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Common Sense


Clint Vogus



Introduction i

1 Invest with Good Fund Managers 14

2 Always Focus on Value 19

3 Steady Results 22

4 Don’t Sit on the Sidelines 25

5 Develop Patience 28

6 Markets are not Rational 31

7 Think Beyond U.S. Stocks and Bonds 35

8 Be Where Markets Are 40

9 Don’t Follow the Crowd 43

10 Have an Investment Plan and Stick to It 46

11 Issues and Outlook for U.S. Economy 49

12 Outlook for U.S. Stocks 58

13 Investment Strategy 60

14 Investment Opportunities 62


This book is written for the individual investor who seeks

a better life by saving and investing.

In presenting my investment approach, I hope that you

gain a better understanding of investing, take control of your
investments and make better-informed investment decisions.

Since this book is written for the individual investor, all

the investments discussed are easily accessible to all investors
and do not require large amounts of money.

I refer to my investing approach as Common Sense

Investing. It is based on a set of clearly defined investment
principles, and an understanding of global economic issues that
affect investments. Common Sense Investing focuses on being
in the right markets at the right time, and also helps avoid being
in the wrong markets.

Twenty years of experience has taught me that being in

the right place at the right time pays off. Being in the wrong place
at the wrong time often causes losses. The challenge is to
determine where the right place is. That is why my approach to
investing requires an ongoing understanding of global economic
issues and trends, and how they might affect specific

The technology market bubble that burst in early 2000

reminds us of the risks of being in the right place at the wrong
time. From March 2000 through October 2002 the Dow Jones
Industrial Average dropped 31%, the S & P 500 47%, and the
NASDAQ 78%. In hindsight, this was a market to be out of
during that period of time. There were other markets, however,
that did well, such as small cap value stocks and bond funds.
Both had positive returns.

This book presents an approach to investing that has

evolved from twenty years of personal investing experience and
studying some of the best minds and many successful investors.

Common Sense Investing

Common Sense Investing consists of ten principles that
are used to guide investment decisions and an investment
strategy, based on current global economic issues and trends.

The investment strategy answers the question what

markets to be in or where to invest based on the economic
environment and trends. The investment principles define how to
invest to take advantage of the environment. As an example, a
market is technology stocks and a how to invest, is a technology
mutual fund.

As the global environment changes, investment threats

and opportunities change. Investments therefore, need to be
changed to take advantage of the new environment and avoid
potential losses.

A global issue that affects investment strategy in 2005 is

the decline in the value of the U.S. dollar relative to other major
world currencies. In this economic environment it would be
appropriate to consider investments in global stocks and bonds
that are unhedged to get the advantage of both foreign asset
appreciation, and appreciation of the foreign currency. This
would not have been a good investment strategy in the mid
1990’s when the dollar was gaining strength against foreign

One of the lessons I have learned is that every market

has a season. Common Sense Investing helps guide me to the
right investment for the right season and avoid what is out of

Investment Experts

Interest in the markets during the boom of 1982-2000

brought a lot of new research and many books about different
approaches to investing. This research gives us insight into how
different investment approaches have performed under various
market conditions.

Several Nobel prizes have been awarded for investment

research that led to a better understanding of market dynamics. I
have read a number of investment books and publications, and

have spent much time trying to better understand what works in
investing and what does not and why.

In this pursuit I have studied some of the brightest and

most successful investors. They range from Ben Graham, the
father of value investing to George Soros, one of the most
successful hedge fund managers, and many others with different

Some of the experts that I have studied include, but are

not limited to the following.

Ben Graham and David Dodd, wrote Security Analysis,

first published in 1934. It laid the foundation for value investing
and was one of the earliest books to present a systematic
approach to investing in stocks.

Their approach was to buy stocks of companies when

they were selling below what they defined as their intrinsic value,
and hold them until they reached their full value. This was a
conservative approach to investing and provided a margin of
safety against general market downturns. Many individual
investors and mutual fund managers use this value investing
approach today.

In 1984, as the great bull market in U.S. stocks was

beginning, Ken Fisher wrote Super Stocks. He started with the
value investing principles of Graham and Dodd and added some
additional valuation measures to identify companies that had
great growth potential but whose stocks were selling at prices
that were low.

Ken referred to these companies as “super companies”

and predicted that they could increase in value 3 to 10 times in
three to five years. Many did during the long bull market that

Jeremy Siegel, a professor of finance at the Wharton

School of the University of Pennsylvania in his 1993 book Stocks
for the Long Run, presented historical research from 1802 to the
present to support his thesis that U.S. stocks are the best and
safest long-term investment. The market performance for the

period from 1994 up to March of 2000 supported his research
conclusions well.

John Bogle, the founder of the Vanguard Group and an

advocate for the individual investor, in his book Common Sense
on Mutual Funds, helped investors to better understand the
mutual fund industry. He presented data on the returns and costs
of managed mutual funds compared to index funds. His book
concluded that investing in index funds was a lower cost
alternative to investing in managed mutual funds, and in many
cases yielded better returns.

The index method of investing became very popular in

the 1990’s and Vanguard had the largest index mutual fund. It
grew to about $100 billion in assets before the market downturn
of 2000, and is still the largest mutual fund today.

Harry Dent, Jr., has been one of the leaders in research

on the relationship between demographics and market returns.
He wrote his first book in 1993 titled The Great Boom Ahead. He
predicted the stock market boom that we experienced in the late
1990’s. He presented many insights into the relationship
between demographics and investment returns.

In his latest book, The Next Great Bubble Boom written

in 2004, Harry presents further demographic trend data that
predicts the final boom in the U.S. stock market before a
downturn, beginning at the end of this decade. He demonstrated,
through his research, that the investment environment and
specific opportunities change over time and are driven by
demographic and technology cycles.

Charles Ellis published the first edition of Winning the

Losers Game in 1975. In this book he presented reasons why
most individual investors do not make money in investing. He
demonstrates that with a sound personal investment policy, and
an understanding of the markets and discipline, investors can
change from losers to winners. Since his early work there has
been much research on the psychology of the individual investor.
The new field of Behavioral Finance attempts to understand why
investors make more irrational or emotional decisions than
rational ones, when it comes to investing.

In The Essential Buffet Robert Hagstrom presents the
principles that Warren Buffet uses to make investment decisions.
Warren’s principles include investing in a business not a stock,
demanding a margin of safety to minimize risk, and focusing on a
few outstanding companies.

Warren has been investing since 1956 through his

company, Berkshire Hathaway, and has the best long-term
record of any investor. He invests for the long term and rarely
sells any of the companies that he invests in.

Soros, The Life, Times and Trading Secrets of the

World’s Greatest Investor, written by Robert Slater, traces the life
of George Soros from his beginnings as an immigrant from
Budapest, Hungry to the most successful hedge fund manager.

Many of Soro’s investment successes resulted from

making large bets on the outcome of world economic or political
events. His ability to understand world macro-economic and
political events, their impact on investment markets, and to
predict how they will turn out, has been a key to his investment

Peter Lynch, one of the most successful mutual fund

managers during his career with Fidelity, describes his approach
to investing in Beating the Street. During his thirteen years, 1977
to 1990 as manager of the Fidelity Magellan Fund, the fund
earned a compound annual return of 29.2%.

Lynch believes in order to make the best investment

decisions you have to understand a company’s products,
management, and business. He traveled thousands of miles
each year to visit companies and meet with management to
assess their growth prospects before making a major

He focused on commonly known products that everyone

was buying as they represented the best opportunities for
growth. Some of his best investment ideas came from his wife.
She would suggest companies that were producing products that
she liked. Identifying high growth companies that had good
management with good products contributed significantly to
Lynch’s success.

William O’Neil, founder of Investors Business Daily, in
his book 24 Lessons for Investment Success, explains his
approach of investing in stocks that have strong earnings growth
and strong price appreciation. His daily newspaper is dedicated
to helping investors follow his momentum investing system. He
recommends buying stocks that have the highest levels of
market activity and strong current price, volume, and earnings
trends. Many investors, through his daily newspaper, follow this

The late Al Frank’s book The Prudent Speculator, details

his value approach to investing, which has earned him one of the
highest and most consistent portfolio returns of most all other
investment newsletters as rated by Hulbert Financial Digest. He
follows many of the value principles of Graham and Dodd but
adds additional valuation measures and the use of margin to
enhance returns. There are now several mutual funds that use
his system.

John Mauldin, an expert on hedge funds and alternative

investments, has written a recent book Bull’s Eye Investing. In it
he outlines his views on where various investment markets are
heading and makes recommendations to align investments to
protect assets and take advantage of evolving trends.

He sees what he calls ‘new economic realities’ as the

drivers for alternative investments. His book provides a road map
to help avoid investment pitfalls in what he predicts to be a very
turbulent investment environment for the next eight to twelve

This brief summary of some investment experts that I

have studied demonstrates that there are a variety of different
and successful approaches to investing. They include value
investing, momentum investing, index fund investing, buy and
hold, large growth stocks investing, demographic trend following,
betting on the outcome of economic and political events, and
alternative hedge fund investing based on macro-economic
trends. There are also a number of others such as day trading,
technical analysis and using puts and calls, just to mention a few.
My Investment Approach

All successful investment professionals have an
approach to investing which defines how they will invest, where
they will invest, what they will invest in, and when they will buy
and sell. It’s these investment principles that guide their

As we have described, they are very different. They all

have been successful over periods of time and under various
market conditions. There does not appear to be one best
approach to investing nor one that necessarily works all the time.

With over twenty years of personal investing and

managing investment trusts, I have had the opportunity to
experience a number of different market environments. They
range from the 1972-1974 market downturn, when the Dow
dropped 39.6%, to the 1982-2000 technology driven bull market,
the 1987 crash, the 1994-1995 downturn, the 2000-2002
technology crash, the 2003 recovery, and now the 2004-2005
seemingly directionless market.

I have learned from my mistakes, such as buying U.S.

bond funds in the late 1970’s when interest rates were rising,
buying gold at its peak in 1980, buying potential acquisition
candidates in the late 1980’s, chasing the technology boom to its
peak in March 2000, and trying some market timing approaches.
My learning has often been painful, but they say that is how we
really learn.

This accumulated investment experience, as well as the

knowledge gained by studying many investment experts has
lead to the development of Common Sense Investing.

Common Sense Investing consists of a set of principles,

which define how I will invest. It also requires an understanding
of the current global environment to help define which markets I
will invest in. The investment principles, together with the
current investment environment, results in an investment
strategy. The strategy defines what specific investment I will

Since the global investment environment changes over

time, which changes market opportunities, I review investments

twice per year and make adjustments as conditions change. I
change my investments as necessary to take advantage of the
changes and avoid losses.

In order to be an effective investor under a variety of

different market conditions, every investor needs to develop an
approach to investing based on the following:

Develop a set of investment principles that fit who

you are as a person and as an investor. Both your
personality and your investment principles need to be
compatible so you can be comfortable with your
investment decisions and sleep at night.

Follow your own principles or adopt someone else’s

that are consistent with who you are, and don’t waver
from them. As an example, if you are a conservative
person, you should not have a principle that says that
you will invest in high-risk investments.

