BI > DECEMBER 2002

The Gift of Investing

There's Much To Learn, Even in Bear Markets

With what's been happening to equity markets this year and last, calling investing a gift might seem far from appropriate. After all, trillions of dollars in equity values have been lost, much of it by individuals counting on those dollars to help fund some of life's most important goals, be they education, a home, a business, a more comfortable retirement, or realization of a lifelong dream. In truth, however, investing is a gift, one well worth giving and receiving -- but only if it comes complete with its own user's guide. And that user's guide is education.

Many of the 700 who attended September's Portland Congress learned more about how to use investing in their own situations and in support of their own objectives. Chief among the lessons for those able to focus on the long term was this one-two punch: 1) Bear markets bring some of the best buying opportunities investors will find; and 2) bear markets always end. They're not statements likely to make today's headlines, which focus on days and weeks, not years, but they are statements likely to contribute significantly to the amount of wealth individuals can accumulate as educated investors over their lifetime. Here's a glimpse of some of what was said and learned at the Congress, presented as excerpts from four of the 62 educational seminars that were offered. We hope you find a comment or two to add to your own user's guide to better investing.

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What to Learn. Deciding which seminars to attend can be a challenge when there are 62 to choose from and you can only get to some of them.

When To Sell

NAIC Chairman Ken Janke had much to say to a crowd interested in learning more about one of the toughest decisions investors have to make. Among his comments were the following:

Companies should be judged long-term. I have been in the stock market for 42 years. I have been with NAIC for 42 years. I keep track of the S&P 500 -- the earnings and the averages. Since I first became an investor, the earnings for the S&P 500 have increased 16-fold (a short time ago it was 17-fold). Prices have also increased 16-fold. My point is that there's a definite correlation between earnings and the price of a stock. It may not be in lock step -- it's not week to week or day to day, and it may not even be year to year, but eventually the company that continues to increase earnings will sell at a P/E ratio that is in relationship to what those earnings are, and those are the companies where the prices will go up.

Don't sell just to do something. There's an old line: "He who sells what isn't his'n either pays or goes to prison." So please don't sell short. Don't try to guess a short-term swing in the market.

Hedging: There is no absolute answer as to when to sell. It really becomes an art; it's not a science. So I've long been a believer in hedging. We did that with ADC Telecom in the NAIC Growth Fund a number of times on the way up and then down. By hedging, you're always half right. If it goes up, you can say, "See how smart I am -- I kept half of it." If it goes down, you can say, "See how smart I am -- I sold half of it."

There is no absolute answer as to when to sell. As long as the fundamentals are good, you're better off holding onto it. But if the fundamentals start to go down, and the company you thought was a growth company no longer is a growth company, you're much better off selling than holding on to that company hoping it will come back.

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General Sessions. More than 700 investors participated in general sessions.

Invest in the Best

Computer Group Honorary Chairman Phil Keating is another presenter who regularly draws standing-room-only participants. Here are some comments made at his "Invest in the Best" seminar.

There are 10,000 publicly traded stocks, and I do an "Invest in the Best" screening monthly when I do the Growth Screen we publish in BITS. Of those 10,000 publicly traded stocks, only about 150 to 200 are really superior companies. But of course there are bunches that are pretending. Another 300 to 500 are pretenders or contenders, so 95 percent of those companies aren't worth your effort to do an SSG.

Here's a set of minimum criteria I use to get at great growth company candidates -- companies that are probably worth doing an SSG on -- at least SSG Section 1 and Sections 2A and 2B. We don't look at valuation at all at this point. The question we're asking here isn't, "Is it a good buy?" rather, "Is it a good company?" It's screening criteria using Value Line data.

Young Investors. Students and teachers participated in a youth program that planners believe will serve as a model for other educational efforts aimed at young investors in the coming year.

