Thinking Small

The world’s greatest investment book was written in 327 B.C.

Nothing by Warren Buffett or George Soros or Peter Lynch has ever surpassed it. And though it was published a couple of millennia before the founding of the London Stock Exchange or the Chicago Mercantile, it contains the essential key to making a fortune in today’s financial markets.

The book I’m referring to is that dusty classic from your sophomore year, Plato’s Apology. Socrates, as you may recall, was on trial for corrupting the youth of Athens. During his defense, he explains how he tried to disprove the oracle at Delphi, who proclaimed that no man in Athens was wiser than Socrates.

Plato’s Apology: The Wisest Man in Athens

Baffled at this revelation, Socrates confessed that – with his meager understanding – he could not possibly be the wisest in the land. And so he set out to visit a local sage, one of the greatest scholars in Athens:

“When I began to talk with him, I could not help thinking that he was not really wise, although he was thought wise by many, and wiser still by himself; and I went and tried to explain to him that he thought himself wise but was not really so; and the consequence was that he hated me, and his enmity was shared by several who were present and heard me.

“So I left him, saying to myself as I went away: I am better off than he is – for he knows nothing, and thinks that he knows. I neither know nor think that I know. In this particular, then, I seem to have slightly the advantage of him. Then I went to another, who had still higher philosophical pretensions, and my conclusion was exactly the same. I made another enemy of him, and of many others besides him.”

In the end, Socrates discovers he is indeed the wisest man in Athens…simply because he realizes the limits of his own knowledge. In short, knowing what you don’t know is the very foundation of investment wisdom.

It took me years to truly absorb this lesson. Although I retired at 42, I spent 16 years on Wall Street as a research analyst, investment advisor and portfolio manager. During that time, I learned a lot about what works in the financial markets…and a lot too about what doesn’t.

Plato’s Apology: Things I Don’t Know

As a result, I can now say with complete confidence…

I don’t know whether the economy will double-dip or triple-dip.

I don’t know whether jobless claims will rise or fall.

I don’t know whether the Fed will raise or lower interest rates.

I don’t know whether the U.S. dollar will rise or fall.

I don’t know whether annual GDP will expand or contract.

I don’t know whether debt-laden consumers will sink or swim.

I don’t know whether commodity prices will head north or south.

And as for the near-term direction of the stock market, don’t ask.

But here’s one thing I’m certain of. Nobody else knows these answers either. There are plenty of folks on Wall Street and in the media, however, who are making a very good living by pretending to know.

And so they do.

However, there is one question that you must answer. And that is this: Given that the future is always uncertain and knowledge always provisional, what is the shortest route to financial independence…or at least to a comfortable retirement?

After all, bond yields hover near 44-year lows. Americans currently hold over $2 trillion in money market funds that pay less than 1%. And the stock market has plunged roughly 40% in the last three years.

Platos’ Apology: Think Small

So how do you reach your financial goals? The answer is, you give up trying to predict the unpredictable, and embrace the magic of thinking small.

Think about it. Does a successful business owner lie awake at night calculating the size of the federal deficit? No, he thinks about what he can do to increase sales. Does he fret about this year’s total GDP growth? No, he imagines how he can further improve his products and services. Does he agonize over when foreigners will begin to repatriate their U.S. assets? No, he thinks up new ways to cut costs…how he can better emulate his most successful competitors…where he can find more qualified employees…and how he can find the cheapest capital to expand.

Successful businesses grow – and their owners become wealthy – by finding a niche and then exploiting the “bejesus” out of it…day…after day…after day.

I call it the magic of thinking small. And it’s exactly what you should be doing as an investor. Forget about forecasting interest rates, the economy or the short-term direction of the market. And instead, look to invest in that select group of companies that have the same characteristics NOW that the highest-returning stocks of the last 50 years had BEFORE they made their spectacular moves up.

Plato’s Apology: Characteristics

What are those characteristics? Here are a handful of the most important ones…

* Each of the last three years’ earnings were up at least 25%.

* Return on equity (earnings divided by book value), a good measure of management efficiency, was 17% or higher.

* Recent quarterly sales and earnings were up 25% or more.

* Heavy insider ownership of the stock.

* Heavy institutional sponsorship (buying by pensions and mutual funds, for instance) in recent months.

* After-tax profit margins were improving and near their peak.

* The companies had recently introduced new products or services.

* The companies were buying back their own shares.

* And they weren’t penny stocks. These companies generally were trading at $12 a share or higher BEFORE they made their big moves up.