Gain an understanding of the current global

environment in which you are investing. Look at what
is going on both in the U.S. and around the world and
how it affects the long-term outlook for specific types
of investments.

Some of the environmental factors to consider include,

demographic trends, the state of the U.S. economy,
current budget status, interest rate trends, valuation of
the U.S. dollar against other currencies and direction,
inflation rates, consumer spending, consumer debt,
and balance of trade.

Knowing these factors helps define what markets to

invest in and which ones to avoid. It is important to
separate long-term trends from short-term conditions,
as it is the long-term trends that are most important in
making investment decisions.

Using this assessment of the global environment and

understanding how it affects various investments,
develop an investment strategy that is based on

your principles and consistent with current trends.
Strategy defines what specific investments to make.

As an example, if current interest rates are high, and

the Federal Reserve is taking action to lower them
down, to take advantage of this trend, a U.S. bond
mutual fund would be an appropriate investment. This
assumes that one of your investment principles is to
invest through managed no-load mutual funds. Always
make your investment choices based on your
investment principles and within the current investment

Review your investments twice during each year.

The reviews should include a look at how each
investment has performed since the last review and
your assumptions about the current environment.

If the reasons you made the investment are still true,

then even if the investment has not performed as you
had expected, continue to hold it. If the environment
has changed, then it may be time to sell the
investment and purchase one that is consistent with
the current environment.

Not doing reviews twice per year can put your portfolio
at risk of potential loss as the environment may have
changed and your current investments may not be
appropriate for the new environment.

There are appropriate investment strategies for every

environment. Buying high-growth technology stocks may have
been an appropriate strategy during the late 1990’s, but perhaps
not an appropriate one for 2001or 2002.

Buying long-term U.S. bond funds is a good investment

strategy when interest rates are declining, but not appropriate in
a rising interest rate environment.

There is a right season for most investment strategies.

Since we have no ability to change the investment environment,
our challenge is to understand what it is and invest accordingly.

Common Sense Investing consists of my personal
investment principles, and a current investment strategy based
on my assessment of the investment environment and trends
that I see. The principles will not change for me, but my
investment strategy will, based on my periodic review and
update of the investment environment. As the world changes,
the specific investments that work best also change.

Before I present my investment principles, let me give a

little background on myself, which will help in understanding

I came from a midwestern family of nine where we all

worked as soon as we could get a job to help support the family.
We learned early in life the value of money and the importance
of saving.

I had the opportunity to get both an engineering and a

business education. I have always had an interest in
mathematics and how things worked, both mechanical and
electrical as well as complex systems. I was also fascinated by
how businesses worked.

During much of my career I worked in manufacturing

companies in a variety of different industries and a number of
management positions. This taught me the importance of costs,
cost reductions, competition, business growth, strategy and
profitability. I have had a lifetime passion for economics, world
events, investments and learning in general. My hobbies include
reading fiction and non-fiction, writing, running, tennis, cycling,
traveling, and motorcycles.

As shown by my investment principles, I am frugal, and

always try to get the best value for each dollar. I am quite
conservative when it comes to taking investment risks. My
principles are a good example of a set of principles for investing
based on personal values. I have no trouble sleeping at night
with my investment decisions.

My overriding principle in investing is to protect assets from

major loss. This is not always possible when there is an abrupt
and unexpected change in the investment climate that causes

the market to drop suddenly. Then the goal is to minimize losses
and move on to the next investment opportunity.

Common Sense Investment Principles

1. Invest With Good Fund Managers

Invest in mutual funds rather than individual stocks

to gain access to professional stock pickers and
reduce the risk of owning a few individual stocks.

2. Always Focus on Value

Never pay more for an investment than you should.

Value never goes out of fashion. Value provides a
margin of safety when markets turn down as well as
an opportunity for additional returns when markets
boom. Even good growth stocks go on sale.

3. Steady Results

As in baseball, always swinging for home runs can

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

4. Don’t Sit on the Sidelines

You must be in the market to win, not on the

sidelines. In any market whether up, down or
sideways, there are opportunities for positive
returns. Market timing is a loser’s game. Being fully
invested in the right investment at the right time is a
key to successful investing.

5. Patience

Good sound investing is boring as there is not a lot

of activity. Trading is not investing. Investing well
requires research, good judgment and then a lot of

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

6. Markets are not Rational

Today’s price of a specific stock may have little to do

with reason, logic or value. Ben Graham, the father
of value investing, described it best. ”Mr. Market, in
the short term, is a voting machine not a weighing

The price of a stock on a given day has more to do

with popularity than with worth.

Don’t spend a lot of time trying to figure out why the

market is where it is and where it might go next. The
markets are not rational and therefore cannot be

7. Think Beyond Traditional Stocks and Bonds

U.S. stocks and bonds are not the only investment

options available nor are they always the best.
Consider foreign stocks and bonds, precious metals,
natural resources, energy, real estate, and

Since all markets move in cycles and not all

together, all investment options need to be
considered in an investment strategy, as there is a
season for every investment.

8. Be Where Markets Are

A buy and hold investment strategy does not provide

the best long-term results, as markets shift over
time. Moving investments to where opportunities are
is necessary to gain the best results.

Traditional asset allocation models for investing do

not maximize the advantage of major shifts in

9. Don’t Follow the Crowd

It has been demonstrated through research that the

consensus of the majority is generally wrong. Doing
the opposite has a better track record. Do your
homework and then follow your convictions, not the

10. Have a Plan and Stick to It

Good investing takes a plan and discipline. A set of

principles, an investment strategy and the discipline
to follow them separates the winners from the losers.
Develop a plan and stick with it. Don’t be swayed.

Having independent outside guidance helps to keep you

on track and assures that your principles are sound and your
strategy is consistent with the current environment.

The next chapters will explain each of these principles in

more detail.

Chapter 1

Invest with Good Fund Managers

There are a number of different ways to invest in the market.

The more common include individual stocks and bonds,
managed mutual funds, index funds, and exchange-traded

Exchange traded funds or ETF’s are similar to index

funds but are traded directly on the major stock exchanges. They
have become popular in the past several years, and both the
number and variety offered have increased. Additional
information on ETF’s can be obtained at,, or

By investing in individual stocks, I learned that it required

both knowledge and time. Knowledge of industries and
companies is required to find good stocks. Time is required for
research, to follow daily price changes, and determine the right
time to buy and to sell. I often bought and sold at the wrong
times and wanted to hold on to my favorite stocks.

Many individual investors have not done well with

investing in individual stocks as they did not have the time nor
did they develop effective buying and selling criteria. Many
ended up with a buy and hold strategy that may have worked
well in the 1990’s when almost every stock went up, but has not
worked since the market downturn in 2000.

Managed mutual funds offer the professional

management necessary to be successful.

One of the advantages of managed mutual funds over

index funds or ETF’s is that they have the flexibility to change
investments, as detailed in the fund’s investment prospectus.

An index fund or an ETF must always be 100% invested

in stocks and must continue to buy as new money comes into
the fund. Index funds or ETF’s only sell when investors want to
redeem shares, which might not be the best time to sell. They
must also buy an equal proportion of all stocks represented by
the specific index that they are mirroring.
Managed mutual fund managers decide what to buy,
when to buy, and when to sell. Fees are higher for managed
mutual funds compared to index funds or ETF’s, but it is worth
paying for a good investment manager.

Buying individual stocks can also be an effective method

for investing if one has the time and technical background
required to analyze stocks, and the discipline for buying and
selling. Individual stock investing limits investments to primarily
U.S. stocks. It is difficult and expensive for individual investors
to buy most foreign stocks. There are a number of newsletters
and services available that recommend individual stocks for
those who are interested in taking this route.

The rapid growth of the mutual fund industry in the

1990’s brought some opportunists that may not have had the
interests of their investors as their first priority. Some old
fashioned self-serving greed crept into the industry during this

Thanks to the efforts of New York Attorney General,

Elliot Spitzer, the Securities and Exchange Commission, and
other regulatory and law enforcement agencies, some of these
mutual fund firms and fund managers have been dealt with.

A number of these firms have been fined and forced to

make restitution to shareholders. Several fund managers and
executives have been barred from the industry. Further
regulation and oversight of the industry is being put in place to
prevent these problems from reoccurring. The mutual fund
industry is now much healthier and more focused on shareholder

During the 1990’s, with the rapid growth in the number of

mutual funds there was also a lack of experienced investment
managers. When the technology bubble burst in March of 2000,
many fund managers did not know how to react. Some thought
the drop was temporary and that stocks would recover quickly so
they held on to their positions longer than perhaps they should
have. This period, however, did produce some good fund

I have found a number of mutual fund managers who
share my investment principles, and have long track records of
consistent performance under a variety of different market
environments. They also have their shareholder’s interest as
their number one priority.

Some of the fund managers that I trust with my money


Stock Fund Managers

Mason Hawkins and Stanley Cates who have been

managing at Longleaf Partners Mutual Funds for
many years.

Bill Nygren of the Oakmark Funds family.

Chuck Royce founder of the Royce Funds over

twenty-five years ago.

James Gipson who has managed the Clipper Fund

since 1980.

John Montgomery, president of Bridgeway Funds.

John Rodgers, manager of Ariel Funds.

Harry Hagey who manages Dodge & Cox Funds,

which was founded in 1930.

Richard Aster, Jr. manager at Meridian Funds.

Ron Muhlenkamp who has managed his Muhlenkamp

Fund since 1988.

Marty Whitman who founded Third Avenue Mutual

Funds over twenty- five years ago.

Wally Weitz who has managed the Weitz Funds since

their founding in the 1980’s.

Christopher Brown and John Spears who have been
managing funds for Tweedy Browne, one of the
oldest and most successful mutual fund firms,
established in 1920.

John Buckingham, who was an understudy of Al Frank

for a number of years, and now manages the Al Frank

Bond Fund Managers

Bill Gross, who is the one of the world’s most

respected experts on bonds, directs the management
of many of the bond funds offered by PIMCO.

Dan Fuss of Loomis & Sayles manages a number of

their bond funds.

None of the mutual funds or fund families mentioned

above charges a sales load or sales fee.. I believe in putting all
my money to work without having to pay a sales commission. I
have found very few mutual funds, which both charge a sales fee
and out perform the best no-load mutual funds over long periods
of time.

I have had the opportunity to meet with some of the

above fund managers and have invested with all of them. What
separates them from the thousands of others are:

1. They have investment experience in a variety of

different market cycles and understand various
market forces.

2. They are long-term investors and are not

reactive to temporary market fluctuations.

3. They are patience in both their buying and

selling. They have a strong bias towards value,
and research companies before they buy.

4. They have most of their personal wealth

invested in their own funds.

5. They are disciplined and have a set of
investment principles, which they follow under all
market conditions.

None of these fund managers or fund families has the

best performing fund each year. They have, over long periods of
time, delivered consistently higher returns than their peers and
often with less risk.

My list of good mutual fund managers is not all-inclusive;

there are others that are in the same league. As an investor it is
important to understand who your mutual fund manager is, what
his experience is in both good and bad markets, what decision
making process he uses to buy and to sell stocks or bonds, and
what his long-term performance record is compared to others in
the same category. Most importantly, where does he invest his
own money?

