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Issue XIII

October 1997

Sharp Investing

Conventional Wisdom:
Truth or Consequences?

In this issue of Sharp Investing we examine some of the commonly held beliefs of the average investor and how the financial services industry perpetuates these beliefs in order to sell financial product to investors.

Belief #1 - When "the market" fluctuates wildly from day to day my portfolio is doing the same

Investors viewing the business headlines are likely to see "Market down 200 points" or "Market up 200 points" in huge bold headlines on any given day. Watching these day to day fluctuations can be a stomach churning experience if you are imagining your personal portfolio is also going through these same wild gyrations as the popular market averages.
What do these headlines make you feel like doing? Buy, sell, buy, sell, buy, sell. Cash registers ring across brokerage houses with every big market headline, regardless of direction.

The important thing to remember is this: changes in most of the popular averages are driven by just a very few large stocks. For example, Microsoft and Intel make up more than 25% of the NASDAQ composite average, so a big move in either of these giant stocks has a huge impact on the average, even if the other 4000 stocks in the NASDAQ do nothing. The S&P 500 Index is the same way, it gives more importance to the biggest stocks and less weighting to the smaller stocks. Most of us, though, don't hold nor would want to hold 100 times more GE stock in our portfolios than that of another stock 1/100th the market size of GE. Most investors diversify by holding stocks in equal weightings (unless invested in index funds which follow market

weighting). We usually have about the same dollar amount of a stock, regardless of its size in the market.

The most popular market average, the Dow Jones Industrial Average, contains just 30 of the 8000 nationally traded stocks. Often when this index is gyrating wildly from day to day, your personal portfolio (depending on the composition) may be doing nothing, or even the opposite of the headlines.

For example, this August the Dow lost 8%, or nearly 700 points, yet Sharp Investments client portfolios gained value. This is because my clients own few large Dow stocks right now; instead they hold more of the smaller capitalization stocks which did make gains in August (as reflected by the Russell 2000 - an index of smaller capitalization stocks) even as the scary headlines dominated the financial news.

With the rare exception of a 1987-type of one day crash, day to day fluctuations in the market are meaningless, especially if your portfolio composition is different than that of the popular market averages. If you are a long-term investor there are very few one day events that could have a long term economic impact on your portfolio. That does not mean that long term trends of these popular averages are not important, but if you've

got a long term investing plan in place with appropriate investments there is no need to agonize over the big ups and downs that make headlines. Headlines may sell newspapers, but investors should be more concerned with tracking the slowly developing details that don't make the front page.

Belief #2 Good companies are always good investments

Everywhere you turn, "experts" are telling you to buy the best companies in America and hold them forever. At first glance, it seems hard to argue with this simple advice. After all, everyone knows who these companies are, all leaders in attractive popular industries with competitive advantages that give them strong predictable earnings. There is less uncertainty to owning the best companies in America. Less risk.

However, with less risk comes less return. The only way investors have made better than average returns on these great companies is if they were purchased prior to their recognition as a earnings powerhouse, or if they were purchased during an industry or market-wide correction (bear market). Once a company is recognized as an industry leader or brand name and attains the status of one of the "best companies in America" the returns from the company stock decline. Why? The company has earnings that are more predictable than most stocks, making it a less risky investment, which by definition provides a lower return.

The best and biggest companies in America, the S&P 500, currently trade at 22 times earnings with a future projected earnings growth rate of 10%. Investors are willing to pay $2.20 for one dollar of future growth in earnings because the future earnings are more predictable and the stocks are less risky to own. The other 7500 stocks in America trade at 15 times earnings with a future projected earnings growth rate of 14%, meaning investors are only willing to pay $1.50 for $1.40 worth of future growth. The smaller and less powerful companies have higher projected growth rates, but are more risky, and therefore pay a higher rate of return to compensate investors for taking the higher risk.

Over the last 70 years stocks of the best companies in America have returned about 10%, while the rest of stocks have returned about 12.5%.
The best companies in America have not been the best investments. So why do the experts recommend these brand names? First, they are popular, comfortable, well recognized investments that investors can get excited about. They are an easy sell. Second, there used to be a saying that "nobody ever got fired for recommending IBM". It is much easier in hindsight to defend a poor investment in a great company than to defend a poor investment in a poor company.

"The best companies in America have not been the best investments"

A study* was done in which the 50 most profitable companies stock returns were compared against the stock returns of the 50 least profitable companies. Over a 45-year time span the dogs beat the high flyers by a wide margin. The higher risk of the dogs provided higher return, the lower risk of the stars provided a lower return.

One caveat to this approach comes during industry- wide or market-wide corrections. Occasionally investors can pick up great companies at bargain prices during market slumps at perhaps 10-12 times annual earnings. This is a case where a great company can be a great investment. However, since these great companies generally trade at market premiums those kinds of opportunities are rare.

