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Hands-On Stock Evaluations
September 18, 2007

There's a school of thought in the investment business that we should buy what we like. That is, I should consider buying shares in the restaurants that I like, the makers of clothing that I wear, the makers of cars that I drive, and so on.

Is this a valid approach?

Ben wrote:
I've had my eye on Crocs (CROX) ever since their outstanding annual report sent their stock soaring. Honestly, after reading how much their revenue increased, I went to their website and bought a pair of their sandals. They were extremely comfortable and I was glad I bought them.

Now that I've had them for awhile, however, I've noticed that in the rain they are horrendous. Every single time it rains and I walk into a building, I slip. I even think about not slipping while slipping. It is almost impossible to walk on non-carpeted floors without slipping if you aren't 100% focused on keeping balance. I've fallen a couple of times in college buildings, and due to the embarrassment and annoyance, I won't wear the shoes again.

I was wondering what your opinion was about this situation. I like to test out products before I buy them, and I apply the same scenario to stocks. I didn't buy Radio Shack because every one I have been to was unhelpful, but bought Amazon.com because I loved their service. Both have worked out well for me.

Would a situation like mine, assuming that after fundamental analysis you aren't sure if the stock merits such a high P/E ratio, be enough for you to not buy? Unlike other shoes, I don't see people re-buying Crocs because of this slipping problem, and these companies thrive off of continued customer purchases on these consumer goods. This is one of the hottest stocks out there, so I assume you've taken a look at it, if only for a minute.

How should I take this into consideration?
As luck would have it, I've taken more than a passing interest in Crocs. The following is taken from the 2008 edition of The Neatest Little Guide to Stock Market Investing:
My mother and sister visited me in Japan in May 2006. My mother wore a pair of Crocs sandals that she raved about the entire visit as we walked around Tokyo and flower parks near my home in the countryside. She told me that Crocs were invented in Colorado, where we're from, and that everybody back home had a pair. When my friends in Japan saw the sandals, they asked about them, tried them on, and wondered if I would buy some for them on my next trip back to the States. An actionable tip? You bet. Shares of Crocs were less than $25 that May. In February 2007, they broke $58 for a gain of more than 132 percent in just nine months. I have a feeling Peter Lynch would love this story.
Since February, shares of Crocs have risen to a split-adjusted $114 as of yesterday's close. They split 2-for-1 on June 15.

Notice in my introduction to Crocs, I paid no attention to my own opinion, but a great deal of attention to the opinions of others. I've found that my own tastes are not generally part of the fat section of the bell curve where most money is made by companies. I live very differently than most consumers. I can't tell you who's hot in music now. I don't know what celebrities are dating whom. I haven't seen the latest Coke commercial. I couldn't care less which family makes the best choppers on TV, and I don't even know what it means to be a good chopper -- or care.

That, however, is a handicap as an investor. Far better to be the person in the know, hip, with it, tuned in on every level. The burden of the sensible misanthrope is needing to listen to all forms of inanity to know what ordinary folks -- whose spending habits keep the economy humming -- think, or at least where their non-thinking leads them to waste money.

One of my favorite examples is bottled water. What a brilliant capitalization of the non-thinking, herd mentality of people. It's a proven fact that all municipal water in America is safer than bottled water. City water is delivered conveniently through a faucet in the house and it's nearly free. Yet, people pay money to haul heavy water that's less safe than what's already in their homes.

Do you know that water used to be used as an example of a product that would be impossible to sell to people who already had it in their homes? It's true. People used to say, "Heck, that guy could sell people water." Apparently, that guy listened to them and did it.

As proof that stupidity has gotten the better of people on the water front, so to speak, look at how some states in the U.S. are considering banning the sale of bottled water because there's no need for the product and its popularity is contributing unnecessarily to greenhouse emissions from trucking an already available commodity around town to the gullible.

Ah, humanity.

Ben, it should be pointed out, strikes me as just the sort of sensible person whose habits come nowhere near reflecting the behavior of his peers. He's written to me many times and each note is a well composed, thoughtful piece. Immediately, we know he's not part of the 80% in the middle. Why, I bet he even drinks tap water.

Most young people buying Crocs for the hipness of them would pay no attention to their ability to grip pavement. No, no. Where appearance is everything, 'tis folly to analyze. If Crocs are popular among people, it's because they're cool looking, fun, have a zippy name, and are eminently decoratable (important to those who value creative piercings and "body art", a euphemism for what used to be called tattoos).

