Beating the Street (45 page)

These are the people who make venture capital loans in return for a stake in the companies that borrow the money. What attracted me to Allied Capital II was its plan to acquire some of the better loans that originally were made by failed S&Ls. These loans were being auctioned off by Resolution Trust, often at a discount.

Since I recommended Allied Capital II, an entirely new Allied fund, Allied Capital Commercial, has been launched to purchase different types of loans. There are now five funds in the Allied family. This proliferation has gotten me interested in Allied Capital Advisors, a separate company that gets the management fees from the other Allied ventures. Allied Capital Advisors is also publicly traded, and this is where the executives who have created the five funds will reap their rewards.

You can't hold on to a cyclical stock the way you hold on to a retailer in the midst of expansion. Phelps Dodge was up 50 percent in six months. It is one of the biggest winners of my 21 selections, but I fear that all the easy money has already been made. It was extremely cheap at the beginning of 1992, based on 1992 earnings, but its future prosperity depends on what happens to copper prices in 1993.

I talked to Doug Yearly, the CEO, who noted that as the price of the stock rose, the Wall Street analysts increased their earnings estimates for the company. This is an example of tailoring the means to fit the ends. Since nobody can predict whether copper prices will go higher or lower, it might as well be soothsayers who are making the estimates. I wouldn't be buying Phelps Dodge at this price. I'd rather be putting my money into Pier 1, Sun TV, or First Federal of Michigan.

General Motors advanced 37 percent from the January price, then
began giving up part of the gains. With car sales still several million under trend, I foresee some good years ahead for the autos. Demand ought to be high, and the lower dollar and the problems in Japan will help the U.S. automakers win back a larger share of the market.

I like GM and Ford, but my most recent inquiries have convinced me to put Chrysler back on the top of my list. I'm doing this in spite of the fact that Chrysler's stock already doubled in price in 1992, outperforming the other two automakers. I am surprised by this result.

Rejecting a stock because the price has doubled, tripled, or even quadrupled in the recent past can be a big mistake. Whether a million investors made or lost money on Chrysler last month has no bearing on what will happen next month. I try to treat each potential investment as if it had no history—the “be here now” approach. Whatever occurred earlier is irrelevant. The important thing is whether the stock is cheap or expensive today at $21-$22, based on its earnings potential of $5 to $7 a share.

On that score, the latest news from Chrysler was exciting. While this company has been skating on the edge of bankruptcy, it has managed to amass $3.6 billion in cash, enough to pay off its long-term debt of $3.7 billion. The Chrysler financial crisis is now overrated. With the company in better shape than before, its finance subsidiary, Chrysler Financial, will be able to borrow money at decent rates. This will improve Chrysler's earnings.

The revamped Jeep Cherokee is so popular that Chrysler has no trouble selling it without the rebate. The company makes several thousand dollars on each Jeep and also on each minivan. These two products alone bring in $4 billion a year in a difficult car market.

The T300 full-sized pickup, which car buffs are calling the “off-the-road BMW,” gives Chrysler its first strong challenge in the truck market, where Ford and GM have made their biggest profits. Chrysler never had a full-sized truck before. Its mediocre small-car lines, the Sundance and Shadow, are being phased out. It has introduced the first really new basic car design in a decade, the LH system.

The LH cars—Eagle Vision, Chrysler Concorde, and Plymouth Intrepid—are all priced high enough to return a decent profit. If they turn out to be as popular as the Saturn or the Taurus have been, they will have a huge impact on Chrysler's earnings.

If anything holds Chrysler back, it's the millions of shares the company has had to sell in recent years to raise cash. In 1986, there
were 217 million shares outstanding; now there are 340 million. But if Chrysler lives up to its promise, the higher earnings in 1993–95 will be more than enough to offset the burden of extra shares.

I was back on “Wall Street Week with Louis Rukeyser” in September. This was the 10th anniversary of my initial appearance on that show, and another chance to recommend a new passel of stocks. I did several weeks of homework, just as I do for
Barron's
, and was ready to share the results with Lou's millions of viewers.

On “Wall Street Week” you have no idea what they're going to ask, and you have a limited time to respond. If they'd let me, I could go on for an entire half hour with my latest picks, the same way grandparents go on about their grandchildren. As it was, I spent so much time struggling to pronounce Au Bon Pain that I didn't get to mention Fannie Mae, or First Federal of Michigan, or several other of my favorite S&Ls.

I managed to get in a good word about Ford and also Chrysler, a stock I recommended the first time I was on “Wall Street Week”—against the advice of several colleagues. I guess we've come full circle.

Before I turn off my word processor, I can't resist this last chance to summarize the most important lessons I've learned from two decades of investing, many of which have been discussed in this book and elsewhere. This is my version of the St. Agnes good-bye chorus:

• Investing is fun, exciting, and dangerous if you don't do any work.

• Your investor's edge is not something you get from Wall Street experts. It's something you already have. You can outperform the experts if you use your edge by investing in companies or industries you already understand.

• Over the past three decades, the stock market has come to be dominated by a herd of professional investors. Contrary to popular belief, this makes it easier for the amateur investor. You can beat the market by ignoring the herd.

• Behind every stock is a company. Find out what it's doing.

• Often, there is no correlation between the success of a company's operations and the success of its stock over a few months or even a few years. In the long term, there is a 100 percent correlation between the success of the company and the success of its stock. This disparity is the key to making money; it pays to be patient, and to own successful companies.

• You have to know what you own, and why you own it. “This baby is a cinch to go up!” doesn't count.

• Long shots almost always miss the mark.

