Devoted to understanding the basics and fundamentals of investing

TRADING STRATEGY MISTAKES THAT EVERYONE MAKES:
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Many of my former colleagues and long-time business associates have asked similar trading strategy questions over the years. This series of strategy postings is my attempt to document both the questions and my answers. These postings go into great detail about the trading strategies which I currently use and used in the past to make a living trading the markets. They are obviously not for everyone. These strategies at best only offer you a different perspective to examine.

The bottom line up front: Making money in the stock market requires
1. Discipline
2. Timing
3. Follow solid rules
4. Disregard emotions and the media
5. Total dedication (related to discipline?)

One can make money on almost any decent selection of stocks if the above five items are followed. Read on to see exactly how you might do this.

Most of the strategies outlined in these postings are TOTALLY DEPENDENT on the proper use and interpretation of your market timing software. Past performance is no indication of future performance, and risk of loss is ever present.

History of My Trading
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I first began trading stocks in January 1975, right after the severe bear market from 1968 through 1974 ended. These trading tips (as follows) were developed over many years of trial and error, and have proven to be pretty successful. As always, past performance is no guarantee of future performance. Further, some of the trading strategies pointed out in these postings require that a long-term bull market be in effect, as defined by your market timing software. (More on bull and bear market definitions in future postings).

The Common Mistakes (Summary)
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If you see yourself in these rules, don't feel offended. Over the years, I have seen these mistakes over and over again. There is nothing personal implied. These things are simply human nature. We all share these problems, including myself, and I certainly know better (or I certainly should by now).

All of these points will be fully explained in later postings. Most of these points are controversial. Please note: If you ask 10 experts about each of the following topics, you will surely get 10 different and conflicting opinions. Further, you will rarely find 10 "experts" to agree on anything.

Even worse, when all of the "experts" do agree, it usually indicates that they are all wrong! Any approach to stocks that generates more profits than losses is a good approach. Certainly my trading techniques are not the ultimate, nor are they for everyone. They do, however, offer you excellent food for thought. If you have better ideas, particularly a successful set of trading rules, please share them with Larry on this blog. Meanwhile, here are a few of mine:

1. Never PLUNGE
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The loser puts all of his money into a single stock, hoping it will just ZOOM. The winner DIVERSIFIES into at least 10 of his best picks. He keeps each position small and MANAGEABLE (reasons explained later). Contrary to popular opinion, more diversification is better. At times, I have been forced into over 40 positions in order to just keep each one small and manageable. Diversification is like money and sex: the more, the better.

2. Never Sell to Break Even
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This one is the most common mistake I've seen repeated. It's just human nature! The loser buys a position hoping it will go up in price. After it goes against him, his strategy suddenly changes: Sell Just to Break Even! The WINNER uses a dollar cost averaging formula to guarantee a low price, and sets a realistic goal for profit. The winner NEVER sells to break even.

3. Never try to buy all of your selected stock at one time.
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The loser makes only a single purchase of a stock, and hopes that his purchase price is THE BEST price. The winner spreads his purchases of stock over time, and uses a special dollar cost averaging formula (which I will describe later in detail). The winner knows his purchase may go either up or down in price, and has a plan for each case.

4. Never sell your winners and keep your losers.
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The SMALLEST of profits usually burns a hole in the pocket of most novices. They sell on a 10% profit, and hold on to 50% losses. They cut off the flowers and water the dirt, so to speak. The loser keeps his losing stocks for many years, hoping they will go back up, and sells his winning stocks, thereafter watching them continue to appreciate in value, year after year. The winner sells his losers, and keeps his winning stocks. (More on this in later postings).

5. Never buy a stock with a HIGH PE Multiple.
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The loser buys a stock without consideration to its PE Multiple. A $10 stock can be VERY EXPENSIVE and a $100 stock can be very cheap (more on this later, too). Would you pay $1,000,000 for an old beat-up Chevy? Of course not! Yet people are eager to jump into a stock that is simply priced to the moon.

6. Never base "Expensive" or "Cheap" on the Dollar price of a stock.
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The loser only buys stocks that are less than $10 because he thinks that they are "cheap." The winner buys stocks that have a LOW PE Multiple for the group of stocks which those selected stocks are in, regardless of their DOLLAR PRICE. The loser wants as many shares as he can get for his $5,000. The winner just wants the stock to double, knowing the number of shares is a MEANINGLESS number. (Since I know that you are in total shock over this one, I promise to prove my point in a later posting).