Okay, so these characteristics may sound fine in theory, you may say. But how do they work in practice?

Beautifully. Let me give you an example. As Investment Director of The Oxford Club, I recently recommended early this year that members purchase shares of Netflix (Nasdaq: NFLX), the Internet-based DVD-rental service.

Netflix allows customers to rent unlimited DVDs (three at a time) over the Internet for $19.95 a month. There are no due dates, late fees or shipping charges. You can watch them whenever you like, return them whenever you like, and the longest trip you’ll ever take is to your mailbox. (As you can see, I’m a satisfied customer myself.)

Furthermore, the company’s financials are exceptional. Netflix reported blockbuster first-quarter revenue of $56 million, up 82% over the same quarter last year. In fact, sales were 23% higher than last quarter!

What does this mean in terms of investment performance?

Netflix is up 122% so far this year. In fact, although there are over 8,000 publicly traded companies in the U.S., Investor’s Business Daily reported last week that – excluding penny stocks – Netflix is the single-best- performing stock in the U.S. market this year.

Plato’s Apology: The Magic of thinking Small

Chalk it up to the magic of thinking small. That’s what we’re doing in the Momentum Alert, a special trading service I run targeting a handful of companies that are doing virtually everything right. Using this system during the bear market of the last three years, we’ve locked in double-digit profits in Panera Bread, Direct Focus, Emcor, Christopher & Banks, Aftermarket Technology, Hovnanian Enterprises, Corinthian Colleges, Agilent and a host of others.

Currently we hold Countrywide Financial, up 148% in the bear market of the last three years. We hold eBay, up 219% in just over two years. And we hold generic drug maker Teva Pharmaceutical, up 669% since the downdraft began three years ago.

But these returns may pale compared to one of our newest discoveries. Out of respect for due-paying subscribers to the trading service, I’ll withhold the name for the time being, but I can tell you the company looks like a good one. It’s a $10 billion oil and gas company with operations in the U.S., Canada, Australia, Poland and Argentina. Earnings have been nothing short of superb. Recently, the company announced that fourth-quarter net income surged 134% from 53 cents a share to $1.24 a share.

And the firm is growing even more rapidly through acquisitions. In fact, it just made its biggest ever, $1.3 billion of North Sea and Gulf of Mexico assets. Fundamentally, the company has a strong balance sheet, rising production and operating margins of 32%. And from a technical standpoint, the stock is very strong. I expect the returns here to be among our best for the year.

Now I realize some folks believe the success we’ve had buying companies like these comes from knowing what we know. But, in truth, it’s also from knowing what we don’t. That’s the magic of thinking small.

Sincerely,

Alex Green,
for The Daily Reckoning
April 24, 2003

————

“No takers for homes,” says a Denver paper.

“Single family permits at 7-year low,” comes the news from Southern California.

“Hot housing market could be cooling,” says USA Today.

The housing market has been cooking for so long you’d think the thing would be done by now. And maybe it is.

“The boom is over,” says Celia Chen, at Economist.com.

We’ve reported rumors of the end of the housing boom on more than one occasion in this space. We’re not going to embarrass ourselves by reporting another one. Month after month, for as long as we can remember, the whole world economy has been sustained by American consumer spending. And for the last couple of years, American consumers have been sustained by credit – by mortgage credit, to be specific.

Without it, even more people would be standing in unemployment lines – everywhere from Baltimore to Bombay. Thanks to lower rates and higher house prices, consumers were able to “take out equity” from their own homes. This cute little phrase perfumed the event like patchouli oil on a sweaty mortgage broker. But sooner or later, we keep saying, the whole thing is going to start to stink.

The housing sector cannot continue to rise 3 to 4 times faster than the rest of the economy forever. Sooner or later, it has to cool off. Personal income rose only 1.7% last year – according to the Bureau of Economic Analysis – the first time since 1958 that the figure has been less than 2%. People whose incomes rise less than 2% cannot afford a 10% increase in housing costs, year after year, for very long.

Sales figures for houses in the San Francisco bay area were down 15% from a year ago. In Southern California, they were down 7.5%.

In the Rockies, the figures are worse – with Denver sales off 18%. Even in Richmond, sales fell 5% from a year ago. And in Massachusetts, housing sales for the first quarter fell 15%.

Could be the war in Iraq, of course. Could be a fluke. Nothing to worry about. Nah…no reason for concern. Forget about it.