Investing with the best fund managers increases your

odds of protecting your assets during market downturns and
getting consistent long-term results. Before buying any mutual
fund, do your due diligence to fully understand who you are
investing your money with and how they invest it.

Chapter 2

Always Focus on Value

Stocks seem to be the only thing that we buy without

much regard for their value. This was taken to an extreme during
the 1990’s technology stock boom. We were willing to pay very
high prices for shares of stock in companies that had never
earned a profit, and had no near term prospects of profitability.
During this period, many companies focused on how much cash
they could spend.

Everything else that we buy, from food and clothing to

cars and houses, we shop around to make sure we are getting
the best possible value.

In our professional business dealings we look for the

best sources of supply, and negotiate for the best prices on
everything from office supplies and airline tickets to raw
materials and equipment. We are not hesitant to change
suppliers for a few percent in savings.

The reason we often ignore the price of an individual

stock in relation to its value, is rooted in human nature and the
psychology of investing. We experienced this in 1999, when the
NASDAQ gained 85.6%, driven by many of the dot-COM startup

During this boom there was a lot of momentum that was

driving up stock prices. We did not want to miss out on the
action. If we could buy a stock today for $15 a share and
tomorrow someone was willing to pay $16, we bought it now.
This worked until there were no new buyers who were willing to
pay more. Those who bought early wanted to sell, and the
prices came tumbling down. Over the next two years, the
NASDAQ lost 67.2% of its value.

This type of momentum investing is similar to a chain

letter. It works as long as the next person is willing to pay more
than you did for the stock. When the chain is broken, panic often
sets in, there are more sellers than buyers, and the stock price
can go into free-fall, taking your paper profits with it.
In order to assure that you are paying a fair price for a
stock when you buy it, you need some criteria for determining
what a fair value is.

Ben Graham, in his work on value investing, developed

a valuation method he called ‘intrinsic value’. His approach
looks at the value of all the assets that a company has on a per
share basis and compares it to the current stock price. If the
stock price was 30-40% below its’ per share net asset value,
then Ben felt the stock was selling at a bargain price. If other
factors were positive for the company, the stock was purchased.

Graham felt that if stocks could be purchased for less

than their ‘intrinsic’ or net asset value, then that discount would
provide a margin of safety in the event the stock market went
down or if the company did not perform as anticipated.

Since Ben Graham’s work, others have refined and

expanded his evaluation criteria. Additional valuation criteria
used today include; price earnings ratio, price-to-sales ratio,
price-to-book value, and price-to-growth rate.

In value investing when a stock reaches full valuation it

is generally sold. This selling strategy can avoid holding
overvalued stocks that could suddenly drop significantly in price.

Unless you are an excellent stock trader and can predict

when a high-flying overpriced stock is about to turn down, value
investing is a safer alternative. Value investing has historically
out performed growth investing as defined by paying a premium
for stocks that are experiencing greater than market rates of

Jeremy Siegel in his book Stocks for the Long Run sites
one analysis that compared returns of large cap growth stocks to
value stocks for the period from July 1963 to December 1996.
Over this period the value stocks gained a compound annual
return of 13.1%, and the growth stocks gained a compound
annual return of 10.3%.

James O’Shaughnessy, in What Works on Wall Street,

presents the results of a number of studies, which showed that

stocks purchased at low valuations relative to the general market
have outperformed both higher valued stocks and the general

For the period of December 31, 1951 through December

31, 1994 all stocks had an annual compound return of 12.81%
and the top 50 P/E ratio stocks returned 8.87%. In another study
during the same period, the 50 stocks each year with the lowest
price-to-book valuation returned 14.66% compound annual
return compared to 12.81% for all stocks. That means that
$10,000 invested in the general stock market at the end of 1951
would be worth $1,782,174. $10,000 invested in the lowest
price-to-book stocks for each year would be worth $3,591,446 at
the end of 1994. Quite a difference.

Buying stocks with low valuations does not result in the

best returns every year, as in 1998 when large cap growth stocks
returned 42.15% and large cap value stocks returned 14.68%.
Over the long run value stocks have produced higher returns
than the stock market in general, and than higher priced stocks.

Past returns are not necessarily an indication of future

returns, but when given a choice, I will always pay less rather
than more and look for good quality companies selling
temporarily at bargain prices.

Value managers, in their stock selection criteria and

discipline, do not over pay. During the second half of 2004,
when there were few bargain stocks, value stock fund managers
held onto cash and waited for stock prices to become

Chapter 3

Steady Results

Growing up in Illinois I played a lot of baseball. It was

always exciting to swing for the fences and pop one over for a
home run. However it did not happen very often and my
attempts resulted in a lot of strikeouts. I was not a Babe Ruth,
Hank Aaron or Barry Bonds who can hit home runs and maintain
high batting averages.

In investing, swinging for the fences is like hunting for

the next Microsoft, Dell Computer, or Harley Davidson. Investing
in an IPO or buying that dot-COM company that should double in
six months are also examples. It’s exciting when you get the
home run, but there are many more strikeouts.

In the mid 1980’s mergers and acquisitions were

popular. I researched to find smaller companies that might be
acquired and potentially gain 30-50% in price quickly.

I learned it was difficult to find potential acquisition

candidates and buy them before the pending acquisition became
common knowledge. Sometimes even when acquisitions were
announced, they were not completed due to regulatory or other
issues. The idea sounded good and some investors did make
money buying acquisition candidates, but they seemed to have
information that was not available to me until the stock price was
already high.

Another example of swinging for the fences is buying the

best performing mutual funds each year.

Many of the best performing funds each year are sector

funds, some of which are leveraged to give returns that are
higher than market returns.

In the technology stock boom of the late 1990’s, there

were a number of technology mutual funds that had over 100%
returns in a year. But like all things that go up rapidly, they can
also come down rapidly. Many of these funds in the following
years were amongst the worst performing. This has been
repeated in recent years with energy funds, biotech funds,
emerging market funds, China funds and others.

When an investment idea becomes popular, prices

become overvalued and it is time to consider alternatives as you
are most likely too late to take advantage of further gains, and
the risk of loss increases.

It is human nature to want instant results in everything

we do and no different with investing. We would like 20% plus
returns every year as we experienced during the 1990’s. That
period was unusual and only occurred one other time in the last
century, which was in the early 1920’s before the 1929 stock
market crash.

During both the 1920’s and the 1990’s, stocks increased

in value not because of great increases in company profits, but
because investors were willing to pay more than the stocks were
worth. P/E ratios expanded greatly.

The demand for stocks was increasing at a rate greater

than the supply and therefore, prices kept rising. Then one day
buyers decided they were paying too much and it was time to
sell. Unfortunately they all wanted to sell at the same time, and
there were not enough buyers willing to pay the price. What
often appears to be an instant result is a high-risk game that
goes on as long as there are more buyers willing to pay more.
When the buying stops our paper gains turn into real losses.
Steady results seem to be a better long-term investing

A steady performing mutual fund that I have owned for a

number of years is the Ariel Fund, a small cap value fund. As
reported in their June 30, 2004 quarterly report, 1-year
annualized returns were +28.90%; 3-year +12.90%; 5-year
+13.09% and 10-year +15.44%. During these same periods, the
S & P 500 Index annualized returns were 1-year +19.11%; 3-
year -0.69%; 5-year -2.21%; and 10-year +11.69%.

The Ariel Fund has never won the prize for being the
best performing mutual fund in any given year, but has delivered
steady results year after year. Their company slogan is ‘Slow
and Steady Wins the Race’. Past performance is not an

indication of future results, but it helps us understand how
various approaches to investing have performed over time.

One of the characteristics of a slow and steady mutual

fund manager is their analysis of a company’s stock before they
purchase it. Before they buy they make sure that the company
has strong financials, good management, good products and
market position, and is not overpriced relative to its future
earnings potential.

Research is necessary as the steady performing mutual

fund managers buy stocks in companies with the intent to hold
them for long periods of time. Holding periods are years not
weeks or months.

If a mutual fund has turnover of more than 50%, that

manager is more likely to be chasing stocks that are moving up
rather than investing in good companies for the long term.

My number one principle in investing is to preserve

assets so there is something to grow. I no longer swing for the
fences or try to catch that occasional stock or mutual fund that
may return 50 or 100% in a year. I have watched a few go by
and have often been tempted. I focus on steady returns over
longer periods of time.

It is not as exciting to win a baseball game with singles,

doubles and an occasional stolen base compared to a grand
slam home run in the ninth inning, but the win still counts and
more games are won that way. This is the same in investing.
“Slow and steady wins the race”.

Chapter 4

Don’t Sit on the Sidelines

The subject of market timing has interested both

professional investors and academics. Many research studies
have been conducted and computer-based models developed to
help predict the future direction of the market.

The question that market timing attempts to answer is

when to be in the market to take advantage of the periods of
maximum gains, and when to be out of the market to avoid
periods of major losses? If answer to these questions could be
found with a high degree of consistency, then overall gains could
be significantly improved.

If we could have avoided being in the market on Monday

October 19, 1987 we would have missed the 508-point or 22.6%
drop. If we were out of the market during the 1973-1974
downturn we would have avoided losses of 55.1%. If we had
sold our technology stocks before March 2000 we would have
avoided losses of 47%. If we had been out of the market during
the 1990 sell-of and reinvested in 1991, we would have avoided
the 1990 decline of 13.8% and gained 39.8% in 1991.

These are some examples of why market timing has

attracted the interest of so many. The history of market returns
over long periods of time shows the market does not move in a
straight line, but in cycles and spurts. If we could catch the right
waves and avoid the storms, we could have better returns.

A study quoted by Charles Ellis in his book Winning the

Losers Game, presents the risk of getting the timing wrong. This
study by Cambridge Associates points out that both major gains
and losses in the market occur in very short periods of time, in
many cases a day, such as occurred on October 19, 1987 when
the market dropped 508 points.

This study by Cambridge Associates reviewed the stock

market’s daily movements from 1982 through 1997. The study
found that if you were out of the market for the ten best days
during that sixteen-year period, the annualized return for the
entire period would be 16.1%, compared to 19.6% if you stayed
invested everyday for the entire period. If you were out of the
market for the twenty best days, the annualized return would
have fallen to 13.9%, and out for the best thirty days, the return
would have fallen to 11.9%.

Looking at a longer period of time, Ellis points out that

during the period from 1926 to 1996, including the 1929 market
crash, almost all the market returns for that seventy year period
occurred in only sixty of the months or seven percent of the time.

Missing just a few of the short upward movements in the

market would significantly reduce your returns. Based on this
and other historical studies, it appears as if the risks of not being
in the market outweigh the risks of trying to time when to be in
and when to be out. Once you have missed a rising market
opportunity, it is gone.

There are a number of professional investors who

practice various forms of market timing, and I do follow several
market timers to get their perspective on the overall dynamics of
the market.

There are a number of technical analysts who have

developed market indicators to help them assess the general
trend and direction of the market. Most are based on looking at
historical data and then developing models that have some
correlation with historical market movements. They use this data
to forecast how the market should move. If we believe that
history repeats itself in predictable ways, then some of the
market timing models may be beneficial. Not many, if any, have
stood the forward test of time.

