Common Sense Investing

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Common Senseinvesting

Clint Vogus

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Contents

Chapter

Introduction i

1 Invest with Good Fund Managers 14

2 Always Focus on Value 19

3 Steady Results 22

4 Dont Sit on the Sidelines 25

5 Develop Patience 28

6 Markets are not Rational 31

7 Think Beyond U.S. Stocks and Bonds 35

8 Be Where Markets Are 40

9 Dont Follow the Crowd 43

10 Have an Investment Plan and Stick to It 46

11 Issues and Outlook for U.S. Economy 49

12 Outlook for U.S. Stocks 58

13 Investment Strategy 60

14 Investment Opportunities 62

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Common Sense Investing consists of ten principles thatare used to guide investment decisions and an investment

strategy, based on current global economic issues and trends.

The investment strategy answers the question whatmarkets to be in or where to invest based on the economicenvironment and trends. The investment principles define how toinvest to take advantage of the environment. As an example, amarket is technology stocks and a how to invest, is a technologymutual fund.

As the global environment changes, investment threatsand opportunities change. Investments therefore, need to bechanged to take advantage of the new environment and avoidpotential losses.

A global issue that affects investment strategy in 2005 isthe decline in the value of the U.S. dollar relative to other majorworld currencies. In this economic environment it would be

appropriate to consider investments in global stocks and bondsthat are unhedged to get the advantage of both foreign assetappreciation, and appreciation of the foreign currency. Thiswould not have been a good investment strategy in the mid1990s when the dollar was gaining strength against foreigncurrencies.

One of the lessons I have learned is that every markethas a season. Common Sense Investing helps guide me to the

right investment for the right season and avoid what is out ofseason.

Investment Experts

Interest in the markets during the boom of 1982-2000brought a lot of new research and many books about differentapproaches to investing. This research gives us insight into how

different investment approaches have performed under variousmarket conditions.

Several Nobel prizes have been awarded for investmentresearch that led to a better understanding of market dynamics. Ihave read a number of investment books and publications, and

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have spent much time trying to better understand what works ininvesting and what does not and why.

In this pursuit I have studied some of the brightest andmost successful investors. They range from Ben Graham, thefather of value investing to George Soros, one of the mostsuccessful hedge fund managers, and many others with differentapproaches.

Some of the experts that I have studied include, but arenot limited to the following.

Ben Graham and David Dodd, wrote Security Analysis,first published in 1934. It laid the foundation for value investingand was one of the earliest books to present a systematicapproach to investing in stocks.

Their approach was to buy stocks of companies whenthey were selling below what they defined as their intrinsic value,and hold them until they reached their full value. This was a

conservative approach to investing and provided a margin ofsafety against general market downturns. Many individualinvestors and mutual fund managers use this value investingapproach today.

In 1984, as the great bull market in U.S. stocks wasbeginning, Ken Fisher wrote Super Stocks. He started with thevalue investing principles of Graham and Dodd and added someadditional valuation measures to identify companies that had

great growth potential but whose stocks were selling at pricesthat were low.

Ken referred to these companies as super companiesand predicted that they could increase in value 3 to 10 times inthree to five years. Many did during the long bull market thatfollowed.

Jeremy Siegel, a professor of finance at the WhartonSchool of the University of Pennsylvania in his 1993 book Stocksfor the Long Run, presented historical research from 1802 to thepresent to support his thesis that U.S. stocks are the best andsafest long-term investment. The market performance for the

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period from 1994 up to March of 2000 supported his researchconclusions well.

John Bogle, the founder of the Vanguard Group and anadvocate for the individual investor, in his book Common Senseon Mutual Funds, helped investors to better understand themutual fund industry. He presented data on the returns and costsof managed mutual funds compared to index funds. His bookconcluded that investing in index funds was a lower costalternative to investing in managed mutual funds, and in manycases yielded better returns.

The index method of investing became very popular inthe 1990s and Vanguard had the largest index mutual fund. Itgrew to about $100 billion in assets before the market downturnof 2000, and is still the largest mutual fund today.