• Owning stocks is like having children—don't get involved with
more than you can handle. The part-time stockpicker probably has time to follow 8–12 companies, and to buy and sell shares as conditions warrant. There don't have to be more than 5 companies in the portfolio at any one time.

• If you can't find any companies that you think are attractive, put your money in the bank until you discover some.

• Never invest in a company without understanding its finances. The biggest losses in stocks come from companies with poor balance sheets. Always look at the balance sheet to see if a company is solvent before you risk your money on it.

• Avoid hot stocks in hot industries. Great companies in cold, nongrowth industries are consistent big winners.

• With small companies, you're better off to wait until they turn a profit before you invest.

• If you're thinking about investing in a troubled industry, buy the companies with staying power. Also, wait for the industry to show signs of revival. Buggy whips and radio tubes were troubled industries that never came back.

• If you invest $1,000 in a stock, all you can lose is $1,000, but you stand to gain $10,000 or even $50,000 over time if you're patient. The average person can concentrate on a few good companies, while the fund manager is forced to diversify. By owning too many stocks, you lose this advantage of concentration. It only takes a handful of big winners to make a lifetime of investing worthwhile.

• In every industry and every region of the country, the observant amateur can find great growth companies long before the professionals have discovered them.

• A stock-market decline is as routine as a January blizzard in Colorado. If you're prepared, it can't hurt you. A decline is a great opportunity to pick up the bargains left behind by investors who are fleeing the storm in panic.

• Everyone has the brainpower to make money in stocks. Not everyone has the stomach. If you are susceptible to selling everything in a panic, you ought to avoid stocks and stock mutual funds altogether.

• There is always something to worry about. Avoid weekend thinking
and ignore the latest dire predictions of the newscasters. Sell a stock because the company's fundamentals deteriorate, not because the sky is falling.

• Nobody can predict interest rates, the future direction of the economy, or the stock market. Dismiss all such forecasts and concentrate on what's actually happening to the companies in which you've invested.

• If you study 10 companies, you'll find 1 for which the story is better than expected. If you study 50, you'll find 5. There are always pleasant surprises to be found in the stock market—companies whose achievements are being overlooked on Wall Street.

• If you don't study any companies, you have the same success buying stocks as you do in a poker game if you bet without looking at your cards.

• Time is on your side when you own shares of superior companies. You can afford to be patient—even if you missed Wal-Mart in the first five years, it was a great stock to own in the next five years. Time is against you when you own options.

• If you have the stomach for stocks, but neither the time nor the inclination to do the homework, invest in equity mutual funds. Here, it's a good idea to diversify. You should own a few different kinds of funds, with managers who pursue different styles of investing: growth, value, small companies, large companies, etc. Investing in six of the same kind of fund is not diversification.

The capital-gains tax penalizes investors who do too much switching from one mutual fund to another. If you've invested in one fund or several funds that have done well, don't abandon them capriciously. Stick with them.

• Among the major stock markets of the world, the U.S. market ranks eighth in total return over the past decade. You can take advantage of the faster-growing economies by investing some portion of your assets in an overseas fund with a good record.

• In the long run, a portfolio of well-chosen stocks and/or equity mutual funds will always outperform a portfolio of bonds or a money-market account. In the long run, a portfolio of poorly chosen stocks won't outperform the money left under the mattress.

Stockpicking is a dynamic exercise, and a lot has happened since I made my selections for the 1992
Barron's
Roundtable, as described in the foregoing text. For starters, I participated in the 1993
Barron's
Roundtable by selecting a new group of stocks, including eight repeaters from the 1992 Roundtable. By the time you read this, I will already have done my research for 1994.

My routine is always the same. I search for companies that are undervalued, and I usually find them in sectors or industries that are out of favor. For two years running, I found no bargains among the blue-chip growth stocks, a group that includes Merck, Abbott Labs, Wal-Mart, and Procter & Gamble. The poor performance of these popular issues is proof that the chart-reading technique described on page 142 actually works.

By looking at the long-term charts of these companies in 1991—92, you would have seen that their stock prices had strayed far beyond their earnings, a danger signal that told us to back off for a while from the Mercks, Wal-Marts, and similar growth companies that were the star performers of the late 1980s, but lately have faltered.

Whenever a popular stock suffers a big drop in price, especially a stock that is widely held by pension funds and mutual funds, Wall Street has to make up a reason for the decline that gets the fund managers off the hook for owning it. Recently we've heard that the drug company stocks declined because Wall Street was nervous about the Clinton health plan, and Coca-Cola declined because investors were worried about the effect of a stronger dollar on Coca-Cola's earnings, and Home Depot declined because of sluggishness in the housing market. The real reason these stocks declined is that they had gotten terrifically overpriced relative to current earnings.

What usually happens to an overpriced blue-chip growth stock is that the stock price will fall or move sideways for a couple of years as the corporate earnings continue to grow as usual, and eventually the price and the earnings will come back into balance. When that occurs, the price line and the earnings line will converge on the chart, as they did for Abbott Labs in late 1993. (See the illustration on page 144.) Perhaps the blue-chip growth sector has had its correction, and some of these stocks can be recommended in 1994–95.

In my experience, the price of a stock, the “p” in the p/e equation, cannot run too far ahead of the earnings, the “e” in the equation, without something having to give.

While some of the larger growth stocks were bid up too high and then stumbled, many bargains could still be found among the smaller growth stocks. The New Horizons indicator described on pages 66-67 has continued to show the smaller stocks at the bottom of their price range relative to the S&P 500. (See the chart on page 66.) As long as the small companies remain cheap compared to their larger counterparts, there's a good chance they will outperform the larger companies, at least until the New Horizons indicator turns north.