One of the current writings on market timing is a 2003

book by Ben Stein and Phil DeMuth titled Yes, You Can Time the
Market! In this book the authors look at stock market returns for
the one hundred years from 1902 through 2001 in relationship to
several valuation criteria.

One of their conclusions is that when the market is

overvalued relative to its most recent fifteen-year valuation trend,
future returns over the next five-year period tend to be negative
most of the time.

Following their valuation market timing criteria, you
would have been out of the market for the entire period
beginning in 1986, through the greatest market boom in our
lifetime. You would also, however, have avoided the 2000 bubble
bursting losses. Their fundamental thesis is to buy into the
market when prices are low relative to historical levels and to be
out of the market during periods when valuations are high. We
have seen in the 1990’s that stocks can remain overpriced for
long periods of time and yet the market continues to go up. If
we were out of the market for only valuation reasons, we may
miss large market increases.

As with all market timing models, we will not know

whether or not they improve overall investment returns until
many years from now, after we have experienced a number of
market cycles. By then it is a bit late if in fact the market-timing
model was wrong.

I have found that in both up, down and sideways

markets; there are always some sectors that perform well. As an
example, in 2004 the S & P 500 gained 8.99%, the Dow 3.5%
and the NASDAQ 8.59%. Market sectors such as natural
resources gained 28.4%, and real estate gained 28.7%. Mid-cap
Value stocks gained 12% and Small Cap Value stocks gained
21%. During the bear market of 2001 and 2002 the overall
market was down each year by double digits but small cap value
stocks were up each year by about 20%.

Since the best investment minds have not demonstrated

over long periods of time that any market timing model
consistently predicts stock market behavior, and we have only
one lifetime to invest, my choice is to be fully invested at all times
in the right market sectors.

My investment decisions will continue to be based on my

investment principles and on the investment environment. I do
not want to miss the surges in the market, which historically have
accounted for most of the long-term gains. I am not going to be
sitting on the sidelines waiting for the precise moment to play the
game and risk missing the season.

Chapter 5


Many successful investors have demonstrated with their

long-term returns that investing is not a game with a lot of daily

As a young teenager I worked for my father in his small

manufacturing business. He would always remind me that
visible activity, or what he referred to as ‘asses and elbows’, was
a sign that you were being productive. If there was not a lot of
activity then you were not productive. Thinking and planning did
not count as productive activity in his world.

That may be true in a production business, but it has not

been proven to be true in the investment business. Investment
results are not necessarily a function of the number of stocks
that are bought and sold in a given year, but rather buying the
right stocks at the right price and selling them when they reach
their full market value.

A lot of trading activity may be a sign of poor stock

selection, as the value of a stock normally does not change
significantly in short periods of time. The more trading activity,
the higher the transaction costs, which also lowers returns.
Frequent trading activity is appropriate if you are a stock trader,
momentum investor or dealing in commodities, but not
appropriate if you are a long-term investor.

In today’s fast-paced, instant results and information

overload world, it is easy to understand why it is difficult to have
patience with investing. There is excitement in buying and
selling stocks and watching them go up and down on a daily
basis. There is not a lot of excitement in spending time
analyzing the financial performance of a company, meeting with
it’s management, talking to their suppliers, customers and
competitors to determine if their stock is a good long-term
investment. This takes time and patience.

It is also not very exciting to buy a good stock that has

been recently discounted by Wall Street and waiting several
years until it reaches its full market value. This is what good
long-term investors do. The portfolio turnover of many of the
best long-term performing mutual funds ranges from 20-25% per
year. This means that their average holding period for a stock is
four to five years. The average portfolio turnover of all mutual
funds ranges from 50-80% and in some cases is 100% per year.

Patient investing does pay off. The Longleaf Partners

Fund, a mid-cap value fund, is a good example. They reported
in their June 30, 2004 semi-annual report that they were having
difficulty finding any stocks that were selling at low valuations.
For the first six months of the year their total activity was to add
no new holdings and sell two stocks that had reached full market
value. The fund’s performance for the past twelve months was
20.33%, for the past five years 7.38%, and for the past ten years
14.65%. The S & P 500 lost 2.2% per year during the same five-
year period.

The Oakmark Select fund, managed by Bill Nygren and

Henry Berghoef, reported in the September 30, 2004 Annual
Report, that no new stock positions were added and no holdings
were eliminated during the past quarter. They reported a
13.64% return for the past year, 14.29% for the past 5 years and
20.21% per year since the fund was started in November 1996. I
like the returns from boring patient investing.

Peter Lynch reported in his book Beating the Street, that

during the last market boom individual investors, on average,
gained one third or less of the market returns due to excess
trading. Many sold their good performing mutual funds or stocks
when they suffered a temporary downturn and bought others as
they hit their peaks and then headed down.

A further example of the importance of patience is shown

in a study published in 1992 by Tweedy, Browne Company, LL.C.
The firm has managed individual investments and mutual funds
since 1920. In their work titled What Has Worked in Investing:
Studies of Investment Approaches and Characteristics
Associated with Exceptional Returns, they use the returns of
individual stocks from 1968 through 1990 to compare relative
performance for different holding periods.

One example they site is the market drop of 27.9% in
1974. If you had held a group of low price-to-book value stocks,
the return after one year would have been 5.0% better than the
market, after 3 years 62.2% better, and after 5 years 172.6%
better. This is pretty strong evidence that doing the proper
research on companies before buying, buying at the right price,
and holding for a long period of time is an effective strategy for
achieving superior market returns. It’s boring but effective.

Being a patient investor takes discipline and courage to

stay the course, particularly during temporary storms, day-to-day
market movements, and the barrage of news.

If thorough research is done before buying a stock,

fluctuations in the market should be ignored, as they occur
everyday and for a variety of different reasons, most of the time
unrelated to the underlying value of the stock.

Stocks should be sold when they reach full market value

or if the fundamentals of the company change in a way that
reduces their long-term potential.

Patient investing is boring but historically has gotten

more consistent results in the long run when compared to many
other investing approaches.

Chapter 6

Markets Are Not Rational

Every day the major market indexes such as the Dow

Jones Industrial Average, the S & P 500 or the NASDAQ go up
or down as a reflection of how investors feel about stocks. If
investors are positive, they are buying, and the averages go up.
If they are negative, they are selling and the averages go down.

The daily buying and selling of stocks does not appear to

be a rational process but rather one based more on the emotions
of fear and greed. If investors fear that stocks may go down,
they sell. If they see opportunities for the market to go up they
buy, as they do not want to miss out. To demonstrate how this
works let’s look at a few typical days in the market.

On Monday December 6, 2004 the Dow Jones Industrial

Average went down by 45.15 points or 0.43%.

After the markets closed on Monday it was reported in

the financial press that the market on Tuesday, December 8,
2004 should go higher as reports that oil prices continued to
decline, productivity in the U.S. was higher than expected, and
holiday shopping looked stronger than anticipated.

What actually happened on Tuesday was that the Dow

dropped 106.5 points for a loss of 1.01%. It was interesting to
read one of the technical market analysts on Wednesday
morning explain why the market declined on Tuesday. He
reported that the weak jobs report released the prior week now
had traders questioning just how strong the economy was and
they therefore had difficulty pushing stocks higher on Tuesday.

Overnight we went from a view that stocks were worth

more and the market should go up, to the view that perhaps they
were overpriced. This pattern is repeated each day in the stock
market where in excess of one billion shares of stock are traded
daily on just the New York Stock Exchange.

This process does not seem to me to be very rational. It

does not appear that investors are looking at the valuation of
each company’s stock price based on the fundamentals of the
company before they buy or sell. Perhaps that is why buying
and selling of stocks on a daily basis is referred to as trading
rather than investing.

One of the classic examples of irrationality in the stock

market is Monday, October 27, 1987. On that one day the Dow
dropped 508 points or 22.7%. What happened that day to make
the value of the thirty biggest and best companies in the U.S
worth billions of dollars less than they were just twenty-four
hours earlier?

It was fear, which led to panic selling. Fear that some of

the domestic and global issues that we were facing at the time
might lead to a major slow down in the economy. There was no
logical reason or fundamental factors that changed the value of
these companies in one day. They were doing what they were
doing the day before when they were valued on average 22.7%

As we experience the daily ups and downs of the

market, the financial press and market analysts report reasons
for the changes. When the market goes up, the headlines in the
Wall Street Journal might read ‘strong jobs report fuels market’
or ‘better than expected profit report from Intel pushes market up’
or ‘market analysts upgrade of G.E. spurs market rally’. When
the market goes down, the headlines might read ‘inflation fears
spooks market’ or ‘factory utilization for March drops by 1%
causing concerns on Wall Street’; or ‘terrorists attack in Spain
sparks sell off’. There are always reasons presented by the
market experts that try to explain why the market acted the way it
did. Many times they sound very convincing.

The reality is that each day the market reacts to what is

perceived either as good or bad for stock investing.

Ben Graham expressed it best when he said that ‘Mr.

Market’, the stock market, in the short term is a voting machine
and not a weighing machine. He meant that everyday, investors,
traders and professional money managers, decide by their
buying and selling of stocks, which ones are the most popular.
The most popular, or hottest stocks are the ones that are being
bought and therefore their price goes up. The stocks that are not

very popular are being sold and therefore go down in price. In
the short term stocks are often valued based on popularity.

For example, on December 6, 2004 a share of

Caterpillar stock dropped in value by $0.35, from $90.92 per
share to $90.57 per share. This represented a reduction in value
of 0.4%. When multiplied by the total number of shares
outstanding, Caterpillar’s value dropped by millions of dollars in
one day.

What happened within the Caterpillar organization in

less than twenty-four hours to cause it loose millions of dollars in
market value? The answer is most likely nothing. The company
most likely ran on Monday December 7, 2004, as it had the
previous day. They got orders, produced and shipped products
and made money just like they had been doing when their
company was valued at $90.92 per share the day before.

On Tuesday, December 7, 2004 Caterpillar stock closed

at $90.82, up $0.25 per share from Monday or 0.3%. It is hard to
imagine what happened in less that twenty-four hours to make
Caterpillar more valuable than the day before. Perhaps the
buyers and sellers on Monday made a mistake when they sold
shares for less and changed their minds on Tuesday. In any
event, Caterpillar went on making and selling equipment and
services around the world and making money, just like every
other day.

There are times when something does change to reduce

the value of a specific company’s stock, such as the loss of
leadership or a scandal, but this happens infrequently compared
to the daily changes in a stock’s price. That is what Ben Graham
meant when he referred to Mr. Market as a voting machine.
Every day the most popular stocks get more votes and the price
of their shares go up. The unpopular stocks get the boot and
their price goes down

Historical research has taught us that the daily price

fluctuations of stocks are primarily reactionary and driven by fear
and greed.

Because of the somewhat irrational approach to the daily

changes in stock prices, there is an opportunity for the astute

investor to gain an advantage. When a stock is selling at a price
below its intrinsic value, the market presents a good buying
opportunity. When a stock becomes priced at or above it’s fair
market value, it is a good opportunity to sell and harvest profits.
Since the market does not consistently price stocks at their true
value, the patient and analytical investor can capitalize. This
approach to buying stocks when they are undervalued and
selling when they reach full value is referred to as value

I have grown to accept that today’s price for a particular

stock or today’s level for the Dow, S & P 500, or NASDAQ may
have little to do with the value of that company or the value of the
overall market. Even though the investment professionals and
the press have reasons as to why the market did what it did, the
reality is that the psychology of the traders and institutional
investors who control most of the daily transactions in the
market, were either a bit fearful that day or a bit greedy.

