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Issue V

October 1995

Sharp Investing

Shooting Where the Rabbit Was?

One of the sure signs of a bull market long in the tooth comes when investors pour money into sectors of the market which have just completed spectacular runs. In July of this year, investors poured a record 14 billion dollars into the stock market, most of it going towards the aggressive growth mutual funds. These funds as a group are very heavily weighted towards technology stocks, which had a spectacular run the first half of 1995. However, since mid-July technology leaders Microsoft and Intel are down 19% and 25% respectively. They led the way up for high tech, and so .....
As I have stated numerous times, many investors are more interested in what has done well recently, rather than what has done well over the long run. Putting your money into a sector after a big run-up is known as "shooting where the rabbit was", as the sector is no more likely to repeat the impressive performance than any other sector of the market. In fact, after a big run-up most sectors historically have underperformed the market for a finite period.
The fact that bond funds saw a withdrawal of over 3 billions dollars during July indicates that many investors, dissatisfied with returns from other investments, are moving bonds to stocks as they have witnessed the large profits reaped by stock owners this year. Many of these investors may have little or no experience with the stock market. Inexperienced investors buying stocks is another classic sign of a bull market top.

Consider these other facts:

- The U.S. is now well into the 5th year of economic expansion, a point we have only reached 3 times in the last 77 years, 1943, 1966, and 1987.

- The current dividend yield, 2.45%, is the lowest since 1906, almost 90 years. Since corporations aren't rushing to increase dividends, the implication is that this yield will attain more normal levels through the falling of security prices.

- Recent Initial Public Offerings (IPO's), such as Netscape, Redhook and others, have found an insane level of demand that has immediately jacked their offering price beyond any reasonable valuation based on reality.

- Merger mania has once again taken over corporate America, with the banking and entertainment industries leading the way.

- According to Barron's indicators, investor optimism is at it's highest point since 1987.

- Finally, the phrase "It is different this time" can be seen daily in newspapers, magazines, and other sources of financial information.

In the summer of 1987 new investors were "shooting where the rabbit was", the dividend yield was 2.6% (compared to a 4.5% average dividend), we were in the 5th year of an expansion, investor optimism was at an all time high, merger mania in the form of hostile takeovers were rampant, and IPO's were raging wildly beyond rational levels. Of course, things were not different that time.

Starting to see a familiar pattern emerge? While no one can predict market tops, breaks, etc., investors just getting into this market are taking on some awfully long odds in their quest for profit.

What to do? Long term investors that have been fully invested for the last 5, 10 or 20 years probably need do nothing as they can ride out any coming storm knowing prospects are still rosy long term.

However, I would strongly advise against beginning a buying program at this time, advice which many investors are ignoring. At Sharp Investments we are not purchasing stocks for clients that are beginning an investment program. We want to buy when everyone else wants to sell, and right now everyone wants to buy, buy, buy!

For those of you finding it difficult to sit on the sidelines (as some of my clients do), let me tell you a little story. In early 1987 Robert Sharp (my father and chief investment council for Sharp Investments), acting on the above noted conditions, started to liquidate his portfolio. For the next nine months he sat on the sidelines and watched as the market continued to climb another 10%. Was it difficult to watch the market continue to climb without being a part of it? Sure it was, but the discipline to pull out when things looked dangerous prevailed.

Guess who was one of the few buyers willing to purchase stocks from the great multitude of sellers, October 20, the day after the crash? Guess who made back that lost 10% in a matter of days, doubled his portfolio in the next six months, and went on to triple his portfolio by 1990, only 3 years later?

Having the discipline to get out when greed fuels the market and having the discipline to buy when fear fuels the market pays off every time.

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

The Virtues of Value

Does Value Investing work during Bull Markets?

In the last issue, I talked about the historical benefits of owning value stocks. I also discussed Richard Roll's 1994 study that showed that small value securities outperformed other styles of

investing by a considerable margin. However, common perception is that growth stocks do better than value stocks during big market moves. In this issue we put this theory to the test by choosing and following a portfolio of small value stocks during a 6 month period from March to September of this year.

The criteria for selection were 4:

1. P/E ratio < 13
2. Market Capitalization < $500 million
3. Dividend Yield > 4%
4. Increasing earnings for each of the last 5 years.

There were 12 securities that met the criteria, which as a group yielded a 6% annual dividend. The table below shows the portfolio, the purchase price, and the current price at press time.

Our theoretical portfolio is currently up 19.3%, including dividends, in the last six months, with 60% of the choices up and 40% slightly down or about even (the usual ratio of winners to losers making random picks). During this time frame, the Dow Jones Industrial Average returned 13.47% with a 1.3% dividend for a total return of 14.77%, and mutual funds were up about 12% during this same time frame. While the results are not scientific because of the small sample size, the smallcap value portfolio is doing quite well compared to the market in general.
Of course, since this portfolio has had a good run in the last 6 months it is no longer a true value portfolio as 7 of the securities have seen their P/E ratios increase towards market averages.
In any event, the value portfolio outperformed the market during a bull run, and I will report how it

holds up during the inevitable market correction that we should see before too many more issues of Sharp Investing hit your mailbox. Theoretically this portfolio should hold up better than market averages during a correction because the value security has a "margin of safety" that growth stocks do not have. Margin of safety was a concept used by Benjamin Graham in which the bigger the difference between true value and actual market price, the safer the investment from a standpoint of downside risk. While not scientific, it is interesting to note that among the underperforming 5 stocks in our portfolio, the biggest loss so far is a paltry 3.8%. Whether this is pure random luck or an example of the margin of safety at work is left to the reader.