Sharp Investing is a quarterly publication focused on investment education. For a subscription contact
Sharp Investments, at:

13160 SW Butner Road
Beaverton, OR 97005
Phone 503-520-5000

Fax 520-0530 email:
Daniel R. Sharp
Registered Investment Advisor

* O'Shaughnessy What Works on Wall Street

Belief #3 - Mutual funds are the best way to take advantage of the stock market
Mutual funds, first offered in the 60's, were originally intended as a mechanism to allow the small investor to "enter" the market and build assets by consistently putting small amounts of money into the stock market. This allowed the small investor to "dollar cost average" into the market, gain instant diversification, and avoid the high commission costs of buying a few shares of a stock at a time. This was a good thing (and still is for the new small investor). However, as mutual fund companies grew, they set up national distribution networks that compensated brokers, financial planners, and other salesmen for selling their mutual funds to the public. Salespeople, compensated much better by funds than stocks, shifted their emphasis to selling funds to everyone, not just the small investor.

Thus, we now have investors with hundreds of thousands or even millions of dollars being sold mutual funds intended for the small investor. The new small investor expects to pay the high costs of mutual funds as the price of first getting into the market. However, the larger investor can get into the market at a much lower cost by avoiding the high fees of mutual funds because they have the economies of scale to do so.

The problem with mutual funds is that 90% underperform the stock market over time, even before fees and loads are extracted. By the time fees, loads, and penalties come out of
the portfolio, the results are even worse. Adding an investment advisor or a financial planner who is paid an additional fee to choose the mutual funds for investors just makes it that much tougher for the portfolio to beat the market.

Although mutual funds are run by competent professionals, these pros are constrained by many non-investment considerations that lead to the overall poor performance of the mutual fund industry. Since funds make money from attracting and keeping money, not from providing superior long-term performance, portfolio managers must do what attracts investors. What attracts investors is good short-term performance, even at the expense of superior long-term performance. What attracts investors is holding lots of popular name stocks. In addition, funds are not permitted to own more than
5% of any one stock, forcing most huge mutual funds to hold over 500 stocks, rather than allowing portfolio managers to choose just their 10 or so best ideas. And finally, funds attract buckets of money they have to invest after the market has run up and the bargains have dried up. They are also forced to respond to redemption requests by liquidating holdings at inopportune times, usually when investors panic as the market goes down and there are bargains everywhere. In other words, funds are forced into buying high and selling low.

One other consideration to buying the average mutual fund (averaging over 100% annual turnover) is the capital gains tax problem created for the investor in taxable accounts. Mutual funds distribute capital gains annually to investors whether they want them or not. Contrast this with a buy and hold strategy where the investor can control when they want to incur the capital gains.

In short, mutual funds are a marketing success, not an investing success. For investors with over $50,000, a portfolio of common stocks have a much better chance of beating the market than a portfolio of mutual funds.

Belief #4 - Portfolios need to have some international holdings

During the last 10 years it has become popular for financial "talking heads" to recommend holding some international assets in a portfolio in the name of diversification. Many investors are not aware of the additional risks and costs to international investing, which need to be weighed against the potential returns from investing overseas. Added to the normal risks of investing in equities are currency risks, political risks, and economic risk. These are very real and substantial risks, currencies fluctuate daily and political and economic systems are much less stable abroad than here in the U.S. Investors in Asian mutual funds found this out recently when their funds dropped an average of 10% in just 2 days.

Since it is very difficult to directly buy a stock on a foreign exchange, most investors either purchase international mutual funds or purchase individual stock ADR's (American Depository Receipts) of which approximately 800 trade on the New York Stock Exchange. Both methods have higher costs than domestic investing. ADR's generally impose a foreign withholding tax of about 20% on income

generated via these ADR's. International mutual funds typically have very high management fees because of the inefficiencies of researching and investing in businesses that are foreign-based. In addition to the costs and risks of international investing, there are other difficulties to owning a foreign-based business.

Owning stock is the same as being a partner in a business. If you were starting your own business, imagine how difficult it would be to operate in a foreign country where you don't know the language, the business customs, the economic and political system, the accounting procedures, the regulatory requirements, and in most countries, the system of bribery. This may be what you are taking on when you hold international assets in your portfolio.

In most cases basic fundamental data on a company and its stock is not available, or does not adhere to an accounting system that meets U.S. standards. John Templeton, known as the father of international investing, admits that economic data on specific countries is unreliable and data on specific companies almost non-existent. Most international funds are simply buying a basket of stocks that represent an entire country that they feel has good prospects. Therefore, most of these expensive international funds are not doing much stock picking, they are basically indexing an entire country based on their macro view of the economic climate.

Sharp Investments
13160 SW Butner Road
Beaverton, OR 97005

If investors feel they must have exposure to growing economies outside of the U.S., I recommend two methods. The first is to purchase an international index fund, which will mitigate the high costs of international investing. The second is to purchase one of the many U.S. based multi-national companies that do significant business in the economies of the world in which you wish to participate. This second method not only eliminates the high costs of international investing, it also completely hedges the currency risk and partially hedges the economic and political risks.
International investing is simply another new and exciting financial product offered by the financial services industry to get investors to buy, but the bottom line is that participation in foreign economies can be accomplished in ways with much lower costs and risks.

These are just four of the many areas in which investors have been taught to believe what they read and hear from the financial services industry. Navigating the differences between what is used to sell an investment versus what actually is best for the investor requires the constant questioning of conventional wisdom. Successful investing is like solving a story problem, much of the information that comes at you is loud and persistent, but distracting and not relevant to solving the problem.
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