7. Never change your strategy in mid-stream.
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The loser starts as a "Short Term Trader" and suddenly becomes a "Long Term Trader" after his stock selections begin to lose. The winner decides BEFORE he buys where his dollar cost averaging points are, and under what conditions he will sell. A friend of mine recently bought a stock that I had recommended to him, after I had done my homework on it. He purchased it at $20. His strategy was to sell it if it ever hit $40. Can you guess what he did when it hit $44? He changed his mind! Now his NEW strategy was to sell at $50! Within a week, the stock had run up to his $50 target. Guess what? Yes, his strategy changed AGAIN. His NEW, NEWER strategy calls for selling out at $60. And as of this writing, it's still at $50, but I somehow suspect that if it should ever make $60, a new, even higher target will be adopted then. How long do you think that this can last?

8. Never go into MARGIN when your market timing software is POSITIVE.
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The loser waits until the market has surged for months before he feels comfortable going into margin. The winner waits until his market timing software is just starting its UP CYCLE before going into margin. This usually is in the face of a declining DOW and severe NEGATIVE PUBLICITY.

9. If you go into MARGIN: You MUST have a target date to GET OUT of margin.
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The loser stays on margin through thick and thin. Some of my really good friends LOST IT ALL during the Crash of 1987 or the HUSSEIN Debacle of 1990. Margin is a double-edged sword that is generally required to be used, if you are to make any REAL money, but it can also literally destroy you if it is not used with extreme caution and a good pre-conceived plan.

10. Never be GREEDY and don't get MARRIED to your position.
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The loser tries to "GET RICH QUICK." Stocks are too slow, so he gets into futures contracts or options, or heavy and routine margin. The loser attempts to squeeze out the LAST POINT of profit when his stocks are going up. (Be happy with any profit, and don't be afraid to leave a few extra points of profit on the table for the next guy, who took YOU out at a profit). The loser always fails to get the LAST POINT of profit, and then helplessly watches his stock going down. Never fear, he will surely sell when it goes back up to that elusive LAST POINT of profit again! Instead, of course, it just keeps going down, and he soon finds his $45 stock at $3. Well, for sure he can't sell NOW! To sell at a loss is to admit to the world that a MISTAKE was made! Heaven forbid admitting to others that you made a mistake! Better to sit on it for years! Perhaps many years later, he sells in disgust because he just can't stand looking at it anymore! The loser fails to sell, waiting for it to "GO BACK UP AGAIN," or sells at an enormous loss. In summary: the loser finds it to be virtually impossible to sell on the way down. In short, he is MARRIED to his stock and can't sell it under any reasonable circumstances short of a "DIVORCE."

When buying a stock, the story is just as amazing. Our loser watches his desired stock, and makes a mental note to BUY if ONLY it went down to $xx. After going down to his target purchase price, he now establishes a NEW lower price to buy! After several rounds of this little routine, he still has not purchased a single stock! Well, you know what happens next. Itg stops going down and now begins going back up. Our friend cannot buy it now. He will wait until it goes back down AGAIN! The usual outcome: He watches it going UP and AWAY! It surges past his original observation price, and zooms into a NEW HIGH territory. He can't stand it anymore! QUICK, BUY before it goes EVEN higher! In summary: The loser cannot BUY LOW but is extremely eager to BUY HIGH.

The winner accepts the fact that he will never sell at the top. (They don't ring any bells to signal the top!) The winner knows he will never buy at the bottom either! The winner is very happy taking a profit in between the top and the bottom. (You will never go broke taking a profit.) There is money to be made by both the Bulls and the Bears. But the Pigs all get slautered.

I can say with some accuracy that the general public cannot buy stocks that are going down. They only like to buy stocks that are going up. I can also say with equal accuracy that the public cannot sell stocks that are going up. They only like to sell stocks when they are going down. (More on this later, too.)

11. Never Sell It All in one trade.
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The loser sells all of his position at once. The winner sells his position slowly over time. It takes several purchases to get the lowest price through dollar cost averaging. It should take several sales to get out at the highest price through sequential sales.

12. Never buy a stock that is not growing.
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The loser buys a stock to scalp a few points of profit out of it. The winner invests for the long term into good growth stocks and watches his investment grow. Popular names are not necessarily good growth stocks. IBM, for example, is always touted by the MEDIA as a GOOD stock. In fact, it's selling price has not even doubled since 1968 (adjusted for splits). The really great growth stocks are never publicised until the PROS want to sell them out to you at a profit to themselves. (More on this subject later).

13. Never be panicked into selling your stocks.
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The loser sells when everyone is selling in panic. The winner buys when everyone else is selling.

14. Never be panicked into buying your stocks.
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The loser gets caught in buying stampedes, afraid the price will go up ("get away from him") before he buys. The winner knows that stmpedes are always followed by selloffs. He holds his purchasing power until his market-timer software tells him to buy. The winner picks buying stampedes to sell stocks that he no longer wants.

