain of a

thousand dollars is reduced to six hundred and fifty dollars. In order to achieve the same

thousand-dollar gain after paying income taxes, a pretax return of over fifteen percent

[$10,000 x 15.38% return x (1 - .35 tax rate) = $1,000] is required. That is fifty percent

higher than the non-taxed ten percent return! That is also fifty percent higher than the

stock market’s long-term rate of return. By waiting more than a year before selling, the

combined income tax rate will be lower because the federal government taxes long-term

capital gains at a lower rate. Assuming the combined rate drops to twenty-five percent,

investors still have to achieve a pretax return of over thirteen percent (1 and 1/3 times the

after tax return) to net the same one thousand dollar gain.

To gauge how tax efficient funds are, look at the level of “turnover” that the fund has

experienced. Turnover is a measure of the amount of buying and selling a fund does

during the course of a year. Turnover is reported in a fund’s prospectus and can also be

found on www.finance.yahoo.com by typing in the fund’s ticker symbol and looking up

the turnover figure in the “profile” section of the web page for that fund. To calculate

turnover, a fund adds up the cost of its purchases and the proceeds from its sales. The

larger of those two summations is divided by the average value of the fund over the past

year. Low turnover is indicative of a fund that tends to buy and hold its investments for

long periods of time. High turnover indicates a manager who buys and sells quickly and

is likely incurring a good deal of short-term gains. The holding period represents the

average length of time that a fund holds its investments. To approximate a fund’s

holding period, simply divide its turnover rate into 100. Today, the average turnover for

an active mid-cap mutual fund is 109 percent. That means the average holding for the

typical active midcap fund is eleven months. If that turnover is due to the portfolio

manager selling losers quickly and letting winners run, then he or she is doing a great job

of managing the tax consequences. However, it is more likely that the tax effect is

largely being ignored, and that a great many of the gains are short-term in nature and

subject to the highest income tax rates.

To explore the impact of turnover and taxes further, assume a beginning portfolio value

of $100,000 to be invested over a twenty-year period. The assumed annual return rate of

twelve percent is a reasonable expectation of what midcap stocks should be able to earn

over the long-term given that the long-term rate of return for the broad stock market has

been ten percent, and midcaps have historically earned about two percent above the broad

market. Income taxes incurred during each year are assumed to be paid directly from the

investment portfolio. The portfolio is not liquidated at the end of the twenty-year period.

The reason for not liquidating the portfolio is because people do not generally reach a

magic number and then liquidate their assets. It is more likely that assets would be

liquidated slowly, resulting in a deferral of the embedded tax liability. Assets may also

be donated to charities tax free or passed on through estates. If it had been assumed that

the portfolio were liquidated at the end of the period, the directional impact of turnover

on retained wealth would not change.

62

Assuming no income taxes were incurred, the original $100,000 portfolio would grow to

$964,629 after twenty years, almost ten times the original investment. Figure 19

illustrates the impact income taxes would have on this theoretical portfolio at various

levels of turnover. For purposes of this example, turnover is expressed as the percentage

of the annual return that was subject to long-term capital gains tax. While this is not the

true definition of turnover, it is a fair approximation assuming that no short-term gains

are realized. In the far right column, the impact of income taxes is shown on a hyper-

turnover portfolio where all gains are short-term, incurring the highest ordinary income

tax rate; in this case a combined federal and state income tax rate of forty percent.

Figure 19. Impact of Income Taxes to Eroding Retained Wealth

Tax Impact on Accumulated Wealth

$964,629$866,371

$777,670$697,641

$625,477$560,441

$401,694

$-

$100,000

$200,000

$300,000

$400,000

$500,000

$600,000

$700,000

$800,000

$900,000

$1,000,000

0% 20% 40% 60% 80% 100% S/T

% of Gains Realized Annually

Beg. Value = $100,000; Annual Return = 12%; Term = 20 Years;

Long-Term Capital Gains Tax Rate = 25%; Ordinary Income Tax Rate = 40%

Government Funding

Retained Wealth

Observe how higher levels of turnover and the recognition of capital gains quickly erode

the amount of retained wealth in the investment portfolio. Even relatively low turnover

of forty percent can reduce retained wealth substantially, in this case by almost twenty

percent. The process of having to pay taxes on recognized gains removes cash from the

investment portfolio that would otherwise remain invested and benefit from

compounding returns. In the most extreme case where all gains are short-term, the

portfolio retained less than half its potential value.

The top shaded part of the bars in figure 19 represents the amount of foregone potential

wealth, which in essence is an investor’s contribution to government funding. As

turnover increases, the contribution to the government also increases. While the funding

of social programs, welfare, roads, infrastructure, security and other government

sponsored programs is an essential and noble endeavor, there is no need to get carried

away with handing over hard earned dollars more than is necessary. After all, when it

63

comes to the efficient deployment of funds for their most productive use, it is difficult to

characterize government agencies as pillars of fiscal prudence. To add insult to injury,

the above chart assumes that the government agencies invested the tax remittances and

earned a similar rate of return. Since that is surely not the case (given that the federal and

most state governments are in debt), by paying more taxes than necessary, investors in

high-turnover active funds are inadvertently contributing to the destruction of global

wealth. Shame on them!

To further illustrate the impact of taxes on investment returns, table 6 details the above

levels of turnover and their effect on both the net realized annual rate of return and long-

term accumulated wealth.

Table 6. Turnover’s Impact on Returns and Retained Wealth

Turnover

Gross

Return

Net

Return

Percent

Shortfall

Potential

Wealth

Retained

Wealth

Percent

Shortfall

5% 12% 11.85% 1.25% $964,629 $939,117 2.6%

20% 12% 11.40% 5.00% $964,629 $866,371 10.2%

40% 12% 10.80% 10.00% $964,629 $777,670 19.4%

60% 12% 10.20% 15.00% $964,629 $697,641 27.7%

80% 12% 9.60% 20.00% $964,629 $625,477 35.2%

100% 12% 9.00% 25.00% $964,629 $560,441 41.9%

S/T 100% 12% 7.20% 40.00% $964,629 $401,694 58.4%

A minimum turnover rate of five percent is included to allow that dividends will be taxed,

and also because even the most efficient index fund will experience some turnover due to

changes in the index’s composition. The Standard & Poor’s 500 index typically

experiences turnover of five percent or less. The S&P MidCap 400 index’s turnover is

generally in the range of ten to twenty percent. The average active midcap index fund

has a turnover rate in excess of 100 percent. The table illustrates that turnover’s impact

to the annual net return is linear. For each additional five percent change in turnover, the

annual return is reduced by 0.15 percent on an absolute basis. Each five percent change

in turnover also represents a 1.25 percent relative shortfall in the gross return. However

when the impact of higher turnover is considered relative to the potential wealth over

time, the relationship is no longer linear, but becomes progressively worse as turnover

and the impact of taxes increases. This represents the increased penalty for lost

compounding. At the twenty percent turnover rate, the 10.2 percent shortfall in retained

wealth is five percent higher than the 5.0 percent shortfall in the annual net return.

However at the eighty percent turnover level, the shortfall in retained wealth of 35.2

percent is fifteen percent higher than annual return shortfall of 20.0 percent. If all

realized gains are short-term, less than half of returns are retained. Clearly the impact of

high turnover and taxes is punishing.

Mutual funds today are now required to include in their annual prospectus a theoretical

after tax return to assist investors in evaluating a fund’s performance. While these

disclosures are a step in the right direction to inform investors of their true economic

64

returns, they are still not perfect. The after tax returns included in prospectuses are based

solely on federal income taxes and exclude any state and local income taxes. Because

each state charges different rates, and each individual’s income tax situation is unique, it

would be unreasonable to expect mutual funds to customize their disclosures for each

situation. However by using only the federal tax rates, the reported after tax return

shown in a fund’s prospectus is most likely overstated.

A quick and dirty way to test a fund’s tax efficiency is to perform a comparative price

chart analysis between the fund and the index. This is a simple check that can easily be

performed on the Internet. The concept behind this test is as follows. Mutual funds are

required by law to distribute realized capital gains to investors each year. When a mutual

fund distributes capital gains, the value of the capital gains reduces the quoted price of

the fund. The fund’s investors can elect either to receive their capital gains in cash, or to

have them reinvested back into the fund. If the gains are reinvested, the investor

automatically purchases additional shares in the fund at the lower price.

For example assume 100 shares of Fund X are purchased for ten dollars per share.

During the year, the fund increases in value by twenty percent. If turnover was zero and

no realized capital gains were incurred by the fund, the fund’s price per share at year end

would be twelve dollars ($10 x 1.2). The investment’s value would increase to 1,200

dollars (100 shares x $12 per share). Now assume that the fund’s turnover was 100

percent and that the entire twenty percent gain during the year resulted in realized capital

gains. At year-end the fund’s price per share would still be ten dollars because the two

dollars in realized capital gains were distributed back to investors. If the fundholder took

the gains in cash, the investment would be worth 1,200 dollars (100 shares x $10 per

share plus $200 cash from distributed gains). If the gains are reinvested, the investment

would still be worth $1,200 (100 x $10 per share plus 20 additional shares purchased at

$10 per share with the $200 in distributed capital gains). Whether the gains were taken in

cash or reinvested, the price of the fund stayed at ten dollars despite earning a twenty

percent return. The gap between the twelve-dollar fund price of the no-turnover fund and

the ten-dollar price of the high-turnover fund represents the amount of capital gains on

which taxes are owed.

Keep in mind that the $1,200 ending value in the above examples is the same because

taxes have not yet been paid. In the zero turnover fund, no taxes are due. Fundholders

keep all their money. But with the high turnover fund, taxes are required on the 200

dollars in realized gains. Retained wealth will be reduced by the taxes paid.

To perform a comparative price chart test, go the “interactive charts” section of

www.finance.yahoo.com. Type in the ticker symbol of the fund to be tested. Click on

the “compare” box in the upper left hand of the chart. A pop up box will appear to input

the ticker symbols of the index or other funds being compared. For Yahoo Finance the

ticker symbols for the S&P MidCap 400 and Russell Midcap indexes are “^mid” and

“^rmc,” respectively. If the price of the fund being researched tracks below the price of

the index, chances are very high that the fund is providing poor after tax returns. Keep in

mind that these are price comparisons only. Dividends earned by both index and active

65

funds are regularly distributed to fundholders and have no impact on the price action of

either fund type.

Figure 20 is an example of a comparative price chart comparing three actively managed

funds against the S&P MidCap 400 index’s price performance for the ten-year period

ended December 31, 2007. Each of the funds selected in Figure 20 are actual funds

whose performance on a total return basis was equal to or slightly better than the total

return of the S&P MidCap 400 index during that period. The turnover ratios are

indicated for the respective funds. However, the names of the funds are not disclosed in

order to protect their identities. Even though the total pretax returns for the funds were

comparable with the index, the impact that turnover has had on each fund’s performance

is visually displayed. In each case, the distribution of capital gains lowered the price of

fund relative to the index. The gap between the index and each fund’s price line

represents the amount of capital gains on which investors were required to pay income

taxes.

Figure 20. Turnover’s Impact on Active Funds Versus the Index

Comparataive Price Chart: Active Funds vs. Index

$0.50$0.75$1.00$1.25$1.50$1.75$2.00$2.25$2.50$2.75$3.00

Dec-9

7

Dec-9

8

Dec-9

9

Dec-0

0

Dec-0

1

Dec-0

2

Dec-0

3

Dec-0

4

Dec-0

5

Dec-0

6

Dec-0

7

10 Years Ended December 31, 2007

Midcap Index

26% T/O Fund

85% T/O Fund

166% T/O Fund

For instance after the end of the ten-year period, the index’s price grew to $2.57 versus

$1.92 for the 26% T/O (turnover) fund. The pretax return for the 26% T/O fund would

have resulted in an ending value of $3.14. This can be calculated simply by

compounding one dollar at the fund’s 12.1 percent ten-year reported return. The $1.22

difference ($3.14 less $1.92) represents realized capital gains that after taxes at a twenty-

five percent rate would leave the investor with a net gain of $0.92. Adding the $0.92

retained net capital gains to the $1.92 ending fund price gives an estimated after-tax

ending value of $2.84. Calculating the internal rate of return on $2.84 back to the

original $1.00 investment equates to an estimated after-tax compound annual return of

11.0 percent. The tax penalty that the fund incurs is simply the difference between the

reported return and the estimated after-tax return, which in this case equates to 1.1

percent.

66

The 26% T/O (a low turnover) fund started with a pretax return higher than the midcap

index’s return, but after removing income taxes, the excess return was eliminated. The

situation for the higher turnover funds is even worse. The estimated tax penalty was 1.7

and 1.5 percent for the 85% T/O and 166% T/O funds, respectively. The reason the tax

penalty is lower for the 166% T/O fund versus the 85% T/O fund is because the 166%

T/O fund had a higher quantity of losses to offset against gains. In either case though, the

tax penalty was substantial and after taxes, both funds had returns that were below the

index’s return. Table 7 summarizes the results.

Table 7. Active Funds Versus Index and Impact of Turnover on After Tax Returns

Pretax

Total

Return

(A) 10 Year

Growth of

One Dollar

(B) Price Only

Growth of

One Dollar

(C=A-B)

Spread

Spread

x 0.75

(B+C) After Tax

10 Year

Value

After Tax

Annual

Return

Midcap

Index

11.2%

$2.89

$2.57

$0.32

$0.24

$2.81

10.9%

26% T/O 12.1% $3.14 $1.92 $1.22 $0.92 $2.84 11.0%

85% T/O 11.1% $2.86 $1.23 $1.63 $1.22 $2.46 9.4%

166% T/O 11.0% $2.84 $1.37 $1.47 $1.10 $2.47 9.5%

Frankly it is not necessary to go through all those calculations to discover that the funds

are not tax efficient. Looking at the chart gives a visual depiction which tells most of the

story. Morningstar also provides an analysis on its website for a fund’s tax efficiency.

Click on the “Funds” tab at www.morningstar.com. Enter the ticker symbol of the fund

in the “Quotes” box. A “Snapshot” for the fund will appear giving various data about the

fund. Next, click the “Tax Analysis” box on the left side of the Snapshot page.

Morningstar provides its estimate of the tax-adjusted return and “Tax Cost Ratio” for the

fund on three, five, and ten-year annualized time periods. The Tax Cost Ratio is

Morningstar’s estimate of the tax penalty that a fund incurs each year as a result of

realized capital gains and dividends. For the funds included above in Table 7,

Morningstar’s Tax Cost Ratio estimates were similar to the above calculated tax

penalties. Morningstar only considers federal income taxes in its calculations, which

makes its estimates of the tax-adjusted return too high, and the Tax Cost Ratio too low if

state and local income taxes are due. Despite that, it is still an excellent way to compare

the estimated after-tax return for a fund to an appropriate index fund option. As an added

bonus, Morningstar currently provides this information free of charge.

When comparing an active fund’s results to an index fund, it is recommend to use an ETF

(exchanged traded fund) for the comparison as ETFs tend to be the most tax-efficient

choice. Most people think that all index funds are alike, but they are not. In fact some

index funds carry high tax-cost penalties due to poor tax management by the fund

complex. Even when investing in an index fund, the fund’s tax efficiency must still be

tested. Do not take for granted that just because it is an index fund, tax-adjusted returns

are automatically optimized. Figure 21 is a price chart comparison of the S&P MidCap

67

400 index versus the MDY exchange traded fund and an actual unnamed index fund

designed to track the performance of the S&P MidCap 400 index. Before taxes the index

fund and the MDY had annual returns that virtually matched the S&P MidCap 400 index.

The only difference was the fund fees. However, the tax-adjusted result tells a

dramatically different story.

On a tax-adjusted basis, the MDY exchange traded fund was vastly superior to the index

mutual fund. Because of nuances in the tax laws, trades that occur within exchange

traded funds do not trigger realized gains. But trades within index mutual funds are

taxed. Midcap indexes periodically change the companies included in the index.

Generally the largest and most successful companies graduate from the midcap indexes

into large-cap indexes. Because the graduates have been successful, they have large

embedded gains. When the index makes the changes, the index funds tracking the index

are forced to sell the graduating companies, triggering realized capital gains. If the fund

is efficiently managed, the tax impact of the required sales will be minimized. However,

most fund complexes do not actively seek to maximize after tax returns, even for index

funds. It is “buyer beware” and the taxable investor needs to be diligent in selecting

investments that provide the best likelihood of the highest tax-efficient returns.

Using the same methodology in Table 7, the index fund’s tax-penalty was 1.5 percent per

year. Morningstar estimated the Tax Cost Ratio for the inefficient index fund at 1.6

percent. This compares to an estimated tax penalty for the MDY exchanged traded fund

of 0.5 percent. While the tax cost penalty between the MDY and the index fund might

seem small, it results in a nine percent shortfall in the after-tax return. Ten thousand

dollars invested for ten years in the MDY would have yielded an after-tax ending value

of $27,200 versus $24,800 for the inefficiently managed index fund, a gain of $2,400 in

wealth the investor keeps as opposed to sending it to the government.

Figure 21. Index ETF Versus Index Fund – Impact of Capital Gains Distributions

Comparative Price Chart: Index Fund & ETF vs. Index

$0.50$0.75$1.00$1.25$1.50$1.75$2.00$2.25$2.50$2.75$3.00

Dec

-97

Dec

-98

Dec

-99

Dec

-00

Dec

-01

Dec

-02

Dec

-03

Dec

-04

Dec

-05

Dec

-06

Dec

-07

10 Years Ended December 31, 2007

Midcap Index

MDY ETF

Index Fund

68

Simply choosing to invest in an index mutual fund or ETF is not enough. Investors must

choose the most tax efficient index option available. Chapter 6 recommended the S&P

MidCap 400 (ticker symbol MDY) and Russell Midcap (ticker symbol IWR) as good

index investment choices because of their low fees and high tax efficiency. Both of these

can be purchased in any brokerage account. As mentioned above, exchange traded funds

typically have a tax advantage over traditional mutual funds due to how income tax laws

are written. For traditional mutual funds, it seems that most index funds are not well

managed for tax efficiency and should be avoided. One exception to this is the Vanguard

MidCap Index Fund (ticker symbol VIMSX). This fund has fees and tax efficiency that

are among the industry’s best and equal to those of the MDY and IWR.

When investing in individual stocks, investors must still consider the impact of costs and

taxes on results just as they would when evaluating fund strategies. This is going to

require some work since there are no independent services tracking anyone’s personal

investment results. The easiest way to track personal investment performance is to first

keep stock investments in a separate account. If stocks are commingled with other assets,

keep track of their performance separately on a spreadsheet or some other means.

Let’s first address fees. Today it is unlikely that a financial institution will charge fees on

a brokerage account. If they do, move the account to Charles Schwab, Wells Fargo, or

some other well-respected financial institution with competitive trading commission

charges and a good reputation for trading execution. Individuals can hardly go wrong

today with most of the larger discount brokerage firms. With regards to trading costs,

individual investors are no longer disadvantaged versus the large institutional players.

That was always the case. Just a couple decades ago, commission charges for the

individual investors were multiples of today’s low rates. Technology and competition

have brought commission costs down substantially. Ten dollars per trade is now

common practice throughout the industry, and many firms offer the batch of trades for

free.

On average, active midcap mutual funds are charging 1.38 percent in fees annually.

Large capitalization active funds are charging 1.1 percent. Assume trading commissions

should be limited to one percent or less of assets. That means a $1,000 limit for trading

costs against a $100,000 account. Each buy and sell in the investment portfolio will cost

ten dollars each, or twenty dollars combined. In a portfolio holding twenty stocks, the

average position size for each stock will be around $5,000. Each buy and sell

combination would then represent 0.4 percent of the position ($20 divided by $5,000

multiplied by 100). That is much lower than fees paid for professional active

management. The calculation can be adjusted to fit any situation. A larger amount to

invest will lower the cost per trade, and vice-versa. If the portfolio hold a greater number

of stocks, average position size will be forced lower and cause the percentage cost per

trade to rise. By dividing commission costs by the gross value of the trade and

multiplying by 100, it is easy to keep track of the percentage rate for commission costs.

To determine the commission rate incurred at year-end, simply sum up all commission

charges during the year and divide by the account balance at the beginning of the year

then multiply by 100.

69

Comparing commission costs to a mutual fund’s fee schedule is actually an apples and

oranges comparison. Mutual funds also incur commission costs that are imbedded in

their gross and net reported returns. Because of their scale though, mutual funds are

often only paying just a couple cents per share. To get commission costs that low, the

average trade size would need to be 500 shares each, or $20,000 for every buy or sell

assuming a $40 average stock price. Although the comparison is not perfect, it is a

reasonable way to handicap against the industry. Another cost to consider is the price of

subscription services used in the research process (i.e. Morningstar, Value Line, IBD

etc.). Mutual funds charge a fee to pay for their research staff and services they use.

Consider the cost of subscription services as the fee for a personal research department.

Investment accounts not held in an IRA or other tax-exempt vehicle will need to consider

the impact of taxes on investment performance. Short-term gains are taxed at the

marginal federal ordinary income tax rate. Long-term gains are taxed at the preferred

capital gains rates (currently twenty percent for stocks held over one year, and fifteen

percent for stocks held over eighteen months). Most corporate dividends are currently

taxed at a preferential rate of fifteen percent for federal income taxes. An exception to

this is dividends from real estate investment trusts (REITs) which are taxed at the

marginal federal ordinary income tax rate. Remember to include the impact for state and

local income taxes, net of the federal deduction.

Table 8 is an example of a portfolios return over a year and how taxes would impact

performance. A marginal tax rate of nine percent is used for state income tax purposes.

Note that this state tax rate is used for dividends, short-term gains and long-term gains

because many states do not provide separate rate schedules for various types of

investment income. A marginal ordinary income tax rate of twenty-eight percent is used

in this example for federal income tax purposes. The preferential rates of fifteen percent

on dividends and twenty percent on long-term capital gains were also used. No tax is due

on unrealized gains. Observe how taxes impact the net realized return, or the return

retained after paying taxes. If income tax rates rise, after tax returns will decline. Living

in a state with low or no income taxes (hooray for Texas and Florida) increases after tax

returns. The example above is eerily silent about commission costs. That is because

commission costs are automatically included in the cost of every trade. The prior

discussion about calculating commission costs is primarily to get a sense of the hurdle

investors must clear on every trade before making money. Because commissions are

already included in the results, it would be improper to double count them in the

performance calculation.

There is not much individuals can do about taxation on dividends, other than to avoid

stocks that pay dividends. However, that is not recommended because many dividend-

paying companies are solid investments. Dividend stocks can also be especially

attractive for conservative investors.

70

Table 8. Calculation of Net Performance After Taxes

Beginning Portfolio Value $ 100,000

Dividend income 2,000

Short term capital gains 1,000

Long term capital gains 2,000

Unrealized gains 7,000

Pretax Ending Portfolio Value 112,000

Pretax Total Return 12.0%

Federal Taxes

Dividends at 15% 300

S/T Gains at 28% 280

L/T Gains at 20% 400

Total Federal Taxes 980

State Taxes

Dividends at 9% 180

S/T Gains at 9% 90

L/T Gains at 9% 180

Total State Taxes 450

Less State Tax Deduction

For Federal Taxes at 28% (126)

Total Federal and State Taxes 1,304

After Tax Portfolio Value $ 110,696

After Tax Return 10.7%

Individual investors have some control over the timing for recognizing realized capital

gains. Imagine an alligator farmer who is trying to maximize his inventory’s yield. In

this process the farmer quarantines sick alligators away from the congregation, and lets

the healthy alligators thrive. Take the same strategy with stock investments. By quickly

selling losers, the overall health of the investment portfolio is maintained. Continuing to

hold losers not only reduces portfolio returns by the losses incurred, but also ties up

investment capital that could be redeployed into another stock or held in cash until a

buying opportunity presents itself.

People generally hate to take losses. They consider it an admission of failure, and in a

way it is. After all, no one buys a stock to lose money. But think of the consequences of

holding losers. If a stock declines five percent, a 5 ¼ percent gain is required to get back

to even. That seems easy enough. If a stock declines ten percent, eleven percent is

required to get whole. A twenty percent decline requires a twenty-five percent gain. A

one-third decline requires a fifty percent gain. Getting the picture? The bigger the loss

incurred, the bigger the hole to climb out from. Investors who take allow a fifty percent

hit on a stock need to double their money elsewhere to break even. That is a tall order!

There is also a good tax reason to take losses quickly (before 365 days, and hopefully

long-before that). Short-term losses receive preferential treatment in the federal tax law.

71

Short-term losses are first applied against short-term gains. If short-term losses exceed

short-term gains, they can then be applied to long-term gains. If losses still remain,

$3,000 in short-term losses can deduct against reported ordinary income. Any losses

above $3,000 get carried over to future years. Short-term losses provide the biggest bang

for the tax recovery buck. Each individual investor will ultimately have to decide how

and when to take losses. When confident that a company’s set back is temporary and the

stock will recover, then consider holding on and riding out the slump. However, by

riding out too many laggards while the market is moving higher, other attractive

investment opportunities may be missed. It may be better to sell some laggards and move

on. Just make sure to stick with leading companies no matter what the investment.

