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Issue IV

June 1995

Sharp Investing

The Virtues of Value

Hot Stocks for Cool Markets

The number one question I am asked when a person finds out what I do for a living is "Do you have any hot stock tips?". Anyone who reads Sharp Investing has probably noticed that unlike other financial newsletters, I never recommend individual securities. There are numerous pitfalls in recommending a specific security to a person without knowing their risk tolerance, investment goals and current diversification of assets. A stock that might be perfectly appropriate for one person could spell disaster for another. It is a no-win situation for someone who hopes to maintain an ongoing relationship with friends, relatives, or business clients.

Of course, the other big pitfall in recommending specific stocks is that I've never found any evidence in either the investment world or the academic financial world that anyone has the skills to consistently pick hot stocks any better than anyone else. In almost all cases 60% of stock picks will appreciate within two years and 40% will not. Four times out of ten even the best investors will fail to pick a stock that appreciates after two years.

When people ask me THE question, I try to answer the question they are really asking "How do I make money in the stock market?". People assume that someone that recommends a hot stock to them will help them to make money. But since no one can consistently pick hot stocks, any money made on a tip is just a lucky coincidence. Studies throughout history have shown that picking good stocks is almost pure luck, which means that your own picks are as good as, or better than, your friend's, relative's or professional's advice. The real way an investor can affect their own destiny is in the proper portfolio management of their securities, not the picking of the securities.
No one is able to consistently pick hot stocks because of the intense competition among investors that evaluate securities. Millions of

investors, professionals and amateurs, are constantly analyzing all available information on a security.

The market price is a consensus average among all the investors as to what the company's shares should be worth. Rarely does the true value deviate much from the market value.

Even the handful of 'super-investors' with long term highly successful track records pick a dog once in a while. Warren Buffett is regarded as the greatest investor of all time, but that didn't stop him from recently taking a large investment loss in US Air.

Unforeseen surprises, both positive and negative, are the prime reason for changes in stock value. No one seems to be much better than the rest of the pack in predicting the largely unpredictable future.

However, having said all that, there is a subset of stocks that have proven over time to be a better investment than randomly picking from the stock market at large. Of course, I am speaking about Value Investing. Undervalued securities are companies that are trading below average market valuations. The price of a value stock is less than that of other stocks with similar earnings. This group contains both winners and losers, but randomly picking a stock from the value group has always been much more successful than randomly picking from the market at large.
When you hear the word 'potential' you probably think of biotech stocks, technology stocks, or other high-flying growth companies. The problem with the occasional high flyer, like a Microsoft or a Starbucks, is that it skews investors' expectations.

They expect all growth stocks to have the same potential as the high profile stocks. However, as a group, growth stocks have under-performed the market in general over a long period of time.

Don't believe it? There was a recent study done in which the 50 most promising software and hardware computer stocks (including Microsoft) of 1985 were tracked until 1995. We all know that Microsoft was up about 5000% during this time, but the group of 50 actually managed to under-perform the market averages over this time, even including the big gains of Microsoft. Microsoft was the exception, not the rule.
This is probably because investor expectations are so high for these types of companies that positive new information doesn't move the stock price up as much as negative information has the potential to move the price down. In other words, investors overestimate the potential of these perceived high flying companies and may underestimate the risks these companies face.

Conversely, the group of stocks that historically have produced the greatest investment results is the opposite of growth - value. Undervalued securities are companies that are trading below average market valuations because of a perceived problem. The perceived problem can be a company-specific problem such as its future potential, or a problem in the industry it competes in, or economic conditions considered bad for its business.

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

On average, the perceived problems are overestimated by investors. Over time value stocks as a group appreciate to higher levels as

investors recognize the problems to be less severe than previously thought.

The virtues of value are supported in a November 1994 study published by Richard Roll, Professor of Finance at Stanford and one of the giants of the academic world. Dr. Roll found that a simple strategy of investing in value securities outperformed the market considerably for the period 1984-1994. This is especially profound in that the study included the "high flying eighties", a time when it was perceived that corporate mergers, takeovers, and initial public offerings were the pathway to wealth. Dr. Roll's study shows that the superiority of boring old value investing persists in the modern era. Many studies have shown the superiority of value investing in the past, but it was thought that modern investors were now too smart to let undervalued opportunities go to waste. Perhaps this is not the case.