• Sales growth equal to or greater than 9 percent compounded annually for five years.
• Earnings growth equal to or greater than 10 percent compounded annually for five years.
• Latest 12-month net margin (Value Line does not present pre-tax margins) equal to or less than last year's.
• Earnings predictability equal to or greater than 75 percent.
• Price growth persistence equal to or greater than 75 percent.
• Positive free cash flow ($1 or more per share).

This screening results in a group of only 70 stocks out of 7,400 companies in the Value Line database. But remember, this is where you start, and then you do your stock analysis.

Keating also presented these characteristics of great growth companies, commenting especially on the last:

• Have sales and earnings growth of about 10 percent or more per year.
• Maintain or improve profit margins.
• Have consistency.
• Have high franchise value.
• Produce excess cash.
• Are visionary.

I've found that great growth companies have a vision other than just making the most money. Ironically, that often leads to greater success in making money.

Information Gathering. Expo 2002 gave investors a chance to get firsthand information from company representatives, including answers to questions they had about their operations.

In the book Built to Last by James Collins and Jerry Porras (see bibliography that follows), the authors note key characteristics of the most admired companies. They had core values that went beyond just making the most profits. They had an idea system that permeated the entire firm and all its activities. Everyone walked the talk. And there was almost a cultlike culture and home-grown management -- 95 percent of the time the CEO came from within the ranks.

Hewlett-Packard was one. Are they still? (Keating asked the quetion of the audience without answering it.) At HP it was always more than the bottom line. Employees weren't competing just to be No. 1 in their industry, but to do better than they had ever done before. Like the great athlete, like the great leader, like the great people we read about in the Iliad and the Odyssey. Heroes. A charismatic leader (Collins and Porras) found, was not necessary.

The key to finding great growth companies is not just finances -- that's merely the symptoms -- but great management, judging greatness by management's record in good times and especially in bad times. You really can't judge a company and management until you see how they handle bad times. So one of the redeeming qualities of the last couple of years is we're certainly going to find out who the real contenders are versus the pretenders.

The No. 1 thing I look for in an employee is the two C's -- Character is No. 1 and Competence is No. 2. These are qualities that have to do with people. By the management culture judge the core values, (whether) they have a core value other than making the most money, or just being No. 1 -- and if they actually walk the talk.

Keating shared a bibliography for his seminars at the Congress. Here are six of the references:

1. Built to Last, Successful Habits of Visionary Companies, James C. Collins and Jerry I. Porris, 1997, Harper Business.

2. Economics: Private and Public Choice, James D. Gwartney and Richard L. Stroup, Dryden Press, eighth edition, 1997.

3. Good to Great: Why Some Companies Make the Leap ... and Others Don't, Jim Collins, Harper Business, 2001.

4. One Up on Wall Street, Peter Lynch, 1989.

5. The SRC Green Book of 5-Trend 35 Year Charts 1967-2001, Securities Research Company, Babson-United, 2002.

6. Stocks for the Long Run, A Guide to Selecting Markets for Long-Term Growth, Jeremy J. Siegel, Richard D. Irwin, Inc., 1994.

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When the Bear Comes Knocking. Cy Lynch's seminar on "What To Do When the Bear Comes Knocking" was of strong interest to attendees.

Avoid "Guaranteed-Loss Orders" When the Bear Comes Knocking

Cy Lynch's "Investing in Turbulent Times -- What To Do When the Bear Comes Knocking" presentation to an overflow audience included these comments about stop-loss orders and Cy's experience with them:

Don't use stop-loss orders. That's one of the biggest temptations that you're going to have right now in a down market, because so many people say the key isn't how much your stocks go up, it's protecting against the loss. To which I say, "baloney." Now, I'm not saying buy and forget.

I'm not saying don't get out of stocks that go down in price. Because there are times, based on the business of the company, that you're going to want to sell. But that's a completely different thing from a stop-loss that's an automatic trigger (to sell) at a 15, 20 percent drop.

Networking. Many attendees reported the chance to talk with other investors with similar objectives was one of the biggest reasons to attend.