Harry Dent, Jr., has been one of the leaders in researchon the relationship between demographics and market returns.He wrote his first book in 1993 titled The Great Boom Ahead. He

predicted the stock market boom that we experienced in the late1990s. He presented many insights into the relationshipbetween demographics and investment returns.

In his latest book, The Next Great Bubble Boom writtenin 2004, Harry presents further demographic trend data thatpredicts the final boom in the U.S. stock market before adownturn, beginning at the end of this decade. He demonstrated,through his research, that the investment environment and

specific opportunities change over time and are driven bydemographic and technology cycles.

Charles Ellis published the first edition of Winning theLosers Game in 1975. In this book he presented reasons whymost individual investors do not make money in investing. Hedemonstrates that with a sound personal investment policy, andan understanding of the markets and discipline, investors can

change from losers to winners. Since his early work there hasbeen much research on the psychology of the individual investor.The new field of Behavioral Finance attempts to understand whyinvestors make more irrational or emotional decisions thanrational ones, when it comes to investing.

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In The Essential Buffet Robert Hagstrom presents theprinciples that Warren Buffet uses to make investment decisions.Warrens principles include investing in a business not a stock,

demanding a margin of safety to minimize risk, and focusing on afew outstanding companies.

Warren has been investing since 1956 through hiscompany, Berkshire Hathaway, and has the best long-termrecord of any investor. He invests for the long term and rarelysells any of the companies that he invests in.

Soros, The Life, Times and Trading Secrets of theWorlds Greatest Investor, written by Robert Slater, traces the lifeof George Soros from his beginnings as an immigrant fromBudapest, Hungry to the most successful hedge fund manager.

Many of Soros investment successes resulted frommaking large bets on the outcome of world economic or politicalevents. His ability to understand world macro-economic andpolitical events, their impact on investment markets, and to

predict how they will turn out, has been a key to his investmentsuccess.

Peter Lynch, one of the most successful mutual fundmanagers during his career with Fidelity, describes his approachto investing in Beating the Street. During his thirteen years, 1977to 1990 as manager of the Fidelity Magellan Fund, the fundearned a compound annual return of 29.2%.

Lynch believes in order to make the best investmentdecisions you have to understand a companys products,management, and business. He traveled thousands of mileseach year to visit companies and meet with management toassess their growth prospects before making a majorinvestment.

He focused on commonly known products that everyone

was buying as they represented the best opportunities forgrowth. Some of his best investment ideas came from his wife.She would suggest companies that were producing products thatshe liked. Identifying high growth companies that had goodmanagement with good products contributed significantly toLynchs success.

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William ONeil, founder of Investors Business Daily, inhis book 24 Lessons for Investment Success, explains his

approach of investing in stocks that have strong earnings growthand strong price appreciation. His daily newspaper is dedicatedto helping investors follow his momentum investing system. Herecommends buying stocks that have the highest levels ofmarket activity and strong current price, volume, and earningstrends. Many investors, through his daily newspaper, follow thisstrategy.

The late Al Franks book The Prudent Speculator, detailshis value approach to investing, which has earned him one of thehighest and most consistent portfolio returns of most all otherinvestment newsletters as rated by Hulbert Financial Digest. Hefollows many of the value principles of Graham and Dodd butadds additional valuation measures and the use of margin toenhance returns. There are now several mutual funds that usehis system.

John Mauldin, an expert on hedge funds and alternativeinvestments, has written a recent book Bulls Eye Investing. In ithe outlines his views on where various investment markets areheading and makes recommendations to align investments toprotect assets and take advantage of evolving trends.

He sees what he calls new economic realities as thedrivers for alternative investments. His book provides a road mapto help avoid investment pitfalls in what he predicts to be a very

turbulent investment environment for the next eight to twelveyears.

This brief summary of some investment experts that Ihave studied demonstrates that there are a variety of differentand successful approaches to investing. They include valueinvesting, momentum investing, index fund investing, buy andhold, large growth stocks investing, demographic trend following,

betting on the outcome of economic and political events, andalternative hedge fund investing based on macro-economictrends. There are also a number of others such as day trading,technical analysis and using puts and calls, just to mention a few.

My Investment Approach

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All successful investment professionals have anapproach to investing which defines how they will invest, where

they will invest, what they will invest in, and when they will buyand sell. Its these investment principles that guide theirdecisions.