15. Never use margin recklessly.
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The loser swings into full margin with no direct plans of what to sell or how to get back out of margin. Losers usually sell their BEST stocks to pay off their margin, and keep their worst stocks. The winner uses margin with extreme care and knows in advance which stocks to sell to get out of margin. He also has a target date from his stock-timing software. The loser can't sell anything to clear out his margin because "ALL OF MY STOCKS ARE GREAT!" The winner will sell a portion of each stock he owns, if he can't decide which one to sell.

16. Never buy on impulse.
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The loser buys on tips, and news media hype. The winner always checks his chartbooks before buying a stock. The winner verifies growth rates, PE Multiple, Debt, etc. It is true that most people spend more time shopping for a suit than shopping for a good stock.

17. Never buy a stock without chartbooks.
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The loser buys a stock "Blind," not really knowing the long-term trendline; not really knowing the long-term growth rates. The loser has no idea what the PE Multiple is, nor does he really care. A good friend of mine bought a stock with a PE Multiple of over 500! I told him not to buy it, but he went right ahead anyway. It was going up several points a week, and was obviously headed for the moon! The week he bought, at $48, it started going down, all the way down to $3. Even at $3, it was STILL grossly overvalued! He is still sitting on it, hoping in vain it will go back up again someday. The winner invests a small fraction of his portfolio into chartbooks and doesn't buy a stock until he has verified for himself whether it is a good investment or not. (More on stock selection later.)

18. Never be influenced by the "NEWS MEDIA."
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The loser buys when the NEWS MEDIA is glowing with goodness, and he sells when the NEWS MEDIA is full of bad news. The winner paces his buying and selling with stock-timing software. When his stock-timing software says to consider selling: The NEWS MEDIA is glowing with GOOD NEWS. When his stock-timing software says to BUY: The NEWS MEDIA is so full of BAD NEWS that you always have this GUT-WRENCHING feeling in the pit of your stomach.

19. Never believe the "EXPERTS."
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The loser buys when the market is high, because "Experts" said it was surely going up another 300 points higher. The loser fails to buy at market lows because there are ALWAYS "Experts" predicting it will go lots lower! The winner sells when his stock-timing software says it is time to consider selling, and buys when his stock-timing software says it is time to consider buying. He turns a deaf ear to all the "Experts," always extending the length of a market move.

When gold hit an all-time high, do you remember what all of the "experts" were saying? They were ALL predicting higher gold prices. Some were even predicting $3,000 gold! Just before the crash of 1987, rampant predictions of a 3,500 DOW were everywhere. Well, okay, we got there eventually, but it took a lot of intervening years first.

20. Don't be influenced by the DOW.
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The loser is influenced by every little quiver of the DOW, and is afraid to buy if the DOW isn't "behaving properly." The winner knows he is not buying the DOW. He knows that he is buying a winning stock, which MAY be a component of the DOW, but whose price action has little to do with the DOW. He is buying it knowing that his market-timing software is rarely wrong in its generation of mechanical signals. After all, the DOW is only 30 stocks! There are more than 4,000 stocks trading on the exchanges! Many stocks trend up when the DOW trends down, and vica versa. Don't let the DOW influence your buying decisions.

21. It is FUTILE to correct for past "MISTAKES."
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The loser will sell sooner "Next Time" or he will sell later "Next Time." The winner knows that EVERY buy or sell decision made in the stock market can be looked at as a mistake. The winner is happly with his profit, and never looks back.

Are you shocked? At ANY price that you buy you could have bought it cheaper, if only you had ... And any price that you sell is also a potential mistake, because if you had only sold sooner (or later) you could have made a lot more money! (The devil has always got 20-20 hindsight!) The winner knows how to ERR in style! You generally have a choice on buying: Buy too soon or buy too late. Your purchase will NEVER be at the exact bottom. Given this choice, we try to buy too late. Many greedy types, of course, consider this to be a big mistake, because they attempt to buy at the EXACT bottom.

On the sell side, you will ALWAYS sell too soon, or sell too late. Don't even think of trying to sell at the exact top. When J.P. Rockefeller was asked by a reporter how he had made all his money, he replied, "I sold too soon." Our constant goal should be to sell too soon.

The winner's motto: Buy too late and sell too soon. Regardless of what you do, or how you do it, the devil will pop into your head and with 20-20 hindsight proclaim that you made a big mistake. NEXT TIME you will hold on longer to wring out the last point of profit, because you saw your stock going up AFTER YOU SOLD! (More on this shocker later.)