When someone asks me where the Dow will be next

month or next year, I say I have no idea. If they ask me where it
might be in five or ten years, I say most likely higher. Historically,
over long periods of time, stocks have always increased in value,
but never in a straight line. Use the ups and downs along the
way to your advantage. Capitalize on the mis-pricing in the
market to buy if under priced, and sell if overpriced.

Don’t spend time trying to predict where the markets are

going to be in the short term, unless you are good at predicting
irrational behavior. Markets do not behave rationally much of the

Chapter 7

Think Beyond U.S. Stocks and Bonds

U.S. stocks and bonds are not the only investments that
are available to us today, nor are they always the best
performing. Alternatives such as foreign stocks and bonds,
commodities, energy, precious metals, natural resources and
real estate are all available through mutual funds and ETF’s, and
should be considered as part of an overall investment strategy.

The U.S. stock market has had a long-term upward trend

for the past two hundred years. There have, however, been
periods when the U.S. market has gone down or has been flat.
From 1965 to 1982 the U.S. market was flat for the entire
eighteen-year period, with some ups and downs in between.
From 1973 through 1974 the U.S. stock market was down by
27.2% in 1973 and 27.9% in 1974. In 1990 U.S. stocks sold off
and ended up down 13.8% for the year. From 2000 through 2002
when the technology bubble burst, technology stocks lost 78% of
their value.

During these flat and down market periods, there were

other markets that were up. In 1987 international stocks gained
24.63%. During the 1993-1994 U.S. market downturn,
international stocks gained 32.56% in 1993 and 7.78% in 1994.
During 2001 and 2002 when the U.S. stock market was still
suffering from the technology bubble bursting, U.S. bonds gained
8.42% in 2001 and 10.27% in 2002.

It is not always true that international stocks do well

when U.S. stocks are down, as the U.S. economy has a great
impact on other economies around the world. However in any
year there is generally a market or market sector someplace in
the world that is doing well.

In 2004, which closed with the DOW up 3.5% and the

S & P 500 up 8.99%, there were a number of international
markets that performed much better. Overall international stocks
were up 11.79%. Countries or regions that performed
exceptionally well included Brazil up 23.3%, Europe up 15.98%,
Mexico up 51.1%, Canada up 12.2%, and Australia up 22.9%.
In the twenty-one year period from 1982 through 2001,
international stocks had better returns than U.S. large cap
growth stocks in ten of the years, and were the best performing
category above all U.S. stocks and bond in five of the years.
This period included the technology boom during which large cap
growth stocks led all markets for five years.

With the development of the mutual fund industry it is

easy to invest in both sector and broad based international
stocks. There are a number of investment styles followed by
international fund managers ranging from growth to value and
from all cap to small cap and large cap. Some funds focus on
emerging markets while others focus on developed countries.
Some hedge against changes in the value of the U.S. dollar
relative to foreign currencies, others are unhedged.

When investing in foreign stock funds it is important to

understand the fund manager’s investment approach as well as
the unique risks associated with international investing, such as
currency and political risks. Today, with the declining value of the
U.S. dollar relative to other currencies, unhedged international
funds provide the investor the additional gains from the currency
appreciation. If the dollar begins to strengthen then this
becomes a disadvantage.

Some of the no-load international mutual funds that I

have used include Artisan International Fund, Oakmark Global
Fund, Third Avenue Value International Fund, Polaris Global
Value Fund, Tweedy Browne Global Value Fund, and Dodge and
Cox International Fund. Since my approach to investing has a
bent towards value, most of these funds have a value approach
to investing. There are a number of other good international
funds as well.

Foreign stocks are also available through index mutual

funds and ETF’s. Both invest in a basket of international stocks
that represent various international stock indexes. There is quite
a variety available. Some represent all foreign stocks, others
represent geographical regions such as Europe, and still others
represent specific investment styles such as small cap value.

Another international opportunity that is often overlooked by U.S.
investors is the international bond market. As we have become
a more global economy and as many counties have developed
more stable currencies and financial institutions, this has
become a viable investment option.

Interest rates and currency values change over time

based on the economic conditions of a particular country or
region. Normally interest rates in developing countries such as
China, India or South Korea are higher than in developed
countries such as Germany, Canada or the United States.
Political risk also increases a country’s interest rates. Interest
rates in Russia or Venezuela would be higher than in the United
States due to differences in political risks.

When interest rates in the U.S. are at the bottom of a

cycle and beginning to rise, investing in foreign bonds could be a
way to gain better-fixed income investment returns. As with
investing in international stocks, there are additional risks with
foreign bond investing, such as rising interest rates, political risk,
foreign currency risk as well as higher investment costs. These
additional risks need to be considered before making foreign
investments. Buying a mutual fund whose management has
experience and presence in the foreign market can help
minimize risks.

Some of the no-load foreign bond funds that I have used

include Loomis & Sayles Global Bond Fund, PIMCO Emerging
International Bond Fund and American Century International
Bond Fund. There are a number of other good international bond
funds as well.

As an example of recent performance, over the past

three years Loomis & Sayles Global Bond Fund returned 52.2%,
PIMCO Emerging Market Bond Fund 78.1%, and American
Century International Bond Fund 66.9%. Past performance is
never an indication of future performance. During this same
three-year period the U.S. stock market had a negative return.

A few other areas of investment outside of traditional

U.S. stocks and bonds include commodities, energy, precious
metals, natural resources and real estate. These investment

sectors present different but unique opportunities due to long-
term world trends.

Gold has done nothing but lose value since it peaked at

over $800 an ounce in 1980. It dropped to as low as $250 an
ounce, and then over the past three years rose to the $425-$450
range. Still a long way from the $800 an ounce I paid in 1981. A
buy and hold gold investor has lost a lot of purchasing power
since 1980.

What has been driving gold up recently has been fear.

Fear of terrorist’s activity and political instability around the
world. Fear of a worldwide recession. Fear of the high budget
and trade deficits in the U.S. Fear of the impact of the declining
value of the U.S. dollar. Fear of inflation.

Very little of the rise in the price of gold in the past few
years has been due to an increase in the demand for gold. Some
foreign central banks have taken the opportunity of gold’s rising
price and have sold some of their holdings.

As long as the high level of uncertainty exists in the

world around economic and political stability, the price of gold will
continue to rise.

When the uncertainties are resolved in positive ways,

the price of gold will revert to more historical values. If they are
resolved in negative ways, such as a recession, then gold may
continue its upward trend until the economy recovers. Gold is a
short-term investment opportunity but brings with it a lot of risk
and needs to be followed very closely for changes in the world

Other precious metals such as silver and platinum are

priced more on actual demand rather than as a hedge against
political or economic stability. I would be cautious with
investments in the gold and precious metals area. Both gold and
precious metals can be purchased through no-load managed
mutual funds, index funds or ETF’s, some of which hold gold
bullion and others invest in gold or precious metal producing

Commodities, energy, and natural resources present an
interesting longer-term investment opportunity.

There is a worldwide long-term shortage of energy

including oil, natural gas, and coal. There are also shortages of
commodities such as timber, steel, and copper.

With the industrialization of China and other emerging

countries, we are more rapidly depleting our natural resources.
In 2004, China consumed 25% of the world’s cooper, 32% of the
world’s coal production, 25% of the world’s aluminum, 50% of
the world’s cement, and 40% of the world’s steel.

As many of these resources are not renewable and

others take a long time to replace, costs will continue to rise until
substitute products are found or additional capacity added. This
upward trend in prices may be interrupted by a temporary
recession. Besides China, countries like India and others are
also accelerating their rates of industrialization.

Commodities and natural resources should be

considered in an investment strategy with a full understanding of
both the opportunity as well as the risk.

Some of the no-load mutual funds that I use that

specialize in these sectors include; RS Natural Resources, U.S.
Global Resources, PIMCO Commodity Real Return, ICON
Energy, and Excelsior Energy & Natural Resources. There are
also index funds as well as ETF’s to consider.

Real estate has been one of the best performing sectors

in the U.S. for the past one, three and five years. In 2004 it was
the best performing of all sectors returning 28.7%. Many now
think since U.S. real estate has done so well over the past five
years, that a bubble has been formed and will burst within the
next several years. This is difficult to judge but real estate
investments through no-load mutual funds are also worth

When putting together your investment strategy consider

other investments besides U.S. stocks and bonds. Consider
foreign stocks and bonds, precious metals, commodities, energy,
natural resources and real estate as they at times present unique

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

Chapter 8

Be Where Markets Are

Over the past 200 years the U.S. stock market has gone
through various cycles. Some were short, such as the 1973-
1974 market downturn. Some were long such as the 1982-2000
technology market boom. Some were positive with good market
gains; others were negative with severe losses, such as the
2000-2002 technology bubble burst, where technology stocks
lost over 70% of their value.

If we stayed invested in technology stocks through the

entire downturn, it will be many years and perhaps my next
lifetime before we would regain our losses.

If we had invested in an index fund representing the Dow

and held it for the period from 1965 through 1982, we would
have had no net gain. For this entire eighteen-year period the
Dow ended at about the same level in 1982 as where it started in
1965. In terms of the purchasing power, our money would have
lost value, as the inflation rate during this period averaged 3.5%
per year.

Within each down market cycle there are opportunities to

avoid losses and make positive gains, if we understand where
that markets are and what the trend is. Often we try to either
hang on during a down cycle in the hope that the cycle will
reverse soon, or bail out of the market all together and miss

During the 2000-2002 downturn, the market suffered a

47% loss and technology stocks dropped by 78%. Some hung
on and are still trying to recover their losses. Others accepted
the reality that technology stocks had gotten extremely
overpriced. They took some losses and then looked for
investment opportunities in other markets.

We found that many small cap stocks were undervalued

relative to large cap and technology stocks, and that this
appeared to be a good area for investment during the recovery
period. In 2000 small cap value stocks gained a 22.83% return
and in 2001 they gained 14.03% when the NASDAQ lost 39.2%
and 21.0%.

During this period the Federal Reserve was reducing

interest rates to stimulate the economy. Therefore U.S. bond
funds were a good place to invest as they appreciated in value
as interest rates went down. In 2000 U.S. bond funds went up
11.6%, in 2001 they went up 8.4% and in 2002 they went up 10.3

Another example of the risk of buying and holding

through a long down cycle was the market crash of 1929. If an
investor had stayed invested through the 1929 crash, it would
have taken 65 years to recover the losses.

Based on an analysis of the history of market returns

over a long period of time, stocks are the best long-term
investment when compared to alternatives such as bonds. To
demonstrate this, Jeremy Siegel in Stocks for the Long Run
presents the historical returns of the market for the past two
hundred years.

This analysis assumes that we all have a very long time

horizon in which to stay fully invested in the market to recover
from inevitable down market periods. As history has shown,
down markets can last for a long time and be quite devastating.