By sticking with leading companies and being careful with buy points, you will be less

prone to making careless mistakes. By the way, a good company usually stays a good

company, but that does not mean it will always be a good stock. Your timing may just be

wrong. There is no shame in taking a quick loss and then coming back to the same stock

later (just make sure you wait at least 31 days before repurchasing to avoid the tax-code’s

rules for disallowing wash sale losses.). Perhaps eighteenth century novelist Oliver

Goldsmith said it best, “He who fights and runs away, may live to fight another day.”

Just make sure to come back and try again. If you lose the desire to pick stocks, or

decide that you are unable to beat the indices over a period of time, don’t worry … The

index funds await you with open arms.2

2 The discussion above about selling losers relates only to individual stocks. When invested in mutual

funds or exchange traded funds, selling fund-holdings should be considered in conjunction with the overall

asset allocation strategy, which may require occasional rebalancing. Market timing as a strategy is not

recommended as very few professionals have shown an ability to be successful at it. When investing in

funds, be “counter manic-depressive.” Buy when the market is selling off and sell when investors are

euphoric. If fund holdings have declined in price, the long-term investor who can accept the risk should be

buying more. Equity markets are inherently volatile. Play against the volatility. Do not get caught up in it.

72

CHAPTER 7: DIVERSIFICATION PART 1: ALLIGATORS & CROCIDILES

As the old saying goes, don’t put all your alligators in one swamp … or something like

that. When a drought hits and the swamp starts to dry up, the abundance of food

supporting the alligator congregation shrinks. In the fight for survival, only the strongest

will endure until the drought passes and the swamp replenishes itself. Worse still, the

swamp may become polluted and unfit to support any life at all. At this point, the

alligators must leave their home in search of a new habitat. Again, only the strongest and

healthiest alligators stand a chance during their migration to more fertile territory. When

arriving at their potential new home, they will have to compete for survival with other

established alligators who already inhabit the area. The immigrants must adapt to their

new surroundings or they will perish.

Just as in nature, the economy will also suffer periodic setbacks. Recessions are akin to

economic droughts and are a normal part of the business cycle. During recessions the

leaders separate themselves from the weaker industry players who will either go bankrupt

or be acquired by stronger companies. When the recession ends and the business cycle

turns positive, the leading companies reemerge stronger than ever to participate in the

growth that lies ahead. Occasionally an industry will suffer permanent decline. New

technology may replace an existing business. For instance, try to find a typewriter

manufacturer today, or witness the current decline of the photographic film business,

which continues to be displaced by constantly improving digital photography. Smith

Corona was never able to adapt. Kodak is struggling to reinvent itself in a declining film

industry that has become more commoditized. Though a difficult task, it is not

impossible to transform. Boeing started as a shipbuilder before becoming a leader in

aerospace.

Diversification is one of the key elements requiring consideration when managing a stock

portfolio and an overall investment plan. By spreading investments across a number of

companies in multiple industries, individuals protect themselves from investing in an

unexpected disaster that will wipe out their nest egg. By balancing portfolio risks, it is

more likely to have some investments doing well while others struggle. For instance,

higher oil and gas prices are good for energy companies but bad for transportation

companies because higher energy prices increases their fuel costs and hurts profits.

Stories will always be touted about how someone who invested in a particular company

and made gazillions of dollars from almost nothing. It would have been nice to have all

your money in Google when it went public and make six hundred percent over the next

three years, or Apple when everyone was convinced that the company was doomed and

could never compete against machines using Microsoft operating systems with Intel

based hardware, only to see Apple revive its brand and see its stock price gain over two

thousand percent from its low in September 2001 through the end of 2007. If only you

had invested a hundred thousand dollars in Starbucks or Charles Schwab back in 1992.

You could be worth millions today and comfortably retire of you sold those stocks at

their peaks.

73

But for every Google, Apple, Starbucks and Charles Schwab, there is a WorldCom,

Gateway Computer, Krispy Kreme and Bear Stearns. By the way, that last group of

companies didn’t fair investors so well. Anyone who invested all their money into one of

those companies, you got decimated! Each of those companies was also considered to be

an emerging leader at the time and had a sound business base to support them. However,

they were beaten by stronger competitors or outgrew management’s ability to

successfully execute their business plans.

Everyone will make mistakes during their investing endeavors. As careful as Warren

Buffet has been, he still made mistakes. However he learned from them and moved on.

Despite those errors, he is still one of the most successful investors of our generation. He

built his record by carefully evaluating his investment opportunities, sticking with leading

companies (the dominant alpha alligators), and patiently waiting for the appropriate time3

to pull the purchase trigger. While Mr. Buffet concentrated his investments in a small

group of companies that he understood, he also diversified. His winners have more than

made up for his losers. Even though Mr. Buffet emphasizes picking leading companies at

discount prices, he understands the importance of diversification. Warren Buffet stated in

his 1987 shareholder letter, “Berkshire’s earnings come from many diverse and well-

entrenched businesses.” Analyzing Berkshire Hathaway’s financial statements will

expose observe a well-diversified investment strategy.

The primary reason to diversify is to control risk by spreading it across multiple

investments. The type of investing will determine the level of assumed risk. Investing in

an individual stock is very risky. Investing in a group of stocks in the same industry is a

little less risky. Investing in a group of stocks in different industries further reduces risk.

Investing in a stock index fund takes risk down another notch. Investing across different

asset categories like international stocks, large-caps, midcaps, bonds, commodities, real

estate and money markets provides enough diversification in various combinations to

match any investment plan to an investor’s risk profile.

The secondary reason to diversify is to enhance investment returns, especially risk-

adjusted returns. This of course depends from where the investments are being

diversified. When starting with all portfolio investments in midcap value stocks,

diversification into other categories will most likely not increase the absolute return

potential since the portfolio is already invested in one of the most promising asset

categories. However if the portfolio is invested solely in a money market account, adding

some stocks into the asset mix will more than likely increase long-term returns. It will

also increase portfolio risk; but the longer the investing time horizon, the less risk being

taken. The impact of time horizon on risk will be discussed in a later chapter. For now,

let’s focus on using diversification to control and spread risk.

3 Warren Buffet does not consider himself a market timer. Even though he does not attempt to time the

market or investments, he does strive to “price” his investments, using the appropriate price in relation to

an investment’s intrinsic value as the determinant whether to buy or sell.

74

Stocks and Sectors

Table 9 summarizes the absolute price increase for the S&P 500 index, the S&P MidCap

400 index and the ten industry sectors for the fifteen years ending December 31, 2007.

Dividends are excluded from the figures, but the results are not materially impacted.

Standard deviations for monthly price performance are also included. Standard deviation

is a common gauge of risk that measures the statistical dispersion of how widely spread a

data set is in relation to its average. The higher the standard deviation, the more unstable

the data set. For example, if a person earned five percent a year each year for ten years in

a row, the standard deviation of those returns would be zero because there was no

variability to the annual results. However if that person earned a five percent average

return for ten years, but five of those years consisted of gaining fifteen percent and the

other five resulted in losing a little over four percent, the standard deviation rises to ten,

reflecting the higher variability of each year’s return. Either case resulted in the same

annualized return, but the second data set was clearly more risky than the first.

The return divided by the monthly standard deviation represents a simplistic measure for

the level of return earned relative to the risk taken. By dividing the total return by the

standard deviation gives a sense for how well compensated investors were for the amount

of risk taken. The higher this figure, the better the reward/risk trade off achieved.

Table 9 Absolute Price Return and Monthly Standard Deviations – 15 Years Ended

December 31, 2007.

A few observations can be made from table 9. Over the past fifteen years, midcap stocks

as a group provided returns substantially above large-caps. Not only that, but when

looking at the return/risk statistic, midcaps also provided exceptional risk-adjusted

returns, indicated by a return/risk figure of 89 for the S&P MidCap 400 versus 54 for the

S&P 500 index. Even though the materials & chemicals sector provided a comparable

return to the S&P 500, it did so at a much higher level of risk. Note that the sector’s

return/risk figure of 39 is much lower than the 54 figure achieved by S&P 500. With

Total Return Standard Deviation Return/Risk

S&P 500 214% 3.94% 54

S&P MidCap 400 396% 4.47% 89

Communication Services 55% 6.06% 9

Consumer Discretionary 148% 4.71% 31

Consumer Staples 200% 3.79% 53

Energy 480% 5.01% 96

Financials 281% 5.25% 54

Healthcare 312% 4.42% 71

Industrials 264% 4.35% 61

Materials & Chemicals 213% 5.40% 39

Technology 379% 8.24% 46

Utilities 88% 4.58% 19

10 Sector Average 242% 3.87% 63

75

only one exception (consumer staples) the standard deviation for each individual sector

was higher than that of the S&P 500 index, demonstrating that concentrating in individual

sectors is riskier than investing across sectors. But when all sectors were averaged

together, the standard deviation dropped to 3.87 percent while the total return increased

to 242 percent, a risk-adjusted return that was above the index’s. The reason for the ten-

sector average being above the S&P 500 index is due to the sectors being equally

weighted at the beginning of the measurement period while the sectors within the index

were held at different weights. Either way it demonstrates the improvement in risk-

adjusted returns by investing across all sectors versus focusing on only one sector. Lastly

when reviewing the individual sectors’ results, notice that only two sectors (healthcare

and energy) had risk-adjusted returns that were better than the ten sector average.

Table 10 Absolute Price Return and Monthly Standard Deviations – 15 Years Ended

December 31, 2003.

But let’s not get too caught up in the individual sectors. The point is that investors need

to diversify across sectors in order to control risk. Table 10 roles the time period back

four years and details the results for the fifteen-year period ending December 31, 2003.

Once again midcaps provided superior returns not only on an absolute basis but also on a

risk-adjusted basis. This time there were no sectors that had less risk than the S&P 500.

The order of performance for the sectors also changed. The consumer sectors were some

of the best performers for the period ended December 31, 2003, but were below average

for the period ended December 31, 2007. The energy sector moved from below average

to become the top performer. It was only half a decade ago when people were sure was

awash in oil and were convinced oil would never go over eighty dollars per barrel, only

to see oil prices spike to 150 dollars per barrel. Home prices were going to rise forever

and easy credit would be available for anyone who wanted it. Today house prices are

falling and banks have gotten much stingier with credit. Most people did not see any of

this coming. Only by diversifying across sectors could investors have protected

themselves from those shifting currents.

Total Return Standard Deviation Return/Risk

S&P 500 280% 4.27% 66

S&P MidCap 400 567% 4.81% 118

Communication Services 98% 6.34% 15

Consumer Discretionary 331% 5.33% 62

Consumer Staples 384% 4.34% 88

Energy 229% 4.60% 50

Financials 506% 5.99% 84

Healthcare 543% 5.00% 108

Industrials 302% 4.60% 66

Materials & Chemicals 139% 5.58% 25

Technology 359% 8.34% 43

Utilities 53% 4.71% 11

10 Sector Average 294% 3.99% 74

76

The easiest and lowest cost way to diversify is to buy a broad market index fund that

tracks the S&P 500 index for large-caps, or the S&P MidCap 400 or Russell Midcap

indexes for midcaps. Every broad market index fund includes companies spread across

all major economic sectors. Invest only in certain individual sectors can easily be

accomplished that today through exchange traded funds. Barclays iShares and Standard

& Poor’s’ SPDRs include several well-managed low cost options for investing in specific

economic sectors. To look up the ticker symbols for sector ETFs, visit www.ishares.com,

www.sectorspdr.com or http://finance.yahoo/eft. You can also get more in depth

research on the individual sectors at those websites. Using mutual funds to invest in

individual sectors is not suggested. Most sector specific mutual funds are actively

managed funds that incur high fees and high turnover. Additionally, there are not very

many sector specific index mutual funds. Stick with ETFs as the best vehicle for

investing in individual sectors.

The discussion thus far has focused on the importance of diversification, and how to

diversify across sectors either by investing in a broad market index fund or by investing

in several sector-specific ETFs. But what if you are a stock-picker at heart? Is

diversification still necessary? … You bet! While a good way to enhance long-term

investment returns is to concentrate investments on specific companies that have better

than average growth prospects, it is essential to hedge portfolio bets by diversifying

across industry sectors. Keep in mind that there is a difference between a good company

and a good stock. A good company is a defensible franchise and a leader in its industry,

run by a focused and effective management team, and generates profits above its cost of

capital. A good stock is one that is making the investor money … period! Investing in

good companies and making money do not always walk hand-in-hand. General Electric,

one of the best companies in the world, consistently increased its earnings from

December 1999 through 2007. Despite this GE’s stock price fell twenty percent during

that period. Bank of America during the same period also showed consistent earnings

growth, but its stock price more than doubled. Both General Electric and Bank of

America are good companies, but only BofA was a good stock during that period. For

the prior three years ending December 1999, it was just the opposite. Bank of America’s

stock stagnated while General Electric’s tripled. By diversifying individual stock

investments across different industries, investors are better protected against the good

company/bad stock syndrome souring them on stock investing.

Tables 11 and 12 demonstrate how focusing on leading companies and diversification can

enhance investment returns while simultaneously controlling risk. Although alligator

investors prefer midcap size companies, Large-caps were used in these examples to

ensure adequate historical data and to demonstrate the benefits over time of investing in a

diverse group of leading companies. Frankly, if this analysis had used leading midcap

companies from 15 years ago, the annual returns would have appeared outrageous. But

then again, that is the point of investing in emerging leading companies.

Group 1 and group 2 both include a leading company selected from each of the ten

economic sectors. Both groups also consist of companies that a reasonably informed

investor would have considered to be an industry leader at that point in time. In both

77

groups, it is easy to see that individual company stocks experienced monthly price

volatility (indicated by the standard deviations) well above the broad market indexes,

higher volatility than the ten stock average for the group. Each stock’s volatility was

higher than its respective sector’s volatility with only one exception (ADP). Investing in

any one stock is clearly more risky than investing in a group of stocks.

Table 11 Absolute Price Return and Monthly Standard Deviations – 15 Years Ended

December 31, 2007. Group 1

Table 12 Absolute Price Return and Monthly Standard Deviations – 15 Years Ended

December 31, 2007. Group 2

Group 1 represents an investor whose returns were about average even though he selected

leading companies. The return for group 1’s ten stock average was 247 percent. While

this was better than the S&P 500’s return of 214 percent, and equal to the ten sector

average of 242 percent in table 9 above, on a risk-adjusted basis, group 1 was about the

Group 1 Total Return Standard Deviation Return/Risk

S&P 500 214% 3.94% 54

S&P MidCap 400 396% 4.47% 89

Abbot Laboratories (ABT) 337% 5.81% 58

Automatic Data Proc. (ADP) 249% 6.35% 38

Chevron (CVX) 358% 5.61% 64

Citigroup (C) 580% 8.53% 68

Coca-Cola (KO) 178% 6.48% 27

Dominion Resources (D) 110% 5.32% 21

Dow Chemical (DOW) 118% 7.65% 15

Emerson Electric (EMR) 273% 5.71% 48

Verizon Communications (VZ) 56% 7.26% 8

Wal-Mart Stores (WMT) 212% 7.26% 29

10 Stock Average 247% 4.24% 58

Group 2 Total Return Standard Deviation Return/Risk

S&P 500 214% 3.94% 54

S&P MidCap 400 396% 4.47% 89

AT&T (T) 123% 7.28% 17

Du Pont (DD) 97% 6.65% 15

Exxon Mobile (XOM) 465% 4.83% 96

General Electric (GE) 393% 6.15% 64

Hewlett Packard (HPQ) 523% 10.79% 48

Johnson & Johnson (JNJ) 474% 5.95% 80

McDonalds (D) 341% 6.86% 50

Proctor & Gamble (PG) 430% 6.10% 70

Questar (STR) 665% 7.41% 90

Wells Fargo (WFC) 506% 6.71% 75

10 Stock Average 402% 3.67% 110

78

same as the S&P 500 index but well below the ten sector average when compared to the

return/risk figures. This not to say that the investor in group 1 did poorly. Remember

that most active mutual funds do not perform better than the market averages, and many

perform much worse after factoring in fees and taxes. By focusing on leading companies

and diversifying investments across multiple industries, the group 1 investor still

achieved slightly better returns than the overall market at a risk level that was

comparable. He also performed better than the average professional fund manager.

Group 2 really drives home the power of investing in leading companies. Again, the

investor in group 2 selected a known leading company in each sector. However, her

picks on average were much better than group 1’s. Group 2’s ten stock combined return

of 402 percent matched that of the S&P MidCap 400 index and nearly doubled that of the

S&P 500 index. Even though each stock in group 2 had a standard deviation in monthly

price volatility that was higher than the broad market and its respective sector, when the

stocks were combined, the price volatility of group 2 dropped to below the broad market

and generated a return/risk figure of 110. On a risk-adjusted basis, the group 2 investor

was the undisputed winner.

At the risk of sounding redundant, this result was achieved by investing in large-caps

with a focus on leading companies that started from a position of strength, and then used

that advantage to further dominate their industries. Imagine the potential when applying

this leadership focus to emerging adolescent midcaps.

Figure 22. Price Appreciation of Stocks vs. Groups vs. Indexes

Price Path Comparisons

-100

0

100

200

300

400

500

600

700

800

15 Years Ended 2007

S&P 500

S&P MidCap

Wal-Mart

General Electric

Group 1

Group 2

Figure 22 plots the path for Wal-Mart, General Electric, the S&P 500, the S&P MidCap

400, group 1 and group 2 for the fifteen-year period ending December 31, 2007. This

graph effectively illustrates how a group of diverse leading companies can provide solid

returns over the course of time. Although some investors may seek the excitement of

79

rapid individual stock moves over short time periods, perhaps an old adage says it best:

The long hard road is often times the easiest path to take.

Here is an easy way to find the industry and sector classification for any stock. In order

to verify how well portfolio investments are diversified, go to www.morningstar.com and

enter the ticker symbol for the company in the web page’s “quotes” box. When the

company’s information comes up, click on the “Quote and News” tab in the upper left

hand of the web page. About half way down this page is a “Key Stats” button which lists

both the industry and sector classifications. Be sure to spread portfolio investments

across at least five different sectors to provide for adequate diversification.

80

CHAPTER 8: DIVERSIFICATION PART 2: MULTIPLE SWAMPS

Asset Classes: Large, Mid, Small, Growth, Value, International

Just as you should not put all your alligators into one swamp, you also should not invest

in just one swamp. Although weather patterns tend to follow the seasons, they are not

perfectly predictable. Mother nature can often be cruel. The rainy season could be

normal, or it could be a monsoon causing floods and wreaking havoc by ruining nesting

sites or destroying portions of the habitat. Rather than too much rain, a drought may

occur, reducing the water and food supply which in turn leads to a more sickly population

as hunger and malnourishment take hold. The first piece of good news is that these

events are temporary and when normal weather patterns return, the swamp rejuvenates.

The second piece of good news is that these events are generally isolated to a specific

region, and although that region may be suffering, it will not result in the end of the

world since the rest of the world is doing just fine.

The economic and ecologic environments are similar in that they generally both follow

patterns, but those patterns are not perfectly predictable. In the economic world – floods,

droughts, earthquakes, locusts, etc. are analogous to recessions, inflation, regulatory

change, political turmoil, and other factors that can disrupt investment fundamentals.

The same good news applies. These events do not last forever and are generally

regionalized. By having a house in Mississippi and Arizona, the odds are very low that

both of them will be flooded at the same time. When inflation spikes, stock investments

may suffer, but cash investments will earn more interest. When inflation subsides, stocks

should take the lead while cash investments will earn less.

By allocating investments across different asset categories, investors are protected against

potential disasters that are looming on the horizon. When disaster strikes and stocks

decline, diversified investors will be in a position to rebalance their portfolios, moving

some money from investments that held up to those that declined (i.e. use cash to buy

more stocks). When times are good and stock investments are doing well, rather than

standing around at the cocktail party and bragging to friends about how well things are

going, the astute investor should be thinking about preparing for the next setback that will

eventually occur … it always does. During good times, winners should be allowed to run

for sure, but also be think about taking some profits and reallocating to more conservative

investments in order to have some dry powder (cash or bonds) to reallocate back to

stocks during the next downturn. As a general rule, when stocks are performing

unbelievably well, that is a good time to raise cash. When everyone is convinced the

world is sure to end, that is a good time to buy.

Be a counter manic-depressive when dealing with investments, buying the worst

performers and selling some of the best. In other words, go against your gut. This is

based on the concept of “mean reversion”. History as shown that stocks generally rise

over time, and that stocks rise because companies have been able to grow their earnings

over time. However stock prices do not rise in a straight line. There are periods when

stocks perform much better than average and periods when they perform much worse.

81

The concept of mean reversion means that when stocks have performed better than

average, they are more likely to experience periods of sub-par performance, and vice-

versa. Or simply stated, what goes up too far must come down, and what goes down

must come back up. Since the S&P 500 index’s inception, the average price increase

(excluding dividends) has been about seven percent. However, in only six of those

seventy-two years did the annual price increase come between four and ten percent. The

annual price return was close to the average less than ten percent of the time. The stock

market has posted annual declines almost thirty percent of the time, and posted large

gains (more than fifteen percent) just over one third of the time. Two-thirds of the time

stocks either lost money or made super-sized gains!

During the twenty-five year period ending 1999, the stock market experienced one of its

most spectacular historical increases. “Buy and hold” and “buy on the dips” became the

mantra. Bear markets (declines of twenty percent or greater) were infrequent and short in

duration. Many pundits believed the United States had successfully shifted from an agri-

manufucturing economy to a service economy, thereby permanently muting any severe

negative effects from the business cycle. Investors were lulled into complacency,

thinking that stock market investing was essentially a one-decision process. Investors

have since learned that is not the case.

Since hitting a peak in the year 2000, the S&P 500 (a popular proxy for the U.S. stock

market) suffered its worst bear market since the great depression. It then rallied back to

its peak in late 2007, and has again entered another bear market. The Nasdaq has been

nowhere near its old high. Thus far this century, U.S. large-cap stocks have been a

disappointment. But that does not mean there was not money to be made. From the turn

of the century through 2007, international stocks included in the Morgan Stanley Europe

Asia Far East index returned over twenty-five percent. Bonds returned over thirty

percent. Emerging market stocks more than doubled, and U.S. midcap stocks (alligator

investors’ favorite asset class) just about doubled. A diversified portfolio spread across

these categories during this period would have fared far better than the investor who

figured the S&P 500 was enough diversification, and it trounced the new economy

speculators who foolishly bet it all on the Nasdaq.

Diversifying a portfolio today is easier than ever due to the numerous available mutual

funds and ETFs, in addition to directly investing in individual stocks and bonds. There is

a veritable plethora of options to choose from. This leads to two potential problems with

portfolio diversification. The first is to make sure the portfolio is invested in truly

different asset classes. Putting half a portfolio’s assets into the S&P 500 index and the

other half into the Russell 1000 index is essentially investing in the same thing twice.

Buying a large-cap growth fund at Fidelity and another large-cap growth fund at

Vanguard is not diversifying. Some professionals have coined the phrase “naïve

diversification” to describe the occurrence when individuals buy multiple funds that are

both highly correlated and very similar in nature, but think they are diversified because

they own more than one fund. Naïve diversification … That is very polite. “Stupid

diversification” is a more accurate description! It only takes a few minutes to research

the strategy and constitution of any fund. If unsure about the nature of an investment,

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spend a little time at morningstar.com or yahoo.com. Stupid diversification can also

happen with individual stocks. Owning Intel, Microsoft, Cisco, Hewlett Packard, and

Oracle is not adequately diversifying. Those stocks are all technology companies that are

heavily tied to the level of business spending. As mentioned previously, make sure that

individual stock investments are spread across at least five different economic sectors.

The other potential problem with diversifying a portfolio is over-diversification. Over-

diversification is the situation where a portfolio holds so many different investments that

it becomes hard to keep track of them all. The portfolio management and rebalancing

process can become confusing and unwieldy. Just because an asset category exists does

not mean it must be included in the portfolio allocation. A visit to ishares.com today

would include investment choices in the following categories:

Market Cap: Small

Medium

Large

Broad

Style: Growth

Value

Sector/Industry: Basic Materials

Consumer Services

Consumer Goods

Energy

Financial

Healthcare

Industrial

Natural Resources

Technology

Telecommunications

Transportation

Utilities

International: Europe

Asia

Africa

Americas

Global

Regional

Emerging Markets

Specialty/Real Estate: Real Estate

Specialty

Fixed Income: Broad Market

Government/Credit Bonds

Credit/Corporate Bonds

Treasury Bonds

Mortgages

Municipal Bonds

83

International

Commodities: Broad Based

Precious Metals

Barclays iShares offers over 120 different ETFs. How is anyone supposed to choose

from a list that big?! Keep in mind that just because something is on the menu it does not

have to be ordered. If fact when it comes to diversification, investors can get the majority

of its benefit with just a handful of investment choices. To make the asset allocation

decision more manageable, let’s first look at diversification of just U.S. equities. Adding

some international stocks to the overall equity mix will be considered next. Following

international stocks, balancing risk by adding fixed income (bonds) and cash equivalents

will be discussed.