As we have described, they are very different. They allhave been successful over periods of time and under variousmarket conditions. There does not appear to be one bestapproach to investing nor one that necessarily works all the time.

With over twenty years of personal investing andmanaging investment trusts, I have had the opportunity toexperience a number of different market environments. Theyrange from the 1972-1974 market downturn, when the Dowdropped 39.6%, to the 1982-2000 technology driven bull market,the 1987 crash, the 1994-1995 downturn, the 2000-2002technology crash, the 2003 recovery, and now the 2004-2005seemingly directionless market.

I have learned from my mistakes, such as buying U.S.bond funds in the late 1970s when interest rates were rising,buying gold at its peak in 1980, buying potential acquisitioncandidates in the late 1980s, chasing the technology boom to itspeak in March 2000, and trying some market timing approaches.My learning has often been painful, but they say that is how wereally learn.

This accumulated investment experience, as well as theknowledge gained by studying many investment experts haslead to the development of Common Sense Investing.

Common Sense Investing consists of a set of principles,which define how I will invest. It also requires an understandingof the current global environment to help define which markets Iwill invest in. The investment principles, together with the

current investment environment, results in an investmentstrategy. The strategy defines what specific investment I willmake.

Since the global investment environment changes overtime, which changes market opportunities, I review investments

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twice per year and make adjustments as conditions change. Ichange my investments as necessary to take advantage of thechanges and avoid losses.

In order to be an effective investor under a variety ofdifferent market conditions, every investor needs to develop anapproach to investing based on the following:

Develop a set of investment principles that fit whoyou are as a person and as an investor. Both yourpersonality and your investment principles need to becompatible so you can be comfortable with yourinvestment decisions and sleep at night.

Follow your own principles or adopt someone elsesthat are consistent with who you are, and dont waverfrom them. As an example, if you are a conservativeperson, you should not have a principle that says thatyou will invest in high-risk investments.

Gain an understanding of the current globalenvironment in which you are investing. Look at whatis going on both in the U.S. and around the world andhow it affects the long-term outlook for specific typesof investments.

Some of the environmental factors to consider include,demographic trends, the state of the U.S. economy,current budget status, interest rate trends, valuation of

the U.S. dollar against other currencies and direction,inflation rates, consumer spending, consumer debt,and balance of trade.

Knowing these factors helps define what markets toinvest in and which ones to avoid. It is important toseparate long-term trends from short-term conditions,as it is the long-term trends that are most important in

making investment decisions.

Using this assessment of the global environment andunderstanding how it affects various investments,develop an investment strategy that is based on

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your principles and consistent with current trends.Strategy defines what specific investments to make.

As an example, if current interest rates are high, andthe Federal Reserve is taking action to lower themdown, to take advantage of this trend, a U.S. bondmutual fund would be an appropriate investment. Thisassumes that one of your investment principles is toinvest through managed no-load mutual funds. Alwaysmake your investment choices based on yourinvestment principles and within the current investmentenvironment.

Review your investments twice during each year.The reviews should include a look at how eachinvestment has performed since the last review andyour assumptions about the current environment.

If the reasons you made the investment are still true,then even if the investment has not performed as you

had expected, continue to hold it. If the environmenthas changed, then it may be time to sell theinvestment and purchase one that is consistent withthe current environment.

Not doing reviews twice per year can put your portfolioat risk of potential loss as the environment may havechanged and your current investments may not beappropriate for the new environment.

There are appropriate investment strategies for everyenvironment. Buying high-growth technology stocks may havebeen an appropriate strategy during the late 1990s, but perhapsnot an appropriate one for 2001or 2002.

Buying long-term U.S. bond funds is a good investmentstrategy when interest rates are declining, but not appropriate in

a rising interest rate environment.

There is a right season for most investment strategies.Since we have no ability to change the investment environment,our challenge is to understand what it is and invest accordingly.

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Common Sense Investing consists of my personalinvestment principles, and a current investment strategy basedon my assessment of the investment environment and trends

that I see. The principles will not change for me, but myinvestment strategy will, based on my periodic review andupdate of the investment environment. As the world changes,the specific investments that work best also change.

