FULL OF BULL - excerpts from Chapter 3

Strategies in Quest of the Ideal Investment

Whenever I mention my professional background to people for the first time, they almost always react by asking me for investment advice. The expectation is that, as an insider, I can relate a nostrum for their haphazard investment endeavors that will put them on a sure track to stock market riches. After trying to change the subject, my normal response is to first inquire as to their goals, requirements, and financial situation. And the predictable reply I usually hear goes something like, “Well, my broker has put me in a bunch of stocks and mutual funds, and I have lost money in....” Individual investors sure need help, and it is not coming from Wall Street. Casual investors seem to believe that what they obtain from their brokers or Wall Street is reasonable investment advice–a big mistake. And they have no clue what to do on their own. This chapter lays out investment strategies and guidance so that you can do it yourself, which combined with an understanding of how the Street operates, should provide individuals with the tools to make smarter investment decisions.

Hold Only a Modest Number of Stocks and Choose Familiar Companies

I suggest owning no more than five or ten different stocks. Too many breeds ignorance. A casual friend sitting next to me at a black tie dinner who fancied himself an avid investor boasted that he held 300 different equities! After gagging on my salmon, I inquired if he was a portfolio manager of the Magellan Fund, which probably doesn't hold anywhere near as many positions. My argument against broad diversification is that an array of so-called alternative investments, like gold, commodities, and emerging market stocks, offer little protection in a falling market. World financial markets are so interlinked now that diversification isn't what it used to be. On the day of the more than 400-point market drop in February 2007, the China and European markets also plummeted, as did corporate bond prices, oil, and even gold.

Dividend Yield Is Important

During the bubble years, dividends were neglected; companies paying them were considered dodo birds. Yield is now back in vogue. Historically, from 1926-2006, the total stock market return averaged close to 11% annually, and 41% of this, or 4.4% of the gain each year, stemmed from dividends according to the Motley Fool Income Investor. They may play an even more important role in the future if the market gains ease to 5%-8%. Dividend yield is a key indicator of financial stability, good cash flow, and quality. And a dividend provides some downside protection during a setback. A $20 stock that pays an $0.80 dividend, a 4% yield, is unlikely to plummet to $8, indicating a 10% yield, unless the firm is about to slash the dividend payout. The downside is more likely $10-$15; that is, a 5%-8% yield-the dividend, if safe, providing an effective floor.

Don't Try to Catch a Falling Safe

You might think a stock is cheap after its price has been sliced to a fraction of its former high. It's not. The stock almost always continues to descend. Remember how many Internet dot.com wonders that hit triple figures seemed cheap when they got to $10? Most went on to $1 or 0. Street analysts make the same mistake all the time. The first bad news is never the last. In spring 2007, the sub-prime mortgage lending firms were imploding. A New York Times story referred to a Bear Stearns analyst who upgraded one such company, whose stock had been axed in 3 weeks by 50% to about $15. The familiar refrain was that downside risk was limited at that point. A couple of weeks later, the shares were selling for less than $1. In the '90s Bubble Era, I resisted the urge to chase Internet and other high-tech stocks that were surging to the moon, which saved me a bundle once the bubble burst. My capital was protected. If the basic fundamentals do not warrant some ridiculous valuation, take a pass. Don't position yourself under a falling safe, thinking you can catch it. You'll get flattened.