Domestic Equities: The Nine-Pack

Today most investment consultants and firms offer U.S. stocks within a matrix that

divides stocks by market cap (small, mid and large) and style (core/blend, growth and

value). This results in nine basic categories of stocks illustrated below from which to

choose.

Large-cap

Value

Large-cap

Core/Blend

Large-cap

Growth

Midcap

Value

Midcap

Core/Blend

Midcap

Growth

Small-cap

Value

Small-cap

Core/Blend

Small-cap

Growth

The Russell Group’s indexes provide one of the oldest and most consistent track records

for the U.S. stock market and include all these categories. In chapter 3, The Joys of

Adolescence compared the results between small-cap, midcap and large-cap stocks for

the core/blend category, and concluded that midcap stocks were the best risk-adjusted

instrument to enhance long-term portfolio returns. Now let’s see the results when further

breaking down the stock market by comparing the growth and value styles for each

market cap segment.

Table 13 Russell Category Index Performance from 1986 Through 2007

Large-cap

Value

Large-cap

Growth

Midcap

Value

Midcap

Growth

Small-cap

Value

Small-cap

Growth

Annualized

Returns

12.5%

10.6%

13.5%

11.9%

12.9%

7.6%

Standard

Deviation

14.3%

19.9%

15.6%

20.1%

18.3%

21.3%

Return/

Risk

0.87

0.53

0.87

0.59

0.70

0.36

84

A few of observations are noteworthy from table 13. It appears the market has a bias

towards value stocks. In all market capitalizations, value stocks had better returns than

growth. This is because growth stocks tend to have higher earnings growth expectations

combined with higher valuations. Because of their higher expectations, growth stocks are

more likely to disappoint investors. And when they do disappoint, they tend to fall

farther because of their higher valuations. It is just the opposite effect for value stocks.

Lower valuations and expectations make it easier for businesses to positively surprise

investors, which results in better long-term performance. The second important point is

that per unit of risk, value stocks have provided far superior returns relative to growth

stocks. Not only did value stocks provide better absolute returns, they did it at lower risk

levels, which in this case is measured by standard deviation. Lastly, whether considering

the growth or value style, midcap stocks were the best long-term performers on both an

absolute and risk-adjusted basis.

For the long-term investor, it makes sense to emphasize value investing over growth.

However there are periods of time when the growth style performs better than value.

Table 14 shows rolling five-year annualized returns (including dividends) for the Russell

indexes segregated by both market capitalization and style. Bold figures represent the

best five-year return ending in the year indicated, while the worst category return is

underlined in italics. This table includes all five-year return periods for the Russell

indexes as far back as all the style boxes were available.4 Despite the stock market’s

long-term bias towards value, there are periods of time when the growth style

outperforms. Having some exposure to growth can make sense to balancing the

investment allocation, and to take advantage of growth cycles when they occur.

However, any exposure to growth indexes should be limited to only the midcap and

large-cap categories. Under no circumstances should anyone allocate investment dollars

to the small-cap growth category. As shown above in table 13, small-cap growth is the

worst long-term investment category for both absolute and risk-adjusted returns. When

broken down into five-year increments, small-cap growth has been the worst performing

category the majority of the time, and has never been the best investment category.

Although large-cap growth has recently been the worst performing investment category,

it has shown in the past the ability to be a top performer. To reiterate, the most consistent

performance over time has been in the midcap category. Both midcap value and midcap

growth experienced five-year periods where they were the best performing categories.

What is noteworthy is that midcap value and midcap growth have never been the worst

performers. Midcaps again have proven their metal by providing the best long-term

performance while avoiding the losers’ bracket.

4 Rolling five-year returns are available from 1983 through 1989 for the large-growth, large-value, small-

growth, and small-value categories, but not for the mid-growth or mid-value categories because Russell did

not separately break those categories out in the earlier time periods. However, a comparison between large

and small in the earlier years would result in small-cap growth looking even more unfavorable as an asset

category, and making small-cap value look slightly more attractive relative to Large-cap value, and roughly

comparable to midcap value. The same impacts also resulted for the rolling ten-year comparisons.

85

Table 14. Rolling Five-Year Total Returns for Russell Indexes

Large Val Large Gro Mid Val Mid Gro Small Val Small Gro

1990 11.3% 12.9% 8.1% 11.2% 2.6% 2.1%

1991 12.1% 17.5% 11.6% 16.3% 8.4% 10.1%

1992 14.9% 17.5% 16.6% 17.6% 15.8% 14.2%

1993 14.0% 15.6% 14.8% 17.3% 14.8% 12.9%

1994 8.5% 9.3% 9.8% 10.5% 11.8% 8.3%

1995 17.8% 16.5% 20.7% 18.4% 22.9% 18.8%

1996 17.2% 13.4% 17.4% 13.2% 19.2% 11.7%

1997 21.4% 18.4% 19.8% 16.0% 19.6% 12.7%

1998 20.9% 25.7% 17.5% 17.3% 13.1% 10.2%

1999 23.1% 32.4% 18.0% 28.0% 13.1% 19.0%

2000 16.9% 18.1% 15.1% 17.8% 12.6% 7.1%

2001 11.1% 8.3% 11.5% 9.0% 11.2% 2.9%

2002 1.2% -3.8% 3.0% -1.8% 2.7% -6.6%

2003 3.6% -5.1% 8.7% 2.0% 12.3% 0.9%

2004 5.3% -9.3% 13.5% -3.4% 17.2% -3.6%

2005 5.3% -3.6% 12.2% 1.4% 13.6% 2.3%

2006 10.9% 2.7% 15.9% 8.2% 15.4% 6.9%

2007 14.6% 12.1% 17.9% 17.9% 15.8% 16.5%

Has judgment been too harsh on small-caps and too flattering for midcaps? Just to be

sure, table 15 is included, which is identical to table 14 except that it shows rolling ten-

year returns. If anything, the picture becomes clearer. Small-cap growth has never been

the best performing asset class and is consistently the worst. Small-cap active mutual

funds like to brag that they have beaten the small-cap growth index, but that is an empty

boast. Being better than the worst should not be difficult. It is like wrestling a toothless

alligator. There is no glory in that victory! The best approach for investing in small-cap

growth is to avoid it altogether. Given its consistently poor track record, allocating any

portion of a portfolio to small-cap growth is stupid diversification. The only acceptable

small-cap investment classification is small-cap value. Small-cap value has performed

well over the long-term, but midcap value has done just as well … and even better on a

risk-adjusted basis. For alligator investment purposes, small-caps should generally be

avoided.

For rolling ten-year returns, midcaps display the same result. Midcaps have shown the

ability to be the leading category and have avoided being the worst. The longer time

horizon actually improves the results for large-cap growth, which can result in being the

top performer, while only rarely being the worst. At face value, it appears that combining

large-cap growth with midcap value may provide the greatest diversification benefit

(lowest R-squared) across the six categories.

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Table 15. Rolling Ten-Year Total Returns for Russell Indexes

Large Val Large Gro Mid Val Mid Gro Small Val Small Gro

1995 14.5% 14.7% 14.3% 14.8% 12.3% 10.1%

1996 14.7% 15.4% 14.5% 14.8% 13.7% 10.9%

1997 18.1% 17.9% 18.2% 16.8% 17.7% 13.5%

1998 17.4% 20.6% 16.2% 17.3% 13.9% 11.5%

1999 15.6% 20.3% 13.8% 19.0% 12.5% 13.5%

2000 17.3% 17.3% 17.9% 18.1% 17.6% 12.8%

2001 14.1% 10.8% 14.4% 11.1% 15.1% 7.2%

2002 10.8% 6.7% 11.1% 6.7% 10.9% 2.6%

2003 11.9% 9.2% 13.0% 9.4% 12.7% 5.4%

2004 13.8% 9.6% 15.7% 11.2% 15.2% 7.1%

2005 10.9% 6.7% 13.7% 9.3% 13.1% 4.7%

2006 11.0% 5.4% 13.7% 8.6% 13.3% 4.9%

2007 7.7% 3.8% 10.2% 7.6% 9.1% 4.3%

Attributes to consider when diversifying a portfolio include the long-term expected

annual returns for the asset category, the volatility of those returns, and the correlation of

returns between different categories. Let’s begin by looking at the correlation of returns

between large-cap and midcap stocks for the blend, growth and value categories. Table

16 details the R-squared for the correlations among those categories. The R-Squared

represents the similarity in the relationship for the two categories being compared. For

purposes of pure diversification, the smaller the R-Squared the better.

Table 16. R-Squared of Russell Category Returns 1986 – 2007

Careful observation of this table shows that style categories are highly similar across

market capitalizations. Growth is similar to growth, etc. The greatest diversification

comes from combining different styles within market capitalizations, or different styles

across market capitalizations. The broader index (the blend category) appears more

closely aligned to the value style versus growth.

Large

Blend

Large

Value

Large

Growth

Mid

Blend

Mid

Value

Mid

Growth

Large

Blend

100%

Large

Value

82%

100%

Large

Growth

91%

52%

100%

Mid

Blend

80%

84%

60%

100%

Mid

Value

54%

83%

27%

84%

100%

Mid

Growth

80%

52%

84%

75%

36%

100%

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To illustrate the power of diversification, a fictional portfolio was created using a 50/50

mix of Large Blend (the Russell 1000 index – ETF ticker “IWB”) and Mid Value (the

Russell Midcap Value index – ETF ticker “IWS”), and a second fictional portfolio using

a 50/50 mix of Large Growth (the Russell 1000 Growth index – ETF ticker “IWF”) and

Mid Value. These two combinations were selected to combine the best long-term

performer (mid value) with the two lowest correlated large-cap categories. Portfolios

were run from 1986 through 2007 and were rebalanced at the end of each year to bring

portfolio weights back to a 50/50 mix. The results for these portfolios and the broad

indexes were as follows:

Large Blend/ Large Growth/ Russell 1000 Russell MidCap

Mid Value Mid Value Index Index

Annual Return 12.8% 12.4% 11.8% 13.3%

Std. Deviation 14.7% 15.5% 15.4% 14.9%

Return/Risk 0.87 0.80 0.77 0.89

Worst Year -15.7% -18.8% -21.7% -16.2%

Despite the admiration for midcap stocks being the best risk-adjusted vehicle for

investing in the U.S. stock market, no respectable investment counselor is going to

recommend that putting all of portfolio investments into one category. However, by

simply allocating half of the U.S. stock market investments to large-caps (IWB) and the

other half to midcap value (IWS), several things will be accomplished. First, the

portfolio will be invested in the biggest and best U.S. companies to exploit global growth.

Second, by using a large-cap blend portfolio, there is no need to worry about whether

growth or value is in style. Third, by allocating half the investments to midcaps, the

portfolio will be taking advantage of emerging alligators as they pass through

adolescence. Fourth, because investments are tilted towards value, the portfolio will take

advantage of a long-term value bias that is inherent in the stock market. A final point

worth mentioning is that the large-cap blend/midcap value portfolio also had the best

capital protection by recording the smallest one-year decline. This simple two-category

combination is easy to manage, adequately diversified, and just makes good common

sense!

But what about all the specific individual sector and industry funds? When does it make

sense to invest in them? Keep in mind that when investing in broad index funds,

investors are already diversified across all of the economic sectors. The issue becomes

whether to increase exposure to a specific sector by owning more of it, or wanting less

exposure by shorting. The topic of using shorts will be avoided in this text because that

is reserved for more advanced investors.

There are some valid reasons to own more of a particular sector. Older investors who are

more concerned with dividends can increase their dividend yield by owning a utility ETF

(ticker symbol “IDU”) or real estate investment trust ETF (ticker symbol “ICF”). Others

may feel confident that the healthcare or technology sectors are going to take the lead in

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the market. Individual reasons for emphasizing particular sectors are personal and each

individual will have to monitor their success with these trades. Some investors fall into a

pattern of chasing the hot group when it is too late. When the sector rolls over, they react

like a deer in the headlights, watching their investments decline rather than selling

quickly to conserve capital. Be aware that the best performing sector for the past five

years is rarely the best performing sector for the next five. After five years, everyone has

had plenty of time to figure out the trend. Investors would be better off identifying which

sectors have performed poorly over the past five years and watching for that negative

trend to turn positive. Monitoring sector trends takes more of an ongoing conscious

effort (weekly updates are recommended). There is nothing wrong with trend following

or channel trading5 so long as a person is committed to putting forth the required effort.

For a cursory introduction to technical analysis, visit of Investopedia website (a Forbes

Digital Company) at http://www.investopedia.com/university/technical. Along with

technical analysis, Investopedia covers many other investment topics within the tutorials

section of their website. For a more focused approach to using technical analysis in the

investment process, “How to Make Money in Stocks” third edition by William J. O’Neil

is recommended. Many other books have been written on the topic, but Bill O’Neil and

investors who have followed his approach have made millions in the real world.

So with regards to the U.S. stock market, dozens of choices have been whittled it down to

two essential ETFs with the ability to emphasize particular needs or sectors depending

upon personal circumstances. That covers the U.S. market, but there is a still the rest of

the world to deal with. How can an investor take advantage of international markets in

an easy to manage and common sense way?

International Equities

The United States is the largest economy in the world today. Americans have a standard

of living that is superior to just about anywhere on the globe. A combination of strong

property rights protections and free-market capitalism have resulted in the U.S. being

roughly twenty-five percent of global domestic product while having less than five

percent of the world’s population. Americans consume more of just about everything

than consumers in most every other country. While that may or may not be something to

be proud of, it raises the awareness that as other countries develop a consumer class, their

citizens are going to want to improve their standards of living. Many of the items

Americans take for granted today such as carpeting, television, dishwashers, microwave

ovens, ground beef, ice cream, etc. are still considered fairly large luxuries in other parts

of the world.

Keep in mind that during the last century, today’s developed economies (America,

Western Europe, Japan, and others) were yesteryear’s emerging economies. The

establishment of energy (electric and fossil fuels), transportation and communications

5 Channel trading is the practice of buying and selling stocks or funds within definable patterns based on

charts. The general theory is that stocks tend to move up and down within an observable channel. Channel

traders buy at the bottom of channels and sell at the top of channels to take advantage of the markets

enthusiasm and pessimism. It is a classic counter-manic-depressive strategy.

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infrastructure along with the many inventions that occurred over time created the living

standards that are now prevalent in the developed nations. A tremendous amount of

wealth was also created as companies took advantage of the growth opportunities created

in their prospering economies.

Why is it that today’s developed economies did so well over the past century while many

other parts of the world lagged behind? While not professing to be an expert on world

economic history, it is probably the result of political regimes that encouraged

development of new technologies, allowed for the incentive to profit from entrepreneurial

endeavors, and protected individual property rights. Those countries did the best.

Advances in energy, transportation and communications infrastructure have made the

world a smaller place. Heads of emerging economies (as well as their citizens) can more

easily see how well the developed economies have performed. Emerging countries

would like to participate in growth because they see the benefits growth can provide. The

biggest difference in the emerging economies today versus the past few decades is that

their governments are finally allowing capitalism to take hold. If this continues and

shareholders rights are protected, there will be a vast amount of wealth created over the

next several decades.

Consider the following statistics as just a few indicators of the remaining opportunities.

As of year 2000, one-third of the emerging countries populations had no access to

electricity in their homes. It is no-brainer that families will not be watching television

without electricity, but did consider that households also cannot refrigerate food, which

results in tremendous food waste? The IEA has shown a relationship between access to

electricity and poverty. That should be no surprise. Here are few other tidbits. As of

2003 Americans have 740 televisions per thousand people. England has 500, China has

310, Brazil has 200 and India has 60. Americans have 770 motor vehicles per thousand

people. England has 430, Brazil has 80, India has twelve and China has ten. In general,

the developed economies have multiples of what the emerging countries own on a per-

capita basis. That leaves a lot of room for growth!

It is not necessary to invest directly in the more mature developed international stock

markets (like Western Europe and Japan). There are a several reasons for this. To begin

with, by investing in U.S. companies investors are already participating in international

growth. About one-third of the earnings in U.S. large-cap companies are generated

overseas. Midcaps earn approximately one-fourth of their earnings from international

sources. By owning U.S. large and midcap stocks either through mutual funds, ETFs or

individual stocks, investors are in effect already allocating a portion of your money

internationally.

A second reason to not invest directly in the developed international markets is that they

have not performed as well as the U.S. market over the long-term. Nor are they likely to.

The purpose of diversifying stock investments is to enhance a portfolio’s risk-adjusted

returns. From 1986 through 2007 the Morgan Stanley Capital International EAFE index,

a proxy for the developed international stock markets, had lower returns with higher

90

volatility versus the 50/50 IWB/IWS portfolio on the previous page. Although allocating

a portion of the portfolio to the EAFA index did lower overall volatility, it also lowered

the overall returns without raising the risk-adjusted returns. Adding the developed

international markets to the mix did not enhance overall portfolio characteristics. The

future will likely be no different. The United Kingdom, Japan, France, Germany,

Switzerland, Spain and Italy are mature economies with stagnant, aging populations.

These countries constitute over two-thirds of the EAFE index’s composition. Business

regulations in these countries do not allow for the re-allocation of labor and capital as

freely as in the United States. This results in a business ecosystem that provides less

opportunity than in the U.S. or the emerging economies. The developed international

economies broad stock market does not need to be part of an investment portfolio mix.

Is it reasonable to invest directly in the stocks of international companies? Sure. The

easiest way is to invest in foreign companies that have listed their stocks directly on the

U.S. stock exchanges. But there are some issues to be aware of. While foreign

companies must follow SEC rules and regulations if they list their stocks in the United

States, it is harder to prosecute their executives in the event of fraud or gross negligence.

Access to a foreign company’s management is more difficult than that of a domestic

corporation. Stock trading liquidity on foreign stocks is generally less than that of

domestic companies of comparable size. If comfortable with these issues, then by all

means invest in foreign companies. But remember to stick with industry leaders that are

profitable, growing, and have much larger business opportunities relative to their current

size. The same rules applied to evaluating and investing in a U.S. company should also

be applied to your international investments.

Alligator investors prefer to focus investing efforts on domestic stock market

opportunities and balancing portfolios with an allocation to the emerging international

markets. Investing in foreign stocks or the EAFA index is not considered stupid

diversification, but it is not considered brilliant either. If the urge to invest in the

developed international stock markets cannot be resisted or if some unique insights give

an edge to international stocks, keep the allocation minimal. Remember, globalization

has already resulted in participating in overseas growth through domestic stock

investments.

It should be clear now that the recommended approach to diversifying into the

international markets is to focus on the emerging economies, not the developed

economies. Emerging countries is where investors will have the best opportunity to own

foreign adolescent companies. Remember that adolescence is the period when companies

blossom into adulthood, creating accelerated wealth opportunities for investors. If the

emerging economies are more likely to be entering a period of accelerated growth

relative to the rest of the world, then they should also be the most likely place to find

higher-growth, midcap companies. Even the local large-caps in emerging counties

should do well because they will benefit from the more rapid growth that those

economies will provide. Keep in mind that most of the dominant, local leading

companies in the emerging economies are still small relative to the large-caps in the

developed countries. The preferred approach with the emerging economies is to own the

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entire swamp because they are still quite young in their development. The leaders in

these markets will naturally rise to the top, just as they have done in every other market.

By owning the emerging market index, investors will own all the leaders by default.

They will also own the losers, but their losses will more than offset by the leaders’

successes.

Large-cap blend stocks were previously combined with midcap value stocks to create a

domestic stock portfolio that resulted in enhanced absolute returns with an attractive risk-

adjusted return when compared to the overall large-cap U.S. stock market. That portfolio

will be referred to as the “LBMV” portfolio. Now let’s include some emerging market

stocks in the portfolio mix by adding the Morgan Stanley Capital International Emerging

Markets index. Investors can own in this index through a Barclays iShares ETF under the

ticker symbol “EEM”. Below are the results for adding EEM to the LBMV portfolio in

increments of ten percent. The portfolio was rebalanced annually. For example, a twenty

percent allocation to EEM leaves eighty percent for the LBMV, which would consist of

forty percent IWB ( half large-cap blend) and forty percent IWS (half midcap value).

Returns were compounded over the same 22 year period ending 2007 as above. Results

are also displayed for the emerging markets index.

90% LBMV/ 80% LBMV / 70% LBMV/ MSCI Emg.Mkt.

10% EEM 20% EEM 30% EEM Index

Annual Return 13.5% 14.1% 14.6% 16.4%

Std. Deviation 14.6% 15.2% 16.3% 31.6%

Return/Risk 0.92 0.93 0.90 0.52

Worst Year -14.8% -13.9% -12.9% -30.3%

Looking first at the emerging markets index results, notice that while the emerging

markets had high returns, they also had twice the risk. This resulted in a risk-adjusted

return that was extremely low. The return/risk coefficient of 0.52 is one of the lowest

seen in the various previous analysis. The worst one-year return was also more severe

than that of large-caps, midcaps, and the LBMV portfolio. But a magical thing happens

when combining emerging market stocks with the LBMV portfolio … returns go up and

risk goes down! Each of the combinations had annual returns that were higher than the

stand-alone LBMV. The worst one-year return for each of the combinations was less

severe than experienced by the LBMV. Each of the combinations had return/risk

coefficients that were higher than the LBMV.

Depending on which factors are considered most important and the overall comfort level

with investing overseas, allocating a portion of portfolio investments to emerging markets

makes sense. The 10% EEM mix resulted in a lower standard deviation than the stand-

alone LBMV portfolio. The 20% EEM mix (the preferred choice) had the highest risk-

adjusted return expressed by the return/risk coefficient. The 30% EEM mix had the

smallest one-year loss.

92

How can adding such a risky asset class to the mix result in a portfolio that exhibits better

overall return and risk characteristics? It goes back to the lack of correlation between

asset categories. During the sample time period the R-squared for the emerging market

index versus the LBMV portfolio was only 7 percent. When U.S. markets were doing

well, profits were taken through the rebalancing process and additional purchases of

emerging markets were made. When emerging markets did well, the rebalancing process

captured those profits and then repurchased U.S. stocks which had lagged behind.

One of the greater risks to this strategy is that the relationship between the U.S. and

emerging markets becomes more linked (more correlated) over time. However, it will

take a long time before that occurs. For that to happen, currency markets would have to

become more correlated. Business cycles between emerging and developed countries

would have to become more correlated. The sector and industry composition of

emerging markets would have to become more aligned with those of the U.S. For

instance, the emerging markets currently have more exposure to commodities and

telecommunications. The U.S. market has greater weightings in healthcare and consumer

stocks. Trade imbalances, political stability, tax rates, interest rates, government

deficits/surpluses, regulation, inflation and a host of other variables make it unlikely that

the emerging economies’ stock markets will ever be highly correlated to the U.S.

To summarize, investing in the emerging international markets makes sense. The amount

of exposure to take is somewhat a matter of personal preference. Limiting exposure to

the twenty percent level with an annual rebalance is a reasonable approach. That mix

should let you sleep at night knowing that you are an American citizen and cannot be an

expert on the emerging countries political and economic structures.

With three ETF’s (IWB, IWS, and EEM), anyone can have a world-class, easily

managed, global equity portfolio.

93

CHAPTER 9: DIVERSIFICATION PART 3: MULTIPLE SWAWPS

Cash and Bonds

The diversification discussion thus far has been limited to stocks and giving a framework

for a global equity portfolio that has an attractive risk-adjusted return profile. The

discussion about risk has primarily been focused on standard deviation, and the

relationship between returns and volatility. There is more to risk, however, than just

price volatility. Academics primarily think about risk as volatility. But most people

think about risk as losing money. People typically hate losing money more than they like

making money (except in Las Vegas where losing money is viewed as a form of

entertainment). If given a choice between receiving 100 dollars with certainty, or

flipping a coin for a 50/50 chance to receive 200 dollars, the majority will choose the

hundred dollars even though the two choices are mathematically identical. It is the old

“bird in the hand” syndrome.

The conundrum is that in order for anybody to meet their long-term retirement goal, they

are going to have to accept risk and invest in stocks. Unless you were born filthy rich,

there is no way around that. While investing in stocks, periodic will losses will be

experienced along the way. Earnings growth however should wash away those losses

over time. Most people however should not be 100 percent invested in stocks. Through

years of saving, they may already be close to or have exceeded their retirement savings

goal. Or they may be lucky enough to have an employer or government-sponsored

defined benefit retirement plan. In general, the older the individual, the more saved, the

more sources of income available during retirement outside investments; the less stocks

needed and the greater exposure to cash and bonds in the portfolio.

Think of it this way. Stocks are for growth and taking risk. Cash and bonds are for

safety and generating interest income to live on. There is no need to take unnecessary

risks with bond investments when portfolios are already accepting risk in stocks. For

bond investing, stick with high-quality bonds rated Baa or better by Moody’s or Standard

& Poor’s, the two major bond-rating organizations. With the popularization of ETFs,

investing in a low-fee diversified high-quality bond portfolio is easier than ever.

Barclays iShares offers several choices covering a range of options from short-term

treasuries to corporate junk bonds. A good ETF choice for general bond investing is the

AGG, which tracks the Lehman Brothers U.S. Aggregate bond index. This is a high-

quality diversified bond portfolio that includes both government and corporate bonds, and

is suitable for most conservative investors.

