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This might be worthwhile for those who rely to heavily on earnings...

In today's world of diverse investing models we face many challenges. The biggest one is the failure of any one model working consistently over time. Every model has proven historically that it won't work 60% of the time, but that in the 40% you will more than make up the lost time in gains… or so you hope.

Please keep in mind that investment habits exist across all disciplines. Therefore behavior patterns regarding patience and fortitude are similar regardless of method.

What is specifically wrong with the models?

Hi-tech investing:
As creatures guided by an emotion called greed we tend to steer our investment research toward finding the next Microsoft (MSFT). We in our simple minds are convinced that we understand all the factors involved in what makes the next Oracle (ORCL) stock. The truth is, most investors read some nice pumping feel good article and are sold by the propaganda to buy the stock. Then we hold on for three years as it goes nowhere and finally sell the loser because it didn't pull an overnight Taser (TASR) return. The truth is if you had found MSFT in the early stages of its being public, and bought it, you would have gone through the routine described above. And here's why…

If you had bought $5,000 worth of MSFT on 3/13/86 for a split adjusted price of $0.10 (50,000 shares) and held till today @ $25 post dividend distribution, your 50,000 shares would be worth @ $1,300,000 plus a dividend of @ $150,000. That's about a 28,900% return or about 1600% annualized over almost 18 years. Here's why you wouldn't have held on…

The MSFT IPO started trading at around $28 per share. That's not equal to 50,000 shares off the bat. It's under 200 shares. Now the average 20-30 something investor doesn't see that as being a big deal. Further, most investors even if they make the lucky pick, have a tendency of selling the winners and holding the losers in the hopes of a comeback. By my estimate, this particular investor would have sold his gain anywhere between late 1988 and mid 1989. the reason is simply that the investor knows he has a long term capital gain of about 350%+ and he wants to take it out of something moving sideways and move it into his next wise choice, or dollar cost average down his loser that is selling for really cheap. The reason I chose the date ranges is based on the known historically accepted fact that most investors will hold on just long enough, and after enough false starts, will dump the holding. This normally occurs just before the stock takes off again on its next ride (or collapses, depending on the trend). MSFT essentially traded flat in a range for nearly 2.5 years. Truth be told, in the '87 crash, this investor would have dumped his holdings out of pure fear of a 1929 repeat. MSFT fell 40% on that fateful day in the '87 crash.

Honestly though, when do most investors typically show up with money to invest? Normally it's after a couple of spectacular years of amazing stock market gains which all the media rave about. Everyone is standing around the water cooler talking about how AOT has moved up 500% in the last three days. So more and more of the regular folk start tuning into wherever they tune into for the latest stock tip and place some buy orders with a broker. Some old guy (Alan Greenspan – the most listened to man on earth) starts saying things like “irrational exuberance” and some other old guy (Warren Buffett – the most watched investor on earth) says that these are dangerous times in the market. But Buffett is “out of touch”, and his stock is experiencing its worst performance years ever. The media plasters him with derogatory articles and other name calling until the vindication arrives.

When the market collapsed in 2000, the truth about the timing flaw was revealed. Few understood how to identify the indicators that were screaming warning prior to the collapse. All our innocent folk who joined us late in the game (late 1999 to early 2000) were left holding stocks like EBAY at a split adjusted cost upwards of $50-$60 per share and watched the stock drop to under $20 by the end of the year. That's a 60% loss for Y2K. Now if our lucky investor had dollar cost averaged down for the following 2.5 years, he'd have made a pretty penny with the stock trading at @ $33 (post splits) today. Most people don't have the discipline and this investor probably sold in the summer scare of 2002 if he was still holding on.

What can one do? Hold on to the hope that it is the next MSFT, EBAY? What if it's just another Corvis (CORV now Broadwing BWNG) which after a reverse split and a corporate overhaul is trading at @ $5 per share down 90% over the last 5 years? Is that the sucker holding of the year or what?

When the stock market crashes all the media pundits start hyping up “the best thing to do in a bear market…”

Value investing:
This method is a wonderful model to prevent you from making the mistake of buying some high flying floozy stock for some outrageous price. That's about all the nice words I have for this method. The problem with buying low price/book stocks is they have a tendency to stay low for a period that exceeds the average investor's patience (approximately 2.5 years). Yes some stocks become undervalued and come back within six months for a nice return of 100% or more. However, there's no telling in the falling stage how long the recovery will take. For example, Aldila (ALDA) was selling at 25% of book value with no debt in November 2001. Then after a write down and a reverse-split, the stock traded at the same 25% and only recovered to book value 2 years later. In the meantime this stock was in a downward trading trend since 1995.

How long is an investor expected to hold on in order to achieve a full return on his discipline if the stock just keeps falling? The fact is this investor most likely dumped the holding as soon as the stock achieved book value (@ $5), and therefore missed the rocket that launched shortly after from $6 to $17, or $1 (through DCA) to $21 today. Low P/B investing is a good method it just has a timing flaw like hi-flying investing.

