It was a balmy Saturday evening in late spring, at the end of a three-day investment conference in the Seattle area. I was about to leave the hotel where I had just finished being on a panel with four other newsletter publishers, when one of the attendees came up to me and said: "It’s really confusing to listen to five experts when they all have such different views of the market."

His comment reminded me of how difficult it is to be an intelligent investor. When you attend a conference with more than 30 experts, you’re exposed to an overwhelming amount of information. And when five compelling, persuasive panelists try to wrap things up by telling you five very different things … what do you do? How do you decide who to believe?

On that panel, R.E. McMaster, publisher of The Reaper (210-598-8255), said he makes major buy and sell decisions based on how investors react to economic and market news. His methods are much too subjective for my own tastes, but his presentation was convincing. The second panelist, mutual fund expert Bill Donoghue (800-642-4276), made a strong case, backed up by many sensible reasons, for investing a major part of your portfolio in Southeast Asia. James Stack, publisher of InvesTech Mutual Fund Advisor (406-862-7777), was adamant in insisting that this is the most dangerous stock market ever, on the brink of turning into a devastating bear market. Jim gave a list of sound reasons why the U.S. equity part of his portfolio is 100 percent in cash.

The next speaker was Al Frank, publisher of the Prudent Speculator (714-497-7657), a likeable, even lovable guy if ever one existed, who gave a convincing talk about why he is totally committed to the market. In fact, he’s so sure he’s right that he advocates buying stocks on margin without any defensive strategy. (That’s not for me. When I cruise down the freeway, I want a set of reliable brakes.)

And then there was Paul Merriman, and what a contrast! I took the microphone and told the audience that I had no idea what’s the best way to "play" the stock market for this month or this quarter or this year. I don’t even try to predict the next hot market sector, the next hot mutual fund or the next hot stock. For accounts that use market timing, I said, I look at the market just one day at a time. Though I am a firm believer in market timing, I told the audience that timing should not be based on common sense. Instead, it should be based purely on mechanical models that completely remove all the emotion, guesswork and predictions from the investment equation.

It was very obvious that of all five presentations, mine was the farthest removed from common sense. (However, I recalled that common sense is what told us for centuries that the earth is flat and the sun revolves around it.) In a way I felt I had let down the 100 or so people who had come out on a Saturday night to hear about investing. They wanted something clever, something that made sense, something that gave them confidence. And what did I offer? I offered only the truth as I see it, and it wasn’t very helpful for people trying to figure out the best place to put their money this year. In the market, what matters is not the past, but the future. Yet the future of the market is unknown. It simply can’t be known. You can (and you should) study the past, but you can’t buy it. Every business day, the future begins right now.

SOCIOLOGY 101

In 1962, I took an introductory college sociology class. The professor began the first classroom session by telling us what he called a fundamental truth about human nature -- and I have seen it again and again in every area of life. He said people would rather have an answer, even if it’s the wrong answer, than to be left with only an unanswered question.

The trouble is, when you’re an investor, the only thing that matters is the question, as in "What’s the market going to do in the future?" Once you know the answer, that answer is useless, because it’s already too late to do anything about it.

So what’s an investor to do? How do people know what strategy to adopt? I believe investors should ask two questions of the strategists: How much might I make following this strategy? And how much might I lose? Unfortunately, most people don’t ask the second question. Maybe they would rather not know the answer. I asked Al Frank about his recommendation to be fully in the market with leverage. Doesn’t that mean an investor could quickly lose everything in a big market downturn? Al’s response was: "We hope that won’t happen." And that’s exactly the problem, as I see it. Too many people base their investment decisions on hope and hype. Too few act on the basis of facts and realistic expectations.

YOUR INSTINCTS CAN BE
HAZARDOUS TO YOUR HEALTH

When the experts are all telling you different things, you can follow your brain or you can follow your instincts. I always recommend the former. In the world of investments, your instincts can be hazardous to your financial health. Here’s an example:

I have a good friend who in 1971 made a $10,000 investment in a one-year-old tiny Seattle company that was doing something he thought was a splendid idea: designing and making superior educational materials for children with special needs. He never thought he’d make a fortune, but he believed in the company’s mission and thought it just might turn out to be a decent investment, something to leave for his children.