So, my first thought is that Ben's slip-sliding through the halls of his college is probably not a harbinger of the end of Crocs.

However, Crocs is in for eventual trouble for other reasons. It's Krispy Kreme all over again. No matter how much people love the product, it can't grow at this pace forever. The bloom will flee the rose. The thoughtless will be lured to another sheen in the distance, earnings will slow, the valuation of the stock will soar, and the price will implode. Seen it a thousand times; expect to see it again.

Too, the appearance of nearly identical footwear from competitors and utterly identical models from China, the copycat capital of the world, bodes ill for the Crocs gang in Colorado. The more they differentiate their models from their originals that put them on the map, the more they look like...a shoe company.

To the issue of whether or not one's own experience is a reliable guide when picking stocks, I'm afraid the only answer is: sometimes. Certainly it's better to like an experience than to dislike it. Both can be misleading, though.

Unlike Ben, I was pleased with RadioShack and it proved to be a wonderful turnaround story. One of our best-performing holdings right now is in the oil services sector, in which I have zero firsthand experience. I soured on Hewlett-Packard when I tried updating my old business calculator to the new version of the same model and found that it was poorly made, nowhere near as pleasant to use as my old one. Yet, the stock soared in the years following that discovery.

Really, the best way to get the word on the street is to ask for it. I'm lucky in that I can tap readers and subscribers for their opinions, which helps a lot. If I didn't have that, I would ask friends and acquaintances and strangers I met in the course of life for their opinions on the products of companies I was considering. If I saw somebody on a plane using a Dell notebook, I'd ask what they thought of it. If I saw somebody park a car made by a company I'm considering, I might ask what they think.

Better still, I'd turn to consumer polls to see what a larger group of people thinks. The risk of small sample groups -- and our own opinion is a sample of one -- is that they won't reflect the view of larger sample groups, which ultimately are the ones that matter in analyzing sales.

There are times when it takes more than knowing what the herd thinks. You want to know what the herd thinks, see why it's wrong, estimate when it will wake up to its mistake, and calculate the results of its realizing it had been wrong. This is Bill Miller's process for investing in Kodak, a company that everybody thought would be kaput after the invention of digital photography.

I'm afraid there's no easy answer to this one, Ben, except that thoughtful looks past one's own opinion are usually worth it.

Enjoy your Crocs on dry days!

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The Cold Facts
August 21, 2007

In my article last Wednesday, Why I'm Not Worried About Sub-Prime, I wrote:
Next, ask yourself how much of the U.S. economy housing represents. By the tenor of the news these days, you'd think half of the U.S. gross domestic product comes from the housing market. It doesn't. Housing accounts for a mere 5% of the economy. Even if housing slipped by 50%, the overall economy would suffer only a 2.5% loss. That's not nothing, but it's not the stuff of The Big One. Besides, housing is nowhere near falling 50%, so we're actually looking at a hit to the overall economy of maybe 1%.

Folks, this is no disaster. The stock market is not finished. We're not seeing the front edge of a storm that will demolish all we've built over the years.
In response to that article, L. Morelli from Colorado Springs wrote:
Your comments on the fraction of GDP are quite correct, but what do they have to do with perception in the market?

When the dot-com bubble burst, the whole market fell 30%. Why? Did people stop buying soap, toothpaste, or food? Did IBM add a dot to its name? Were the dot-com companies 30% of the US economy? Hardly!

So, why are you giving the cold facts? They are just confusing the issue. The market had been going up for a very long time without a correction, and the sub-prime issue is a fine excuse to have one.

Is the economy in bad shape? Not at all. Is the job market collapsing? With 4.6% unemployment, it isn't even close. Have companies stopped turning a profit? No, but the rate of increase has slowed down and will presumably stop at some time. If Americans weren't so bad at math, they would realize that any growth rate of 30% has to stop way before it reaches the size of the national budget. House prices increasing at 20% to 30% per year is unsustainable even in the not-so-long run.

But, then, I am making your mistake, using facts to justify my arguments.

A much better issue is why a family with an income of $145K/year buys a house for $900K with $0 down. Income of $145K/year is not chicken feed, but is not enough to pay a mortgage more than six times its value, unless the residents live a life of pork and beans, Goodwill shopping, a 20-year-old jalopy, etc. That's hardly what one expects from people buying a $900K home. And, guess what? They lost the house.

So, is there an explanation for this situation? I can think of three: greed, stupidity, and bad math, none of which is fixable, especially the second. Cases like these are nationwide and it will take a while before we see all the consequences.