Eric…? Your news, please…

————

Eric Fry in New York…

– A herky-jerky session on Wall Street yesterday jerked the Dow Jones Industrial Average higher by 31 points to 8,516 and yanked the Nasdaq Composite up 1% to 1,466 – a three- month high for the high-tech index. The dollar fell slightly against the euro…to $1.10. And bonds drifted lower for the third straight day, as the yield on the benchmark 10-year Treasury inched up to 3.99% from 3.96%.

– Now that stocks are approaching their highest levels of the year, stock market bulls are popping up like so many crocuses and daffodils. But we suspect the bulls will fade away as quickly as these delightful spring flowers. The recent mini-rally on Wall Street should not be confused with the beginnings of a new bull market.

– We’ve all heard how splendidly stocks perform over the long run. But how long might that “long run” be when the starting point is 30 times earnings? To be sure, long-term investing covers a multitude of short-term sins, like paying 30 times earnings for S&P 500 stocks. But why sin in the first place?

– “Over the long term, stocks have returned about 10% a year and have always rewarded the patient portfolio,” observes Barron’s Michael Santoli. “But like the Bible verse promising a life span of three score and 10 years, it’s a rough guideline describing a broad pattern, not a rule applicable to every time and place. And, unfortunately, unlike human life expectancy, the expected returns from stocks are likely to be lower in the years to come.

– “From 1926 through 2000,” Santoli continues, “the Standard & Poor’s 500 and its predecessor indexes generated annualized profits of 10.7%…[However,] according to recent work by Ibbotson Associates, 4.6 percentage points of the 10.7% return through 2000 came from dividends. Another 3.1% of equity market gains can be attributed to inflation…Together, then, dividends and the salutary effect of inflation on earnings delivered more than 70 cents of every dollar of wealth produced by stocks in the 75 years through 2000…The best 20-year period for stocks over bonds came in 1941-61, during which equities returned 16.9% a year.”

– Not coincidentally, stocks yielded 7% in 1941 and sold for less than 9 times earnings. Little wonder that stocks rewarded investors handsomely over the subsequent 20 years…And the only thing an investor had to do to reap such ample rewards was to buy U.S. stocks immediately after the attack on Pearl Harbor and continue holding them throughout the second World War, Korean War and Cold War…nuthin’ to it!

– Typically, the stock market rewards those who buy when the masses are eager to sell and valuations are depressed, and punishes those who do the opposite. When the lumpeninvestoriat are still eagerly buying and stocks still are pricey and Mary Meeker is still gainfully employed on Wall Street, the stock market is unlikely to bestow ample rewards over the ensuing 20 years.

– “Perhaps the most dramatic hindrance to those betting on a recurrence of historical equity returns is stocks’ vastly elevated valuation,” Santoli winds up. “The multiple of the previous year’s earnings…averaged about 15 for the 75- year span. Today, the market sits at 31 times 2002 results.”

– But perhaps corporate earnings will accelerate rapidly, thereby lowering P/E ratios to attractive levels. Dream on, says Morgan Stanley’s Stephen Roach. “The dream merchants are hard at work peddling the tale of another economic revival,” scoffs Roach. “The magic of postwar relief is widely billed as the catalyst…Just as America led the charge to Baghdad, the U.S. economy is now presumed to lead the way to global recovery…To me, this is a leap of faith of Herculean proportions…global imbalances have now reached the point where another burst of U.S.-led growth would be inherently destabilizing.

– “Reflecting a U.S. economy that accounted for fully 64% of the cumulative increase in world GDP over the 1995 to 2001 interval, the U.S. current-account deficit hit a record $548 billion in the final period of 2002, or 5.2% of GDP. If the world stays the path of its U.S.-centric growth dynamic and if America’s federal budget goes deeper into deficit, as certainly seems likely, the U.S. current- account deficit could easily surge toward 7% of GDP…For those of us who choose to remain cold, calculating, and unemotional, the world still looks like a very treacherous place. Call me a dreamcatcher.”

————

Bill Bonner, back in Paris…

*** Gold fell $2.90 yesterday. No comment.

*** Meanwhile, nature’s weapon of mass destruction, the SARS epidemic, seems to be getting worse. The death rate has climbed to 5.9%. Contrarians take note: this may be the perfect time for a vacation in Hong Kong; the restaurants, hotels and airlines are nearly empty.

*** “The world probably is a safer place, since the Americans took out Saddam,” said our friend, Michel, after lunch yesterday. “The other governments in the area are running scared. The last thing they want to do is to give the U.S. an excuse to attack.”

Whatever else may be said of this New World Order… it is different. More tomorrow…