The long-term returns of the market have averaged

about 10-12% per year; however there have been many years
when returns have been negative. There have also been years
when they have been in excess of 20%, such as the late 1990’s.
The range of market returns from the period of 1952 through
1994 has been -27.9%, and +55.9%.

If we had about fifty years before retirement, we could

invest in market index funds, ride out the up and down cycles,
and expect by our 70th birthday to have earned on average 10-
12% per year. The only risk is that we retire at seventy when the
market is in an up cycle and not a down cycle.

The reality is that most of us are not 30, or 40 or 50

years from needing some of our retirement funds.

We have recently experienced the greatest bull market
in our lifetimes. It is unlikely that many of us will experience
another one of similar length and magnitude.

This leaves most of us with the necessity of following the

market cycles, and structuring our investment strategy to take
advantage of them. To maximize our potential returns and avoid
major losses, we need to keep abreast of the changing global
environment and move our investments as the environment and
the markets change.

When large cap growth stocks are overpriced, don’t hold

large cap growth stocks. When small cap value stocks are under
priced, buy good small cap stocks. When interest rates are in a
period of long-term decline, consider buying U.S. bond funds.
When the world economy is growing rapidly, consider
commodities and natural resources.

Sticking with an investment for a long period of time

through down market cycles is a risky strategy when your time
horizon to recover losses is limited. It is always easier to row
with the tide than against it.

Portfolio changes should be made very thoughtfully and

based on long-term trends, not on a reaction to today’s drop in
the Dow or the S & P 500.

Most major trend changes in the economy or the world

environment occur over periods of months or years, not days or
weeks. Make sure the change represents a trend that has
developed or is developing.

As Charles Ellis puts it in Winning the Losers Game, “As

an investor you must adapt to the market. The market won’t
adapt to you.” Be where the market is, not where it was or
where you would like it to be. This approach should increase
your odds of avoiding major losses and getting positive gains.

Chapter 9

Don’t Follow the Crowd

Robert Shiller in Irrational Exuberance explains how

investors get caught up in the mass psychology of the markets
and abandon rational thinking. We are reminded of this when we
examine how investment decisions were made during the
technology boom. As Shiller points out, investor’s behavior then
was no different than in the early 1920’s before the 1929 market

As we look back at the 1990’s technology boom, it is

hard to understand why we paid over 100 times projected
earnings per share for companies that had only been in business
a year or two. It is also hard to understand why we paid ever-
increasing amounts for shares of start-up Internet companies
that had no earnings.

Many new technology and Internet companies bragged

about how fast they could spend cash. The executives of these
companies would report not on profits but on how much they
were spending on marketing and promotion. A new term ‘burn
rate’ came into being as a measure of how much cash a
company was spending. In Internet companies a measure of
business success was how many sets of eyeballs a website
could attract per day. During this time the belief was that profits
did not matter anymore. This was a new era for business, or so
we were led to believe as we followed the crowd.

Ken Fisher, an investment manager and author has a

favored expression that captures the essence of following the
crowd. He says, “When everyone knows or believes something,
it generally is not true”. This certainly turned out to be the case
during the technology boom. Many of the things that we came to
believe about technology companies and the new business era
turned out not to be true. We experienced this in March of 2000
when the bubble began to burst.

Ken demonstrates his point about common knowledge

and crowd following by reviewing the annual forecasts of
investment managers. Each year he gathers data on what
investment professionals around the country think the markets
will do in the next year.

If the majority of the investment professionals forecast

that the market will go up by 6-8%, Ken believes that there is a
likelihood that the market will either go down or go up much
higher. Ken looks either at the minority view or at what the
experts did not forecast to get the best indication of what the
market will do during the next year.

Ken’s track record in using this approach to predict how

the market will perform has been quite good. In the majority of
the years, the consensus of the professional investors has been
wrong. Yet this is what most of us follow. Following the crowd is
easy, as everyone is agreeing. Going against the crowd takes
courage and there is often little support.

Robert Shiller further explains that as mass hysteria

builds, as it did in the early 1920’s, again it the late 1950’s, and
in the 1990’s, business writers and analysts try to help us justify
our beliefs and keep the momentum going. Do you recall all of
the articles and broadcasts about the era of the 1990’s being a
new and different time?

During the 1990’s, there was a lot of talk about the

impact the baby boom generation would have on the continued
growth of the economy. This time we believed we had a new
economy and had licked the business cycle. Technology was
going to contribute to unprecedented growth in productivity; and
our declining interest rates would continue to stimulate both
personal and business spending.

We even heard that profits did not matter any more. The
technology boom and its benefits were changing forever the
economy of the U.S. Anyone that did not invest in it would lose
out. Many technology companies were forecasting growth rates
of 60, 70, and 80% to continue for many years.

During the technology boom, the number of families

investing in the stock market grew from about 40% to about
65%. There was no way we thought that any technology
investment was a bad bet. We did not want to miss out so we
dove in and drove stock prices even higher.

Reality hit in March of 2000 when the house of cards
began to fall.

During this time, most of us abandoned rational thinking

as we got caught up in the momentum of the crowd. We were
tempted by the rewards of instant gains and feared being left out.
We did not take time to analyze what was happening to the
valuations of stocks we were buying.

There were a few investment professionals who were

saying in 1998 and 1999 that the market was over priced, the
free-for-all spending could not go on forever, companies had to
make a profit if they were going to survive, and the market
always returns to historical valuations.

A few got out of the market in 1998 and 1999 only to be

severely criticized as the market continued to rise. In March of
2000 they became instant geniuses as the market began its
decline. The few lone wolves in the crowd were right as
rationality began to return to the market.

The lesson learned from this experience is to understand

what makes sense, what is rational, and what is not. Even
though the market reacts somewhat irrationally every day,
means that its valuation may have little to do with reality.

Don’t get caught up in the hysteria of the crowd. Stick

with investment fundamentals. Make your own assessment
based on your investment principles and your view of the current
economic environment.

In the long run the fundamentals of a company and the

health of the U.S. economy determine what a fair value is for a
company’s stock and for the entire market. When these values
get out of touch with reality, as they have for periods of time, they
have always returned to fair value and reality.

Chapter 10

Have a Plan and Stick to It

As we reviewed in the introduction, there are many

different ways to invest. They range from momentum investing,
such as the CANSLIM system that William O’Neil developed,
to index investing, asset allocation, value investing, hedge funds
and many others. One common characteristic of all successful
investment approaches is they have a set of rules or principles,
which define how they will invest, what they will invest in, and
under what conditions.

William O’Neil in his book 24 Essential Lessons for

Investment Success outlines the specific conditions under which
a stock should be purchased and when it should be sold. When
the system is followed, in certain market environments, good
investment returns can be achieved, as many followers of his
system have demonstrated.

Ben Graham and David Dodd, in Security Analysis,

present a method for determining the intrinsic value of a
company, which they believe is the price at which the stock
should be purchased. The fair market value then defines at what
price to sell. Their method of value investing clearly defines how
they invest, what they invest in, and under what conditions.

Proponents of traditional asset allocation have

developed models that define how an investment portfolio should
be structured so that assets are invested in all the major sectors
of the market, and rebalanced each year to maintain prescribed

Technical analysts have built computer models that track

both short-term changes in stock prices and long-term price
trends. These models are used to take advantage of small
changes in the price of a stock as well as determine when to be
invested in the market, and when to be on the sidelines.

Warren Buffet, the most successful long-term investor of

our time has a strict set of criteria, which define under what

conditions he will buy a company for his portfolio. Often he waits
years until the conditions are right.

These and other approaches have worked because the

investor also has an understanding of how markets act. They
understand that markets are influenced by both economic trends,
and irrational reactions. To effectively follow any system of
investing, a good understanding of the markets, the economics
of business, global trends, as well as the psychology of the
market are required.

The most important reason many systems of investing

have worked is that they have a defined process and set of
decision rules. They are documented and always followed. This
unemotional and disciplined following of sound investment
decision rules separates the successful investors from the rest.

The investment model for decision-making might be right

but if not followed all the time, the results will not be consistent.
If the model is flawed, then the results will also be inconsistent. I
have found approaches to investing that did not pass the test of
time as they were based on specific market conditions. When the
conditions changed, the system no longer delivered results.

Every investment system may not be effective under all

market conditions. As we have shown earlier, investing in sector
stocks such as technology may have been an effective
investment model to follow during the 1990’s. It has been a very
poor investment model so far in the 2000’s.

Changing this model to a broader sector rotation model

may be a good alternative as other market sectors such as
energy, transportation, and natural resources have been strong
in the early 2000’s. This change might broaden the model so that
it works in all markets.

The model used for making investment decisions must

be one that is good for all seasons and must pass the test of a
number of different markets cycles.

My model for investing consists of investing with good

mutual fund managers, to be fully invested at all times in the
appropriate investments based on the world economic and

political trends, to consider not only U.S. stocks and bonds but
also foreign and specialty investments, to be where the markets
are, to make my own informed investment decisions and not
follow the crowd, and to re-evaluate the market environment and
make gradual changes to my portfolio to reflect any changes in
long-term trends.

This is not the only way to invest. As I have shown, there

are many other investment approaches. What is important is to
find a defined investment process that has worked under a
variety of market conditions. Make sure that it is consistent with
your own individual values and stick with it all the time, not just
when it seems to be working.

Your individual approach to investing needs to fit who

you are or you will not stick with it. I am somewhat conservative
and could not be a momentum investor since I focus more on
paying the right price than following a stock’s price up beyond its
fair value. I also could not invest by following an event driven
hedge fund strategy, as I am not a big gambler. George Soros
and Julian Robertson have done extremely well using this
strategy. They have often taken what appeared to me as great
risks and have gotten great rewards much of the time.

Develop an investment plan and stick with it. Good

investing takes knowledge of the markets, discipline, patience
and often courage. If you do not have an investment plan, find
an independent investment advisor who has an investment
approach that you can understand and are comfortable with. He
will make sure that you stick with the plan and help prevent you
from making emotional investment decisions or following the

It may be difficult to find independent investment

advisors, as many are associated with selling a particular
investment product, which can color their view and limit your
investment options. Remember that every investment approach
must define how you will make investment decisions, what you
will invest in, and under what conditions.

Chapter 11

Issues and Outlook for U.S. Economy

As part of my investment process I review each year the

major issues and trends facing the U.S. and the world, and
access how they might affect the investment environment over
the next few years.

I believe that long-term investment returns are impacted

by major world economic and political trends. A review of the
investment environment is like looking at a long-range weather
forecast. They both help prepare us for the upcoming season.

I see a number of major issues facing the U.S. as well as

trends in the world that should be considered when making
investment decisions. I will cover some of the significant ones
that might influence investment decisions for 2005 through 2008.

Aging Population and Declining Workforce

Harry Dent, in The Next Great Bubble Boom, presents

projections for the retirement age population and the number of
entrants into the work force. In 2005 there will be 3.5 million
Americans reaching retirement age. This compares to an
average of 2.6 to 3.25 million per year for the period 1988-1995.
This increase is occurring at a time when the number of new
entrants into the work force is declining.