22. THE DEVIL LIVES WITHIN ALL OF US.
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I like to call my emotions the devil. You can paper trade, pretending to buy and sell stocks for years, and be extremely profitable on paper. Your rules will be flawless. Your brilliance will be dazzling! The devil is sound asleep deep within you, during all of this practice. A person can practice playing a musical instrument for years. Not until he plays in the big band at Carnegie Hall does he ever become a musician.

The minute you put real CASH into the market, the devil takes over. You can feel the tug of war in your fingers and arms as you call the broker to place an order. (Don't buy now, Bob... it will go lower... you will LOSE.) When you attempt to sell a stock, the devil takes over again. (Don't sell now, Bob... it will surely go higher... you will LOSE AGAIN, you fool!)

The devil becomes more and more powerful as your profits and portfolio grow. You begin to look at your portfolio through a magnifying glass. Every drop in value becomes a crisis. Every up movement becomes a euphoric experience. Every paper loss is devastating. (More later.) Every one or two point move is telescoped into a REALLY BIG EVENT. When you study the long-term chartbooks that I will recommend to you, you will understand the futility of looking at day-to-day prices.

MY NEXT POSTING COMMENT TO FOLLOW WILL BE ON STOCK VALUATION AND STRATEGY.

STOCK VALUATION & STRATEGY
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Buy Low & Sell High (An Introduction)
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To profit from the sale of stock, one must be able to buy the stock at a low price and sell it later at a higher price. Obviously, everyone is trying to do this. If it were easy, everyone would be rich. So this is EASIER SAID THAN DONE. It is easy to think of strategies that seem to work on paper, but which never work in practice. The methods for buying low and selling high are mechanically easy to the most casual observer. Everyone knows how to make money in the stock market. In fact, it is fair to say that everyone that I ever met was a self-proclaimed "expert" on how to make money in the markets.

That is why the stock markets function in the first place. If there are 100 or 1000 people in the market, I guarantee that each is an "Expert" (if asked) and that each uses a different strategy (if they have any strategy at all). Most of those I have worked with shoot from the hip, responding to the news and events, and with no really clear rules to follow at all. I will freely admit that I could not make many profits at all if everyone did the same things that I do. I can even say that your trading style will evolve to be different from mine, even after you have read all of these postings. I don't expect you to use every one of my trading rules. I really don't want you to do that, because you may not be able to sleep at night. I am providing this information because it may provide some ideas to make your trading more profitable. It is offered with the intention of providing you with a lot of good information.

It seems that I don't personally know of a single person who made enough money in stocks to retire early. I have heard of people who have done it, but I just don't know them. Even worse, the results achieved by these self-proclaimed experts that I do know are universally dismal: from a total loss of capital to a portfolio that does not even perform as well as a savings account at the bank. You may not like my approaches to the market, but they have worked well for me in the past. As usual, past performance is no guaranty of future performance. Your mileage may vary. Your results could be far better or far worse than mine.

In order to buy low and sell high, you must learn a most fundamental skill: You must know what a stock is really worth. If you don't know what a stock is worth, how can you possibly determine a real "bargain" when you see it? If you have no real idea of what a stock is really worth, how can you presume to know when a profit is too small or excessive? How can you be sure that the stock you sell is not going to keep right on moving up while you sit helplessly by with your thumb up your behind, watching on the sidelines? Even worse, how can you be sure that the price you paid will not lead to immediate losses as it goes into a tailspin? The proper valuation for a stock CAN be determined. The answers may surprise you, or shock you. For sure, you will not believe some of my statements initially. However, over time, you will become a believer, as more and more of the facts are presented for your careful consideration.

It is ESPECIALLY TRUE in the stock market: You feel smart when you don't know what you don't know! My favorite definition of this phenomena is: IGNORANCE SQUARED. PUT THE ODDS IN YOUR FAVOR: BUY STOCKS THAT ARE UNDERVALUED. PUT THE ODDS IN YOUR FAVOR: SELL STOCKS THAT ARE OVERVALUED. Neither of these judgements are made in dollars per share! THE DOLLAR PRICE OF A STOCK IS MEANINGLESS!

PE RATIOS MEASURE THE VALUE OF STOCKS
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What is a cheap stock?
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If you think that a cheap stock is $2.00 and that an expensive stock is $150, you are DEAD WRONG! A career of losses and frustration will follow you forever. You will find yourself buying CHEAP stocks that go down and selling EXPENSIVE stocks that go up dramatically. If you don't believe this, then read on.

REMEMBER THIS RULE: The DOLLAR price of a stock MEANS NOTHING. (I have over-simplified this on purpose). Don't scoff at me just yet.