Finally the economy starts to recover and the stock market picks up steam again and the media pundits of course are touting “the best way to invest in a recovering economy…”

Investing on earnings:
Timeline November 2000, Merck (MRK) has just released a quarterly earnings statement of $17 billion. The stock price has been rising steadily from $65 and now you hear the wonderful reason why. Luckily you manage to jump in quick enough and you now own MRK at $76 on its way up to $90. Barely 2 months later, you received a very short formal letter from the company explaining a data entry error. The number should have been $1.7 billion, we're very sorry for the inconvenience. The stock reacts instantly on the news and you luckily get out with any losses. My congratulations on not losing anything on this one, but you are a statistical anomaly. Most folks jumping onto a fast moving stock like this would have gotten in at $83 and out at $81 if they were lucky. In 2003 and 2004 MRK restated all quarterly reports for the prior two years, and is currently trading @ $35. This is not intended to bash MRK, they just happen to be in the top 100 of the 2003 Fortune 500 list. ***

Now you're saying “that's such an odd event, it can't be used as an example”. Well, how would you like to be the proud owner of Krispy Kreme (KKD) in September 2001? After watching this stock fantastically advance with a few stock splits along the way and outstanding earnings every quarter through a recession, you decide to take advantage of a new low and get in at $30. KKD resumes its climb upward and you are sitting on a 50% gain after 3 months. You ask yourself “should I sell now?”, “no way, this stock is great!!!” then it slides into a trading range and goes sideways for the next 12 months. You consider selling, but you're in it for the long haul and you don't want to feel bad for missing the 50% gain so you stick it out into the second half of 2003 and enjoy watching the climb up to the 50% gain marker that you missed last time. Now you're happy. All the news is positive and you decide to hang on. Then KKD scares and drops below $40, but quickly recovers to $44. You decide not to lose a selling opportunity in this volatile trading range, so you sell at $43 and take a nearly 50% return. You happen to be a very wise stock picker with more than enough time to keep an eye on your stock. Luckily you got out near the top as KKD Plummeted to $10 over the next twelve months. Unfortunately, your total annual return was about 23%. You achieved a solid return considering the period, but most investors aren't as fortunate and hang on all the way down stubbornly refusing to let go of this “staunch performer”

The bottom line is TIMING. There is a time to be in a stock and a time to get out quickly. Not knowing when to buy is just as dangerous as not knowing what to buy. The two are merged at the hip and with the right tools an investor can make a lot of money choosing winning stocks all the time.

Aldila (ALDA) is a prime example of merging the book value method with timing. Our earlier investor had picked this stock up when it was probably trading around $1 and change if he was lucky. He later sold it for a short term gain @ $5 following his principal of selling upon achievement of book value. That's a fantastic return for a less than one year holding.

Except for one thing, Bernard Baruch said “the trend is your friend”. This roughly means if the stock has moved up consistently for the last 12 months, its inertia would have to be reversed in order for the positive trend to reverse itself. According to the charts, this stock was positively trending and forming a solid base from which to launch a new price climb. Our lucky value investor took his gain at the wrong time in this case. Merging analysis would have guided our lucky investor to purchase the stock in late 2003 @$3. Had our lucky investor held on he would have had a smarter long term gain with the current price sitting around $21.

Another prime example of value merging with timing is Parlux (PARL). PARL traded almost flat under $5 for about 10 years. With a low P/B ratio, no debt, and heavy insider buying in 2003, PARL begins to awaken. Our lucky value investor would have picked up this stock in 2003 @ $2 and sold it at the book value @ $6. Proper analysis placed an entry into PARL in January 2004 @ $5 and a long term gain currently with PARL currently @ $20.

Keep in mind that our lucky investor in this case has no emotions. Had he any emotion he would have sold both ALDA and PARL very early due to the high volatility of price movements of both stocks as they established their positive trends. The trend is probably the least understood, most misquoted term used on Wall Street. Trends need to be fully understood and appreciated in order for an investor to improve the analysis.

The reality for analysis is, while no school of analysis is wrong, keeping the schools of analysis apart simply causes fantastic gains to take place over much longer periods of time. The time has come for a merger, and it starts by merging the lessons of the greatest analysts of the last century; namely, Ben Graham, Jesse Livermore, Robert Edwards, Philip Fisher, and Warren Buffett.

Thank you for reading this article.

The stocks listed in this article are not a form of recommendation in any way.

*** A funny thing about the Fortune 500 list:
1. Enron was listed #7 on the 2001 list released in 2002 after Enron had declared bankruptcy.
2. Freddie Mac failed to make the 2003 list, while Fannie Mae was #20. This list was released in March 2004. Within nine months Freddie restated earnings upward and Fannie restated downward forcing the resignation of its CEO and CFO.
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