During the 1980’s there were 2.5 million new entrants to

the work force each year. In 2005 there will be 2.0 million. Over
the next twenty years the projections are:

Reaching Retirement Age New Work Force Entrants

(Per Year) (Per Year)

2005 3.5 million 2.0 million

2009 4.25 million 1.0 million
2015 4.5 million 750,000
2020 5.0 million 350,000

By the year 2050, 26% of the U.S. population will be
over the age of 65, compared to 16.3% in 2004.

Japan’s retirement aged population will increase from

23.9% in 2004 to 44.7% by 2040, Germany’s from 23.5% to
37.4%, and Canada’s from 17.0% to 33.3%.

In 1950 there were 16 wage earners for each social

security recipient. In 2003 that dropped to 3.3, and by 2033 it is
projected to drop to only two workers per retiree.

In the entire developed world in 2004 there were 100

workers for every 30 retirees. In 2040 it is projected to be 70. In
the U.S. by 2030 28% of the GDP will be required to support
retiree benefits, and by 2050 46%. In all of Europe the percent of
GDP spent on elderly benefits will go from 15% in 2004 to 30%
in 2040.

These demographic trends will limit the investment

opportunities in most developed countries as a higher
percentage of each country’s GDP will be required to support
elderly benefits. Fewer financial resources will be available for
business development and other investments.

Of particular concern in the U.S. is consumers generate

65-70% of GDP. If there is less for consumers to spend, then
growth opportunities will be limited. This trend could limit
potential investment opportunities in the U.S. stock market.

In developing countries the trends are the opposite. In

China, 69% of the population is under 40. In South Korea 65%,
and in Indonesia 74%. These counties will not only be growing
their work forces over the next 20-30 years, but they will also be
growing their internal markets. Developing countries could
present future investment opportunities as their economies grow
and their political and banking systems stabilize.

Growing Federal Budget Deficit

In the fourth quarter of 2004 the U.S. Congress

authorized an increase in the budget deficit of $800 billion,
increasing it to a record $8.2 trillion dollars. In 2004 the $568
billion dollar budget deficit represented 4.2% of GDP. This

means our U.S. government spent $1.9 billion more than it took
in each day.

There were a number of reasons for the deficit in 2004,

including funding the wars in Iraq and Afghanistan, fighting the
war on terror, and an earlier tax cut to stimulate the economy.

One of the current risks of a high government budget

deficit is that foreign governments and foreign investors are
financing it. In 2004 foreign individuals, foreign financial
institutions, and foreign governments held 43% of all U. S.

If foreign investors found other investments that were

more attractive, it could cause a sell-off of U.S. Treasuries,
forcing interest rates higher. This has been of particular concern
in the past few years when the U.S. dollar has been declining in
value against major world currencies.

Continuing high government budget deficits can have

harmful effects on the economy. During the 1920’s excessive
government debt from funding the First World War coupled with
excess consumer and corporate debt, contributed to the market
crash in 1929 and the recession that followed. It also led to a
devaluation of the U.S. dollar in 1933.

If we do not get our governmental financial house in

order and continue to overspend, our economy will suffer, and
we need to be aware of this in our investment decisions.

Increasing Personal Debt

The U.S. has changed from a nation of savers in the

1960’s and 1970’s to a nation of spenders in the 1980’s and
1990s, to a nation of super spenders and borrowers in the

In 1962 the personal savings rate was 8% of income. In

2004 it was 0.2%. In the 1960s total savings represented 7.5% of
GDP. Since 2000 it has been 1-2% and declining each year.

In 2004 U.S. household debt, which is the total debt of

all households, hit $9.7 trillion dollars, up 39% from 2000.

During the ten year period from 1993-2003 consumer debt grew
by 140%, while GDP grew by 70%. Since 2000 mortgage debt
increased by $2.65 trillion or 42%. Fortunately during much of
this period interest rates were decreasing to their lowest level in
50 years.

With the lack of individual savings, money is not being

reinvested in the economy to provide business growth for the
future, limiting growth potential for many U.S. companies.

As interest rates increase, as they have recently,

consumers will be forced to spend more of their income on
servicing their debt and have less income for other purchases.
During 2003 and 2004 record numbers of homeowners
refinanced with adjustable rate mortgages. Their monthly
mortgage payments will begin to increase as interest rates rise.

Overspending by the consumer can continue for a long

time, as it has already, but not indefinitely. Consumers cannot
spend all their income on debt interest. In 2004 it took 14% of
personal income just to pay debt interest. At some point
consumer debt may cause the economy to slow, and therefore
limit investment opportunities.

Growing Foreign Trade Imbalances

Not only are consumers spending more than they earn

each year, but more of what they buy comes from foreign
countries. Our appetite for low cost foreign goods is causing an
ever-increasing foreign trade deficit. In 2004 the foreign trade
deficit was about 6% of GDP. This is double what it was in 1986,
the last peak before the revaluation of the U.S. dollar.

Individual foreign investors, foreign central banks and

foreign governments are increasingly financing a higher
percentage of our total debt and our balance of trade deficit. In
2004 with China and Japan alone, our trade deficit was in excess
of $500 billion. If our current rates of consumption continue, the
balance of trade deficit could reach $825 billion by 2006.

In 2004, foreign investors held 43% of all U.S.
Treasuries, 25% of all corporate debt, and 12% of all U.S.

Balance of trade deficits and budget deficits are putting a higher

and higher percentage of total world savings in the U.S. It now
takes about 80% of the world’s total savings to finance the
balance of payments deficit. This severely limits the ability of the
U.S. to continue to increase its net imports without a
corresponding increase in exports.

In 1980 the U.S. was the largest creditor nation in the

world, with a $360 billion trade surplus. In 2004 our total foreign
account deficit was $2.7 trillion. Over the past several years U.S.
exports have remained steady at 5% of total GDP while imports
have increased to 15%. This puts increasing pressure on
interest rates in the U.S. as foreign investors seek to maximize
their investment returns. If foreign governments and investors
would decide to reduce their total investment in the U.S., this
could drive up U.S. interest rates and slow the U.S. economy.

Declining Value of the U.S. Dollar

In the past few years, as our balance of payments deficit

increased, the U.S. dollar has lost value relative to other world
currencies. From 2002 through 2004 the dollar declined by
about 30% relative to world currencies.

The last time the U.S. faced severe trade imbalances

and budget deficits was in 1984. As a result, by 1987 the U.S.
dollar had lost about 50% of its value.

As the U.S. dollar loses value against foreign currencies,

U.S. investments become less attractive to foreign countries, and
we as Americans loose much of our purchasing power when
buying foreign goods. This can lead to higher costs for imported
goods and inflation.

Until the U.S. can reduce its trade deficit, the U.S.
economy is at risk of higher interest rates, higher costs of foreign
goods, lower foreign investments, and inflation.

Increasing Cost Inflation

Since the mid 1980’s inflation in the U.S. has ranged
from 1.5-2.5% per year. 2004 brought some concerning signs
that future inflation rates might be higher.

The cost of health care continues to increase each year

at rates much greater than general inflation.

Energy costs, led by the cost of crude oil, is a long-term

threat as the world’s demand is growing and supply declining.
Demand is now accelerating by the industrialization of China.
China is now a net importer of oil, and in 2004 consumed 5% of
the world’s supply. China also consumes over one-third of the
world’s coal.

Many commodity prices also saw sharp increases in

2004, as supplies are outstripping demand. This is also being
fueled by increased worldwide industrialization.

China now consumes 25.5% of the world’s aluminum,

40% of the world’s steel, 30% of the world’s iron, 32% of the
world’s coal, and 50% of the world’s cement. As China
continues to grow at 8-10% a year, costs for major industrial
commodities will continue to rise and shortages will continue.

In 2004 the price of copper increased by 78.5%, natural

gas by 10.2%, and platinum by 38.4%.

Since the 2003 economic recovery, costs of services in

the U.S. have also begun to increase.

If the dollar continues to decrease in value, many of the

imported products that we have come to rely on in the U.S. will
also increase. Increasing interest rates will also put pressure on

These are some of the forces that are putting pressure

on rising costs. Higher inflation rates will change the investment
environment, and need to be watched over the next several

Rising Interest Rates

The current Federal Reserve policy to increase interest
rates, started in June 2004, could slow the economy as the cost
of borrowing increases for government, business, and the

The balance of trades deficit and the decline in the value

of the U.S. dollar puts pressure on the U.S. to increase interest
rates to continue to attract foreign investment.

Slowing Corporate Profit Growth

Corporate profits have grown at double-digit rates since

the third quarter of 2003. This helped to fuel the recovery in the
market in 2003 and 2004. During the second half of 2004, profit
growth began to slow and is projected to slow further during
2005. U.S. corporate profit growth will decrease from 15% in the
fourth quarter of 2004 to about 8% during the first half of 2005.

In real dollar terms, total corporate profits peaked in

1997 at $508.4 billion and were expected to be at $448.8 billion
in 2004.

The long-term trend for total corporate profits has been

down to flat since the recession of 2000. The growth in 2003
and 2004 is primarily a result of the recovery from the 2000-2002

With increasing cost pressures, rising interest rates, the

falling value of the U.S. dollar, and higher consumer debt, it is
unlikely that double-digit rates of corporate profit growth will

There has also been a decline in capital investments in

the U.S. This may reduce the rate of productivity increase we
experienced in the 1990’s, further limiting corporate profit growth.

Collectively, these factors will have a dampening effect

on the growth of U.S. profits over the next several years and
therefore, limit opportunities in the U.S. stock market.

Slowing Growth and Stagnant Economy

Since consumers drive 65-70% of the U.S. economy, if
consumers are not increasing their purchases each year, the
economy’s growth is limited. Over the next several years the
consumer may not be in a good position to fuel the economy to
exceptional growth.

Consumer debt is at an all time high, and debt service is

becoming an increasing percentage of consumer disposable
income. Interest rates are on the rise. 35% of the mortgages
are adjustable rate. As interest rates increase, monthly
mortgage payments also increase for many homeowners.

Growth in wages is still somewhat depressed. Costs of

energy, healthcare, and other necessities are increasing at rates
greater than income growth. If the value of the U.S. dollar
continues to decline, the costs of imported foreign goods could
increase significantly.

Job creation remains below levels required to both

employ new work force entrants and reduce the level of
unemployment. With the federal government deficit building, it is
unlikely that any new fiscal stimulus will be forthcoming.

These issues in aggregate suggest that the U.S.

economy will struggle to grow at any significant rate over the
next several years, thus limiting the opportunity for U.S.
companies to grow in sales and profitability.

Overvalued U.S. Stock Market

The valuation of the U.S. stock market, as measured by

the P/E ratio of all the companies in the S & P 500 at the end of
2004, was 19.8. This compares to 26.7 at the end of 2003. The
improvement during 2004 was the result of profit growth for the
year in excess of 20%, much of which occurred in the first two
quarters. During 2004 the S & P 500 increased by 9%, which
helped the P/E ratio valuation improve. During 2004 the U.S.
stock market moved towards becoming more fairly valued.

Even though the aggregate price to earnings ratio

declined in 2004, it is still at the upper end of historical ranges.
Looking at the historical data over the past 100 years, the
average P/E ratio has been 15. The upper end of the range has

been 21-22, which has only been exceeded twice, once prior to
the 1929 crash and in 2000 before the bursting of the technology
bubble. The low end of the range has been 8-11.