A friend of mine once purchased a stock for $3 and called to let me in on the fantastic deal. The stock was under a great deal of HYPE and promotion by the groups who would gain most from the sale of this stock. I looked it up in my Long Term Values chartbooks, and suggested to my friend that he get out of it immediately! This stock ws SO EXPENSIVE that it should have been selling for TEN CENTS or less per share! I told him to expect a steep price decline, and suggested he get into another stock, selling for $85. I pointed out that this $85 stock was so CHEAP that it had no where to go but up.

Within two years, his $3 stock had declined to two pennies per share, and was eventually delisted from the NASDAQ. The $85 stock doubled and split, and continued going up. It is currently about $210, ($55 after the split) and still a bargain. It is STILL CHEAP. The amateur always argues that I obviously don't know what the hell I'm talking about, and that I should have my head examined. However, please keep an open mind as you are reading the rest of this posting.

YOU MUST KNOW THE PROPER VALUE OF A STOCK IF YOU EXPECT IT TO GO UP AFTER YOU BUY IT! Those who purchased the above $3 stock were just as wrong as someone who would pay $1,000,000 for an old used Chevrolet, but did not even begin the suspect foul play.

A stock selling at $10 may be EXTREMELY EXPENSIVE and priced to the MOON! As a result, its price has no where to go but DOWN! You can only LOSE by buying this stock.

At the same time, a stock selling for $120 may be AN INCREDIBLE BARGAIN! This stock has no where to go but UP. This stock will double in price while the above $10 stock PLUNGES to pennies.

If this sounds confusing, then it probably IS! Hang in there with me, and you will see why. We will look into the mechanics of stock pricing. All will eventually become CRYSTAL CLEAR (or you weren't paying proper attention)!

We will look into a simple example: You will buy a business. You will issue common stock for your business. You will declare STOCK SPLITS and examine shares OUTSTANDING. It is absolutely essential to fully understand these principles, if you aspire to have profitable trades. Do not roll your eyes and gloss over this stuff.

LESSON #1: THE FUNNY MONEY MANIPULATION OF STOCK PRICING
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Let's assume that you want to buy the corner drugstore. You want to buy the ENTIRE BUSINESS from Walgreen's, so as to provide yourself with a new career. You actually discover TWO drugstores for sale by Walgreen's that are exactly equal in all aspects except:

Drugstore #1 has the following: 50,000 shares of stock outstanding priced at $100 each. Total market value of all stocks: $5,000,000. Therefore, if you bought ALL of the stocks for 5 million dollars, you would be 100% owner of this drugstore.

Drugstore #2 has the following: All the same stuff as drugstore #1 above, except for the following: One million shares of stock outstanding priced at $5 each. Total market value of all stocks: $5,000,000. Therefore, if you bought ALL of the stocks for 5 million dollars, you would be 100% owner of that drugstore.

KEY POINT: As we can see, Drugstore #1 and Drugstore #2 are identical except that one has more shares of stock outstanding than does the other. Is one drugstore "cheaper" than the other? Of course not! You would pay the same $5,000,000 to buy Drugstore #1 as you would to buy Drugstore #2.

However, you consult with your favorite stock broker and discover that his COMMISSION for handling 50,000 shares priced at $100 is MUCH CHEAPER than for handling one million shares priced at $5.

In this example, had you gone for the "cheaper" stock of $5.00 your commission expenses would have been MUCH HIGHER! Your broker charges for the number of shares traded, in addition to the dollar cost of the stock sale itself. However, you were SMART and went for the higher priced stock to REDUCE your commission expenses. As you can clearly see, the dollar price of each stock has NOTHING to do with the value of the drugstore! The $5.00 stock and the $100.00 stock each represent a different percentage of ownership of the drugstore. But if you are going to buy the entire business, you will spend the SAME $5,000,000, regardless of how many shares of stock the business is split up into.

Imagine that the Drugstore is a pie and that this pie can be cut up into as many pieces as the drugstore owner wishes. If the pie is cut into 3 pieces or into 10 pieces, does it matter? When you put all of the pieces back together, you still have the same pie, don't you?

The drugstore owner had discovered that if he divided his business into 10 shares of stock, each share would cost $500,000. To his dismay, he discovered that no one could afford to buy even a single share. So to get around this problem, he did a 5,000 for one stock split. Now there were 5,000 new shares in for each of the old 10 shares. The drugstore ownere's business was now divided up into 50,000 pieces and each piece was worth $100.00. Again to his dismay, people thought his stock was priced "TOO HIGH," even though they all could afford to pay the new price of $100. This time the drugstore owner arranged for yet another stock split. This time 20 for one! Now each share was worth $5.00, and there were 1 million shares outstanding!