Warren Buffett of Berkshire Hathaway is the world's most patient investor. In 1951 he started purchasing Geico Insurance. Recently he completed his purchase of Geico by buying out the remaining 51% he didn't already own. He has been purchasing Geico for 44 years with no signs of selling in sight. Do you find it difficult to believe Buffet in describing his favorite holding period for a stock as "forever"? Buffett's original $100 investment in 1956 is now worth almost 15 billion dollars so apparently he is doing something right.

Quality Control Investing

Limit Orders: Wholesale
Purchasing of Securities

In this issue we will tackle the use of limit orders as the first step in a Quality Control portfolio strategy.

In order to make the following meaningful, we will use the example portfolio from the previous article to show how the use of limit orders can increase portfolio returns.

A limit order is an order placed with a brokerage to buy a particular security only if it reaches the price

the investor wishes to pay below the current market price. Limit orders are usually honored until the investor requests a cancellation or, if after several months the security price has moved considerably away from the limit order, the broker may ask the investor to cancel the order. The cost of placing a limit order is the same as buying a security at the current market price.

The critical question then is - how far below the market price should a limit order be set and how long should an investor expect to wait until the limit order is triggered and the stock is purchased?

The answer depends on several factors. How badly does the investor want the stock? How patient is the investor? Does the investor have several stocks each of which could adequately fit into the portfolio?

Because of the random short term nature of security prices it is a fairly simple exercise to calculate the probability of triggering the limit order within a specified number of days. The "beta" value of a stock, which measures the volatility of the stock in relation to the stock market in general is used to calculate the range the stock price can be expected to move through within a specified time frame.

To simplify our example we will use one month as the time period in which we would like to acquire the security. Assuming a short term normal distribution and a three month beta leaves just one decision to be made - how badly do we want the security?

In practice Sharp Investments routinely sets multiple limit orders (3) that are each at 40% probability of occurring but have a 80% chance of at least one limit order occurring within several months. Caution: there is a small chance that you could buy all three securities in the same day, but it is very rare. In most cases, one limit order fills and you have time to cancel the other two. For this example we'll make it easy and assume each security is prized enough to warrant a 70% probability of hitting within 20 trading days.

The following table shows the results of taking each of the 12 stocks in our portfolio, calculating the beta values based on the previous three month day to day price changes, and setting a 70%, 20 day limit order below the current market price. Those of you interested in the actual mechanics behind this table can contact me for the excruciating details.

Results of Placing Limit Orders on Sample Portfolio

The chart above shows that by placing the limit orders we purchased 8 out of our 12 securities (67%), quite close to the theoretical 70%. The average number of days for a limit order to take effect was 19.25, again close to our theoretical 20 days.

The average gain of our portfolio from using limit orders is 4.12%. Remember that this gain is not a scientific result because of the small sample size used for this example.

This gain can be even more impressive if investors are willing to wait up to 60 days to purchase each stock. Also, the example only used 12 stocks. If an investor could set limit orders on 30 stocks looking for 10 hits to build a 10 stock portfolio, the gains again can be increased.

Limit orders can also be used in the selling of securities but the investor should be aware of the differences in using this approach. Since the investor is now the seller rather than the buyer, obviously you can only set a single limit order per stock you are trying to sell. Also, if you are selling because of some perceived change in the stock it may be better to get out at the market price quickly. But, if you are selling the stock for a personal reason rather than a perceived problem with the stock, setting a limit order slightly above market prices can add another couple of percentage points to the holding period return.

Sharp Investments
13160 SW Butner Road
Beaverton, OR 97005

The last piece of advice on limit orders has to do with avoiding setting them at round numbers, popular with many buyers and sellers. In other words, if your calculations would have you set a buy limit order at 19, set it at 19.125 to avoid the crowd. Conversely, if your calculations would have you sell at 19, set the order at 18.875 to avoid joining the end of a long line of sellers at 19.

However you choose to use limit orders, they can significantly add to the chances of overall success. The investor must be willing to occasionally miss out on a stock that turns out to be a winner (you'll miss out on some losers too), but the discount to market on every stock purchased will more than make up over the long run.

In the next issue we will continue to cover more quality control points in the quest to increase returns, provide more examples of strategies that have worked in the past, and report on the state of the market in general as it stands. While no one can consistently predict whether the market will correct today, tomorrow, or next year, 300 years of data indicate that we are and have been in an overvalued market for quite some time.

Let's be careful out there.
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