Before I present my investment principles, let me give alittle background on myself, which will help in understandingthem.

I came from a midwestern family of nine where we allworked as soon as we could get a job to help support the family.We learned early in life the value of money and the importanceof saving.

I had the opportunity to get both an engineering and abusiness education. I have always had an interest inmathematics and how things worked, both mechanical and

electrical as well as complex systems. I was also fascinated byhow businesses worked.

During much of my career I worked in manufacturingcompanies in a variety of different industries and a number ofmanagement positions. This taught me the importance of costs,cost reductions, competition, business growth, strategy andprofitability. I have had a lifetime passion for economics, worldevents, investments and learning in general. My hobbies include

reading fiction and non-fiction, writing, running, tennis, cycling,traveling, and motorcycles.

As shown by my investment principles, I am frugal, andalways try to get the best value for each dollar. I am quiteconservative when it comes to taking investment risks. Myprinciples are a good example of a set of principles for investingbased on personal values. I have no trouble sleeping at night

with my investment decisions.

My overriding principle in investing is to protect assets frommajor loss. This is not always possible when there is an abruptand unexpected change in the investment climate that causes

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the market to drop suddenly. Then the goal is to minimize lossesand move on to the next investment opportunity.

Common Sense Investment Principles

1. Invest With Good Fund Managers

Invest in mutual funds rather than individual stocksto gain access to professional stock pickers andreduce the risk of owning a few individual stocks.

2. Always Focus on Value

Never pay more for an investment than you should.Value never goes out of fashion. Value provides amargin of safety when markets turn down as well asan opportunity for additional returns when marketsboom. Even good growth stocks go on sale.

3. Steady Results

As in baseball, always swinging for home runs canresult in a lot of strikeouts. There are very few homerun hitters who also bat 0.350. Waiting for the rightpitch and sticking with the game plan is important towinning in both baseball and investing. Steady dayin and day out small gains is the best way toaccumulate good investment returns.

4. Dont Sit on the Sidelines

You must be in the market to win, not on thesidelines. In any market whether up, down orsideways, there are opportunities for positivereturns. Market timing is a losers game. Being fullyinvested in the right investment at the right time is akey to successful investing.

5. Patience

Good sound investing is boring as there is not a lotof activity. Trading is not investing. Investing wellrequires research, good judgment and then a lot of

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patience to wait for results. As in farming, giveinvestments time to germinate, grow and then beharvested.

6. Markets are not Rational

Todays price of a specific stock may have little to dowith reason, logic or value. Ben Graham, the fatherof value investing, described it best. Mr. Market, inthe short term, is a voting machine not a weighingmachine.

The price of a stock on a given day has more to dowith popularity than with worth.

Dont spend a lot of time trying to figure out why themarket is where it is and where it might go next. Themarkets are not rational and therefore cannot bepredicted.

7. Think Beyond Traditional Stocks and Bonds

U.S. stocks and bonds are not the only investmentoptions available nor are they always the best.Consider foreign stocks and bonds, precious metals,natural resources, energy, real estate, andcommodities.

Since all markets move in cycles and not all

together, all investment options need to beconsidered in an investment strategy, as there is aseason for every investment.

8. Be Where Markets Are

A buy and hold investment strategy does not providethe best long-term results, as markets shift over

time. Moving investments to where opportunities areis necessary to gain the best results.

Traditional asset allocation models for investing donot maximize the advantage of major shifts inmarkets.

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9. Dont Follow the Crowd

It has been demonstrated through research that theconsensus of the majority is generally wrong. Doingthe opposite has a better track record. Do yourhomework and then follow your convictions, not thecrowd.

10. Have a Plan and Stick to It

Good investing takes a plan and discipline. A set ofprinciples, an investment strategy and the disciplineto follow them separates the winners from the losers.Develop a plan and stick with it. Dont be swayed.

Having independent outside guidance helps to keep youon track and assures that your principles are sound and yourstrategy is consistent with the current environment.

The next chapters will explain each of these principles inmore detail.

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Chapter 1

Invest with Good Fund Managers

There are a number of different ways to invest in the market.The more common include individual stocks and bonds,managed mutual funds, index funds, and exchange-tradedfunds.