So the drugstore owner went back out on the street to sell his stock and was SHOCKED, mind you, to see that people would NOT buy his stock because they thought it was "TOO CHEAP." The general public is SO STUPID! They felt that there MUST be something wrong with the company since its stock price was so CHEAP! Well, back to the drawing board! Our poor drugstore owner was by this time getting downright annoyed with the FUSSY public. This time he arranged for yet another stock split, but this one was a REVERSE SPLIT, which gave each stock holder one share for every four held. The reverse split now placed the stock at $20.00 per share with 250,000 shares outstanding.

THIS time the drugstore owner went back out on the street to sell his stock, and was pleased to discover that the public thought his stock was priced to sell "JUST RIGHT," and the public bought up all of the shares available. The public thought that a $20.00 stock would rise in price faster than a $100.00 stock. (Of course, they were wrong -- again. Read on to see why.)

LESSON #2: VALUATION OF A SINGLE SHARE OF STOCK Against The BUSINESS VALUE (Or How To Go Crazy In One Easy Step)
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Disclaimer: This posting is not intended to provide a quick Masters in Business Administration degree. If you need to know more about business and business valuation, there are many fine books and classes on the subject. I am watering down a very complex subject into simplistic terms to help you to determine a stock's true value. Many concepts are OVER SIMPLIFIED to make a point here. Perfect technical accuracy is neither attempted nor intended within this lesson.

What we need is a method of determining what a stock is really worth, since its price can be so easily MANIPULATED through stock splits on a moment's notice. We certainly cannot trust the dollar price of the stock to mean anything. Agreed? Right! We just proved it, remember? If you DON'T agree, the re-read the previous lesson again, and again, and again, until you DO agree.

KEY POINT: Value PER SHARE
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Obviously, the number of shares outstanding and the "VALUE" of the company must be KEY to a true value per share. And you are right. If you divide the VALUE of the company by the number of shares outstanding, you will have "THE TRUE" VALUE per share! In our example, the drugstore was worth five million dollars, and there were one million shares of stock. The VALUE PER share is expressed as $5.00. (Wasn't that easy?)

Company's True Value
-------------------- = True Value/Share
# shares outstanding

Why, this is simplicity itself! However, there is a GIANT FLY IN THIS OINTMENT: NO TWO PEOPLE can really agree on what the drugstore is really WORTH! The best that anyone can give is an OPINION, good for the day, on a good day. Opinions are like assholes: everyone has one and most of them stink. If you don't believe it, read on.

There are many different ways of expressing how much a drugstore is worth. This is not an exact, precise science. Three different experts may estimate the value of the drugstore to be worth three different prices. Even more interesting, they all believe that their own estimates are the only ones which are correct!

Valuation Theory #1: GROSS SALES
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As a general rule of thumb, a business is worth 5 times the gross sales amount per year.

It is worth much more if gross sales can be expected to double every year for the next 10 years.

It is worth much less if gross sales are expected to decline by 50% every year for the next 10 years.

Whose CRYSTAL BALL is the most accurate to predict future sales?

Valuation Theory #2: NET INCOME
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As a general rule of thumb, a business is worth 10 times the net income amount per year! If you own the drugstore, net income is what is left from sales after paying the rent, the insurance, the wages, and deducting for the cost of doing business, such as shoplifters and employee theft, etc. The net income is YOURS to keep. It is your PROFIT from running this store. Since you are the owner of the business, your income for all of your work and planning comes from PROFIT.

It is worth much more if net income can be expected to double every year for the next 10 years.

It is worth much less if net income can be expected to decline by 50% every year for the next 10 years.

Who really has a CLEAR crystal ball to accurately predict future NET INCOME?

Valuation Theory #3: BOOK VALUE
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As a general rule of thumb, a business is worth the value of the buildings, the furniture, the fixtures, the inventory, and the "goodwill" of its customers. Add all of this up and then subtract out the DEBT. You are then left with BOOK VALUE. However, this method is not at all accurate either, since no two people will agree on what all of those things are really worth! The value of the real estate changes every year, and the inventory can not really be sold for its original cost (think depreciation). Even worse, the BOOK VALUE generally relates to the *original prices paid* for PLANT AND EQUIPMENT. The PLANT may have been built 100 years ago for $1,000, and today it would cost over $100,000 to rebuild if it burned to the ground. Yet it may be carried on the BOOKS of the company for the original cost of only $1,000.