The virtues of value can be narrowed down further to produce even better odds of success. Dr. Roll found that small undervalued securities produced the best results of any of the strategies he studied. His study grouped all nationally traded stocks into portfolios according to size (large or small), value (growth or undervalued) and book value to market value (low or high). Roll constructed 8 portfolios out of the combination of these 3 factors. The graph below shows the results of the study. The S&P average is also shown.

where L = low and H = high

The portfolio returning 21% (LHH) = low size, high value, and high book to market value and the portfolio returning 5% (LLL) = low size, low value (growth), and low book to market value. As you can see, the three portfolios outperforming the market averages (S&P) all were high in value, meaning they contained undervalued stocks.

Roll ended up with 8 portfolios containing about 1250 stocks each. At the end of each year he re-evaluated the securities in each portfolio and if they had changed from a small size to a large size, or from value to growth, he would move them to the appropriate portfolio. Once a year - that's it. No market timing, no security analysis, just a simple grouping based on size, value and book value/market value.

The results were quite interesting:

The worst performing group was the low size, low value (growth), low bv/mv portfolio, which returned 5%. This contradicts the popular notion that small speculative growth stocks pay off. They don't.

The best performing group was the low size, undervalued, high bv/mv portfolio. Using Roll's simple strategy this group returned 21% annually for the 10 years studied, compared to the 14% market average for this time. It was determined that the value factor added most of the extra return, the smaller size a small amount of extra return, and the book value factor was almost negligible in terms of adding any extra return.

21% annual return from random picks of small undervalued stocks, with no stock picking, market timing, or portfolio management.

One would like to think that even this impressive return could be improved upon with the proper portfolio management skills (which I continually espouse in this publication).

Of course, in overvalued markets (such as the current one) undervalued stocks are difficult to find, but when the market cools off, you now know how to pick the hot stocks.

Therefore, the next time you are asked "Do you have any hot stock tips?", you can boldly look your brother-in-law's cousin's friend in the eye and tell them "I know of over 1000 hot stocks!".

Take the Retirement
Readiness Test

Retirement income. Those two words may mean Social Security checks to some, pension checks to others. Those retiring more than 20 years in the future may wonder how they'll finance their retirement. Corporate retirement plans have been shifting away from the

traditional pension plan (defined benefits plan) to employee managed retirement plans (defined contribution plans). This places the burden for assuring retirement income on the employee through 401k plans and IRA's. The self-employed have always had to fend for their own retirement through Simplified Employee Pensions (SEPs) or Keoghs.
The following is a process designed to aid you in determining how much you should be socking away each year to retire at the level you desire. You'll need a simple calculator for this test, or if you prefer you can call me for on-line help. There is an example running through the test to help you navigate the process.
STEP 1: Fill in your current annual income

Example: $80,000

STEP 2: Multiply your current income by your comfort factor (.75, 1.0 or 1.25) to obtain retirement income in today's dollars. For instance, if you are 25 and just starting your career you probably want a more comfortable retirement lifestyle than you have now - use 1.25

If you are 50 and at the peak of your earning power and at the time you retire you'll own your home and have the kids out of the house, you should be able to get by on less at retirement - use .75

If you are in between these examples, use your current income (1.0 multiplier).

Ex: 80,000 x 1.25 = $100,000

Current Income x Comfort factor = Adjusted Current Income

STEP 3: Use Table (1), on the next page, to select the inflation multiplier based on the number of years from now until you think you'll retire. Multiply by your adjusted current income from Step 2.

Ex: $100,000 x 1.99 (20 years) = $199,000
Adjusted Current Income x Inflation = Retirement income needed

Table1: Inflation Factor

STEP 4: From Table 2 below determine your current life expectancy, add it to your current age and subtract your estimated age of retirement. The result is an estimate of the number of years you are going to need a retirement income.