Exchange traded funds or ETFs are similar to indexfunds but are traded directly on the major stock exchanges. They

have become popular in the past several years, and both thenumber and variety offered have increased. Additionalinformation on ETFs can be obtained at reuters.com,iShares.com, or etfconnect.com.

By investing in individual stocks, I learned that it requiredboth knowledge and time. Knowledge of industries andcompanies is required to find good stocks. Time is required forresearch, to follow daily price changes, and determine the right

time to buy and to sell. I often bought and sold at the wrongtimes and wanted to hold on to my favorite stocks.

Many individual investors have not done well withinvesting in individual stocks as they did not have the time nordid they develop effective buying and selling criteria. Manyended up with a buy and hold strategy that may have workedwell in the 1990s when almost every stock went up, but has not

worked since the market downturn in 2000.

Managed mutual funds offer the professionalmanagement necessary to be successful.

One of the advantages of managed mutual funds overindex funds or ETFs is that they have the flexibility to changeinvestments, as detailed in the funds investment prospectus.

An index fund or an ETF must always be 100% investedin stocks and must continue to buy as new money comes intothe fund. Index funds or ETFs only sell when investors want toredeem shares, which might not be the best time to sell. Theymust also buy an equal proportion of all stocks represented bythe specific index that they are mirroring.

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Managed mutual fund managers decide what to buy,when to buy, and when to sell. Fees are higher for managed

mutual funds compared to index funds or ETFs, but it is worthpaying for a good investment manager.

Buying individual stocks can also be an effective methodfor investing if one has the time and technical backgroundrequired to analyze stocks, and the discipline for buying andselling. Individual stock investing limits investments to primarilyU.S. stocks. It is difficult and expensive for individual investorsto buy most foreign stocks. There are a number of newslettersand services available that recommend individual stocks forthose who are interested in taking this route.

The rapid growth of the mutual fund industry in the1990s brought some opportunists that may not have had theinterests of their investors as their first priority. Some oldfashioned self-serving greed crept into the industry during thisperiod.

Thanks to the efforts of New York Attorney General,Elliot Spitzer, the Securities and Exchange Commission, andother regulatory and law enforcement agencies, some of thesemutual fund firms and fund managers have been dealt with.

A number of these firms have been fined and forced tomake restitution to shareholders. Several fund managers andexecutives have been barred from the industry. Further

regulation and oversight of the industry is being put in place toprevent these problems from reoccurring. The mutual fundindustry is now much healthier and more focused on shareholderinterests.

During the 1990s, with the rapid growth in the number ofmutual funds there was also a lack of experienced investmentmanagers. When the technology bubble burst in March of 2000,

many fund managers did not know how to react. Some thoughtthe drop was temporary and that stocks would recover quickly sothey held on to their positions longer than perhaps they shouldhave. This period, however, did produce some good fundmanagers.

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I have found a number of mutual fund managers whoshare my investment principles, and have long track records of

consistent performance under a variety of different marketenvironments. They also have their shareholders interest astheir number one priority.

Some of the fund managers that I trust with my moneyinclude:

Stock Fund Managers

Mason Hawkins and Stanley Cates who have beenmanaging at Longleaf Partners Mutual Funds formany years.

Bill Nygren of the Oakmark Funds family.

Chuck Royce founder of the Royce Funds overtwenty-five years ago.

James Gipson who has managed the Clipper Fundsince 1980.

John Montgomery, president ofBridgeway Funds.

John Rodgers, manager ofAriel Funds.

Harry Hagey who manages Dodge & CoxFunds,

which was founded in 1930.

Richard Aster, Jr. manager at Meridian Funds.

Ron Muhlenkamp who has managed his MuhlenkampFund since 1988.

Marty Whitman who founded Third Avenue Mutual

Funds over twenty- five years ago.

Wally Weitz who has managed the Weitz Funds sincetheir founding in the 1980s.

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Christopher Brown and John Spears who have beenmanaging funds for Tweedy Browne, one of theoldest and most successful mutual fund firms,

established in 1920.

John Buckingham, who was an understudy of Al Frankfor a number of years, and now manages the Al FrankFunds.