In the meantime, the market will gyrate and hopefully offer some real bargains as in the post-dot-com collapse.
I give the cold facts because to the non-stupid out there -- among whom I count most of my readers by virtue of their choosing my material from a sea of alternatives -- understanding the relatively low threat level of the scare-of-the-moment provides confidence needed to buy when prices are low. Keeping the facts handy when emotions run wild is a good way to see if those runaway emotions are providing an opportunity that the more rational can exploit.

Mr. Morelli is right to flag emotions as a key part of market analysis. The only reason price-to-earnings ratios change is that emotions surrounding the stock or index in question change. We could all agree, for instance, that it never makes sense to pay more than 10x earnings for a stock. If we did so, anybody with a calculator could tell you what a stock will trade for at a future date if its earnings estimates are met.

It never goes that smoothly, though. Emotions magnify the distance traveled in both directions. When the news surrounding a company is bad in conjunction with its earnings falling, people sour on it. "It's dead money," they say. "All past and no future. Move on."

The stock might have sported a P/E of 20 prior to the storm, but suffers both a drop in earnings and a drop in sentiment to drive its price lower than is reasonable. If the earnings fell 10% in a rational world where the P/E never changed, the stock price would also fall 10%. In the real world, though, it falls that much and more as the multiple people are willing to pay also drops.

Look at an example.

Say a home building company named T.R. Norton earns $2 per share and has a P/E of 20. Let's prove to Mr. Morelli that not all Americans are bad at math by grasping immediately that $2 earnings times a P/E of 20 gives us a share price of $40. In reverse, a $40 price (the "P") divided by $2 in earnings (the "E") gets us back to a P/E of 20. All clear on the how the numbers relate?

Suddenly, T.R. Norton hits a rough patch in the housing market and its earnings drop a sickening 40%. Improving the image of Americans yet again, we nimbly subtract 80 cents from $2 to get a new earnings-per-share of $1.20. OK all you American math whizzes, if the P/E remained constant, what would the new share price be? That's right: $24. I know you Americans know this, but for any math-challenged foreigners, I'll explain. The new $1.20 earnings times the P/E of 20 gives us $24. The earnings dropped 40%, so the share price dropped an equal 40%.

That's not how it really goes, though, and here's where our keen math skills reach their limit in the stock market. If all it took were math, professors would be the richest among us. They're not.

What would actually happen is that headlines would report that T.R. Norton is facing the worst business environment it's ever seen, that some analyst somewhere thinks the housing market may never recover, and that the company president recently sold a bunch of shares.

Now, we've got a company that nobody wants. Out go the calculators, in come the animal spirits and bar room commentary until nobody's willing to pay 20x earnings anymore. Are you kidding? For such an out-of-luck, no-future, dead-in-the-water piece of junk as T.R. Norton?

So the multiple drops. Instead of paying 20x earnings, investors are willing to pay just 12x. Take $1.20 earnings-per-share times a P/E of 12 and you get a new share price of $14.40. The earnings shortfall brought the share price down 40%, and emotions brought it down another 40%. Understanding emotions, something even the best calculator won't help you do, was just as critical to analyzing this situation.

When the turnaround arrives, it all happens the same way in reverse. The earnings improve, the news brightens, the image of the company turns up, some analyst somewhere thinks housing looks great for the next five quarters, the president invests a million dollars in the depressed stock, the bar room talk turns in favor of ownership, the multiple expands back to 20, and you get a raging climb in the share price. That's the cheery consensus Warren Buffett talks about being absent among low prices.

Keep the facts in mind because they'll help you see the good news waiting to happen down the road. Once you know the facts, watch how current emotions are ignoring them and take advantage of the discrepancy.

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Is Holding Or Trading Better?
August 09, 2007

I'm a long-term investor at heart, but occasionally take advantage of medium-term swing trading opportunities. I never daytrade.

You may wonder why so many investment services sell short-term tools. The reason is that there's no money in selling long-term investing tools. People will not subscribe to a product that tells them the same thing no matter what's happening in the market, such as, "Buy more of the S&P 500 each month," even though that's precisely the advice that would be best for the rest of most people's investment lives.

There are times, however, when an especially great inefficiency presents itself. The market simply misprices some stocks now and then, and the finding of such mispricings is what gives some investors an edge. They put the bulk of their money in an index or something based on an index to get the 10% per year that the market returns. Then, they use a smaller portion of their money to chase individual stocks to try to bump up that 10% by a little bit.