Historically most bull market cycles started when the market P/E
ratio was at or near the low end of the range when the
P/E ratio reaches the high end of the range it generally corrects
through several downturns, as it did in 1929 and through the
1930’s, to the low end of the range. As we are still at the high
end of the range, and the prospects for significant growth in
corporate profits is unlikely, the risk is that the market may
continue to correct to the range of more historical valuations,
over the next several years.

There may, therefore, be less opportunity for growth

stocks in the U.S. and low valuation stocks may be a bit more
difficult to find.


As we have seen from above discussion of the major

issues facing both the U.S. and the world, the overall
environment over the near terms is not one that is conducive to
high growth for U.S. stocks. Until some of these issues are
resolved in a positive way it will be difficult for most U.S.
companies to grow at rates that would support strong growth in
the U.S. stock market. It will also be difficult to find many
currently under priced stocks. Caution should, therefore, be
exercised when making investment decisions in U.S. stocks.

With the current interest rate environment in the U.S.,

and the unfavorable balance of trade, it will also be risky to
invest in U.S. bonds. Over the next several years, investment
opportunities appear to be better in both foreign markets and
alternative investments.

Chapter 12

Outlook for U.S. Stocks

There are many interrelated factors that affect the U.S.

market and what investors are willing to pay for stocks. Some
factors are rational, such as the economy and world trends, and
others are less rational such as investor sentiment. This is why it
is so difficult to predict short-term changes in the market.
Predictions can often be counter to what should happen based
on facts and trends.

On the rational side, we have identified several long-

term economic trends and issues that will impact the U.S.
economy, future corporate growth, and profits. In the long run,
as history has shown, stock values and the value of the stock
market as a whole are based on current profits, the outlook for
future profits, investment risks, and a fair valuation.

The U.S. stock market is currently overvalued. As

pointed out in the previous chapter, high growth in corporate
profits over the next several years is unlikely. Therefore, it is
doubtful that profit growth alone will reduce current high P/E
levels. Issues such as governmental, U.S. economic,
demographic, and world, will limit potential growth.

Major governmental issues include an increasing budget

deficit, the costs of the war on terror, increasing social costs,
increasing dependence on foreign energy, rising interest rates,
an increasing trade deficit, and the declining value of the U.S.

Major demographic issues include an aging population

and shrinking work force. Coupled with increasing consumer
debt, lack of savings, rising interest rates, and rising inflation,
there may be limited opportunity for continued high consumer
spending and limited resources for future business growth and

Major world issues include the rise of terrorism, the

industrialization of China and other countries, the increasing

demand for energy and other commodities, and the increasing
level of U.S. debt held by foreign countries.

Until we see positive progress on issues such as the

budget deficit, consumer spending, and the unfavorable balance
of trade, it would be difficult to argue that the U.S. economy will
grow at rates required for significant market returns.

As the daily stock market goes up and down based

somewhat on emotional reactions, we may go through periods of
optimism, which could drive the market higher in the near term.

In the long run, however, as history reminds us, the price

of stocks is based on rational fair market valuation. I therefore,
see quite a bit of risk in the U.S. stock market for the next
several years.

The most likely trend for the market is a long-term

secular bear market. It could last from eight to twelve years as
some past bear markets have, but would likely include periods of
bull market advances.

In its mild form it could be similar to 1965-1982 when the

market was flat from end to end, but had some ups and downs in

It is also likely, given the U.S. and world issues; there

could be a major market correction within the next several years.

It is unlikely that a period such as 1982-2000, with

double-digit returns, will reoccur for some time, as the market is
currently overvalued and a high growth economy is unlikely.

The major difference between today’s investment

environment and the 1990’s is there is more risk and uncertainty.
It is therefore, imperative to preserving and growing your
financial assets that you pay continued close attention to the
global environment. Be nimble and stick to your investment
principles. Be vigilant to changes in the environment.

Chapter 13

Investment Strategy

Given the current investment environment with the

issues facing both the U.S. and world, an appropriate investment
strategy should include the following:

1. In the U.S., focus on undervalued stocks as the

market is overvalued in aggregate, and growth
opportunities appear limited. Value stocks provide
a margin of safety that could minimize losses
during a down market and offer some growth
opportunity in an up market. Stock selection is
extremely important in an overvalued and slow
growth market, so pick the best mutual fund

2. Look beyond U.S. stocks and bonds for

investment opportunities. With the risk of
continuing decline in the value of the U.S. dollar
and the growth of developing economies in Asia,
Eastern Europe and other areas around the world,
both foreign stocks and bonds offer the potential
for better returns. The offsetting risk is that many
foreign economies are dependant on exports to
the U.S. and a slow down in the U.S. economy
could also affect other foreign economies.
Selection of the country and the company are
extremely important as well as keeping up to date
on the developments in each country. Use
seasoned foreign investment managers to
minimize risks.

3. Include commodities and natural resources in your

portfolio. With the industrialization of China, India
and Eastern Europe, the world’s capacity and
supply of oil, coal, natural gas, copper, timber, and
other essential commodities is less than projected
long-term demand.

In 2004 there were significant price increases in a
number of commodities, lead by energy. Until
supply catches up with demand or alternatives are
found, prices will continue their upward trend. If
the world economy slows, commodity prices will
decline but most likely only temporarily.

4. Minimize investment costs. In the next several

years’ double-digit returns are unlikely. It is
therefore important to minimize the cost of
investing. Avoid high brokerage fees, and loads
on mutual funds. Use low cost on-line brokerages.
Every dollar of cost avoided in investment fees is
another dollar invested.

5. Invest with the best fund managers within each

investment category. Now is the time to count on
the experienced mutual fund managers who have
been successful in both up and down markets,
and who have the investor’s interest above their

6. Be in the right markets at the right times to

minimize risk of loss and maximize gains. This is
not the time to buy and hold investments. To gain
consistent positive returns pay closer attention to
where the opportunities are and what areas to
avoid. As these change, change your investments.

During these times it is important to have an independent

advisor that understands the markets and can guide you to the
areas that offer the best promise. Now is not the time to entrust
your financial assets to those who represent a financial product
that may color their objectivity or limit investment options.

There is a risk, given the current environment, that there

may be a downturn in the U.S. stock market within the next
several years so asset protection and risk avoidance should be
in the forefront.

Chapter 14

Investment Opportunities

Given the environment for the U.S. stock market over

the next several years, I see investment opportunities in the
following areas:

1. U.S. small and mid-cap value stocks currently

present the best opportunities for growth in what will
likely be a sideways to down market over the next
several years.

In slow growth markets, small and mid-cap stocks

have performed better than large caps. Smaller
companies focused on specific markets can grow at
rates greater than the general economy. Large
companies tend to grow at the growth rate of the
economy. In the current market environment, it is
risky to pay high prices for stocks, as we are not in a
growth environment and need the margin of safety
as protection against downturns. A no-load small or
madcap value fund, a small or madcap value index
fund or a small or madcap ETF would be appropriate
investment vehicles.

2. Commodities and natural resources present growth

opportunities, as worldwide demand will outrun
supply for some time. The risks are volatility, as they
tend to go up and down in large moves. If the
growth of the world economy slows for a time, as it
might, there could be a sudden temporary drop in
commodity prices. They need to be watched closely.

Gold has been attractive in the past few years due to

political unrest in the world and the decline in the
value of the U.S. dollar. Gold and precious metals
are high-risk investments as they often change
course quickly and dramatically. Investments in any
of these areas can be made through no-load mutual
funds, index funds or ETF’s.

3. Real Return U.S. Bonds. With the threats of inflation
and the rising interest rate environment, the best
way to invest in U.S. bonds is through TIP’s or
Treasury Inflation Protected Bonds, which pay the
appropriate U.S. Treasury interest rate and are
indexed for inflation. They are available through a
number of no-load mutual funds or through direct
purchase from the U.S. Government.

4. Foreign Stocks. With the declining value of the U.S.

dollar relative to other currencies, and with higher
growth rates in developing countries, foreign stocks
appear to offer some opportunity for investment

Stocks of some foreign counties are selling for lower

valuations than the U.S. A value approach should
be taken in this area, as there are additional political
and currency risks. Foreign emerging market
countries such as Russia performed well in 2003
and 2004 and could provide future opportunity, but
carry additional risk. A number of no-load mutual
funds, index funds and ETF’s are available in this
investment area.

5. Foreign Bonds. With higher interest rates offered by

some countries, foreign bonds offer the potential of
higher returns than U.S. bonds. The decline of the
dollar helped returns in 2003 and 2004. Political and
currency risks need to be considered.

6. Real Estate. Over the past five years real estate has
been one of the few asset classes that has shown
consistent double-digit returns. Some experts say
that we now have a lot of overpriced real estate and
the bubble will burst, sending prices down. This
could occur with a downturn in the U.S. economy.
However, commercial real estate could still provide
an opportunity for gains. They can be invested in
through either no-load mutual funds, real estate
development company stocks, Real Estate
Investment Trusts (REITs) or ETF’s.


In this book I have shared with you an approach to

investing that I have developed over the last twenty years both
by trial and error, and by studying some of the brightest and most
successful investors.

There are many different approaches to investing. All

have a set of principles and the discipline they stick with even
when the market and outside pressures try to sway them in other
directions. There are some approaches that are more effective
in certain market environments than others. As an example,
momentum investing is more effective in rising markets, and
value investing is more effective in flat or declining markets.

My approach to investing is based on value principles

and considers major trends in the U.S. and world economies that
may impact specific investments. I invest in those markets that
offer the best current opportunities. With investment reviews
twice per year, I keep my investments current with the changing

My investment principles define how I will invest, and the

current environment defines what I will invest in and when.

We are facing some very challenging times in the new

century of the 2000’s. Consistent investment returns are going
to be more difficult to achieve than in the 1990’s. It will take a
disciplined approach as well as a continual awareness of the
outside world to win.

I have written this book for the individual investor and

encourage each of you to either develop a set of investment
principles and the discipline to follow them, or find someone that
shares your investment philosophy that can help keep you on

If there are any questions about investing that I can help

answer, contact me through our website at
We are here to help you in your journey through the treacherous
waters of investing. I hope this book has been helpful.

Recommended Reading

I would encourage you to explore different views on

investing. Some of the books that I have found insightful include:

Title Author

Beating the Street Peter Lynch

Common Sense on Mutual John Bogle


The Essential Buffet Robert G. Hagstrom

What Works on Wall Street James P. O’Shaughnessy

Irrational Exuberance Robert J. Shiller

The Next Great Bubble Boom Harry S. Dent, Jr.

Winning the Loser’s Game Charles D. Ellis

Stocks for the Long Run Jeremy J. Siegel

24 Essential Lessons for William J. O’Neil

Investment Success

Bull’s Eye Investing John Mauldin

Security Analysis Benjamin Graham and

David Dodd

Financial Reckoning Day William Bonner with

Addison Wiggin

Soros – The Life, Times & Robert Slater

Trading Secrets

Prudent Speculator Al Frank

Yes, You Can Time The Market! Ben Stein and Phil