Bond Fund Managers

Bill Gross, who is the one of the worlds mostrespected experts on bonds, directs the managementof many of the bond funds offered by PIMCO.

Dan Fuss ofLoomis & Sayles manages a number oftheir bond funds.

None of the mutual funds or fund families mentionedabove charges a sales load or sales fee.. I believe in putting all

my money to work without having to pay a sales commission. Ihave found very few mutual funds, which both charge a sales feeand out perform the best no-load mutual funds over long periodsof time.

I have had the opportunity to meet with some of theabove fund managers and have invested with all of them. Whatseparates them from the thousands of others are:

1. They have investment experience in a variety ofdifferent market cycles and understand variousmarket forces.

2. They are long-term investors and are notreactive to temporary market fluctuations.

3. They are patience in both their buying and

selling. They have a strong bias towards value,and research companies before they buy.

4. They have most of their personal wealthinvested in their own funds.

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5. They are disciplined and have a set of investment principles, which they follow under allmarket conditions.

None of these fund managers or fund families has thebest performing fund each year. They have, over long periods oftime, delivered consistently higher returns than their peers andoften with less risk.

My list of good mutual fund managers is not all-inclusive;there are others that are in the same league. As an investor it isimportant to understand who your mutual fund manager is, whathis experience is in both good and bad markets, what decisionmaking process he uses to buy and to sell stocks or bonds, andwhat his long-term performance record is compared to others inthe same category. Most importantly, where does he invest hisown money?

Investing with the best fund managers increases yourodds of protecting your assets during market downturns and

getting consistent long-term results. Before buying any mutualfund, do your due diligence to fully understand who you areinvesting your money with and how they invest it.

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Chapter 2

Always Focus on Value

Stocks seem to be the only thing that we buy withoutmuch regard for their value. This was taken to an extreme duringthe 1990s technology stock boom. We were willing to pay veryhigh prices for shares of stock in companies that had neverearned a profit, and had no near term prospects of profitability.During this period, many companies focused on how much cash

they could spend.

Everything else that we buy, from food and clothing tocars and houses, we shop around to make sure we are gettingthe best possible value.

In our professional business dealings we look for thebest sources of supply, and negotiate for the best prices oneverything from office supplies and airline tickets to raw

materials and equipment. We are not hesitant to changesuppliers for a few percent in savings.

The reason we often ignore the price of an individualstock in relation to its value, is rooted in human nature and thepsychology of investing. We experienced this in 1999, when theNASDAQ gained 85.6%, driven by many of the dot-COM startupcompanies.

During this boom there was a lot of momentum that wasdriving up stock prices. We did not want to miss out on theaction. If we could buy a stock today for $15 a share andtomorrow someone was willing to pay $16, we bought it now.This worked until there were no new buyers who were willing topay more. Those who bought early wanted to sell, and theprices came tumbling down. Over the next two years, theNASDAQ lost 67.2% of its value.

This type of momentum investing is similar to a chainletter. It works as long as the next person is willing to pay morethan you did for the stock. When the chain is broken, panic oftensets in, there are more sellers than buyers, and the stock pricecan go into free-fall, taking your paper profits with it.

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In order to assure that you are paying a fair price for astock when you buy it, you need some criteria for determining

what a fair value is.

Ben Graham, in his work on value investing, developeda valuation method he called intrinsic value. His approachlooks at the value of all the assets that a company has on a pershare basis and compares it to the current stock price. If thestock price was 30-40% below its per share net asset value,then Ben felt the stock was selling at a bargain price. If otherfactors were positive for the company, the stock was purchased.

Graham felt that if stocks could be purchased for lessthan their intrinsic or net asset value, then that discount wouldprovide a margin of safety in the event the stock market wentdown or if the company did not perform as anticipated.

Since Ben Grahams work, others have refined andexpanded his evaluation criteria. Additional valuation criteria

used today include; price earnings ratio, price-to-sales ratio,price-to-book value, and price-to-growth rate.

In value investing when a stock reaches full valuation itis generally sold. This selling strategy can avoid holdingovervalued stocks that could suddenly drop significantly in price.