Cash investments (or cash equivalents) should be kept in the highest quality money

market funds, certificates-of-deposits, or treasury bills. Investing in anything but the

highest quality assets with cash reserves is foolishness. In the recent period of low

interest rates, many investors in the search for higher interest rates took risks they didn’t

understand with their cash. They shopped around at different banks for the highest

certificates-of-deposit or money market rates. In this search for higher yields, many

94

people unwittingly deposited their money in unfit financial institutions. When IndyMac

Bank declared insolvency and was taken over by the Federal Insurance Deposit Agency,

customers were scrambling at the doors to get their money back. If their account

balances were below the 100,000 dollar insurance limit, depositors got their principal

back plus any accrued interest. But depositors above the insured limits did not get all

their money returned. Countrywide Financial may very well have suffered the same fate

had it not been acquired (more like bailed out) by Bank of America. At the time of this

writing, more banks are likely to go bankrupt. If a bank is offering interest rates on cash

deposits that are among the highest offered versus most other banks, depositors should at

least protect themselves by restricting deposits in those banks to the insured limit,

remembering to leave room for accruing interest. It is tempting in today’s low interest

rate environment to chase yield where available. People who enjoy shopping around for

high rates should protect their money by spreading deposits across multiple banks,

restricting each bank’s deposits to the insured limit.

With bonds, it is recommended to generally stick with quality. While there are times that

high-yield (“junk”) bonds represent attractive investments, those times generally coincide

with when stocks are also attractive. Alligator investors prefer to stick with high-quality

bonds and think of them primarily as interest generating instruments. Within this

context, there are still a couple of items to consider when thinking about bond

investments.

The first is whether bonds will be held in a taxable or tax-exempt account such as an

IRA. When holding bonds in a taxable account, consider investing in municipal bonds.

Municipal bonds are tax-free in the state that issues them and also exempt from federal

taxation. For example a California resident holding California municipal bonds will earn

interest on those bonds would avoid both state and federal income taxes. But a California

resident holding New York municipal bonds would pay California income taxes but not

federal. Because some municipal bonds are subject to the federal alternative minimum

tax rules, check the potential exposure to the alternative minimum tax before buying any

municipal bonds. Due to their tax preference, municipal bonds typically pay lower

interest rates than corporate bonds. Individuals in low income tax brackets may be better

off in corporate bonds for the higher yields even after considering taxes. If bonds are

held in a tax-exempt account, stick with high-quality corporate bonds in order to capture

more yield. Never buy municipal bonds in a tax-exempt account except in the rare

occurrence that they provide an absolute interest yield higher than an equivalent quality

corporate bond.

Another item to consider with bond investments is whether long or short duration bonds

are preferable. This decision is mainly dependent upon the current interest rate

environment, and whether interest rates should be substantially increasing or decreasing.

Duration basically measures a bond’s life. The longer the remaining life or duration, the

more sensitive a bond’s price is to interest rate changes. For example a three-year and

ten-year bond both pay five percent interest. Because of rising inflation fears, interest

rates suddenly climb to ten percent. The ten-year bond’s price will fall more than that of

the three-year bond because the ten-year bondholder will be stuck with receiving a five

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percent coupon6 for a longer period of time. The ten-year bond investor will also have to

wait seven more years before his principal is returned. Interest rate changes have a

greater impact on longer duration bonds due to the time value of money. When interest

rates fall, the ten-year bond’s price will increase more than the three-year’s. It is the

same effect, but in the opposite direction. If interest rates are near historic lows, investors

would generally be better off sticking with shorter duration bonds since the odds of

interest rates moving higher would be greater than normal. To reduce interest rate

sensitivity and avoid the worry about future interest rate changes, stick with intermediate

maturities by investing in an ETF which tracks the Lehman Brothers Intermediate U.S.

Credit Index (ticker symbol “CIU”).

Figure 23. Normal Yield Curve

Normal Yield Curve

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The steepness of the yield curve may also have an effect on the decision whether to

emphasize short or long duration bonds. The yield curve graphically plots interest rates

across maturities (i.e. three and six months, one, two, three, five, seven, ten, twenty, and

thirty years). The yield curve is widely publicized in online and print publications.

Yahoo Finance shows the yield curve in the bond indices section of its web site at

http://finance.yahoo.com/bonds. Morningstar.com includes it in the “Markets” tab on

their site at http://www.morningstar.com/cover/Markets.html. The Value Line Investment

Survey includes the yield curve in their weekly “Selection and Opinion” publication, and

you can find it in the “Futures and Bonds” section of the Investors Business Daily. The

best source for current and historic yield curve data is on the U.S. Treasury’s Internet site

at www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.html.

An upward sloping (“normal”) yield curve has long-term interest rates higher than short-

6 The coupon is the stated interest rate that a bond pays on its par value. Par equals 100. A bond trading at

a discount to par will trade below 100, and above 100 if trading at a premium. Bonds will trade at a

discount to par when current prevailing interest rates are higher than the bond’s coupon rate. Bonds will

trade at a discount to par when prevailing interest rates are below the bond’s coupon. For example a ten

year bond with a stated coupon of 5 percent will trade at par when current interest rates are also at five

percent. If current rates rise to 7 percent, the price of the bond will fall to $85.79. If interest rates fall to 4

percent, the bond’s price will rise to $108.18. The corresponding prices for a three-year bond with a 5

percent coupon would be $94.67 and $102.80 at current rates of 7 and 4 percent, respectively.

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term rates, and generally indicates an expectation for continued economic growth and/or

rising inflation. An inverted yield curve slopes downward, with long-term rates below

short-term levels, and is often a leading indicator of an oncoming recession.

As a general rule, the steeper the yield the curve, the better it is to hold longer duration

bonds because the higher long-term rates are attempting to compensate investors for the

additional risk taken. These risks encompass anything that could cause long-term interest

rates to rise, the main one being a rise in inflation above existing expectations. Other

factors include accelerating economic growth that increases the demand for borrowing

and pushes interest rates higher, or the perception of increasing default risk requiring

higher interest rates to encourage investors to hold bonds. A steep yield curve is no

guarantee that interest rates will not increase further due to higher inflation. It merely

reflects the prevalent collective thinking of all bond market participants, whose opinions

can change as events unfold. If interest rates rise across the duration spectrum, all bond

prices will fall. The primary consideration for choosing duration remains the perception

about the future direction of inflation and interest rates. However, a steep yield curve at

least provides some added compensation for an uncertain future.

Figure 24. Inverted Yield Curve

Inverted Yield Curve

5.60%5.80%6.00%6.20%6.40%6.60%6.80%7.00%

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An inverted yield curve can be a leading indicator for recession, but it is not a perfect

predictor. In fact the inverted yield curve may have been too enthusiastic, having

predicted 13 of the last 11 recessions. A recent publication by Glenn D. Rudebaush and

John C. Williams of the Federal Reserve Bank of San Francisco concluded that “…

forecasts from the yield spread model, based on real-time estimates are significantly more

accurate than the SPF (Survey of Professional Forecasters) for forecast horizons of three

and four quarters.” Numerous other studies support the inverted yield curve’s predictive

capabilities. In general, when the ten-year treasury bond rate is one percent or more

below the three-month treasury bill rate, the odds of a recession are better than 50/50.

The bigger the inversion, the greater the probability for a recession. The silver lining to

the recession cloud is that recessions typically ease inflation pressures because they cause

weaker demand for goods and services.

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How does an inverted yield curve impact the bond investment strategy? Again, the

primary consideration in determining to emphasize long versus short duration bonds is

the perception about future inflation and interest rate directions. Because an inverted

yield curve has long-term rates below short-term rates, additional compensation is not

provided for assuming the risk of an uncertain future. The choice to stay in longer

duration bonds depends on one’s belief that short-term rates will fall without causing a

rise in long-term rates. A reduction in short-term interest rates is generally brought about

by the Federal Reserve lowering interest rates in order to stimulate economic growth and

avoid a potential oncoming recession. Because long-term rates are already below short-

term rates in an inverted yield curve, they may not fall much further while the Federal

Reserve is lowering rates. On the contrary, the prospect of reinvigorated economic

growth may actually drive long-term interest rates higher because a renewed business

cycle increases the demand for credit. During economic expansionary periods capacity

utilization increases, causing inflation pressures to resurface and forcing long-term

interest rates to trend higher. In that scenario, a good strategy would be to invest in

intermediate (duration around four years) bonds in order to hedge portfolio exposure to

the opposing forces.

Figure 25. 10-Year Treasury Bond Yield History

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1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

Figure 25 shows the ten-year treasury bond’s yield history since 1900, and illustrates the

impact that rising inflation had on interest rates during the seventies and eighties, and

how the taming of inflation over the past two decades has returned interest rates to their

long-term normal levels. In the current environment of rising commodity costs (despite

their recent retrenchment) and loose monetary policy, it is more likely that interest rates

will rise from today’s level of approximately four percent. If that assumption is true,

extending duration beyond the intermediate range may be taking more risk than

warranted.

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The last basic variable to consider in bond investing is the risk spread. The risk spread is

the difference in interest rates between treasury bonds and corporate bonds. Treasury

bonds are considered the safest of all bonds because they are backed by the Federal

Government’s full faith and taxing authority. Corporate bonds are considered more risky

since their promise to repay is supported solely by a company’s business. Depending on

variables such as cyclicality, current debt coverage ratios, market share dominance,

geographic diversification, industry health, and other factors, corporate bonds can be

rated from AAA (highest quality) to D (junk). Bonds are rated primarily by the two

major rating agencies, Moody’s and Standard & Poor’s. Together they monitor the

companies’ progress for developments that will favorably or unfavorably impact their

ability to satisfy obligations to bondholders. Chapter 2 discussed how stocks fluctuate in

the short-term because of investor sentiment and the willingness to accept risk. When

risk tolerance is high, stocks get expensive, and when investors become fearful, stocks

become cheaper. Investor sentiment impacts bonds in the same manner. When investors

are more concerned about the economy’s health they demand more compensation for

assuming the additional risk. This manifests itself in the form of higher interest rates for

corporate bonds versus treasuries … a higher risk spread. A widening risk spread is often

characterized as a “flight to safety” with investors selling corporates to buy safer

government bonds. During periods of rising prosperity, risk spreads decline as investors

chase yield to maximize returns. The risk spread is simply the difference between ten-

year corporate bond yields and the ten-year treasury bond yield.

Figure 26. AAA bonds versus Ten-Year Treasury Risk Spread

AAA Bond Spread

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Figure 26 shows the AAA bond risk spread for the twenty years ended December 31,

2007. As a general guideline when the risk spread is less than 1.25, bond portfolios

should be more heavily weighted in treasury securities. When the spread is between 1.25

and 1.75, a normal mix of 35/65 treasuries/corporates is appropriate. When the spread

rises above 1.75, tilt bond investments more heavily towards corporate bonds. To get a

current indication of the risk spread, visit Yahoo! Finance at

http://finance.yahoo.com/bonds/composite_bonds_rates. Yahoo lists the current yields

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for treasury and corporate bonds by maturity. Subtract the ten-year treasury bond yield

from the ten-year corporate yield to calculate the current spread.

Bond portfolio adjustments should not be frequent as trends affecting the bond market

tend be longer term in nature. Rather, adjustments to bond portfolios should take place

primarily when substantial moves in interest rates and/or risk spreads have already taken

place; or if there is a significant change in an investors overall goals or objectives. The

cost of short-term trading in the bond market will most likely eliminate any potential gain

to excess returns. When it comes to tactical shifts within bond investments, be patient.

Wait for significant moves and inflection points … then act.

Barclays iShares offers a full suite of fixed income (bond) ETFs to satisfy most investors’

needs. The matrix below provides a guideline for strategically positioning a bond

portfolio, indicating which ETF to emphasize depending upon whether interest rates are

rising or falling, and whether risk spreads are wide, normal or narrow. This doesn’t have

to be an all or nothing decision. A good approach would be to use the AGG as the core

bondholding and then use the other ETFs as a way to shift duration and credit risk higher

or lower. A brief description of these ETFs is presented below. More detailed

information may be obtained at Barclays iShares website.

SHV - Short Term U.S. Treasury Bills; 4 months average duration

SHY - Short Term U.S. Treasury Bonds; 1.75 years average duration

IEI - Intermediate U.S. Treasury Bonds; 4 years average duration

TLH - Long Term U.S. Treasury Bonds; 9.2 years average duration

GVI - Intermediate Government & Corporate Bonds; 3.75 years average duration

AGG - Government & Corporate Bonds; 5 years average duration

CSF - Short Term Corporate Bonds; 2 years average duration

CIU – Intermediate Corporate Bonds; 4.25 years average duration

CFT – Long Term Corporate Bonds; 6 years average duration

Rates Falling Rates Steady Rates Rising

Spread Wide CFT CFT or CIU CSJ

Spread Normal AGG AGG or GVI CSJ

Spread Narrow TLH IEI SHY or SHV

One last item to clarify pertains to when rates are interest rates are holding steady. If

rates are steady and low, tilt towards intermediate or shorter duration bonds since the

odds of them rising are greater than the likelihood of them falling. If interest rates are

high and steady, emphasize longer duration bonds.

Now that some bond strategy basics have been reviewed, it is time to see the impact that

bonds can have to an overall portfolio. The most important bond decision to make is to

determine what percentage of the overall investment portfolio will be invested in bonds.

The multipurpose of adding bonds to the portfolio is to improve risk-adjusted returns, to

limit the overall risk of loss, and to generate current income in the form of interest. For

this analysis, the AGG, which tracks the Lehman Brothers U.S. Aggregate bond index,

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was used as a proxy for bonds, and the SHV, which tracks the Lehman Short Treasury

Bond fund, will be used as a proxy for cash. For stocks, the LBMV portfolio is combined

with 20 percent in emerging markets (“EEM”). Thus, the total stock portfolio includes

40 percent Large Blend, 40 percent Midcap Value, and 20 percent emerging markets.

Table 17. Historical Performance Results for Various Stock vs. Fixed Income

Allocations.

Performance Results for 22 Years Ending December 31, 2007

Ending

Annualized Standard Worst Worst Value of

Stocks/Bonds/Cash Return Deviation Return/Risk 1 Year 3 Years $100,000

All Stocks 14.10% 15.2 0.93 -13.9% -19.3% $1,821k

All Bonds 8.45% 9.5 0.89 -8.6% 10.8% $596k

All Cash 4.80% 1.9 2.47 1.1% 4.2% $281k

90/0/10 13.25% 13.7 0.97 -12.3% -16.3% $1,545k

80/15/5 12.95% 12.7 1.02 -9.4% -10.7% $1,457k

70/25/5 12.43% 11.7 1.06 -6.9% -5.8% $1,316k

60/35/5 11.91% 10.8 1.11 -4.4% -0.7% $1,189k

50/45/5 11.34% 10.0 1.14 -4.3% 4.6% $1,062k

40/55/5 10.79% 9.3 1.16 -4.8% 10.0% $953k

30/65/5 10.18% 8.9 1.15 -5.3% 13.5% $844k

20/75/5 9.56% 8.7 1.10 -5.9% 12.8% $745k

10/85/5 8.93% 8.7 1.02 -6.4% 12.1% $657k

Table 17 details the twenty-two year period ending December 31, 2007 results for

investing in various mixes of stocks versus bonds versus cash. Portfolios were

rebalanced at the end of each year to bring the weightings back into the original mix

indicated. No fees were included and returns are before income taxes. A few key

observations are worth highlighting. First as would be expected, stocks provided the

highest annualized return and the highest level of volatility (standard deviation).

However, on a risk-adjusted basis, bonds were actually slightly less favorable than stocks

illustrated by bonds having a return/risk ratio of 0.89 compared to stocks at 0.93.

The second observation relates to the absolute risk of loss, which is indicated by the

worst one and three-year return figures. The only asset class with absolute protection

against losing money over one year was cash. Investing an entire portfolio in cash and

treasury bills is clearly safe, but also the worst choice for enhancing future wealth. The

worst asset class for protecting short-term capital was of course stocks. Bonds are safer

than stocks, but even over short time horizons, investors can lose money in bonds. When

interest rates rise, either due to renewed economic growth or rising inflation, bond prices

fall. If rates rise at a fast enough clip, the decline in bond prices will more than offset the

interest received from the coupons. Some people think that by only investing in bonds

and cash, they are best protected against losing money. But history shows that this is

clearly not the case.

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Let’s look at the facts. Yes it is true that over one-year time frames, people will not lose

money being 100 percent in cash. However, the decision to time the market with

precision is difficult, if not near impossible. Investors may protect themselves in the

short-term, but in the long-run they will lose more money by missing out on the superior

returns offered by stocks. Over a one-year time frame, bonds can lose money, but it

unlikely that bonds will lose money over three years, though not impossible. During the

runaway inflation periods in the last century, bonds recorded absolute losses even across

multiple years.7 During the sample period above, the worst three-year return for bonds

was a gain of almost 11 percent. However, the bottom of the table 17 shows that

portfolios that included anywhere from ten to forty percent in stocks also did well on the

three-year loss-risk test. In each case, the worse three-year return was a ten percent gain

or better. On a one-year basis, portfolios that included stocks also had lower one-year

losses than bonds alone. Adding a riskier asset has once again resulted in a portfolio with

overall lower risk. This is because the correlation between fixed income and stock

returns over time has been less than twenty percent. Often times when bonds are

declining, stocks are rising and vice versa.

Which brings up a final important point. There is such a thing as being too conservative!

Everybody should have some portion of their investment in stocks, even if it is just a

small percentage. By completely avoiding stocks investors not only lose by exposing

themselves to greater short-term loss risk, but they also achieve lower long-term wealth

accumulation. For example the overall volatility (standard deviation) of the 40/55/5 mix

portfolio was the same as investing in bonds only. The worst three-year results for both

portfolios was also about the same, but the 40/55/5 portfolio’s worst one-year return was

only half that of bonds only. The 40/55/5 portfolio was overall slightly less risky than

just investing in bonds. But on an annualized return and risk-adjusted return basis, the

40/55/5 mix was clearly superior to investing in bonds only. For the same level of risk as

bonds, the 40/55/5 portfolio had annualized returns over two percent higher than bonds

alone, and generated an incremental $357,000 in accumulated wealth. That is lot of

alligator boots! Even by taking out taxes incurred for interest, dividends and capital

gains due to the rebalancing process, the incremental gain versus bonds alone would be

substantial.

So what is the appropriate mix of assets? That depends on each individual’s situation,

but here is some information to help in the evaluation. In determining portfolio asset

allocation, assumptions are required to estimate future returns for stocks, bonds, and cash.

Stock returns over the last century averaged about ten percent. Returns were not even

over this period and generally experienced multi-year cycles that were above average,

followed by multi-year cycles that were below average. If history is any guide, the stock

market is currently in the midst of a multi-year below average cycle as it works through

the excessive valuations of the past century and potential unwinding of a decades long

leveraging by U.S. consumer. For time horizons less than ten years, a reasonable

assumption for large-cap stock returns would be 7 to 8 percent. For midcaps, 9 to 10

7 During the twentieth century there were five five-year periods when bonds posted negative total returns.

During each of those instances, stocks recorded gains that more than offset the bond’s losses. In other

words, investors were better off with a mix of stocks and bonds, versus just bonds alone.

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percent. For emerging markets, 10 to 12 percent. Long-term returns for bonds last

century were approximately 6 percent. Today interest rates treasury bonds are at the low

end of historical ranges at around 4 percent. With inflation pressures rising, there is a

good likelihood that interest rates will move higher. Because credit spreads have

widened a forecast of 5 to 6 percent over 7 years or more would be reasonable. Stick

with 4 to 5 percent for time horizons less than 7 years or if the bond portfolio only holds

treasury bonds. For cash, assume 1.5 percent. Most people probably will not hold much

in cash reserves so the cash rate assumption is not that critical. Don’t forget to factor in

taxes if necessary. Armed with this information along with the current savings balance,

expected annual future contributions, the number of years left until retirement, other

sources of income available outside investments during retirement, and the amount

needed annually for spending during retirement; anyone will be prepared to visit one of

the many retirement planning tools that are available on the Internet to determine the best

course of action.8

A Brief Review of Diversification

1. Diversification is essential to controlling risk and optimizing risk-adjusted returns.

2. Diversification is necessary for individual stock investing, sector specific fund

investing, stock investing, overall stock investing across categories (large, mid,

growth, value, international, etc.), and to balance between fixed income and

equity investments.

3. It only takes a few different loosely uncorrelated asset categories to adequately

diversify portfolio investments. A well-diversified, tax efficient, low cost, easily

managed portfolio can be created through index funds or ETFs with just the five

following categories: large-cap blend, midcap value, emerging markets,

intermediate to long duration government/corporate bonds, and a cash equivalent.

4. Approach portfolio allocation decisions with a series of simple questions. What is

the proper mix between fixed income and equities?

5. Within bonds, is there any reason to tilt duration shorter or longer? Also, do risk

spreads justify accepting a greater allocation to corporate bonds?

6. Within stocks, do you intend to stick with funds only or do you intend to pick

individual stocks? If picking individual stocks, remember to factor that into the

asset allocation exposures for how equity investments are spread across large-cap,

midcap, etc. For individual stocks and sector specific funds, remember to spread

investments across at least five different economic sectors. How much exposure

to emerging markets can be comfortably tolerated?

7. Is the portfolio truly diversified, or are similar investment categories being

selected from different providers? Remember to avoid stupid diversification.

8 Retirement planning calculators can be found on various websites. Yahoo! Finance provides many good

retirement tools in the “Personal Finance” section under the “retirement” tab at

http://finance.yahoo.com/calculator/index. Microsoft’s Money Central is also a good choice. Visit the

“Personal Finance” section of MSN Money at http://moneycentral/msn.com/personalfinance and select the

retirement option.

For information relating to social security, the social security administration provides an excellent website.

Visit http://www.ssa.gov/. The site presentation is user friendly, self-explanatory, and easy to navigate.

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8. Has the small-cap growth category been avoided? It should be. There is no sense

to throwing good money after bad.

9. Is it time to rebalance? At a minimum, address the portfolio allocation decisions

at least once a year, generally towards the end of the year in order optimize the

tax impact of any potential reallocation decisions. The key question is how does

the current asset allocation match the target allocation? If each asset class is

within 3 percent of target, consider making no changes. However, if categories

have shifted by more than 3 percent from the target, the portfolio should probably

be rebalanced. If stock markets have just experienced a severe move either up or

down, consider rebalancing at that time to take advantage of the market’s

volatility. For example, if the stock market just declined twenty percent, but it is

only half way through the year, consider selling some bonds and add to stocks to

take advantage of cheaper stock prices. But rather than rebalancing all the way

back to the target allocation, just do half currently and the rest at the end of the

year.

10. Does the target allocation still match your investment objectives? This is an

important question. Every few years everyone should review their savings and

investment objectives to make sure their target asset allocation is still consistent

with the investment goals. If the allocation target was set fifteen years ago and no

changes have been made, chances are the allocation targets have become too

aggressive. Maybe not. But you will never know until the situation is reviewed,

or until it is too late!

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CHAPTER 10: TIME’S IMPACT ON RISK

The expression “patience is a virtue” has never been more appropriate than when applied

to stock market investing. By just listening to the daily news reports, almost anyone

would think the stock market was extremely dangerous and nonsensical. One day stocks

are surging because the Federal Reserve unexpectedly cut interest rates in order to

support the economy. The following day stocks are plunging because the economy was

so weak that the Federal Reserve had to unexpectedly cut interest rates. This kind of

action really takes place.

Figure 27. Range of Investment Returns in Relation to Time

How can anyone make sense of a stock market that acts so irrationally? The answer is …

don’t even try. Experienced investors understand that over short periods of time, the

stock market is driven primarily by irrational human emotions oscillating back and forth

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between fear and greed. Over time, these periodic bouts of depression and euphoria

become offsetting, canceling each other out, allowing the impact of earnings growth and

interest rate levels to become the primary determinants for stock prices.

Figure 27 graphically illustrates performance results for stocks, bonds, and treasury bills

(considered for our purposes to be a cash equivalent) for one, five, ten, twenty and thirty-

year time periods from 1900 through 2007. This time period encompasses the three

largest U.S. bear markets over the last century: the great depression, the 1973/’74 decline

due to stagflation, and the recent technology bubble-burst at the turn of the millennium.

You can see that for each asset class, the average return remained the same no matter

what time horizon was used; about 10 percent for stocks, 5 ½ percent for bonds, and 4

percent for treasury bills. However the range of returns was greatest over short time

periods and steadily declined as the time horizon lengthened. This effect was most

dramatic for stocks, whose one-year maximum and minimum returns were positive 52

and negative 42 percent, respectively; and whose 30-year maximum and minimum

annualized returns were positive 14 and 5 percent, respectively. That is correct … the

worst 30-year annualized stock return since 1900 was a positive 5 percent annualized

return, which is about the same as the average return for bonds, and higher than the

average return for cash equivalents. That result, by the way, is for the broad stock

market, which is dominated by large-cap stocks. By adding midcaps and international

emerging markets to the mix, it is highly likely that the worst 30-year return would have

been closer to 7 percent.