Table 2: Life Expectancy

Ex: 41.36 (life expectancy) + 32 (current age)
- 52 (retirement age) = 21.36 (years of retirement)
Life expectancy + Current Age - Age of Retirement
= Years of Retirement
STEP 5: At this step some assumptions are necessary.
· Since you can't take it with you we'll assume you plan to spend it all
· We'll also assume that at retirement your funds are fixed income investments keeping pace with inflation

These assumptions allow you to calculate the nest egg necessary to fund your retirement. From Table (3) below, determine the nest egg multiplier by looking at the number of years of retirement you calculated in step 4. Then multiply your annual retirement income (from step 3) by the nest egg multiplier to obtain the nest egg.

Table 3: Nest Egg Multiplier

Ex: $199,000 x 14.63 (22 years) = $2,911,370

Retirement Income (step 3) x nest egg multiplier = nest egg required

STEP 6: The last step is to determine how much you need to be investing each year in order to accumulate the nest egg for retirement. Again we will make assumptions:

· The investment return from your annual retirement contributions yield around the long term market rate: 10%
· Investments grow tax free in a retirement account such as an IRA, 401k, Keogh or SEP

From Table 4 below (last one, I promise), look up your contribution factor based on the number of years from now until retirement (be consistent with step 3). Multiply your nest egg by the contribution factor to determine your annual retirement contribution.

Table 4: Contribution Factor

Ex: $2,911,370 x .0165 (20 years) = $48,038

Nest egg x Contribution Factor = Annual Retirement Contribution

Do your actual retirement contributions match the end result of this test??
If you are underfunded it might be time to consider starting a tax sheltered retirement plan or increasing contributions to your current plan.

If you are overfunded, congratulations, but businesses should be wary of hostile takeovers, and individuals of greedy heirs.

Quality Control Investing

In the previous three issues of this column, I have presented the traditional investment model (1), made a case for a new investment model (2), and presented a technique for improving investment results based on the new model and statistical process control (SPC), a continual improvement process being used more and more in the business world. SPC is just one technique available in what I call "Quality Control" Investing.

For many years, investors have made decisions much as businesses used to make decisions - by the seat of their pants. Best guesses, intuition, experience - all of these play a part in both business and investing decisions. However, the eighties and early nineties have proven to be a time of tumultuous change for businesses. Intuitive decision making was being beat out by competition that used "Quality Control" decision making processes.

Today, virtually all manufacturing and more and more service businesses use Quality Control concepts. Terms such as ISO 9000 and the Malcom Baldridge Award are an entrenched part of the business lexicon.

The financial services industry is one of the few industries left where intuition is used more often in decision making than quality control concepts. For many years intuition was all an investor had to work with as the information on investing was very closely held and not widely available. In today's world, anyone with an internet connection can

obtain real-time stock quotes, information on virtually any public company, and access databases of financial and economic statistics - all for free.

Armed with a fast powerful personal computer, an amateur investor has virtually the same information and analysis tools as the top portfolio manager at Merrill Lynch.

Investing is rapidly becoming a very level playing field in terms of information availability. This increases competition, and decision making by the seat of your pants may not yield the results it once did for you.

Quality Control concepts can increase the odds of investment success in a world where competition takes away some of the previous edges certain sophisticated investors used to hold.

What do I mean by Quality Control concepts? Sharp Investments uses an eight point quality control program for clients that can be used to illustrate the concept (see the enclosed brochure). Things such as the use of limit orders and dollar cost averaging may each add only a small amount to investment return, but by collectively applying a variety of proven techniques, overall returns may outperform intuitive investing. The idea is to use experience and intuition within the framework of proven successful techniques. Doesn't it make sense to first stack the odds of success in your favor, and then apply experience and intuition?

Sharp Investments
13160 SW Butner Road
Beaverton, OR 97005

By managing your portfolio according to a group of proven strategies and continually looking for a way to improve the process you are implementing Quality Control Investing.

Of course, investors can still use their experience and intuition in addition to the quality control techniques to apply the best of both worlds to their investment techniques.

In future issues this column will present different methods of quality control investing designed to improve the odds of investment success. If a particular topic interests you please feel free to contact me for more detailed information.

See you in the fall.
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