For the first 18 years, my friend’s stake in the company was worth less than what he had paid for it. At one point it was down to 17 percent of what he paid. Eventually the company found its niche when in the late 1980s it became apparent that personal computers had started to revolutionize the way young people were taught in schools, and later in homes. Seeing opportunity, in 1989 the company hired one of the most admired and respected businesswomen in Seattle as its new chief executive officer. She hired some programmers and began cranking out software titles that captured the imagination of children. The software started capturing the wallets of teachers and parents ... and the company’s stock started capturing the imagination of Wall Street.

Brokers and analysts started treating the company like a tempting takeover target, although management insisted it wanted to remain independent. Before long, my friend’s stock, which must have seemed like an embarrassment to his portfolio for many years, was his largest asset except for his home. In late 1995, he owned 30,000 shares and the stock reached $50. He could have sold out for $1.5 million.

At that point, what should my friend have done? What would you do? Would you sell and take your profits? Would you hang on, hoping you had latched onto "the next Microsoft?" Or would you split the difference and sell half your shares in order to lock in at least some of those profits? My friend, who is very savvy about financial matters, completely understood the dilemma he faced, and that dilemma was complicated by tax considerations.

If he sold, virtually all his proceeds would be profit and subject to the 28 percent capital gains tax. Had he sold at $50, he’d be required to write a check for $420,000 to Uncle Sam. If he held on, he hoped that eventually his children could inherit the stock and receive a stepped-up tax basis, meaning that enormous capital gain would never be taxed.

Even so, he knew that he should sell it, because the price-earnings ratio had reached astronomical levels. But he didn’t, he said, because he hoped the price would remain high long enough so he could defer his big capital gain until the start of the next calendar year.

Does this story have a happy ending? I’ll tell you the facts, and you decide. Shortly after its stock peaked at $50, the company’s sales fell short of expectations. In the world of technology stocks, that’s as popular as a hospital announcing it has discovered a virus in the operating room. Suddenly Wall Street analysts began looking more critically at the company’s financial results and all the competition it faced. The stock fell like a rock, its still highly respected CEO resigned for health reasons and the day after her announcement the stock hit a low of $11. Still, my friend stayed the course. Within a few months, IBM bought the whole company for $16.50 a share in cash, leaving my friend with $495,000.

A 49-BAGGER

Peter Lynch, who managed the mighty Fidelity Magellan fund in its glory days, used to talk about the thrill of what he called a 10-bagger, an investment that wound up being worth 10 times what he paid for it. My friend did much better than that, with a 49-bagger (virtually all of it taxable at 28 percent). Few people are ever that successful on a single investment, and my friend certainly earned the right to brag about his investment prowess. But he didn’t feel much like bragging while he watched that stock fall from $50 to $11. In hindsight, it’s obvious he should have sold at $50, right? That would have left him with a 150-bagger that even Peter Lynch would envy! That seems like a dream achievable only through a stroke of pure luck. But please read on.

While a 49-bagger is nothing to sneeze at, remember it took 25 years. That’s about five and a half doubles, or a compound rate of return of 15.7 percent.

That’s a great return, but hardly out of the realm of reality for aggressive investors who have the right stuff. My friend, in fact, demonstrated a lot of that "right stuff." He had a vision. He had faith, patience and a long-term perspective. He had a strategy, and he stuck with that strategy even when his investment let him down by dropping at one point from $1 a share to 17 cents. What he did not have was a discipline to tell him when to sell. And without a discipline, the only thing he had to rely on was his own best judgment. "It was a dumb move," he says now of his decision not to sell. But that, of course, is hindsight. And even though his market timing turned out to be awful, he still multiplied his money nearly 50 times. How many of us have done that with a single investment?

NOW, THE REST OF THE STORY

I told you my friend is savvy in financial matters, and he didn’t put all his eggs in one basket. Back in 1971, he made five investments in small local companies of $10,000 each. The other four were losers. So you could say that my friend invested $50,000 into a slightly diversified group of ventures. From that point of view, you could say my friend really got more like a 10-bagger instead of a 49-bagger. That’s still impressive, except that it took 25 years. That’s an annual compound rate of return of 9.2 percent, much less than that of the Standard & Poor’s 500 Index. And remember it took the entire quarter of a century to realize that gain. Had my friend abandoned his investment after 20 years, he might have wound up with only a two- or three-bagger.

 

 

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