Here are other facts about historical stock results. Since 1910, there have only been two

ten-year periods when the absolute return on stocks was negative. Both of these periods

encompassed the great depression. During the depression, the U.S. was experiencing

deflation, so real returns for stocks were actually positive. To be fair, although absolute

ten-year returns were positive from the mid-1970’s to early 1980’s, high inflation

resulted in negative real returns (returns adjusted for inflation). However even during

that period investors remained better off in stocks than in bonds. During those runaway

inflation days, treasury bills provided the best protection against rising inflation because

treasury bill rates adjusted the quickest to inflation changes. If rising inflation reoccurs,

consider holding a portion of investments in treasury bills or TIPS (treasury inflation-

protected securities).

Since 1900, there have been no twenty-year periods when stocks recorded negative

absolute or negative real returns after adjusting for inflation. Stocks have been the best

solution when it comes to protecting against inflation over long periods of time. They

have been far better than bonds and treasury bills, which only beat inflation about two-

thirds of the time over twenty-year time horizons. The reason for stocks having a better

record is that during periods of rising inflation, companies have the ability to increase

prices to pass through higher input costs. Higher prices contribute to earnings growth,

which is the primary long-term determinant to higher stock prices. The ability for

companies to effect real-time adjustments to their business policies allows earnings, an

hence stock prices, to keep pace with inflation. In contrast, most bonds pay a fixed

coupon. When rates rise, bond prices fall to account for the bond’s coupon being worth

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less in a higher interest rate environment. Bondholders must wait until the bond matures

before they can reinvest proceeds at the new higher interest rate level. This time lag for

waiting to reinvest is the primary reason why bonds lag when inflation is rising, and why

short duration bonds are preferable under those circumstances. An exception to this is

TIPS (treasury inflation-protection securities). TIPS are U.S. government backed bonds

that adjust automatically for changes in the consumer price index (CPI). The adjustment

occurs by adjusting the maturity value of the bond for CPI changes. For example, if

inflation rises five percent between the time a TIPS was issued and the time it matures,

then $100,000 in purchase price will be redeemed for $105,000. If the U.S. were to enter

a period of deflation, TIPS values would fall. But TIPS are still required to pay

bondholders back their original principal investment. The requirement to pay

bondholders back for at least par value also makes TIPS a good choice during

deflationary periods, especially when TIPS are priced below par. During periods of

rising inflation, TIPS are a good choice for protecting your money’s purchasing power.

Figure 28 Volatility of Investment Returns in Relation to Time

Are stock returns truly less risky over time? Figure 28 shows the standard deviation of

investment returns for stocks, bonds, and treasury bills in relation to the time horizon

from 1900 through 2007. While figure 27 expressed risk as the overall spread between

the high and low return for the respective time period, figure 28 uses a more traditional

measure of volatility. Statistical rules state that ninety-five percent of the time, periodic

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1 Year 5 Year 10 Year 20 Year 30 Year

Stocks Bonds T-Bills

107

returns will fall within two standard deviations from the average result. Unsurprisingly

stocks experience the widest variability of returns over short periods of time, and cash

equivalents are consistently less volatile. But as time increases, risk declines

dramatically. At the thirty-year time horizon, the volatility of stock returns was no worse

than for treasury bills, and the average return for stocks was two and half times better.

Using average returns, $10,000 invested in stocks over thirty-years would have increased

to $133,000. Bonds would have yielded $46,000, and $31,000 for cash equivalents.9

Witness again the power of compounding. While annual stock returns were two and a

half times treasury bill returns, the ending balance was over four times larger for stocks.

Taking all this into consideration, it would appear that over long time horizons, stocks

indeed are less risky than bonds and cash, and can offer tremendous rewards to the

patient investor.

Perhaps one of the biggest mistakes a person can make is to underestimate their

investment time horizon. A person retiring today at age 65 is expected to live about

fifteen more years. But that is the average life expectancy. Half the population is going

to live longer. Hopefully you will be in that half. With advances in medicine and

generally more healthy lifestyles, living into the nineties is a common occurrence. The

longer the lifespan, the more inflation will eat away at purchasing power, and the more

important it becomes to have a some portion of an investment portfolio allocated to

stocks. Inflation over the long run has averaged about three percent a year. Today’s

dollar will be worth 63 cents in fifteen years if this trend continues. In thirty years, it will

be worth only 40 cents. So far this has been a very selfish discussion, focused on

protecting an individual’s money and their security. What about their heirs? What about

charitable foundations and endowments? If planning on leaving money to others, the

investment time horizon is lengthened. Investors owe it to their benefactors to be

partially invested in the stock market at all times.

In the preceding chapter looked at some brief history and saw how keeping even a small

percentage of portfolio investments in stocks improved returns and reduced the risk of

loss, even over just a three-year time period. This chapter looked at even more history

and found the same result. How much more convincing is required? Maybe some

wisdom from Rolling Stone’s Mick Jagger will help, even though he wasn’t singing

about investing: “Time is on my side … yes it is!”

The Cycle of Stock Returns Over Time

The U.S. stock market has experienced two types of cycles over time. The first is a long-

running bull market with periodic corrections. Following these cycles are long periods of

consolidation where the market seesaws back and forth without making any significant

progress. Bull cycles are characterized by economic prosperity and mild or declining

9 The rates of return used above were 9, 5.25, and 3.85 percent for stocks, bonds and cash equivalents

respectively. These rates are lower than the actual averages to allow for subtracting fees. Taxes were not

considered in the above calculations as it was assumed the investments were held in pension and retirement

accounts.

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inflation that result in strong earnings growth and the creation of real wealth. These bull

periods trigger rising investor enthusiasm until it reaches a feverish peak. Earnings

multiples rise to unsustainable levels just when most people are convinced that good

times are here to stay. And then it happens. A recession hits, or a bubble pops, or

inflation starts to pick-up, or some other reason emerges to change the investment mood.

Optimism turns to pessimism and the market begins a multi-year consolidation. During

these periods, bear markets become more frequent and severe with intermittent bull

rallies that fade away as the old highs are approached. Corporate earnings become more

erratic, declining during recessions, then growing again when a new expansion phase

resumes. Eventually valuations compress to a level where selling pressure abates and a

new secular bull cycle can emerge. The length of the long-term bull and correction

cycles are typically ten to twenty years in length depending upon the circumstances

surrounding each cycle. Since 1920, the U.S. has experienced three secular bull cycles,

and appears to be in the middle of its third consolidation cycle. Following is a brief

history of these cycles.

With the Dow Jones Industrial Average closing above 100 for the first time in history in

early 1906, the stock market entered a consolidation phase that lasted almost two

decades. Despite the adoption of recent inventions like the automobile, light bulb, air

flight and other discoveries, political instability around the world and at home kept the

stock market in a holding pattern. When World War I commenced in 1914, the stock

exchange was closed for four months in an effort to avert a financial panic. That strategy

backfired because investors prefer liquid markets, ensuring orderly transaction clearing.

When the exchange reopened in December 1914, it tanked 24 percent. Since then, the

stock market has never been closed for more than a few days due to disasters or

geopolitical events. The early 1900’s had to contend not just with geopolitical turmoil,

but also with the largest epidemic in modern history. The outbreak of Spanish Flu in

1918 is estimated to have killed from 25 to 50 million people globally, including 675,000

Americans … more Americans than were lost in World War I. After 1915, inflation

spiked into double digit territory for four straight years, driving stock market multiples

down to a 10 P/E (price/earnings ratio) from their previous peak of 20. To cap things off,

prohibition was enacted in 1920. So much for drinking away your sorrows!

Figure 29, Stock Market Price and Earnings, The Roaring Twenties

Dow Jones vs. Earnings

50

75

100

125

150

175

200

225

250

275

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325

1922 1923 1924 1925 1926 1927 1928 1929

$2.00

$4.00

$6.00

$8.00

$10.00

$12.00

$14.00

$16.00

$18.00

$20.00

$22.00

$24.00

Dow Jones E.P.S.

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But the situation started to improve in the 1920’s. A new era of peace had begun.

Efficiency from the modern assembly line was making the past two decade’s inventions

affordable for the masses. The booming automobile industry stimulated many related

industries such as glass, rubber, steal, oil, and road construction. Along these newly

constructed roads emerged motels, restaurants and gas stations. Radio was popularized

and became the first wave of affordable home entertainment. Calvin Coolidge’s hands-

off approach to business regulation encouraged entrepreneurship and speculation. Three

cuts in federal income tax rates didn’t hurt either. People were in a good mood. The

“flapper” style had women revealing their calves. Al Jolsen in the Jazz Singer introduced

talking movies. Mickey Mouse arrived on the scene. The stock market experienced an

unprecedented five-year run of strong double-digit annual returns beginning in 1924 due

to a combination of rapid earnings growth, declining inflation and an expanding P/E

multiple, which reached 19 at the market’s peak in 1929. The Dow Jones Industrials had

more than quintupled from its lows. Sliced bread had just been invented. The stock

market had become a sure bet. Everyone wanted in. People were borrowing money at

record levels in order to invest in stocks. It was the first speculative bubble for the U.S.

stock market. Cautionary comments by more sane prognosticates fell on deaf ears.

Figure 30, Stock Market Price and Earnings – The Great Depression & World War II

It was bound to end, and did so with the biggest stock market crash in U.S. history. From

peak to trough, the Dow Jones Industrial Average lost almost ninety percent of its value.

Reckless lending and speculation had come to a head. Household wealth was

eviscerated. Unemployment spiked and consumer spending declined. The Federal

Reserve was slow to act in supporting the banking system. Runs on bank deposits only

Dow Jones vs. Earnings

5075

100

125150175200

225250275300

325350

1929

1931

1933

1935

1937

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1941

1943

1945

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1953

-$1.00$2.00$5.00

$8.00$11.00$14.00$17.00

$20.00$23.00$26.00$29.00

$32.00$35.00

Dow Jones E.P.S.

110

worsened the situation as depositors believed their mattresses were safer than financial

institutions. Corporate earnings were wiped out, and the country was thrown into a

deflationary spiral. Shantytowns were popping up across the United States. Millions of

Americans were residing in “Hoovervilles” and sleeping under “Hoover blankets.”

America needed more than hope. It needed a plan. Franklin Delano Roosevelt took the

reins in 1933 and implemented his “New Deal,” a massive job creation and infrastructure

program. New roads and highways, bridges, dams and buildings were built. The Hoover

Dam, one of America’s greatest engineering feats, was completed in 1936. Even better,

prohibition was repealed in 1933. Not only did Americans get a new deal, they could

now legally drink to it! The early 1930’s also strengthened labor protections and

business regulation. The Securities and Exchange Commission was created along with

more effective regulation and shareholder rights protections.

The stock market quickly rebounded, but then stalled again in the mid-thirties as the

geopolitical environment became more volatile. Germany was becoming more

discontent after being disarmed in World War I. It was rebuilding its military and its

ambitions for European domination. Japan was also becoming more imperialistic. World

War II commenced in 1939, and America joined the fight in 1941 after Pearl Harbor was

bombed. America’s industrial and intellectual capabilities were applied to wartime

efforts building planes, jeeps, ships, guns and provisions. Natural resources were

prioritized to the war rather than commercial and consumer interests. Corporate earnings

growth was in a virtual holding pattern during the first half of the 1940’s but the stage

was being set for the next meaningful expansion.

When World War II ended in 1945, the seeds were planted for a new era of peace and

prosperity. The population’s mood was again improving. Bikinis were introduced in

1946, followed shortly thereafter by the Polaroid instamatic camera. Call it coincidence?

Credit cards were introduced in 1950 and color televisions in 1951. A new phase of

consumerism was beginning. Corporate earnings growth had rebounded. By the end of

1954, the stock market finally regained the lost ground from the prior 1929 peak. Lasting

twenty-five years, it was the longest consolidation period of the past century,.

The stock market’s P/E multiple in 1954 was about twelve, declining from the 19 P/E

multiple at the 1929 peak. Typical for a consolidation phase, earnings expanded while

multiples shrank. P/E multiples stayed low during the early 1950’s despite inflation

being under control, which was less than one percent at the time. The primary reason for

low valuations was investor complacency. After years of not making any real money in

the stock market, people had tired of it.

But that changed in the mid-fifties. The world was mostly at peace. Since the end of

World War II, the stock market had more than doubled. It broke through the old highs,

and investors were increasingly taking notice. The automobile industry was back on

track. The commercial airline industry was entering its glory and glamour days. Thanks

to washing machines, dryers, dishwashers and other everyday conveniences, leisure time

increased. Disneyland opened in 1955. McDonalds was also founded. Transcontinental

vacations were more common. Rising employment and easier access to credit was a

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powerful formula to drive corporate earnings higher. When Russia launched Sputnik in

1957, it triggered a decades long race for space exploration dominance. It was perhaps

the most wholesome time in America as families sat in front of their televisions watching

Leave it Beaver, Andy Griffith and the Apollo space launches. From 1954 to 1968,

corporate earnings doubled, and the stock market tripled in value. The P/E multiple

climbed to 18. Investors had once again become enthusiastic. It was the best stock

market since the invention of sliced bread.

Figure 31, Stock Market Price and Earnings - Ozzie & Harriet and the Space Race10

During the late stages of this market expansion, social and economic pressures were

starting to build. Neil Armstrong landing on the moon in 1969 could not offset the

discontent over racial inequality or tensions about Vietnam and the draft. Assassinations

of Martin Luther King Jr. and John F. Kennedy dashed Americans good spirits. Thanks

to loose monetary policy, inflation was again rising. OPEC took control of the oil

markets and implemented an embargo. Gas prices at the pump were skyrocketing.

President Nixon responded with price controls which only worsened the situation. There

is no incentive to supply gas when businesses can not earn a profit at it. It is basic

economics. The result … rationing and gas lines at the filling station. U.S.

manufacturing had lost its competitiveness to higher quality, less expensive goods from

Japan. Unemployment was rising again and the economy was headed for recession. To

make matters worse, Watergate created a political crisis. America could not trust its

leadership. The combination of all these issues was too much for investors to handle, and

10

The Dow Jones Industrial Average was used for the periods before 1954 because the S&P 500 index had

not yet been established. The precursor to the S&P 500 was the Standard & Poor’s Composite index,

created in the early 1920’s and consisting of 90 stocks. In 1957, the composite was increased to 500 stocks

and retitled. Today the S&P 500 covers approximately three-fourths of the U.S. stock market’s total

capitalization and is considered a representative barometer for the overall stock market.

S&P 500 vs. Earnings

30

40

50

60

70

80

90

100

110

1954

1955

1956

1957

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1968

$2.50

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$5.50

$6.00

$6.50

S&P 500 E.P.S.

112

the market entered its next consolidation phase, treading water for a few years before the

1970’s stagflation caused the worst bear market since the depression. From peak to

trough, the S&P 500 would lose half its value.

President Nixon resigned from office in 1974, replaced by President Gerald Ford. Price

controls were lifted and inflation spiked into double-digits, territory not seen in the U.S.

since the early 1900’s. It was too much for stock investors to bear. They sold in droves,

driving the P/E ratio down to seven times earnings. Stock valuations achieved historic

lows. The mood couldn’t have been worse. Television sitcoms like “All in the Family”

and “Good Times” reflected the struggles faced by the American public. When President

Jimmy Carter took office, inflation remained high. To make matters worse, Americans

were taken hostage in Iran.

Despite all the gloom and doom during this period, corporate earnings growth remained

strong. Companies responded to inflation by raising prices. During the 1970’s, the S&P

500’s earnings compounded at a 10 percent annual rate, but stock prices remained

virtually unchanged. During this consolidation period, the P/E multiple shrank from 18

to 7. The investing public had once again mostly abandoned interest in the stock market.

Figure 32, Stock Market Price and Earnings, Civil Unrest and Stagflation

The stage was now set for a new secular bull market. All it took was a couple catalysts to

contain inflation and renew faith in American business and competitiveness. First,

President Carter appointed Paul Volcker as the Federal Reserve’s chairman of the board.

It was perhaps the most important and successful decision he made during his presidency.

Volcker had the foresight and tenacity to make the hard decisions required to control

inflation. Loose monetary policy had to stop. Volcker’s Federal Reserve took control

of the money supply and the Federal Funds rate rose from ten to a peak of twenty percent.

Tight money and high credit costs choked the economy and forced it into a recession, but

S&P 500 vs. Earnings

60

70

80

90

100

110

120

1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979

$4.00$5.00$6.00$7.00$8.00$9.00$10.00$11.00$12.00$13.00$14.00$15.00

S&P 500 E.P.S.

113

Volcker achieved his desired effect. Inflation peaked in 1980 and steadily declined for

the rest of the decade. When Alan Greenspan assumed the Federal Reserve chairman’s

post, the legacy of controlling inflation continued to the end of the twentieth century.

The second catalyst to rekindle the new secular bull cycle was the election of Ronald

Reagan as the 40th United States President. At that time, America needed a charismatic

cowboy to rally the country’s spirits. President Reagan quickly got to work. On January

20, 1981 (the day he assumed office) the hostages in Iran were freed. People’s incentive

to work had been hampered by high income tax rates. Supply-side economics was

implemented. Reagan cut the highest marginal tax rate from 70 to 50 percent, and later to

28 percent. The combination of reduced income tax rates and lower interest rates put

more money into consumers’ pockets, and there were plenty of new goodies to buy.

Personal computers, videogame consoles, walkmans, and brick-size cell phones were in

demand. American manufacturing was also responding to foreign competition by

producing better quality, more stylish products. With oil prices easing, trucks, sport

utility vehicles and mini-vans were in high demand, and American manufacturers led

those categories. The U.S. was also a global technology leader. Intel, Microsoft, IBM,

Oracle, Apple and others were leading innovators. Eli Lilly, Pfizer, and Merck

dominated pharmaceuticals. Advances in technology and telecommunications were

leading to a productivity boom. The United States had regained its economic leadership

and American brands like Coke-Cola, Disney, Gillette and McDonalds were the world’s

envy.

Figure 33, Stock Market Price and Earnings, Consumerism and the New Economy

In 1980, the stock market broke through its old highs and a new secular bull cycle began.

A periodic setback took place when Volcker sent the economy into recession in the early

S&P 500 vs. Earnings

100200300400500600700800900

100011001200130014001500

1979

1981

1983

1985

1987

1989

1991

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1999

$10.00$15.00$20.00$25.00$30.00$35.00$40.00$45.00$50.00$55.00$60.00$65.00$70.00$75.00

S&P 500 E.P.S.

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eighties, but investors were quick to look through it. Stocks were cheap and the investing

public was getting on board. In 1987, when Alan Greenspan became the Federal Reserve

chairman, inflation had bottomed at below two percent, but economic strength was

threatening to bring it back. The new chairman was not about to let the inflation genie

back out of the bottle. Interest rate increases were implemented. Investors got spooked

and the crash of ’87 occurred. On “Black Monday,” the S&P 500 lost twenty percent, the

biggest one day loss in the stock market’s history. The market’s decline was exacerbated

because of a tool called “portfolio insurance” that was supposed to protect investors from

big losses by selling if the market declined by a stated amount. It ended up having the

opposite effect. Program selling triggered by portfolio insurance flooded the stock

exchange with selling orders until it reached a level where enough buyers arrived to

support prices. The ’87 crash turned out to be more of a psychological event for the

market, versus a fundamental change. Corporate earnings continued to grow, stocks were

still cheap, and investors returned. Within two years from the crash, stocks were again

hitting record highs. The “buy on the dips” mantra for investors was beginning.

Chairman Greenspan was correct to worry about inflation, which continued to rise for the

next several years before peaking above 5 percent in 1990. The Berlin wall coming down

in 1989 raised hopes for ongoing world peace and prosperity. With significant gains

during its final two years, the eighties turned out to be the best decade for the stock

market in thirty years, posting an annualized total return over 17 percent. Only about 1/3

of this was attributed to earnings growth, which compounded at six percent. The big

gains came from P/E multiples doubling from a historic low of 7 back to the historical

average of 14. The best was yet to come, but not before another brief test.

The 1990’s got off to a slow start, to say the least. The U.S. experienced a mini-credit

crunch created by excessive speculation in commercial real estate. The savings and loan

crisis was swiftly averted as the Federal Reserve cut interest rates, put bankrupt financial

institutions into receivership, and sold assets back to the public at a discount. With the

world mostly at peace, the defense industry entered a slump. Reaganomics was starting

to show some cracks. Budget deficits ballooned during the 1980’s. Tensions were rising

in the middle-east. The U.S. entered a mild recession and stocks declined twenty percent,

triggering a bear market. The Federal Reserve with Greenspan at the helm continued to

cut interest rates in order to stimulate investment. The invasion of Kuwait by Iraq was

the final spark to reinvigorate the economy and the stock market again took off. The

Gulf War seemingly ended just after it began and within seven months, the stock market

was hitting record highs. “Buy on the dips” was reinforced.

Despite the quick victory, Americans were still discontent with the state of the economy

and record budget deficits. The public wanted change and elected for President a virtual

unknown, Arkansas Governor William Jefferson Clinton. Much was accomplished

during the Clinton Presidency. Income taxes were raised in order to shore up the budget

deficit. In 1998 government budget surpluses were achieved for the first time since 1969.

Free trade was advanced with NAFTA’s (the North American Free Trade Act)

ratification. President Clinton was effective largely due to his centrist positions and

ability to work across party lines.

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The economy was expanding, inflation was contained and jobs were being created.

Pocket-size cellular phones were becoming everyday household items and the internet

was going mainstream thanks to America On-Line (AOL). The internet had in fact

existed for decades, but due to advances in network, computing and communications

technologies, AOL was able to offer the first user-friendly dial-up subscription service to

consumers. It wasn’t long before Yahoo! was established, offering free services and

unlimited content supported by advertising revenues. The new economy had arrived and

it was dominated by technology, telecom and media companies. When the Asian

currency crisis and the failure of Long-Term Capital hit in 1998, the market again

declined twenty percent, registering another bear. Four months later, new highs were

being achieved. “Buy on the dips” was confirmed!

Stocks had become a sure bet. Unemployment was at its historic low. It was another

decade of high-teens returns, even better than the eighties. And again only about 1/3 of

the returns could be attributed to earnings, which grew at a seven percent rate. The stock

market’s multiple had expanded from 14 to an unprecedented level of 29. The mania had

taken hold. People were borrowing on credit cards and quitting their jobs to invest in the

stock market. Earnings had become irrelevant.

Figure 33, Stock Market Price and Earnings, Bursting Bubbles and Financial Crisis

In December 1996, Alan Greenspan cautioned investors about “irrational exuberance.”

Robert J. Shiller, a Yale University Professor, liked the phrase so much he wrote a book

in the year 2000 with same title and stated “…if the history of high market valuations is

any guide, the public may be very disappointed with the performance of the stock market

S&P 500 vs. Earnings

800.00850.00900.00950.00

1,000.001,050.001,100.001,150.001,200.001,250.001,300.001,350.001,400.001,450.001,500.00

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

$40.00

$45.00

$50.00

$55.00

$60.00

$65.00

$70.00

$75.00

$80.00

$85.00

$90.00

$95.00

$100.00

S&P 500 E.P.S.

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in coming years.” Investors ignored the warnings just as they did seventy years prior. It

was more fun to read books entitled “Dow 36000” and “The Roaring 2000’s.” The stage

had been once again set for a severe bear market and the beginning of a new

consolidation phase.

At the millenniums turn, the technology bubble burst and sent stock prices plunging.

Unemployment was on the rise. The Federal Reserve cut interest rates aggressively in

2001 to stimulate the economy that had slipped into recession, and President George W.

Bush enacted income tax cuts. The terrorist attacks on September 11, 2001 further

shattered American spirits. It was the first foreign attack on U.S. soil since Pearl Harbor.

More interest rate cuts were implemented throughout 2002 to invigorate the economy and

head off a potential deflation cycle. When the S&P 500 bottomed in October 2002, it

had lost half its value. The NASDAQ, which included the high-flying technology issues,

lost over three-fourths of its value. It became the worst bear market since the great

depression.

In late 2002, tensions were rising over the situation in Iraq and prospects that Suddam

Hussein was building weapons of mass destruction. In an effort to prevent destabilization

of the middle-east and the threat of terrorism, America declared war on Iraq in 2003 with

the goal of effecting a regime change. The Federal Reserve cut interests further to a fifty

year low Federal Funds rate of 1.00 percent. At first it looked like the war would end

quickly. Americans became optimistic. More tax cuts were enacted. With low interest

rates and low taxes, the housing market ignited. A new bubble was in the making. Easy

credit and teaser-rate loans sucked in buyers and home prices rocketed. The mania

reached its climax in 2006 when homeowners were flipping Florida condominiums that

were still under construction. Sub-prime mortgages were being repackaged by financial

institutions into SIVs (“structured investment vehicles”) and sold as high-grade debt to

fixed-income investors. Greed was pervasive by both buyers and lenders.

But why quit with one bubble, when you can have several? Growth in the emerging

markets, particularly in China and India had triggered a commodities boom. From 2004

through 2007, oil prices tripled. Copper, silver and gold prices more than doubled.

International investing had become the rage. The Morgan Stanley Capital International

Emerging Markets index posted returns over twenty percent for five consecutive years,

more than quadrupling. International emerging stock markets reached record high

valuations.