For that smaller portion of your money, is trading or holding a better approach? I say holding, for a variety of reasons.

Jeff in New York asked me if I saw any benefit to swing trading. I answered:
Swing trading in the medium term is a good way to make money. I've done quite a lot of it in The Kelly Letter, actually, by owning something for 4 to 6 months and getting 60% out of it.

That's not where the truly big money happens, though. Look at the list of giants in the investing business and you'll see that all of them bought at great prices and held and held and held with no sales to incur capital gains taxes, little stress, and the power of compounding sending their worth to the moon. I'll take Hansen's Natural five years ago over a half-year swing trade any day. $10k invested in Hansen's five years ago is worth $860k, and that's down from a year ago when it was worth a cool $1 mil. The stock is currently up 8,500% in five years, but who heard of it and who wanted it back then? Almost nobody.
Jeff replied:
I understand the theory of the long-term approach. But that has its pitfalls too. You can identify a great stock but then feel it's time to move out of it too early.

I noticed your pick of DECK. Great stock. Made 40%. But had you stayed in, it would be five or six times that and still climbing. If you -- someone who knows much more than me -- jumped out of a big gainer when there was still a lot more life in it, I certainly can make the same mistake (or overcompensate and hang on too long).

Yes, we all want the Hansen's Natural 8,500% gain. It's a home run. It's a grand slam. Bottom of the ninth, walk-off World Series ending grand slam. But that's not everyday life. Everyday life of everyday people like myself is grinding out singles. Getting on base. Doing little things.
The DECK example underscores my point that holding is usually better than trading, at least when it comes to well-researched investments.

The Kelly Letter began watching Deckers Outdoor (DECK) in March 2005 when it traded at $40, down from $48 the previous December. After watching and waiting for half a year as the stock kept dropping, I finally bought it in October 2005 at $23. It then plunged almost immediately to $17, where I doubled down. The letter's average price was $20. I then sold the stock just two months later for a quick 40% gain.

Since I sold in December 2005, DECK has risen 296% to close yesterday at $111. What became a 40% gain for my subscribers would have become a 455% gain had I held on for the long term. That was my mistake.

Instead of seeking the quick buck, I should have trusted the research I'd done on Deckers, had faith in the insider ownership of the company that had seen it through tough times before, and resisted the urging of some subscribers to get out while the getting was good.

A significant portion of my subscribers at that time had been schooled in the O'Neil method of stopping losses at -8%, so there was an outcry when instead of stopping out, I bought more at a price 26% below my initial buy.

I average down relentlessly. I rarely stop out. I've done it on high-risk trades that were clearly identified to subscribers as high-risk trades, and those times ended up being the right moves as the stocks in question kept sinking far past the prices at which we stopped out, but those times were exceptions.

When I bought more DECK after it sank 26% below my first buy, people were already wringing their hands. I assured them that all looked well with the company, in my opinion, and that the lower price was just a better bargain. When the price then shot past both of our buy prices and put us firmly in the black, those hand-wringers were crying to get the money out before we had to suffer through another plunge.

I should have realized that one of the reasons people subscribe to a letter is to help them get around their own shortcomings. It was my responsibility to show them that their powerful but misleading emotions were in the way of a great opportunity. Instead, I took the quick gain, added it to my list of successes for the marketing department, and let a big one get away.

Sitting on swelling gains is not the way to make money in the investment advice business. People who subscribe later are frustrated when they see they missed out on most of the gains. A rapid turnover is the way to keep subscribers happy, even when it's not in their best interests.

What I vowed after the Deckers mistake was that I would strike a balance between turnover and core positions. I keep new ideas coming these days, but not at the expense of ideas that I think still have a lot of potential.

Also, importantly, I have more faith in my own research as time goes by. Most of my mistakes have been of the Deckers variety, resulting in more lost opportunity than lost money. That's the better of the two options, but is still not acceptable.

Research is hard, clear choices are few, and firm conviction rare. When the hard research turns up one of the few clear choices that creates strong conviction, that alignment should be respected and exploited for the multi-bagger profit potential it brings.

Jeff wrote that if I could make such a mistake as selling Deckers too soon, so could he. Yes, he could, and so could you. We're all capable of investing mistakes. The key is to learn from them and improve over time.

Most investments do indeed become the single base hits Jeff refers to. He's right when he says that grand slams are not everyday life. They're rare. As Hansen's and Deckers and Apple and so many others prove, though, fat pitches over the plate exist. It's our job as investors to keep stepping up to that plate, keep our eyes on the ball, and just once or twice in our lifetimes to hit it out of the park.