Valuation Theory #4: CHARGE ALL THAT THE MARKET WILL BEAR!
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As a general rule of thumb, a business is worth whatever the traffic will bear! The owner of an apartment building or of a drugstore will want to sell out at the HIGHEST PRICE POSSIBLE (surprise, surprise), regardless of what the foregoing valuation theories say! (After all, they're just theories.) The laws of supply and demand will push prices UP BEYOND BELIEF if there is a limited supply with unlimited demand AND people believe that prices are still going higher (inflationary psychology). In fact, they will pay ANY price as long as they think it can be sold later at an even HIGHER price! (Think about some of the recent oil company takeovers and consolidations, for example). Is this an example of the old greater fool theory or of Crowd Mania, in its essence? Remember the Tulip Bulb Mania?

This Is It! The "TRUE" VALUE OF THE DRUGSTORE IS ...
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As a general rule of thumb, a business is worth ALL of the above: in total or (more frequently) in part! So you can see that there is a really WIDE range of values: the TOP value being on the MOOON, and the bottom price being absolutely absurd. So IT IS in the stock market, as well. By any measure of the above, you could buy any business for prices that are equally unreal. (It happens ALL the time). Can you see some light at the end of this tunnel?

THE COMMON UNITS OF STOCK VALUE MEASUREMENTS:
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As related to the price of the single share of stock, you may PROPERLY express value as:

* BOOK VALUE PER SHARE
* GROSS SALES PER SHARE
* EARNINGS PER SHARE
* THE PE MULTIPLE PER SHARE

NOTICE that the selling price in dollars per share is conspicuously absent. That is because, as an astute student of the market: people who are fairly-well educated in the wiles of the market don't really care what the dollar price of a stock is! If there is a concern, the astute trader will prefer a $75 stock over a $20 stock. He has $5,000 to invest and he wants that $5,000 to double or triple in value. The number of shares is meaningless toward that goal. However, his commission is lower if he buys the stock selling at $75, all other things being equal.

KEY POINT: STOCK VALUATION EXAMPLE
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Let's examine a hypothetical company which has 100 shares outstanding. Our company has a book value of $500. It has sales of $1000. It has earnings of $100.

* BOOK VALUE per share = $5.00
($500 book value divided by 100ss)

* GROSS SALES per share = $10.00
($1000 sales divided by 100ss)

* EARNINGS PER SHARE = $1.00
($100 earnings divided by 100ss)

* PE MULTIPLE PER SHARE = ????
(Price divided by Earnings per share)

Learn this well! Example:

stock price $15.00
------------------ = P/E of 15
earnings per share $1.00

(The PE MULTIPLE PER SHARE = 15)

The MOST COMMON and MOST POPULAR valuation method is the PE MULTIPLE. It is expressed as a multiple of earnings per share. It is ESSENTIAL that you understand this concept COMPLETELY AND THOROUGHLY. Keep in mind for all of the following examples that EARNINGS PER SHARE = $1.00

FOR EXAMPLE #1: If the stock of our little company were selling at $10.00 per share, THEN IT IS SELLING AT 10 TIMES THE EARNINGS PER SHARE! This price of 10 times earnings is deemed to be the PROPER price by many.

FOR EXAMPLE #2: If the stock of our little company were selling at $20.00 per share, THEN IT IS SELLING AT 20 TIMES THE EARNINGS PER SHARE! This price of 20 times earnings is considered by many to be HIGH PRICED.

FOR EXAMPLE #3: If the stock of our little company were selling at $40.00 per share, THEN IT IS SELLING AT 40 TIMES THE EARNINGS PER SHARE! This price of 40 times earnings is considered by most to be OUTRAGEOUS.

FOR EXAMPLE #4: If the stock of our little company were selling at $75.00 per share, THEN IT IS SELLING AT 75 TIMES THE EARNINGS PER SHARE! This price of 75 times earnings is considered by all but the insane to be PRICED TO THE MOON! Nobody in their right mind would pay that much money for a business! Having said that however, stocks have been sold to the public many times over, in teh past, at this HIGH price, and even higher! Remeber, THEY can split a stock price to make it anything they want in dollars per share! In real life, there would probably be a 4 for one stock split announced, so as to bring the selling price down to $18.75 each. This would (of course) reduce the earnings per share from $1.00 to $0.25, since there will now be 4 times more stock outstanding! Now the GENERAL PUBLIC will consider this stock to be at a bargain price, and will crawl out of the woodwork to buy it! Of course, you and I know that IT IS STILL BEING SOLD AT 75 TIMES EARNINGS. (The GENERAL PUBLIC really IS pretty stupid, aren't they?)

THE WHOLE MARKET PE MULTIPLE TELLS ALL
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The DOW-JONES is made up of something like 30 stocks (I think), and the Dow Average is just simply the dollar price it would take to buy all 30 stocks.