Stock markets peaked in October 2007. A new global bear market began and continues

through the time of this writing. Housing bubbles have burst in England, Spain and the

United States. The United States is in a recession, and Europe is entering one. The

developing international economies are growing, but at slower rates. Because each cycle

is different, it is uncertain how long the current weakness will last or how severe it will

be. But one thing is certain: The state of affairs will eventually stabilize at some level

and a new growth cycle will begin for both the world economies and the stock market.

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People can argue with this interpretation of history, but there is no denying that the stock

market tends to run in cycles. During secular bull markets, the best strategy is to have a

maximum allocation in stocks and to let it ride in order to take advantage of the tax-free

compounding that will occur. Portfolio rebalancing should be infrequent. During secular

consolidations, the strategy is to have a smaller percentage allocation to stocks (say fifty

percent or less) with the rest in bonds and cash reserves. Portfolio rebalancing should be

more frequent (at least annually or after extreme stock market moves) in order to take

advantage of the market’s volatility; selling a portion of stocks after they have risen, and

buying stocks after they have declined. In either case, rebalancing should bring the

portfolio back to targeted allocations for stocks, bonds, and cash reserves.

Figure 34 Historical Rolling 10 and 20-Year Stock Market Total Returns

Average Annualized Total Returns Since 1900

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10-Year Annualized Return

How do you know whether you are in a secular bull or consolidation phase? Most of the

time you don’t! That is why the primary determinants for an investor’s portfolio

allocation should be based on current savings, expected future contributions, time

horizon, additional sources of future income, risk tolerance, and other relevant factors.

However, there are a couple of things to consider when gauging what the future may

bring. Both relate to the concept of mean reversion. First, stocks have historically

experienced around ten percent annual returns. Figure 34 above graphs the 10-year

annualized returns (including reinvestment of dividends) for the stock market since 1900

through year-end 2007. When presented graphically it is easy to see the waves of above

and below average returns experienced by the stock market. When the 10-year return

exceeds 15 percent, mean reversion forces it back to average through a period of below

average returns. When the 10-year return falls below 5 percent, future returns are more

likely to be above average. If the stock market loses twenty percent in 2008, the 10-year

annualized return will fall to 1.4 percent. After experiencing low returns over the recent

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past, returns over the next decade should be at least eight percent and could be in the

double-digits.

Figure 34, 10-Year Annualized Returns Versus Beginning Price/Earnings Ratio

10-Year Returns vs. Beginning P/E Ratio

-5%

0%

5%

10%

15%

20%

25%

- 5 10 15 20 25 30

The second way mean reversion comes into play relates to valuation. When stock

valuations are high, one of two things must happen. Either earnings must catch-up to

stock prices, or prices must decline. In either scenario, the returns will be below average.

Conversely, when stock valuations are low, above average returns are more likely to

occur. Figure 34 plots the calendar year-end price/earnings ratio for the S&P 500 since

its inception through today, and the corresponding subsequent ten-year total return.

Although the correlation is loose, the lower the price/earnings ratio, the higher the

subsequent 10-year return will likely be. Historically when the P/E ratio has been below

10, the subsequent 10-year annual return has been 15 percent. A P/E ratio between 10

and 15 has resulted in 11 percent returns; between 15 and 20 produced 7 percent returns;

and when the P/E ratio has exceeded 20, the average 10-year annualized return has been

just below five percent. As of September 2008, the S&P 500’s P/E multiple was about

sixteen. This would suggest a stock market return over the next decade in the seven

percent range, better than what can currently be expected from bonds or cash equivalents,

and better than what was experienced over the past ten years.

To summarize, the stock market over long time periods has provided the best protection

against inflation and has been a superior investment over bonds and cash equivalents.

The longer the time horizon, the less risky stocks become because negative short-term

results are more than offset by subsequent positive returns. The lowest 30-year stock

return is higher than the average return for bonds and cash equivalents.

The stock market experiences cycles of secular bull runs followed by consolidation. The

twenty-five years ended 1999 was one of the most powerful bull runs ever. During that

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period, the S&P 500’s price increased over 20 times. On a total return basis, allowing for

the reinvestment of dividends, investors earned 5,000 percent! A combination of rising

earnings, rising price/earnings multiples, rising home prices, declining inflation,

declining interest and income tax rates, unemployment declining to a record low, a

primarily peaceful world, and global growth created the perfect environment for stocks.

It was an era of consumption and leverage. The U.S. personal savings rate declined from

9.5 percent down to virtually nothing, and household debt reached historic high levels.

The public was in a spending mood. So was the U.S. government, which is now

experiencing record budget deficits and debt levels.

That period is over and the stock market is currently in a consolidation phase with the

S&P 500 seemingly stuck in a range between 850 and 1,550. Households must repay

their debts and rebuild their savings. Inflation has been rising. Interest rates cannot go

any lower. Income taxes are likely to increase. Home prices are falling. Unemployment

is rising. Financial bailouts have become commonplace. With record high debt levels

and budget deficits, there is little the government can do at this juncture to provide

meaningful stimulus. Government’s main goal at this juncture is to avert a financial

meltdown. A global recession is likely already in process.

Circumstances appear dire, but they always do during consolidations. The good news is

that the correction process is underway. The stock market has gone virtually nowhere in

almost a decade and is well below its highs. Earnings have risen, and stock valuations

are near historical averages. The pace of inflation is likely to peak this year. Housing

affordability is rapidly improving. It is only a matter of time before excess inventory gets

absorbed. Internet and wireless technologies are nowhere near maturity. The opportunity

for global growth has not diminished. China, India, Africa, Latin America, Eastern

Europe and other developing economies have tremendous wealth creation potential for

both local companies and U.S. multinationals. If history is any guide, the U.S. should

currently be on the backside of this consolidation and a new secular bull market cycle is

not far on the horizon. Eventually, the stock market will break through and go on to

achieve a string of new record highs.

Remember the Oracle of Omaha’s advice: “… Be fearful when others are greedy. Be

greedy when others are fearful.”

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CHAPTER 11: VALUATION: SIZING UP THE PREY

It is essential that investors focus their efforts on leading, profitable, durable businesses

that have the potential to grow and be much larger than their current size. It is also

important to understand whether or not the stock price represents good value for the

investment dollar. During the stock market bubble at the turn of the century, investors

got carried away by ignoring two important principles. First they speculated on

unproven, unprofitable businesses that had no durable competitive advantage that were

run by managements with no real track record for success. That is hardly a formula for

profitable investing. The second problem was that even for good companies, investors

simply paid too much. They ignored basic valuation principles and the laws of

mathematics. Many investors believed a new era of investing had arrived and the old

rules for valuing businesses through measuring cash flows no longer applied. The

business cycle was dead and existing high growth rates could be extrapolated infinitely

into the future. The more people were rewarded for buying overpriced stocks, they more

they believed the hype. It is no wonder that it ended so badly.

For each investment made, it is imperative to evaluate the potential gain as well as the

possible amount of potential loss. This is referred to as the risk/reward trade off. In

order to gauge this, investors formulate an opinion about the company’s intrinsic value

per share and compare that to the existing stock price. The bigger the discount between a

company’s stock price and its intrinsic value, the better the risk/reward opportunity will

be for the investment. With a reasonable level of confidence in the company’s future and

an opinion of the intrinsic value that is substantially higher than the current stock price,

then consider the stock a buy. If the estimated intrinsic value is below the current stock

price, be patient and wait for a good price to buy later. If intrinsic value is about the

same as the current price, judgment is required to decide if paying up now is acceptable,

or waiting for a better price is warranted. In most cases investors are better off waiting

for a more attractive buy point … when the company’s stock is at a discount to its

intrinsic value. While owning a stock whose intrinsic value is substantially above its

current price, consider selling some or all of the holdings in that stock depending on how

extended the price has become.

What is intrinsic value? Intrinsic value is today’s value of the cash flows that will be

received in the future from an investment. It does not matter if the investment is a

certificate of deposit (CD’s), a bond, a stock, an apartment building, or any other kind of

asset. An asset can only be worth the current value of the cash flows it will return to its

owner. So in order to determine the intrinsic value of any asset, only two questions must

be answered: (1) What will be the future cash flows received on the investment, and (2)

What is the appropriate interest rate to convert the future cash flows into the present day

value? For contractual investments like CD’s and bonds, that is a fairly simple process.

For example, a $100,000 five-year bond with a seven percent interest coupon will pay

$7,000 in interest each year for five years. At the end of the five years, the bond will also

pay back the $100,000 in principal. The interest rate to convert this cash flow stream to

today’s value (the “discount rate”) is the current prevailing interest rate for bonds of

similar quality and duration. These rates are readily available through public sources. If

121

the current prevailing interest rate for a similar bond is six percent, the intrinsic value of

the bond would be $104,265. That’s just how the math works. There is no debate about

what the future cash flow stream will be, since it is a stated contract. There is little

debate, if any, about the appropriateness of the discount rate. Calculating bond values is

a straightforward exercise. Buying the bond for less than $104,265 will be paying a

discount to intrinsic value and result in earning a return greater than the prevailing market

rate.

When investing in a stock, the same two questions must be answered to determine the

intrinsic value. What will be the future cash flows received on the investment, and what

is the appropriate interest rate to convert the future cash flows into the present day value?

But unlike investing in a contractual instrument like a bond, there is a great deal of

uncertainty when trying to answer these questions about stocks. The world is dynamic

and constantly changing. Companies are trying to implement their business plans while

dealing with competitive and regulatory forces, pricing and cost dynamics, financing and

a host of other issues. Earnings and cash flows fluctuate because of this and because of

the business cycle, which constantly seesaws between expansion to recession, then back

to expansion. Even after getting a firm enough grip on the cash flows, estimating the

discount rate poses its own problems. Stocks are competing against bonds, real estate,

commodities, and other assets for investment dollars. If an investor can invest in

government bonds and earn ten percent, a higher return is required on a stock to

compensate for the additional assumed risk. But how much higher? The extra return

required depends on the overall stock market risk premium (which tends to fluctuate) and

the individual stock risk premium (which also tends to fluctuate).

When it comes to calculating a company’s intrinsic value, remember to keep this in mind

… it is nothing more than one big guess! It is an educated guess based on fundamental

analysis, but it is a guess nonetheless. Despite this, it is still necessary to perform the task

of developing an opinion about a company’s worth. The objectives in this process should

be to (1) obtain a fair understanding of the business’s fundamentals and growth strategy,

(2) determine the reasonableness of the assumptions used in forecasting future results,

and (3) calculate an estimate for intrinsic value and determine the attractiveness for

owning the company’s stock. Both Morningstar and ValueLine provide estimates for

intrinsic value as part of their subscription service. If you don’t want to prepare your

own analysis, relying on their work is a reasonable alternative. But even if reliance is

placed on an external valuation opinion, it is still worthwhile to understand the basics of

the stock valuation process.

The gold standard for calculating a company’s value is the discounted cash flow estimate

or “DCF.” A DCF is a detailed estimate of a company’s future business results and free

cash flows, which are then discounted to present value. A DCF includes not only looking

at the income statement results, but also the cash investments in working capital and

capital equipment that are required to sustain and grow the business. A DCF is, in fact, a

calculation of intrinsic value. The DCF approach to valuation is the only reliable

approach that can compare the attractiveness of alternative investment opportunities

across multiple industries. This is because all cash flows within a business (operational,

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capital, and financial) are considered in a DCF valuation model. Remember that at the

core, all businesses are nothing more than vehicles for generating profits and free cash

flow. A dollar of free cash flow from a beverage company and a dollar from a

semiconductor company is still a dollar. A DCF valuation makes it possible to compare

the relative attractiveness of those dollars.

All other valuation metrics, such as price-to-earnings ratios, or enterprise value-to-

EBITDA (earnings before interest taxes depreciation and amortization) are simpler to

calculate than DCF’s, but ignore certain aspects of cash flows and are not comparable

across industries (or for companies within industries to a large extent). But when used in

conjunction with DCF’s, the other valuation methods can be helpful in evaluating

individual companies. Some of the other valuation methods will be reviewed later in this

chapter, but let’s first walk through a DCF example with a fictional business.

Gator Enterprises is the leading manufacturer and purveyor of premium alligator-based

consumer products. The bulk of Gator’s sales come from alligator boots, alligator purses,

luggage, wallets and other products constructed from the highest quality alligator hides.

Gator also sells gourmet, marinated alligator tail meat products. Gator’s customers are

specialty boutique and luxury goods retailers. No customer constitutes more than two

percent of the company’s sales. Gator was founded in the 1950’s as a family business by

Colonel Wally Gator who had a vision of providing the finest alligator-based products to

discriminating consumers who possessed the finest tastes and a desire for the exotic.

Colonel Gator is a savvy businessman who understands the exotic goods industry and has

surrounded himself with a team of capable associates to handle marketing,

manufacturing, supply-chain logistics, distribution, infrastructure, finance and

administration. The Colonel wasn’t always a successful millionaire. When the business

was founded, it had to focus on efficiency just to sustain its operations. As the business

grew and obtained scale, the focus on efficiency became engraved in Gator’s culture,

which is now the low-cost producer of premium alligator-based products. Although

Gator is cost and efficiency conscious, it does not starve the business from required

investments. Technology, manufacturing, and other systems are routinely upgraded and

maintained with an eye towards handling the next five year’s growth. Colonel Gator

understands that the business also depends on motivated personnel who embrace the

company’s culture of quality, efficiency and fairness. The labor force is not unionized

and is provided with competitive compensation and benefits. Employees earn incentive

pay based on achieving business results that target operating margins, asset turnover, and

growth.

The alligator products industry is a $3 billion market with annual unit volume growth of

three percent. Gator is the largest company in this specialized industry with an 18

percent market share, over four times the size of its nearest competitor. The Colonel

believes the company will ultimately be the industry dominator with a goal of at least

doubling its current market share. Gator has been growing its organic sales faster than the

industry due to its recognized product quality and operational excellence. The

fragmented nature of Gator’s customers and competition gives the company the ability to

raise price consistently to pass on higher raw materials and inflation costs. Gator has

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been consistently able to increase operating margins by obtaining scale and productivity

efficiencies as it grows. Management’s objective is to increase operating margins

annually by 20 to 40 basis points through cost control programs and scale. Margins will

decline however in 2008 due to a rapid rise in alligator hide costs which the company

chose to absorb rather than shock customers with higher prices. Over time, gross margins

should recover to the fifty percent level. Gator consistently invests one percent of sales

into research and development to maintain product quality and innovation ahead of

competitors. Tax planning should reduce the corporate tax rate to 33 percent for the next

couple years, but given the dire condition of state and federal budgets, it is likely that the

corporate income tax rate will increase in the future.

The business throws off a healthy amount of free cash flow. Management’s priorities to

deploy excess cash are (1) pay a consistently growing dividend to shareholders, (2)

acquire competitors to strategically increase distribution, and (3) return shareholder

capital through corporate share repurchases. Acquisitions have historically been made at

1 ½ times sales. Because Gator is able to fold the acquired business into its operational

systems, this results in attractive returns on capital for Gator. Gator has exercised good

discipline by not overpaying for acquisitions. It uses the same discipline with corporate

share repurchases and will only buy its stock when management believes it is below

intrinsic value. Because of Gator’s business stability, the company manages its capital

structure to maintain a debt-to-equity ratio of approximately fifty percent. Management

is comfortable with that level of debt and believes it optimizes the company’s cost of

capital. Even though the business could handle more debt, Colonel Gator is not

interested in leveraging the capital structure any further due to his belief that excessive

leverage could jeopardize the franchise in times of extreme financial or economic stress.

Gator has survived and grown through past recessions (largely due to the durability and

stability of the market for alligator-based products) and intends to maintain this track

record.

Executive compensation is set to be fair for the company and its executives, and to

motivate behavior that drives shareholder value. Annual incentives are based on

achieving targets for return-on-capital and sales growth based on the annual budget. A

portion of annual bonuses also depends on how well managers perform in employee,

vendor and customer relations, continuing education and other items that the Colonel

believes are vital to the maintaining Gator’s corporate culture. Stock options are granted

to Gator’s senior executives except for the Colonel, who already owns one-third of the

company. Annual grants amount to around 100,000 options per year, about one-half

percent of the shares outstanding. A portion of the options vest based on the achievement

of business results based on the five-year plan for sales growth, operating margins, and

asset turnover. Gator is judicious in its use of stock options and is not interested in

excess dilution of existing shareholder interests through overly generous stock

compensation schemes.

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Figure 35: Gator Enterprises Discounted Cash Flow Valuation

Gator Industries

Dollars in Thousands

Terminal

Est Est Est Est Est Est

Discounted Cash Flow Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13

Net Income GAAP 44,690 40,504 46,018 49,373 54,689 60,253 62,788

Reverse interest expense (income) 5,100 7,794 7,941 8,786 10,057 11,127 12,429

Tax effect of interest (GAAP) (1,516) (2,572) (2,621) (3,163) (3,621) (4,006) (4,474)

Net operating profit after tax 48,274 45,726 51,338 54,996 61,125 67,374 70,743

Depreciation 26,090 29,673 32,195 34,931 37,900 41,122 43,178

Amortization 3,100 4,000 3,700 3,600 3,500 3,400 2,000

Stock based compensation 3,790 4,154 4,507 4,890 5,306 5,757 6,045

Change in working capital 6,280 2,094 (3,141) (3,338) (3,489) (3,545) (2,450)

Deferred taxes 250 (1,500) (1,500) (1,500) (1,500) (1,500) (1,000)

Capex and intangibles acquired (45,410) (41,077) (44,569) (48,357) (52,468) (56,926) (51,814)

Loss (gain) on sale of equipment (1,100) - - - - - -

Acquisitions and other (23,020) (12,195) (13,175) (14,236) (15,386) (16,629) (1,528)

Free cash flow 18,254 30,875 29,355 30,986 34,988 39,053 65,174 1,268,079

Present value factor 1 2 3 4 5 6 6

Present value of free cash flow 27,967 24,086 23,030 23,556 23,816 36,003 700,508

Present Value of Future FCF 858,967

Cash and investments 13,740

Debt including current portion (100,340)

Value to equity holders 772,367

Diluted shares 25,180

Estmated Fair Value per Share 30.67$

Cost of capital Balance Rate Cost of Equity

Equity 193,570 12.8% Risk Free Rate 6.0%

Debt 100,340 9.0% Equity Risk Premium 4.0%

Tax rate 36.0% Beta 1.70

After tax cost of debt 5.8% Total Cost of Equity 12.8%

Weighted Average Cost of Capital 10.4%

Terminal growth rate 5.0%

Terminal multiple 18.5

125

Figure 36: Gator Enterprises Historical and Projected Balance Sheet

Gator Industries

Dollars in Thousands

Est Est Est Est Est Est

Balance Sheet Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13

Cash & equivalents 22,944 48,400 13,740 22,109 22,717 18,600 16,709 12,238 27,171

Accounts receivable 74,352 86,760 97,400 102,431 111,138 120,585 130,834 141,955 149,053

Inventories 48,825 54,735 67,620 73,897 79,861 86,304 93,453 101,397 106,467

Deferred taxes 6,588 8,690 8,940 8,940 8,940 8,940 8,940 8,940 8,940

Other current assets 5,725 5,020 6,570 7,227 7,877 8,507 9,102 9,557 10,035

Total current assets 158,434 203,605 194,270 214,604 230,533 242,936 259,038 274,087 301,666

Property & equipment 86,805 95,160 108,340 114,274 120,713 127,700 135,281 143,505 152,141

Goodwill 93,702 103,590 127,920 138,859 150,728 163,606 177,579 192,739 192,739

Intangible assets 20,294 22,380 32,890 34,360 36,595 39,434 42,921 47,101 45,101

Other long-term assets 36,695 35,450 31,400 32,656 33,962 35,320 36,733 38,202 39,730

Total assets 395,930 460,185 494,820 534,753 572,531 608,996 651,552 695,634 731,377

Accounts payable & accr comp 65,455 76,605 84,930 94,424 102,044 110,278 119,413 129,562 136,041

Curr portion long term debt 22,682 50,900 40,350 40,350 40,350 40,350 40,350 40,350 40,350

Deferred taxes 50,869 67,930 66,890 65,390 63,890 62,390 60,890 59,390 58,390

Other current liabilities 40,066 41,020 49,090 53,655 58,215 63,163 68,532 74,358 78,075

Total current liabilities 179,072 236,455 241,260 253,819 264,499 276,181 289,185 303,660 312,856

Long term debt 51,937 55,710 59,990 69,990 79,990 89,990 99,990 109,990 109,990

Common stock 64,921 49,700 43,730 28,730 8,730 -16,270 -41,270 -71,270 -96,270

Retained earnings 100,000 118,320 149,840 182,214 219,312 259,095 303,647 353,254 404,801

Total shareholders equity 164,921 168,020 193,570 210,944 228,042 242,825 262,377 281,984 308,531

Total Liabilities and equity 395,930 460,185 494,820 534,753 572,531 608,996 651,552 695,634 731,377

OTHER INFORMATION

Receivable DSO on sales 60 65 65 63 63 63 63 63 63

Inventory DSO on COGS 79 83 92 90 90 90 90 90 90

A/P DSO on COGS 106 116 115 115 115 115 115 115 115

Deferred revenue DSO on sales 0 0 0 0 0 0 0 0 0

Other current liabs DSO on sales 32 31 33 33 33 33 33 33 33

126

Figure 37: Gator Enterprises Historical and Projected Income Statement

Gator Industries

Dollars in Thousands

Terminal

Est Est Est Est Est Est

Income Statement Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13

Net Sales 453,480 489,580 546,960 593,452 643,895 698,626 758,009 822,440 863,562

Cost of sales 224,880 241,610 269,170 299,693 323,879 350,012 379,005 411,220 431,781

Gross profit 228,600 247,970 277,790 293,759 320,016 348,614 379,004 411,220 431,781

Op. expenses

Selling and marketing 134,011 143,623 161,521 174,475 188,661 203,999 220,581 238,508 250,433

General and admin 35,749 38,187 42,115 45,102 48,292 51,698 55,335 59,216 62,176

Research and development 4,612 4,974 5,454 5,935 6,439 6,986 7,580 8,224 8,636

Operating income 54,228 61,186 68,700 68,247 76,624 85,931 95,508 105,272 110,536

Interest income (expense) (4,420) (4,440) (5,100) (7,794) (7,941) (8,786) (10,057) (11,127) (12,429)

Income before taxes 49,808 56,746 63,600 60,453 68,683 77,145 85,451 94,145 98,107

Income taxes 17,870 19,860 18,910 19,949 22,665 27,772 30,762 33,892 35,319

Net income GAAP 31,938 36,886 44,690 40,504 46,018 49,373 54,689 60,253 62,788

Fully diluted shares 26,010 25,710 25,180 24,568 24,412 24,134 23,759 23,433 23,048

Fully diluted eps - GAAP 1.23$ 1.43$ 1.77$ 1.65$ 1.89$ 2.05$ 2.30$ 2.57$ 2.72$

COMPOSITION

Gross margin 50.4% 50.6% 50.8% 49.5% 49.7% 49.9% 50.0% 50.0% 50.0%

Selling and marketing 29.6% 29.3% 29.5% 29.4% 29.3% 29.2% 29.1% 29.0% 29.0%

General and admin 7.9% 7.8% 7.7% 7.6% 7.5% 7.4% 7.3% 7.2% 7.2%

Research and development 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0% 1.0%

Operating margin 12.0% 12.5% 12.6% 11.5% 11.9% 12.3% 12.6% 12.8% 12.8%

Income tax rate 35.9% 35.0% 29.7% 33.0% 33.0% 36.0% 36.0% 36.0% 36.0%

GROWTH

Sales 13.7% 8.0% 11.7% 8.5% 8.5% 8.5% 8.5% 8.5% 5.0%

Volume 5.0% 3.7% 4.4% 4.0% 4.0% 4.0% 4.0% 4.0% 3.0%

Pricing 2.0% 2.0% 3.0% 2.5% 2.5% 2.5% 2.5% 2.5% 2.0%

Acquisitions 6.7% 2.3% 4.3% 2.0% 2.0% 2.0% 2.0% 2.0% 0.0%

Gross profit 14.0% 8.5% 12.0% 5.7% 8.9% 8.9% 8.7% 8.5% 5.0%

Selling and marketing 12.5% 7.2% 12.5% 8.0% 8.1% 8.1% 8.1% 8.1% 5.0%

General and admin 13.5% 6.8% 10.3% 7.1% 7.1% 7.1% 7.0% 7.0% 5.0%

Research and development 13.9% 7.8% 9.7% 8.8% 8.5% 8.5% 8.5% 8.5% 5.0%

Operating income 15.1% 12.8% 12.3% -0.7% 12.3% 12.1% 11.1% 10.2% 5.0%

Diluted shares -0.8% -1.2% -2.1% -2.4% -0.6% -1.1% -1.6% -1.4% -1.6%

EPS 17.6% 16.8% 23.7% -7.1% 14.3% 8.5% 12.5% 11.7% 5.9%

OTHER DATA

Price per share 28.00$ 32.00$ 36.00$ 40.00$ 46.00$ 52.00$

Interest income (expense) yield 9.0% 9.0% 9.0% 9.0% 9.0% 9.0%

127

Figure 38: Gator Enterprises Statement of Cash Flows

Gator Industries

Dollars in Thousands

Est Est Est Est Est Est

Statement of Cash Flows Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13

Net income 31,938 36,886 44,690 40,504 46,018 49,373 54,689 60,253 62,788

Depreciation 22,270 23,580 26,090 29,673 32,195 34,931 37,900 41,122 43,178

Amortization 3,420 3,280 3,100 4,000 3,700 3,600 3,500 3,400 2,000

Stock based compensation 3,910 3,630 3,790 4,154 4,507 4,890 5,306 5,757 6,045

Deferred taxes (1,300) (1,880) 250 (1,500) (1,500) (1,500) (1,500) (1,500) (1,000)