From the opening paragraph of my stock book:
When I was eleven years old, my grandfather explained to me in less than ten seconds why he invested in stocks. We sat by his pool in Arcadia, California and he read the stock tables. I asked why he looked at all that fine print on such a beautiful day. He said, "Because it takes only $10,000 and two tenbaggers to become a millionaire." That didn't mean much to me at the time, but it does now. A tenbagger is a stock that grows tenfold. Invest $10,000 in your first tenbagger and you have $100,000. Invest that $100,000 in your second tenbagger and you have $1 million. That, in less than ten seconds, is why everybody should invest in stocks.

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Getting Started In Stocks
July 17, 2007

It's common for newcomers to the market to think that they better get going right away or they're going to miss the current opportunity.

That's almost never the case. Remember that the market has been doing more or less the same thing for over 200 years: fluctuating. A good way to get discouraged right out of the starting gate is to buy into a strong rally and then see it reverse and your seed money shrink by 20%. Some people swear off stocks forever after that.

Recent Kelly Letter subscriber Jeff in New York captures this common sentiment with these questions:
"If a person has only $7-10k to invest now, what would be the best strategy? Invest in one stock? Two? More? Which stock? Many of the open ones in your portfolio are now much more expensive than when you got in; is it too late to jump now on any one of them? Would you recommend using it for your Dow One, Double The Dow, or Maximum Midcap strategies instead? Should one wait for the individual stocks you're watching to come down into your buy zone? How would you recommend someone best use their limited resources with the recommendations currently on your [subscriber] site?"
For anything less than $10k, I suggest waiting for a pullback in the market and then starting my Maximum Midcap strategy. It's perfect for a rebound because its purpose is to return twice what the medium-sized company index returns and, in my research, I've found that medium-sized companies bring more potential than large companies, but less volatility than small companies. Mid-caps are the market's sweet spot, not too big but not too small. They're just right.

You can see how extremely well Maximum Midcap has done over the years on my Strategy Page. As of last Friday, it's up 28.5% so far this year.

It's far more effective than almost all professionally run portfolios, but is simple enough to be managed on your own between work and family responsibilities.

It's volatile, by design, and that's what most critics point to when attacking it. What they miss is that almost nobody invests a lump sum of money and then just leaves it for 30 years. The vast majority of people start with a modest sum, and contribute to it monthly or quarterly as it grows.

This tactic of regularly contributing new money is called dollar-cost averaging, and it works best when used with a volatile investment, like my Double The Dow and Maximum Midcap strategies. Why? Because when the price of the investment goes down, your new money invested buys at the cheaper price. That way, you take advantage of the volatility rather than getting scared by it.

Plus, my permanent portfolios use the Dow and S&P MidCap 400 indexes, so you're not betting on one company. Critics scoff at the volatility, but nobody I've approached for a shoot-out with one of the portfolios over a time period longer than one year has ever accepted. They're wise to walk away -- like Fortune magazine, they'd lose.

You won't, however, when you put these powerful doubling strategies to work for your money. Save your cash, wait for a significant pullback, and then get going with one of my permanent portfolios.

That's part one.

Part two for subscribers is waiting for an active order from me. If I'm not saying to buy more shares of a company at a certain price, then I don't advocate doing anything at the moment. There's a lot of watching and waiting with my approach, and that's fine. It gives newcomers time to see how this business really works.

Forget the ads. Forget the split-second pressure that so many trading services push. Forget almost everything you've ever been told about the market. This whole business is about watching companies that you think have a bright future, studying their stock's price history compared to its earnings history, thinking about what's going to drive its earnings in the future, and then calculating a fair price to pay from all that. Once you have the fair price target, you wait for the stock to get down to it or for the company's prospects to change.

None of that requires a stressful life filled with cell-phone alerts telling you to buy GOOG at 9:47 and then sell it at 10:12. Give me a break. That doesn't work, it's expensive, and the companies pushing that approach profit from your activity, not your success.

For both the stocks I'm watching and the stocks I already own, I send active order alerts to subscribers that almost never require immediate action. I usually alert subscribers to an active order in a weekend note, giving everybody plenty of time to get the order on the books and then wait to see if and when it executes.

I don't like stress and assume that you don't either, so I strive to minimize it.

Tomorrow: SiCKO and feedback on the U.S. health care system, whether or not Starbucks is a buy, and further thoughts on the iPhone.

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