Unless you are an excellent stock trader and can predictwhen a high-flying overpriced stock is about to turn down, value

investing is a safer alternative. Value investing has historicallyout performed growth investing as defined by paying a premiumfor stocks that are experiencing greater than market rates ofgrowth.

Jeremy Siegel in his book Stocks for the Long Run sitesone analysis that compared returns of large cap growth stocks tovalue stocks for the period from July 1963 to December 1996.

Over this period the value stocks gained a compound annualreturn of 13.1%, and the growth stocks gained a compoundannual return of 10.3%.

James OShaughnessy, in What Works on Wall Street,presents the results of a number of studies, which showed that

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stocks purchased at low valuations relative to the general markethave outperformed both higher valued stocks and the generalmarket.

For the period of December 31, 1951 through December31, 1994 all stocks had an annual compound return of 12.81%and the top 50 P/E ratio stocks returned 8.87%. In another studyduring the same period, the 50 stocks each year with the lowestprice-to-book valuation returned 14.66% compound annualreturn compared to 12.81% for all stocks. That means that$10,000 invested in the general stock market at the end of 1951would be worth $1,782,174. $10,000 invested in the lowestprice-to-book stocks for each year would be worth $3,591,446 atthe end of 1994. Quite a difference.

Buying stocks with low valuations does not result in thebest returns every year, as in 1998 when large cap growth stocksreturned 42.15% and large cap value stocks returned 14.68%.Over the long run value stocks have produced higher returnsthan the stock market in general, and than higher priced stocks.

Past returns are not necessarily an indication of futurereturns, but when given a choice, I will always pay less ratherthan more and look for good quality companies sellingtemporarily at bargain prices.

Value managers, in their stock selection criteria anddiscipline, do not over pay. During the second half of 2004,when there were few bargain stocks, value stock fund managers

held onto cash and waited for stock prices to becomereasonable.

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Chapter 3

Steady Results

Growing up in Illinois I played a lot of baseball. It wasalways exciting to swing for the fences and pop one over for ahome run. However it did not happen very often and myattempts resulted in a lot of strikeouts. I was not a Babe Ruth,Hank Aaron or Barry Bonds who can hit home runs and maintainhigh batting averages.

In investing, swinging for the fences is like hunting forthe next Microsoft, Dell Computer, or Harley Davidson. Investingin an IPO or buying that dot-COM company that should double insix months are also examples. Its exciting when you get thehome run, but there are many more strikeouts.

In the mid 1980s mergers and acquisitions werepopular. I researched to find smaller companies that might be

acquired and potentially gain 30-50% in price quickly.

I learned it was difficult to find potential acquisitioncandidates and buy them before the pending acquisition becamecommon knowledge. Sometimes even when acquisitions wereannounced, they were not completed due to regulatory or otherissues. The idea sounded good and some investors did makemoney buying acquisition candidates, but they seemed to have

information that was not available to me until the stock price wasalready high.

Another example of swinging for the fences is buying thebest performing mutual funds each year.

Many of the best performing funds each year are sectorfunds, some of which are leveraged to give returns that arehigher than market returns.

In the technology stock boom of the late 1990s, therewere a number of technology mutual funds that had over 100%returns in a year. But like all things that go up rapidly, they canalso come down rapidly. Many of these funds in the followingyears were amongst the worst performing. This has been

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repeated in recent years with energy funds, biotech funds,emerging market funds, China funds and others.

When an investment idea becomes popular, pricesbecome overvalued and it is time to consider alternatives as youare most likely too late to take advantage of further gains, andthe risk of loss increases.

It is human nature to want instant results in everythingwe do and no different with investing. We would like 20% plusreturns every year as we experienced during the 1990s. Thatperiod was unusual and only occurred one other time in the lastcentury, which was in the early 1920s before the 1929 stockmarket crash.

During both the 1920s and the 1990s, stocks increasedin value not because of great increases in company profits, butbecause investors were willing to pay more than the stocks wereworth. P/E ratios expanded greatly.

The demand for stocks was increasing at a rate greaterthan the supply and therefore, prices kept rising. Then one daybuyers decided they were paying too much and it was time tosell. Unfortunately they all wanted to sell at the same time, andthere were not enough buyers willing to pay the price. Whatoften appears to be an instant result is a high-risk game thatgoes on as long as there are more buyers willing to pay more.When the buying stops our paper gains turn into real losses.Steady results seem to be a better long-term investing

alternative.