Tax benefit from stock options (1,170) (1,980) (2,060) - - - - - -

Other noncash items (90) 130 690 - - - - - -

Loss (gain) on equipment sales - 40 (1,100) - - - - - -

Change in A/R (4,480) (6,680) (3,440) (5,031) (8,707) (9,447) (10,249) (11,121) (7,098)

Change in Inventories 260 (1,800) (1,930) (6,277) (5,964) (6,443) (7,149) (7,944) (5,070)

Change in other current assets (2,190) (2,710) 2,070 (657) (650) (630) (595) (455) (478)

Change in accounts payable 1,900 4,550 (1,000) 9,494 7,620 8,234 9,135 10,149 6,479

Change in deferred revenue - - - - - - - - -

Change in other current liabilities 4,530 5,840 10,580 4,565 4,560 4,948 5,369 5,826 3,717

Cash from operations 58,998 62,886 81,730 78,925 81,779 87,956 96,406 105,487 110,561

Investing activities

Acquisitions/divestitures (2,550) (4,370) (20,960) (10,939) (11,869) (12,878) (13,973) (15,160) -

Investments (12,510) 12,510 - - - - - - -

Capital expenditures (& software) (25,850) (29,540) (35,410) (35,607) (38,634) (41,918) (45,481) (49,346) (51,814)

Intangibles purchases (2,000) (10,000) (5,470) (5,935) (6,439) (6,987) (7,580) -

Other (1,256) (1,306) (1,358) (1,413) (1,469) (1,528)

Cash from investing activities (40,910) (23,400) (66,370) (53,272) (57,744) (62,593) (67,854) (73,555) (53,342)

Financing activities

Long-term debt 9,570 26,220 (11,430) 10,000 10,000 10,000 10,000 10,000 -

Proceeds from common stock 4,970 8,790 9,670 10,000 10,000 10,000 10,000 10,000 10,000

Stock repurchases (21,330) (28,280) (37,140) (25,000) (30,000) (35,000) (35,000) (40,000) (35,000)

Common dividends (8,980) (10,120) (11,400) (12,284) (13,427) (14,480) (15,443) (16,403) (17,286)

Cash from financing activities (15,770) (3,390) (50,300) (17,284) (23,427) (29,480) (30,443) (36,403) (42,286)

Net Change in cash 2,318 36,096 (34,940) 8,369 608 (4,117) (1,891) (4,471) 14,933

Dividends per share 0.345$ 0.394$ 0.453$ 0.50$ 0.55$ 0.60$ 0.65$ 0.70$ 0.75$

OTHER INFORMATION

Depr as % of revenue 4.9% 4.8% 4.8% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0%

Capex as % of revenue -5.7% -6.0% -6.5% -6.0% -6.0% -6.0% -6.0% -6.0% -6.0%

Stock comp % of revenue 0.9% 0.7% 0.7% 0.7% 0.7% 0.7% 0.7% 0.7% 0.7%

Growth in other current assets 10.0% 9.0% 8.0% 7.0% 5.0% 5.0%

Growth in other assets 4.0% 4.0% 4.0% 4.0% 4.0% 4.0%

128

Gator Enterprises fits the mold of being an emerging adolescent company with an

industry leading position. The company is profitable, generates significant free cash,

achieves high returns on beginning equity and returns on total invested capital (20.9%

and 17.8%, respectively, for 2008), and has the potential to more than double its size on a

per-share basis.11

But what is Gator Enterprises worth? Figures 35 through 38 are a DCF

valuation and the key financial statements for the company, including the balance sheet,

income statement, and statement of cash flows. The historical financial statements are

shown for the past three years, and estimates are shown for the next six years based on

projections founded on the above fundamental analysis. Individual estimated

components on the DCF and within the financial statements are shown in bold and italics.

The purpose of the DCF is to convert the GAAP financial statements into a format that is

conducive to calculating an estimate of intrinsic value. The first step is to convert GAAP

net income into net operating profit after tax. To accomplish this, net interest expense is

added back to net income. If the company has no debt or if cash balances exceed debt,

then net interest income is subtracted from net income. Because interest expense is tax

deductible, income taxes related to interest are reversed out of net income. If net interest

was subtracted, add back the tax effect. The tax effect is calculated by multiplying net

interest expense by the company’s corporate income tax rate for GAAP accounting

purposes. This process converts GAAP net income into net operating profit after tax

(NOPAT). NOPAT represents the accrual based accounting income that is generated by

a company’s operating assets.

The next step in a DCF valuation is adjustments required to convert NOPAT into free

cash flow generated by the business. These adjustments include (1) adding non-cash

expenses back to NOPAT, (2) subtracting the increase in net working capital needed to

sustain growth, and (3) subtracting required capital expenditures and investments in

intangibles and acquired businesses.

The most common non-cash expenses consist of depreciation, amortization, deferred

income taxes, and stock-based compensation. These items can all be found in the upper

portion of the statement of cash flows in the cash from operations section. If the line

item is indicated as a subtraction in the cash flow statement (deferred taxes can be

positive or negative), then it should also be subtracted from NOPAT.

11

Growing intrinsic value on a per-share basis is what really matters over the long-term in driving increased

shareholder value. Be wary of companies that are too eager to grow through acquisition, especially when companies

are acquiring targets by issuing stock to the selling company, or by issuing stock in the secondary public markets in

order to subsequently pay for cash deals. Often times, managements that are constantly issuing stock to acquire

businesses are more interested in building empires than they are in building shareholder wealth. While such companies

grow revenues, earnings, and free cash flow; the per-share growth in these metrics is substantially lower. Shareholder

and intrinsic value per share grow slower that the overall company because of the substantial equity dilution caused by

new share issuance. For example from 1990 through 2000, Tenet Healthcare grew total revenues 250 percent, but

earnings-per-share grew only 41 percent. During that period, shareholders were diluted 86 percent because of new

share issuances to fund acquisitions. Net margins were also cut in half because management’s overly optimistic

forecasts for acquisition “synergies” never materialized. The result, Tenet’s shareholders earned less than money

market funds for those ten years.

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Working capital is current assets (accounts receivable, inventory, and other assets that are

typically used within one year) minus current liabilities (accounts payable, accrued

compensation and other obligations payable within one year). As a business grows, it

typically requires more working capital for the increased level of business activity. An

increase in working capital should be considered similar to a cash expense and subtracted

from NOPAT in deriving free cash flow. Changes in the components of working capital

are generally summarized in the cash from operations section of the statement of cash

flows.

Cash expenditures for capital equipment (machinery and equipment, real estate,

capitalized software, etc.) should be subtracted from NOPAT in deriving the annual free

cash flow. Just as depreciation expense was added back to NOPAT because it is a non-

cash expense, the annual cash outlays for capital equipment that are a required part of

business operations need to be subtracted from NOPAT. Accounting treatment for

capital expenditures is to place them on the balance sheet and then depreciate them over

time as an expense on the income statement. By subtracting annual capital expenditures

from NOPAT (and adding back depreciation expense), you get a more accurate depiction

of a company’s annual free cash flow. The same principal applies to purchases of

intangible assets and business acquisitions. Cash outlays for acquired businesses and

intangible assets need to be subtracted from NOPAT to derive free cash flow.

NOPAT plus non-cash expenses minus the working capital charge, capital expenditures

and acquisitions yields free cash flow generated from the business’s operations.

Terminal free cash flow value is estimated by taking the last year’s free cash flow figure,

multiplying by 1 plus the terminal growth rate, and then multiplying that by the terminal

multiple. The terminal multiple is calculated as 1 divided by the weighted average cost of

capital minus the terminal growth rate. Gator’s terminal multiple is 1 / (.104-.05) = 18.5.

Gator’s terminal free cash flow value is $65,174 * (1+.05) * 18.5 = $1,268,079. This

figure in theory represents a rough (you’ll see what rough means soon enough)

approximation of the Gator’s business in six years.

Free cash flow has now been estimated for the following six years, as well as the value of

all remaining future free cash flow after the sixth year. The next step is to discount the

future free cash flow amounts back to present value. The discount rate that should be

used to bring future cash flows to present value is the weighted average cost of capital.

This is the blended cost of capital for both debt and equity. Cost of debt is the after-tax

cost of the company’s outstanding debt, in this case 7% * (1-.36 tax rate) = 5.8%. Cost

of equity, according to the Capital Asset Pricing Model is calculated as:

Risk Free Rate + (Equity Risk Premium * Beta).

Gator’s cost of equity is estimated at 6% + (4% * 1.7) = 12.8%.

A good proxy for the risk free rate is the 10-year treasury yield. The equity risk premium

has had a tendency to fluctuate over time and has ranged from 1 to 5 percent (sometimes

more) depending on the general public’s risk appetite. The equity risk premium is

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multiplied by the company’s stock beta to determine the individual risk premium for that

particular security. Beta is a measure that compares an individual stock’s price volatility

to that of the market. But beta has two problems. First, beta is calculated based on

historical volatility data and has not been shown to have any predictive power. Second,

beta is related to a company’s stock price data, not its fundamental business

characteristics. Frankly, the same cost of equity can be calculated as 5% + (4% * 1.95) =

12.8%. If you have some time to waste, you can probably come up with at least a dozen

more combinations to calculate the same number, but what is the point of that?…None!

A more common sense approach for the cost of equity is to consider the required annual

return desired for the stock investment. To make 15 percent annually when the Treasury

bond yield is 5 percent, an incremental 10 percent return is demanded for that stock. If

the business is volatile or highly debt-leveraged, that may be reasonable. If the business

is extremely stable (like Coke Cola), only an incremental 5 percent equity risk premium

may be required, bringing the total cost of equity to 10 percent. Some judgment can be

utilized in determining the cost of equity, but be conscious of the rate being used, why it

is being used, and the sensitivity to the company’s valuation for being more or less

conservative with the discount rate assumptions.

Using Gator’s relative capital weightings and its cost of debt and cost of equity, the

weighted average cost of capital comes to 10.4 percent. This is the combined rate of

return required by shareholders and banks that have extended credit to Gator. This is also

the rate that future free cash flows are discounted back to the present value. Gator’s

future free cash flows, discounted at 10.4 percent amount to $858,967. To this figure we

add Gator’s current cash balance (from the balance sheet) and subtract its current

outstanding debt (also from the balance sheet). This provides the total estimated

company value that is available for common shareholders, in this case $772,367.

Dividing this by the current fully diluted shares (from the income statement) provides

Gator’s calculated intrinsic value-per-share of $30.67. If Gator’s stock can be purchased

significantly below $30.67, do it. If not, wait. The market will eventually provide an

opportunity to buy at a bargain price.

The main separate assumption made on the DCF valuation worksheet was to determine

the cost of equity. All of the other data was based on assumptions used in constructing

Gator’s projected financial statements. For the income statement, these assumptions

included unit volume growth, pricing, acquisition activity, gross margins, various

operating expense spending levels, interest rates, income tax rates, and assumed prices

paid for share repurchases. The statement of cash flows included assumptions for

intangibles amortization, deferred taxes, acquisition pricing, additional borrowings,

proceeds from stock issuances due to options, corporate share repurchases, dividend

payments, depreciation expense, capital expenditure levels, and non-cash stock

compensation levels. The balance sheet included assumptions for the amounts of

accounts receivable, inventories and accounts payable required based on the level of

business. Over twenty different assumptions are made in each projected year. These

assumptions are based on the fundamental analysis employed to evaluate Gator’s

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business opportunity. The result of these assumptions is a very precise calculation of

intrinsic value per share equal to $30.67.

Now replace the word “assumption” in the previous paragraph with “guess.” That $30.67

doesn’t seem so precise anymore, does it? To drive the point home, let’s make some

small tweaks to the guesses and observe the impact it has on Gator’s estimated intrinsic

value. If Gator’s corporate income tax rate rises to 40 percent from 36, intrinsic value

falls to $29.19. If Gator ends up paying three times revenues for acquisitions instead of 1

½ times, intrinsic value drops to $27.82. If Gator can’t recover all the cost increases and

gross margins permanently decline to 48 percent, intrinsic value falls to $24.77. If after

six years, Gator’s terminal growth rate slows to 4 percent rather than 5 percent, intrinsic

value falls to $26.00. Intrinsic value is $22.60 if the terminal growth rate is only 3

percent. If the cost of equity rises to 15 percent from 12.8 percent, intrinsic value falls to

$22.85. If the cost of equity declines to 11 percent, intrinsic value rises to $41.14.

Seemingly small changes in the assumptions used to project future results can have a

super-sized impact on the estimate for intrinsic value. After preparing an analysis on a

company, take a step back and challenge the reasonableness of the various assumptions.

Is the analysis attempting to be accurate or conservative? Were assumptions and

variables stretched to make the analysis fit the current stock price? Especially challenge

the discount and terminal growth rates used in calculating intrinsic value since they can

have outsized impacts on the result. Once a model is constructed on a company, a good

exercise is to run a few different scenarios in order to gauge the potential range of

outcomes. That is essentially what the previous paragraph did. If a stock can be

purchased at a discount to estimated intrinsic value using conservative assumptions, a

much greater chance of experiencing large gains on the investment is possible for two

reasons. First, investors will be rewarded when the stock rises to approach intrinsic

value. Second, if the company’s business results are much better than forecasted,

intrinsic value may be much higher than the DCF model’s conservative estimate.

Before addressing some of the other valuation methods, let’s briefly discuss stock options

(and other forms of stock grants) and non-cash stock compensation expense. In the

above example, non-cash stock compensation was added back when deriving free cash

flow. This may be considered controversial because options and restricted stock grants

are a form of compensation and somehow need to be considered when valuing a

company. Generally accepted accounting principles (GAAP) currently require

companies to estimate annual stock compensation expense using the Black-Scholes

option pricing model. It is strange coincidence that the initials for the Black-Scholes

model are “B-S”! The B-S model makes various assumptions, including a stock’s

historical price volatility, in estimating stock compensation expense. It has no real

relation to the ultimate cash flow per share that a shareholder will realize on his

investment. That is the reason to remove stock compensation determined by existing

account rules.

There are two better ways to estimate the cost that stock options and restricted stock

grants have on a business. The first method would be to estimate a company’s net cash

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cost to keep the share count constant. Remember that in the case of stock options, the

company will receive some cash upon exercise, so in the order to keep the share count

constant, the company will only have to pay the difference between the option exercise

price and the current market price. For restricted stock grants, the company would have

to pay the full market price in order to repurchase enough shares to keep the share count

constant. But there is a twist – no surprise yet again. A lot of company’s don’t bother

buying back their shares. That leads to the preferred method, which is also simpler.

Reduce the company’s expected growth rate for the annual dilution caused by equity

compensation arrangements. If a company is growing at a 12 percent rate but grants

options and/or restricted stock equal to 2 percent of its outstanding shares every year,

then its growth per share for preexisting shareholders will only be 10 percent. In the

example above, Gator’s terminal growth rate was assumed to already include the ½

percent annual impact from stock option grants. If Gator was more aggressive in its

equity compensation policies, its growth rate assumptions would have to be lowered; and

you’ve seen the impact that a lower growth rate has on intrinsic value. Reducing the

growth rate for the impact for a company’s stock option and restricted stock granting

policies effectively adjusts intrinsic value for these costs.

Gator’s DCF is a simple form model. For emerging companies, a two-stage model can

be used. A two-stage model uses a faster growth rate in the early years for the first stage,

then a maturing (declining) growth rate in the second phase before returning to the

terminal growth rate. To learn more about discounted cash flow modeling, Damodaran

on Valuation – Security Analysis for Investment and Corporate Finance by Aswath

Damodaran is recommended. Also visit Damodaran Online at

http://pages.stern.nye.edu/~adamodar/ for various preformatted DCF models that can be

downloaded and used in excel spreadsheets.

Other Valuation Metrics

The Discounted Cash Flow method is the only valuation technique that can both estimate

an asset’s intrinsic value and provide a meaningful comparison between assets of

different types (stocks, real estate etc.), between companies in similar industries, and

between companies in different industries. However, other valuation metrics are popular

with investors because they are simple to use. It should be understood that all other

valuation metrics are derived from the DCF method and a company’s financial

statements. These methods, while simple to use, suffer deficiencies in that they only use

specific aspects of the financial statements and are thus incomplete in their analysis and

can be misleading. The more common metrics that investors use are the Price/Earnings

ratio, the Price/Book ratio, the Price/Sales ratio, and the Enterprise Value/ EBITDA ratio.

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The ratios for Gator Enterprises are shown below as of December 31, 2007 and assume

that Gator’s stock was trading in the public market for $25 per share. Figures are shown

based on the December 31 market value, along with target multiples if Gator’s stock were

to trade at intrinsic value of $30.67.

12/31/2007 Target

Price/Earnings (trailing) 14.1 17.3

Price/Book 3.3 4.0

Price/Sales 1.2 1.4

Enterprise Value/EBITDA 7.5 8.9

The Price/Earnings Ratio

The price/earnings ratio is the most popular ratio used by investors. This is mainly due to

its simplicity. Investors are buying earnings and they want to know how much they are

paying for them. What could be easier, just divide a company’s current stock price by its

current earnings-per-share. In Gator’s case $25 / $1.77 = 14.1. It is also easy to see a

company’s historical range for the price/earnings ratio because historical price and

earnings-per-share data can be obtained free on the internet through various sources and

through subscription services including Morningstar and ValueLine. Analysis can then

be performed to see how the current price/earnings ratio compares to the company’s

history to help gauge if the stock is over or under-valued. If a company operates in a

stable industry and has fairly stable operating margins and capital returns, then

comparing the current price/earnings ratio to the historical range is a reasonable method

for looking at “relative valuation.”

But if a company operates in a more cyclical industry that is characterized by wide

swings in profitability, the price/earnings ratio can be deceiving. For instance, at October

2005, near the peak of the housing cycle, Toll Brothers (America’s leading luxury

homebuilder) was trading at a P/E multiple of 7.7 compared to a historical average of

about 10. But at October 2007 after the stock had lost over half its value, Toll Brother’s

P/E was 110. The P/E ratio for cyclical businesses makes them look cheap at cycle peaks

(when they are actually expensive) and expensive when they are potentially cheap (at

cycle bottoms). In the case of cyclical companies, it would be preferable to use

“normalized earnings”, which is an estimate of a company’s earnings based on its

average profit margin across a business cycle.

The main pitfall to the price/earnings ratio is that it uses only accounting earnings and

ignores the balance sheet (a company’s financial position) and cash flow statement. For

example, a company with a huge cash hoard and no debt will have an artificially low P/E

ratio. Also, a company could use less conservative accounting policies to artificially

boost its short-term earnings (accounting shenanigans). What may seem attractive on a

P/E basis may actually be a value trap since the earnings aren’t supported by real cash

flow.

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Here are some other things to be aware of when looking at P/E ratios. Companies that

convert a higher portion of their GAAP earnings into real cash flow and have higher

returns on capital will have a higher P/E ratio than companies that don’t. In essence, you

are paying for what you get. This is especially important when comparing P/E ratios

between companies, a practice that is discouraged. Here is a real life example why

comparing P/E ratios between companies is a bad idea.

Bed Bath & Beyond and Linens & Things are two companies in the exact same business.

Both are specialty retailers of home accessories with a format to offer consumers

everyday low prices. The merchandise assortment between the two companies is

virtually identical. Both were implementing a growth plan that involved increasing their

store counts across the United States. These two companies were direct competitors in

the purist form. From 1996 through 2000, Linen’s & Things grew its earnings at a 42

percent rate, compared to Bed Bath & Beyond’s growth of only 31 percent. At the end of

2000, both companies were expected to grow their future earnings at a 15 to 20 percent

rate. But since its initial public offering Linen’s & Things had consistently traded at a

big P/E discount to Bed Bath & Beyond. By December 2000, Linens & Things’ P/E ratio

of 17.3 was half of Bed Bath & Beyond’s multiple. It seemed outrageous to some

analysts that Linen’s & Things should trade at such a large P/E discount to its closest

competitor, especially when Linen’s & Things had been growing faster.

But by digging a little deeper, a major difference between the two companies would have

become apparent. Bed Bath & Beyond was a far better run operation. Its average return-

on-equity12

was over double that of Linen’s & Things. Linens & Things was also

spending more than its operating cash flow to fund its growth. During the five years

ended December 2000, free cash flow was negative $81 million. Conversely Bed Bath &

Beyond, because of its superior return-on-capital, was able to fund its rapid store

expansion and still generate $156 million in positive free cash flow. Fast-forward to

today and Bed Bath & Beyond is the home accessories retailing alpha alligator. Linens &

Things?…road kill!

A low P/E is tempting, but it can be the sign of either an undervalued company or a

company that is terminally ill. You can’t be sure until you examine all the vital statistics.

Blind faith in the income statement is inadequate and lazy analysis. That is why

comparing P/E ratios between different companies is a bad idea, whether or not they are

in the same industry.

The expected future growth rate can have a big impact on the P/E ratio. The higher the

future expected growth, the higher the P/E ratio. That just how the mathematics work.

To illustrate this, let’s look at two companies, “FAST” and “SLOW”. Both companies

currently generate $1.00 of earnings-per-share and are identical in every way except that

FAST is going to grow its earnings at a 20 percent rate over the next ten years, and

SLOW is going to grow at a 12 percent rate. At the end of the ten years, both companies

will have a terminal growth rate of 5 percent. Assuming a ten percent discount rate, the

12

Neither Bed Bath & Beyond or Linens & Things had any debt on their balance sheets. Because of this,

the return on equity is a good proxy for return on capital when comparing these two businesses.

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P/E ratio for FAST and SLOW at the beginning of the ten-year period would be 48 and

24, respectively. Even though both companies will have the same terminal growth rate,

FAST’s rapid growth during the initial ten year phase justified a higher P/E valuation.

The discount rate an investor uses to value a company will also impact the P/E ratio.

Above, FAST had a P/E ratio of 48 using a ten percent discount rate. If the investor’s

required rate of return rises to twelve percent, FAST’s P/E ratio should drop to 28. The

higher the required rate of return, the lower the P/E ratio.

Several books have been written documenting that investors who buy stocks with low

P/E ratios generally get better results than investors who buy stocks with high P/E ratios.

this is generally true. All things being equal, you are better off buying a company with a

low P/E versus a high P/E. But all thinks are not equal in the investment swamp. Some

companies with high P/E ratios will have higher than average growth and may still

represent good value. The high P/E is merely a reflection of the future potential that

could be realized. Other companies with high P/E ratios are suffering from extreme

optimism about their future prospects. When these companies fail to meet investors’

lofty expectations, both earnings estimates and P/E ratios will suffer. Investors who own

these stocks will be punished severely if they don’t cut their losses quickly when these

high P/E companies post disappointing results. A low P/E company has a better chance

of being a winning investment, but as mentioned before, a low P/E ratio may be

indicative of either a fallen angle (buying opportunity) or a bad business with lousy

prospects (value trap).

Figure 39: Winners and Losers Comparisons for High and Low P/E Ratio Stocks

Figure 39 compares a group of high P/E ratio stocks and a group of low P/E ratio stocks.