The DOW-JONES sells at a PE multiple, as well. This number can be found in the BARRON'S newspaper. If the DOW is selling at a PE of 20 (which is historically high), then you will find that overall PE multiple on many stocks will be HIGH. If, however, the DOW is selling for a PE of only 8, then you will find the PE multiple of most stocks to be low.

When you look at the PE multiple of an individual stock, you ask: Is this PE HIGHER OR LOWER than the DOW? If it is a higher PE than the DOW, then it should be a BETTER stock than one you find in the DOW. If its PE multiple is less than the DOW, then it is either a bargain or is WORSE than a typical DOW stock.

At all times then, the WATER LEVEL of the MARKET TIDE may be measured in terms of the DOW-JONES PE multiple. Let's examine some historical numbers taken from one of my chart books:

Year DOW PE Comments
---- ------ ------------------------
1949 7 Beginning of the massive
1949-1957 bull market

1961 27 Just prior to the
massive 1962 selloff

1974 6 Beginning of the giant
1980 bull market

A study of the chart books tells us that a DOW PE above 20 is HIGH. This is the time to be careful and wary of sell-offs! Plan on selling out your high-priced issues in this area. You could (properly) find yourself selling everything because everything is HIGH PRICED (above the 40 to 50 times PE multiple).

A DOW PE below 10 represents a MAJOR BUY of a lifetime! Major buys occur only a few times in your entire lifetime. If you should live long enough to see another time like 1949 or 1974, then be prepared to buy with both hands and both feet. NEVER bet the ranch, but DO come close: become a much more aggressive buyer!

LET'S TIE IT ALL TOGETHER
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A business is worth some multiple of sales, earnings, and property.

A business expected to have stongly growing sales and earnings is worth more.

A business expected to have falling sales and earnings is worth less.

The value of a stock can be measured in terms of a PE Multiple.

The BEST stock to buy is in a company that can be expected to grow for many years.

The WORST stock to buy is in a company that is experiencing negative growth.

The IDEAL stock is in a company growing at a fast clip AND selling for a low PE multiple, too. (This is the true definition of a bargain stock!)

Sell stocks when the PE multiple gets too high, and buy stocks when the PE multiple gets too low. Keep stocks that are fairly priced (in terms of their PE multiple) and growing at a rapid clip.

What About Dividends?
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There are many stocks that have little or no growth. There are just as many stocks that have negative growth. I will not buy any of them.

If I accept market risk to buy a stock, I want growth of my investment. If I simply stashed my wad in the bank, I could get about a 6% rate of growth with NO RISK OF LOSS! If a company is growing less than 6% per year, why should I take the risk of buying it?

EITHER BEAT THE BANK OR BECOME THE BANK!
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Dividend payouts are not meaningful unless they can beat the bank's 6%. In most normal times, dividend payout rates are less than 5%, so why would anyone bother? GROWTH is the answer. It is the hope of increasing dividends that makes people willing to settle for a dividend payout of only 3%. However, if sales and earnings of the company are NOT growing better than 6%, why would anyone buy the stock? I don't know why. I won't. Growth of the company is the PRIMARY reason to buy and hold a stock. Dividends are for the old, retired people, not for you. When you eventually retire (of old age, that is), you too will then be looking for dividends so that you don't have to screw around anymore with this trading and timing stuff.

STOCK PRICE MOVEMENT
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Okay, IT'S TIME TO SHOCK YOU AGAIN: Stock prices move in percentages of the current price, NOT IN POINTS! I know this shocks an inexperienced investor, because of their reaction over the years.

GROUND RULE #1: The $$ per share of a stock follows the sales and earnings of the company, both up and down (over time).

GROUND RULE #2: Sales and earnings of a company are measured as a percentage of change over the previous year. A growth of 50% in sales and earnings will ultimately be translated into a 50% INCREASE IN THE STOCK PRICE. This rule may take days, weeks, months, or even years to unfold, but eventually it will unfold.

KEY POINT:
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COROLLARY to GROUND RULE #2: Stocks move in percentages, NOT in points. A 20% gain on a $10 stock moves it to $12. A 20% gain on a $50 stock moves it to $60. To say this in a different manner, a $2 profit on a $10 stock is exactly the same as a $10 profit on a $50 stock: both earn you 20%.

Furthermore, it is just as difficult for a $10 stock to move to $12 as it is for a $50 stock to move to $60! Don't scream at me! We will go into this in a subsequent posting. At this point, you may want to take an aspirin...

MY NEXT POSTED COMMENT WILL BE ABOUT NAVIGATING THROUGH TREACHEROUS WATERS.