When I first bought (Affiliated Computer Services), it went up in price; I was a genius. But then suddenly it dropped down almost 20 percent below my buy price. And of course, I had a stop-loss in at 20 percent, and I said: "Whew! Thank goodness I didn't lose more money." And then, hopefully, I went to sleep. Because my choices were (taking) a 20 percent loss or (waiting and seeing) a 125 percent-plus gain.

That was just luck, right? Let's look at Cardinal Health, a company featured in Better Investing magazine about the time I bought it. We were all geniuses; it went up. Then suddenly it plunged. It was down 20 percent or so from the purchase price. Thank goodness I sold out with my stop-loss. But look: a 20 percent loss, or an 80 percent gain, even with a significant price drop very recently that Cardinal has experienced.

Guaranteed-loss orders: We talk about paper losses -- "It ain't a loss until you sell it, it's only on paper" -- for that matter, they're paper gains, too. But guaranteed-loss orders turn those paper losses into real losses.

So don't use them. Watch your stocks on a monthly basis, evaluate them on business fundamentals and make your decisions based on that.

Don't panic and sell. Price drops are irrelevant if the business is solid. One of the best signs I see is a price that has stayed (flat) and an earnings line on an SSG that has (continued to rise), because that is very likely -- I want to do the rest of my analysis -- a buying opportunity.

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Standing Room Only. Even with 62 investment seminars on the program, classrooms often were standing room only for investors wanting to learn.

Adding Judgment to the SSG

NIA Director Gary Ball used sample Stock Selection Guides to explain some of the finer points of the SSG in his seminar, "SSG Bloopers: Adding Judgment."

Dividend yield: If that high yield ends up being roughly what you're getting on money markets or something like that, then that's an important number.

Let's assume the high yield was half a percent. Would you buy a stock to get a half a percent dividend? No, you wouldn't. But let's assume today that you have a stock that you have a 4 percent yield on. Would you buy it? You might, if it was a pretty reasonable stock.

You're not going to buy a lousy stock for the 4 percent. But if you had a good quality company that maybe just wasn't doing anything for a while, the growth wasn't quite there -- if you got a 4 percent dividend yield on it with a potential for good growth, you easily might say, "Boy, the 4 percent's a heck of a lot better than what I'm getting in my money market or my checking account."

Estimating earnings growth: Most companies, certainly as they get bigger, slow down. It's kind of a law of large numbers. It's very hard to grow a company faster and faster.

The Gift Goes On. Attendees left with two inches of handouts in their Congress binders and audio tapes of many sessions to aid their further study.

My assumption on Stock Selection Guides is that I never allow my future earnings to grow faster than sales. I think it's just too risky.

Back in '92, (IBM) was doing terribly -- it lost 14 cents on the dollar. And then they turned things around. They made 8 percent, and then 10 percent, and then 11 percent, and then 13 percent. Obviously, the trend was up. A very good trend; that's what you want to see in a company. So looking at that historically, that's why earnings in the past grew faster than sales.

But to make that same assumption going forward, you're really saying: "They're not going to stop at 13. It's going to go to 16, 18, 20" -- well, let me tell you, that's a pretty good profit number right there. I would think that would be very hard to continue improving, particularly in a tough economy.

My assumption is: You know when that profit margin is going to quit going up? The day you buy the stock.

P/E ratios: For a company with recent high P/E ratios of 22, 18, 20, 22, and 14, I threw out 20 and 22. Why would I throw out 20 and 22? They don't look like much of an outlier. Always look at the earnings (per share) of companies. The earnings started out at $2.83, went up to $3.35, then went down to $3.00, then they went down to $2.80 before they went back up to $3.80.

To get a higher P/E ratio, you can have two things happen: One is you can have a high price that's growing faster than the earnings -- typical of a growth company, when the company's really growing and people like the company and bid up the price. The other way you can have a higher P/E ratio is (for the company not to earn it.) The earnings can drop.

In most cases, when I see the earnings going down, I almost always get rid of the (resulting) high P/E ratio.

NAIC's 2003 Congress will be held Oct. 31 - Nov. 2 in Norfolk, Va.