Selections were made as of December 31, 1999, near the peak of the market at the turn of

December 31, 1999 December 31, 2007

Expected Actual Stock

Growth Growth Price

Name Industry Price EPS P/E Rate Price EPS P/E Rate Change

Higher P/E Ratios

Genentech Biotech 33.63 0.23 146.2 28% 67.07 2.94 22.8 38% 99%

Ebay, Inc. Internet 15.65 0.02 782.5 50% 33.19 1.53 21.7 72% 112%

Expeditors Int'l Industrial 10.95 0.28 39.1 20% 44.68 1.23 36.3 20% 308%

Express Scripts Healthcare 8.00 0.22 36.4 30% 78.00 2.47 31.6 35% 875%

Starbucks Retail 6.06 0.15 40.4 25% 20.47 0.89 23.0 25% 238%

Amgen Biotech 60.06 0.99 60.7 15% 46.44 4.28 10.9 20% -23%

Yahoo, Inc. Internet 108.17 0.12 901.4 50% 23.26 0.47 49.5 19% -78%

General Electric Industrial 51.58 1.07 48.2 15% 37.07 2.14 17.3 9% -28%

Pfizer Healthcare 32.43 0.82 39.5 20% 22.73 2.20 10.3 13% -30%

Home Depot Retail 68.75 1.00 68.8 24% 26.94 2.24 12.0 11% -61%

Lower P/E Ratios

Fortune Brands Household Products 31.11 1.99 15.6 12% 72.36 5.08 14.2 12% 133%

Nike, Inc. Consumer Products 24.78 0.95 26.1 15% 64.24 3.17 20.3 16% 159%

Cummins Engine Auto/Truck Parts 12.08 1.33 9.1 24% 63.69 3.70 17.2 14% 427%

General Dynamics Aerospace/Defense 26.38 1.77 14.9 11% 88.99 5.10 17.4 14% 237%

Kellogg Food 30.81 1.50 20.5 9% 52.43 2.66 19.7 7% 70%

Masco Household Products 25.38 1.56 16.3 15% 21.61 1.67 12.9 1% -15%

Newell Rubbermaid Consumer Products 29.00 1.65 17.6 15% 25.88 1.96 13.2 2% -11%

Goodyear Tire Auto/Truck Parts 28.06 2.12 13.2 8% 28.22 1.65 17.1 -3% 1%

Honeywell Int'l Aerospace/Defense 57.69 2.68 21.5 15% 61.57 3.16 19.5 2% 7%

Campbell Soup Food 38.69 1.84 21.0 10% 35.73 2.04 17.5 1% -8%

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the millennium. Each group contains ten stocks in five similar industries. The stocks are

divided into two sections; the top section being the winning stocks and the bottom section

consisting of the losers.

Let’s look at the high P/E stocks first. You can see that in general the high P/E stocks

had much higher than average expected growth rates. Because of the lofty growth

expectations, it was critical that those companies met or exceeded those forecasts. When

comparing the actual earnings growth for the period ended 2007 against the 1999

expected growth rate, observe that earnings growth either met or beat the expected future

growth rate for all of the high P/E stocks that experienced gains. Rapid earnings growth

was essential to making money in high-P/E stocks because in every case, the P/E ratio

shrank over time, sometimes substantially (look at EBay and Genentech). But for high

P/E stocks, meeting the growth expectation didn’t guarantee a profitable scenario for the

investor. For example, Amgen’s actual earnings growth was thirty percent higher than

the forecast, but a shrinking P/E ratio more than offset the earnings growth.

When high-P/E companies failed to meet expectations, the stocks were potential

disasters. The lesson here is that new emerging companies rarely trade for cheap

valuations. Tremendous gains can be had when these companies execute their business

strategies according to plan. But if they misfire, the losses come fast and furious. There

is no valuation support in the stock market for high P/E companies when they go wrong.

Now examine the lower P/E stocks. For the most part, the expected earnings growth

rates were also lower. One exception to this was Cummins Engine. In Cummin’s case, it

is likely that investors didn’t believe Cummin’s earnings growth would be that high, and

in fact earnings indeed fell short of the lofty expectations. However, earnings growth

was still respectable. In the case of all the winning stocks in the lower P/E group,

earnings growth either met or exceeded the expectations, or was good enough to achieve

gains in the stocks over an extended time period. When looking at the bottom section

(the losers) of the lower P/E group, notice that actual earnings growth was a

disappointment. Earnings-per-share went virtually nowhere for eight years. The result

… the stocks went virtually nowhere. This is a much better result, however, than was

achieved by the higher P/E stocks that missed their growth expectations. Because the

valuations were already low, investors in these stocks did not have to worry about

“multiple contraction.” On average P/E multiples for these disappointing stocks in 2007

were similar to the 1999 P/E ratios. The upside comes when a low P/E stock combines

solid earnings growth with P/E “multiple expansion.” Look at Cummins Engine again.

The fourteen percent earnings growth, although below the expected growth rate, was

sufficient to attract enough investor dollars to drive the P/E multiple higher, from 9.1 to

17.2. Almost half the 427 percent gain in Cummin’s stock was due to multiple

expansion.

A low P/E is no guarantee that a stock will be winner, just as a high P/E doesn’t always

result in tragedy. No matter what type of stock being invested in, earnings growth will

have a significant impact on the outcome. But understand this … investing in a high P/E

stock (any stock with a trailing P/E ratio greater than 30) means fighting a long-term

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valuation headwind. All high P/E ratio stocks will eventually experience multiple

contraction. No ifs, ands, or buts! At some point the “law of large numbers” will kick in

and earnings growth will not be sufficient to support the high valuation. The higher the

P/E ratio, the greater the risk for multiple contraction. With high P/E stocks, there is no

room for error when estimating earnings growth (unless of course it is to guess low).

With high P/E stocks, be selective and watch their progress carefully. By comparison,

low P/E stocks offer a greater margin of safety. Investors are less likely to incur

significant losses on lower P/E stocks, especially if when sticking with leading,

profitable, defensible companies. In addition, outsized gains can be realized if the

business performs better than expected. Cheap stocks that beat expectations typically

attract an increasing number of investors and drive the P/E multiple higher. Remember

Cummins Engine?

The Price/Book Ratio

Value investors most commonly use the price/book ratio. The ratio is calculated by

dividing a company’s price by its book value per share; which is shareholders’ equity

(excluding preferred stock) divided by the number of shares outstanding. Gator’s

price/book ratio is $25 / ($193,570 / 25,180) = 3.3. The book value per share is a rough

approximation of a company’s net worth. The price/book ratio represents how expensive

a stock is relative to its net worth. Studies have shown that low price/book ratio stocks

tend to perform better than high price/book ratio stocks. Similar to the P/E ratio, the

price/book ratio is simple to calculate and historical information is easy to obtain. The

price/book ratio can be a useful tool in gauging the downside risk for a stock, but there

are some nuances to be aware of.

To begin, book value should in no way be considered representative of intrinsic value.

Intrinsic value is the current value of the future free cash flows that a company will

generate over its existence. Book value is the net some of all historical accounting

transactions that have occurred during the company’s history. For example a company

that has overpaid for acquisitions in the past may have a large goodwill asset on its

balance sheet, but if the acquired businesses were losers, intrinsic value will be below

book value. Intrinsic value looks forward; book value looks backward.

Book value is sometimes used to estimate a firm’s liquidation value, but even in that

capacity book value is a rough estimate. While you can be certain that a company’s debts

will be paid dollar for dollar, assets on the balance sheet may not be fully realizable.

Cash is pretty safe, but the accounts receivable may not be fully collectable. Inventories

may have to be unloaded at a loss. If the company owns land, it may be worth more than

the stated book value. Machinery and equipment may be worth more or less depending

on its replacement value and if there is a functioning market for used equipment. For

example used computer equipment is virtually worthless, but a used oil drilling rig may

still have tremendous value. Any goodwill on the books will be worthless if the company

is in a liquidation mode.

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Corporate share repurchases can also distort book value and the price/book ratio. When

corporations repurchase their shares, they usually pay a price in excess of the stated book

value per share . This can still be a good deal for shareholders if the company is paying

less than intrinsic value for the stock (remember that shrinking the share count increases

the cash flow per share available to the remaining shareholders). But due to distortions

caused by accounting rules, a company could spend enough repurchasing its shares that it

significantly reduces or completely eliminates the company’s stated book value,

especially if it borrows money to buy back its stock. A good example of this is Avon

Products, a leading marketer of consumer products across the globe. Avon has an

outstanding franchise that generates consistent profits and lots of free cash flow. In 1999,

Avon’s management felt that the trading price for their stock in the public market was

significantly below its true value. To take advantage of this, Avon took on $750 million

in debt and aggressively repurchased its shares, which caused its stated book value to fall

to negative $400 million. This negative accounting book value in no way was

representative of Avon’s true intrinsic value. By the way, did management make a good

decision? Over the following five years, Avon’s stock price more than tripled. For stable

companies that consistently repurchase stock with their free cash flow, the price/book

ratio is not a good indicator of a company’s true worth.

Despite its pitfalls, the price/book ratio is useful when examining the relative value for

cyclical companies. Unlike the P/E ratio which makes cyclical companies look cheap at

cycle peaks and vice-versa, the price/book ratio gives a clearer picture. Let’s revisit the

Toll Brothers example from above. At the peak of the housing cycle Toll Brothers

price/book ratio was about 3 times, near the high end of its historical range. By October

2007, Toll’s price/book ratio had fallen to 1.0, near the low end. For cyclical companies,

investors will be better served looking at price/book ratios when trying to gauge a

company’s relative value to its history.

The Price/Sales Ratio

The price/sales ratio is also a favorite among value investors. Again, the calculation is

simple and it is easy to get historical data for comparison purposes. The price/sales ratio

is the market price divided by sales-per-share, so Gator’s ratio would be $25 / ($546,960 /

25,180) = 1.2. As with price/earnings and price/book, studies have shown that stocks

with lower price/sales ratios have rewarded investors with above average returns. An

advantage that the price/sales ratio has over the other ratios is that it is harder for

companies to manipulate accounting rules pertaining to recording sales. This makes the

price/sales ratio a little more reliable than price/earnings or price/book.

But the price/sales ratio, as with the other ratios, must still be understood in the context of

a company’s business quality. For example, McDonald’s mid-2008 price/sales ratio was

almost triple Starbuck’s, but McDonald’s net profit margin was also triple. Google and

EBay’s profit margins were similar, but Google’s price/sales ratio was double EBay’s

because Google’s expected growth rate was double. Two points require mention. First

the price/sales ratio is impacted by a company’s overall profitability, especially as it

relates to net margins and asset turnover. Second price/sales ratios should not be used to

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determine relative value between companies because each company’s growth rate,

profitability and capital efficiency will differ. However, it is acceptable to compare an

individual company’s current price/sales ratio to its historical range to help gauge the

company’s relative value, but only if its future prospects and profitability will be

comparable with its past.

The Enterprise Value/Earnings Before Interest, Taxes, Depreciation, and Amortization

Ratio (“EV/EBITDA”)

The EV/EBITDA ratio is the perhaps the most ridiculous valuation metric being used

today. The first step is to calculate enterprise value, which is the current equity market

value of a company (current shares outstanding multiplied by the quoted stock price) plus

all outstanding debt and preferred stock (if any). Gator’s 2007 enterprise value is ($25 *

25,180) + $100,340 = $729,840. Divide that by EBITDA (just as described above). Start

with Gator’s net income of $44,690 and add back $5,100 of interest expense, $18,910 in

taxes, $26,090 of depreciation and $3,100 in amortization expense for total EBITDA of

$97,890. Divide it into enterprise value for an EV/EBITDA ratio of 7.5.

The major problem with the EV/EBITDA ratio is that it is almost totally meaningless.

You will be far better served looking at discounted free cash flow valuations or P/E

analysis than if you used the convoluted EV/EBITDA ratio. This ratio became popular

with investment bankers because they could make an expensive company look like a

bargain. Gator’s 7.5 EV/EBITDA ratio is far lower than its P/E. Investment bankers try

to convince you that EBITDA is a reflection of cash earnings, when nothing could be

farther from the truth. The EV/EBITDA ratio ignores three important aspects of any

company. By eliminating interest, the cost of leverage in the business is ignored.

Second, alligator investors are only interested in profitable businesses, and profitable

businesses pay income taxes. No self-respecting business owner would ignore taxes as a

real cost to their business operations. Finally, adding back depreciation and amortization

because they are non-cash charges is just flat out deception unless actual cash

expenditures for plant, equipment and acquisitions is subtracted in their place. Nobody

can run a long-term business by starving if of required investment for infrastructure.

Depreciation is a reflection of the cash charge being taken for that investment. Same

goes for amortization. Depreciation and amortization would not exist unless there was a

previous cash outlay in the business to create it. Frankly, a more appropriate description

of EBITDA is “Earnings Before Ignoring Transactions to Deceive Analysts.”

To summarize, the discounted cash flow (DCF) method of estimating intrinsic value is

the most meaningful approach to valuing any asset, and the only method that can be used

to compare the relative attractiveness across different investment opportunities. Despite

the DCF being the preferred method, it is still imprecise because of the series of

assumptions that are required during its construction. Owning investments at substantial

discounts to estimated intrinsic value gives you a better chance of making money, even if

the assumptions in the DCF turn out to be optimistic. Relying on a quality subscription

service like Morningstar or Value Line is an acceptable alternative to construction a

separate valuation analysis. However, when using an external service, challenge the

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service provider’s analysis for reasonableness and conservatism. Price/earnings,

price/book/ and price/sales ratios can be useful on individual company analysis when

trying to gauge current relative value against a company’s history. However, these ratios

are limited in their abilities and should not be used to compare the relative attractiveness

between different investments. Finally, avoid EV/EDITDA like the plague!

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APPENDIX A: STANDARD RESEARCH QUESTIONS

You wouldn’t go alligator hunting without being properly outfitted with the proper gear,

would you? Not only would your chances of a successful expedition be impaired, but

you could be unnecessarily putting yourself in harm’s way. Don’t take unnecessary risks

with your money either. The following list of questions can be used to evaluate almost

any business. This list should be customized and/or supplemented with specific

questions catered to particular nuances involved with a particular potential investment.

Sales and Revenues

1. How big is the market for the company’s products and services? How fast is the

market growing and why? What segments of the market do the company’s products

address? What is the potential to address a greater segment of the market?

2. What is the company’s current market share? How fragmented is the industry? Is the

company gaining share, what backs up that claim, and why is it gaining share? What

potential market share is ultimately achievable?

3. How are the company’s products or services priced? Does the company have the

power to raise prices and why? What has been the historical trend for pricing? Is the

pricing environment improving or deteriorating?

4. Does the company sell high-frequency low-price items to a lot of customers, or high-

price low-frequency products? What percentage of the company’s revenues are

contractual, recurring, subscription, or transactional (with high frequency – like fast

food restaurants)? All of these impact the cyclicality and predictability of a business.

5. What percentage of sales and growth are from new customers versus existing

customers? Why are sales to new customers increasing? Why are sales to existing

customers increasing? What is the nature of repeat or add-on sales? What drives

sales growth?

6. Who are the company’s customers? Into what industry segments does the company

sell (consumer, financial, industrial, medical, educational, government, etc.)? What is

the penetration of the company’s products and services within these segments? How

fast are these segments growing, and which segments provide the best growth

opportunities and why?

7. Is the company dependent on any key products or customers? What is the risk that

key customers leave or key products and services become less relevant?

8. What potential new products and services does the company plan to introduce and

what are the opportunities for them? What has been the company’s success rate in

launching new products?

9. Into what geographic segments does the company sell? How saturated are the

company’s products within those segments? How fast are the segments growing and

why? How does the company plan to increase sales within the geographies? What is

the opportunity to add new geographies?

10. Try to get the company to quantify its objectives for long-term revenue growth for

industry volume growth, plus market share gains, plus pricing, plus new products,

plus acquisitions (see below).

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Competition (Consider Michael e. Porter’s 5 Forces Analysis (first five questions)

1. How intense is the competitive rivalry within the industry? What is the industry

fragmentation? On what factors is competition based (price, quality, scale, etc.)?

2. What is the threat from substitutes? How mission critical are the company’s products

and services? What is the availability of substitutes and their perceived

differentiation, and a buyer’s willingness to try alternatives?

3. What is the threat from new industry entrants (barriers to entry or exit, brand equity,

regulatory barriers, technology, access to distribution, scale, etc.)? Is the company

the absolute low cost provider?

4. What is the bargaining power of customers (customer concentration, availability of

substitutes, ability to integrate, etc.)? Is the company a price setter, or a price taker?

5. What is the bargaining power of suppliers (differentiation of inputs, availability of

substitutes, supplier concentration, ability to integrate internally, etc.)?

6. What competitive actions are being taken in the market place, or expected to be

taken? Who holds the power within the industry and who are the potential

disruptors?

7. What are the potential threats to the overall industry? How fast is the industry

growing and what could disrupt it?

Cost of Goods Sold/Gross Margins

1. What are the key cost components for the company’s products and services?

2. How do the company’s cost of goods or services break down between direct

materials, direct labor, and overhead costs?

3. Have there been any recent key management changes in the areas of manufacturing,

distribution or logistics?

4. What percentage of the cost structure is fixed versus variable? What is the

incremental leverage (or margin) for a percentage increase in sales?

5. What is the company’s philosophy on manufacturing and capacity planning? How

will the company control costs (i.e. relocating manufacturing to cheaper

geographies)?

6. What are areas of cost pressures and opportunities for cost efficiencies or savings

(health care, utilities, labor, etc.)? How do these factors offset each other and what

should be the resulting net effect on margins, both positive and negative (expected

basis point improvement/deterioration)?

7. What is the various gross margin for key product/service segments, and how is the

mix of sales expected to impact gross margins?

Selling and Marketing Expenses

1. Does the company use a direct sales force, sales agents, or distribution networks to

sell its products? What percentage of sales come from the various channels? What

sales channels will the company emphasize and why?

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2. What is the current sales force size and sales force turnover? What are the companies

goals for adding sales people? How big will the sales force ultimately need to be?

3. What are the sales force economics, compensation and structure? How is the sales

force managed? Have there been any recent key management changes?

4. What are the company’s key marketing strategy (television, trade shows, internet,

etc.), programs and how is their effectiveness measured?

5. What percentage of sales and marketing expenses are fixed in nature versus variable

costs? What percentage of sales does the company intend to spend on selling and

marketing?

6. Within selling and marketing expenses, where are the areas of cost pressures and

areas for leverage? What is the offsetting impact of these forces (i.e. expected basis

point improvement/deterioration)?

Research and Development

1. What is in the new product pipeline and what is the expected timing for new product

launches?

2. How is the company’s R&D effort focused ,and how is it managed to determine its

return on investment? Have there been any recent changes in key management of the

R&D area?

3. What is the R&D staff’s size, turnover, and plans for additions?

4. What percentage of R&D expenses are fixed in nature versus variable costs? What

percentage of sales does the company intend to spend on research and development?

5. Within research and development, where are the areas of cost pressures and areas for

leverage? What is the offsetting impact of these forces (i.e. expected basis point

improvement/deterioration)?

6. Are there any key projects that are about to begin or end that have a material impact

on research and development spending?

7. What are the company’s goals for sales of products introduced within the past three

five years?

General and Administrative Expenses

1. What percentage of G&A expenses are fixed versus variable in nature?

2. Within G&A, where are the areas of cost pressures and areas for leverage? What is

the offsetting impact of these forces (i.e. expected basis point

improvement/deterioration)?

3. Have there recently been any changes in key management positions at the company?

What key hires does the company need to make to support the business?

4. Are there any planned upcoming unusual increases in spending, or items just

completed?

5. What legal issues is the company facing? Follow-up on any litigation mentioned in

the company’s financial statement footnotes?

6. What are the plans for growth in G&A staffing levels?

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Income Taxes

1. What is the company’s expected income tax rate and reasons for any changes?

2. What is the company’s cash tax rate versus accrual rate and how is that relationship

expected to change, if at all?

3. Does the company have significant unused Net Operating Loss carryforwards? If so,

how big are they and when should they expire or be used in full?

Acquisitions

1. What is the company’s acquisition strategy and addressable target population/size?

2. Who is on the company’s due diligence team and describe the due diligence process?

3. What deal economics does the company seek on acquisitions? What is the required

after tax return on investment threshold?

4. What is the company’s integration and retention strategy for acquired businesses?

5. Why do the acquired businesses sell them?

Capital Expenditures

1. What level of capital equipment expenditures (as a percentage of sales) is required to

sustain and grow the business?

2. What are the dynamics in the business that will cause the intensity of capital

expenditures to increase or decrease?

3. What is the required return on investment for capital expenditure projects?

4. Are there any key capital expenditures (new buildings, software installations, etc.)

that are planned or in process that create an unusual spike in the level of capital

expenditures? Has the company cut back on any required capital expenditures in

order to conserve cash balances?

5. What are the company’s software capitalization policies, and construction in process

capitalization policies?

6. Are there any key information technology systems upgrades required?

Incentives

1. What forms of equity compensation does the company issue and what is their

philosophy regarding compensation (both cash and stock)?

2. What level of stock (options, restricted stock, etc.) grants does the company expect to

make annually? What is the expected dilution to existing shareholders (calculated as

annual grants as a percentage of current fully diluted shares)?

3. What performance metrics (if any) are used to determine stock and option grants?

4. What causes restricted stock to be forfeited/lost other than termination?

5. How do options or restricted stock vest? Are there any accelerated vesting clauses?

Are options and restricted stock be forfeited if performance metrics are not achieved?

6. Cash incentives: annual cash bonuses as a percent of base compensation;

triggers/goals for achievement of cash bonuses and how do these relate to increasing

the company’s intrinsic value: when are cash bonuses zero?

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7. How are incentive comp triggers set relative to guidance that the company states

publicly to investors and analysts? It is desirable that management has set the bar

internally higher than goals it speaks about publicly.

Overall Financial Statement

1. What are the company’s operating margin model and targets; how do they get there

from today and what is the time frame for achievement?

2. What are the company’s goals for return on capital, return on equity, and tolerance

bands for debt leverage?

3. What is the company’s overall philosophy for managing its capital structure? Does

the company maintain a simple capital structure or does it make use of complex and

creative financings (simple is generally better)?

Working Capital

1. What are the targeted days accounts receivable and what could impact its direction?

2. What are the reserving policies for bad debts, sales returns etc.? Does the company

have exposure to any key customers or industry groups that could be under stress?

3. What are the targeted days or turn levels for inventory?

4. How does the company manage its part levels?

5. What are the reserving policies for obsolescence?

6. How does the company manage its accounts payable and vendor relations?

7. What is the company’s overall philosophy on working capital management?

Free Cash Flow

1. Prioritize uses for excess cash flow (internal growth, acquisitions, dividends,

repurchases?

2. What is the company’s dividend payment philosophy and targeted payout ratio?

3. What is the company’s share repurchase philosophy and required ROI? How does

the company determine if it is repurchasing shares below their intrinsic value?

Miscellaneous

1. How do various currencies impact the company? What hedging strategies does the

company employ?

2. What regulatory issues impact the company? Are any key patents expiring within the

next few years?

3. What recent insider buying or significant selling has taken place?

4. What is the company’s philosophy to providing guidance to Wall Street analysts?

How has the company’s track record been at executing on its guidance or objectives?

5. What is the company’s 5-year growth objective for top and bottom line on a per share

basis?

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Culture (ask CEO’s and CFO’s about this stuff)

1. How do they define the culture?

2. What attributes do they look for in personnel?

3. How do they think about training, development, succession in all positions?

4. What do they find intolerable?

5. What were their three major disappoints over the last 12 months? (and what did

they do about it … but let them come up with that part themselves.)

6. What three things do they wish they had in the business today that they are

missing?

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APPENDIX B: THE TRUTH ABOUT GROWTH AND VALUE INDEXES

Investors know that stocks give them the best opportunity to grow their real net worth

over the long run. Stock prices grow because their earnings-per-share grow over time. In

an attempt to assist investors in their quest for growth stocks, the index database

companies have created separate growth and value indexes. By herding together in a

separate index all the companies that they consider growth stocks, the index database

providers have theoretically made it simpler for individuals to invest in growth

companies and benefit from the power that superior earnings growth provides. But as

Chuck Reid said, “In theory, everything works in practice. In practice, it’s different.”

Comparing Russell Investments’ growth and value indices sheds some light on the facts.

Russell Investments is a well-respected organization in the investment community and

provides many valuable services for institutional and individual investors. That said, no

one gets everything right. Russell categories its indices by market capitalization (large,

mid or small) and by style (growth or value). Following is a quote from Russell

describing how they determine style.

“Russell Investment Group uses a “non-linear probability” method to assign

stocks to the growth and value style indexes. The term “probability” is used to

indicate the degree of certainty that a stock is value or growth based on its relative

book-to-price (BP) ratio and I/B/E/S forecast long-term growth mean. This

method allows stocks to be represented as having both growth and value

characteristics, while preserving the additive nature of the indexes. …

For each base index, stocks are ranked by their adjusted book-to-price and their

I/B/E/S forecast long-term growth mean. These rankings are converted to

standardized units and combined to produce a Composite Value Score (CVS).

Stocks are then ranked by their CVS, and a probability algorithm is applied to the

CVS distribution to assign growth and value weights to each stock. In general,

stocks with a lower CVS are considered growth, stocks with a higher CVS are

considered value…”

To paraphrase, Russell classifies more expensive stocks with higher consensus growth

forecasts as growth stocks, and cheaper stocks with lower growth expectations as value

stocks. At year-end 1997, the Russell 1000 Value and Growth indexes had forecasted

long-term earnings growth rates of 14 and 20 percent, respectively. Growth stock

earnings were expected to grow 6 percent faster than value stock earnings on an

annualized basis. But for the following decade, actual earnings growth was 7 percent for

the value index, and 6 percent for growth. Value stocks delivered earnings growth that

was one percent better annually than growth stocks delivered. The result … the value

index’s annual price performance beat the growth index by over 2 percent. Half of the

better performance was due to higher earnings growth and the other half was because the

growth index suffered a greater degree of earnings multiple contraction. When the value

index’s higher price performance is combined with their higher dividend yields, total

returns for the value index trumped the growth index.

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The main challenge to the growth index is using analysts’ consensus forecasted growth.

Forecasted growth is no guarantee for what actual future growth will be. In fact, the

higher the expected future growth, the more likely investors will be disappointed.