A steady performing mutual fund that I have owned for anumber of years is the Ariel Fund, a small cap value fund. Asreported in their June 30, 2004 quarterly report, 1-yearannualized returns were +28.90%; 3-year +12.90%; 5-year+13.09% and 10-year +15.44%. During these same periods, theS & P 500 Index annualized returns were 1-year +19.11%; 3-

year -0.69%; 5-year -2.21%; and 10-year +11.69%.

The Ariel Fund has never won the prize for being thebest performing mutual fund in any given year, but has deliveredsteady results year after year. Their company slogan is Slowand Steady Wins the Race. Past performance is not an

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indication of future results, but it helps us understand howvarious approaches to investing have performed over time.

One of the characteristics of a slow and steady mutualfund manager is their analysis of a companys stock before theypurchase it. Before they buy they make sure that the companyhas strong financials, good management, good products andmarket position, and is not overpriced relative to its futureearnings potential.

Research is necessary as the steady performing mutualfund managers buy stocks in companies with the intent to holdthem for long periods of time. Holding periods are years notweeks or months.

If a mutual fund has turnover of more than 50%, thatmanager is more likely to be chasing stocks that are moving uprather than investing in good companies for the long term.

My number one principle in investing is to preserve

assets so there is something to grow. I no longer swing for thefences or try to catch that occasional stock or mutual fund thatmay return 50 or 100% in a year. I have watched a few go byand have often been tempted. I focus on steady returns overlonger periods of time.

It is not as exciting to win a baseball game with singles,doubles and an occasional stolen base compared to a grandslam home run in the ninth inning, but the win still counts and

more games are won that way. This is the same in investing.Slow and steady wins the race.

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entire period would be 16.1%, compared to 19.6% if you stayedinvested everyday for the entire period. If you were out of themarket for the twenty best days, the annualized return would

have fallen to 13.9%, and out for the best thirty days, the returnwould have fallen to 11.9%.

Looking at a longer period of time, Ellis points out thatduring the period from 1926 to 1996, including the 1929 marketcrash, almost all the market returns for that seventy year periodoccurred in only sixty of the months or seven percent of the time.

Missing just a few of the short upward movements in themarket would significantly reduce your returns. Based on thisand other historical studies, it appears as if the risks of not beingin the market outweigh the risks of trying to time when to be inand when to be out. Once you have missed a rising marketopportunity, it is gone.

There are a number of professional investors whopractice various forms of market timing, and I do follow several

market timers to get their perspective on the overall dynamics ofthe market.

There are a number of technical analysts who havedeveloped market indicators to help them assess the generaltrend and direction of the market. Most are based on looking athistorical data and then developing models that have somecorrelation with historical market movements. They use this datato forecast how the market should move. If we believe that

history repeats itself in predictable ways, then some of themarket timing models may be beneficial. Not many, if any, havestood the forward test of time.

One of the current writings on market timing is a 2003book by Ben Stein and Phil DeMuth titled Yes, You Can Time theMarket!In this book the authors look at stock market returns forthe one hundred years from 1902 through 2001 in relationship to

several valuation criteria.

One of their conclusions is that when the market isovervalued relative to its most recent fifteen-year valuation trend,future returns over the next five-year period tend to be negativemost of the time.

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Following their valuation market timing criteria, youwould have been out of the market for the entire period

beginning in 1986, through the greatest market boom in ourlifetime. You would also, however, have avoided the 2000 bubblebursting losses. Their fundamental thesis is to buy into themarket when prices are low relative to historical levels and to beout of the market during periods when valuations are high. Wehave seen in the 1990s that stocks can remain overpriced forlong periods of time and yet the market continues to go up. Ifwe were out of the market for only valuation reasons, we maymiss large market increases.

As with all market timing models, we will not knowwhether or not they improve overall investment returns untilmany years from now, after we have experienced a number ofmarket cycles. By then it is a bit late if in fact the market-timingmodel was wrong.

I have found that in both up, down and sideways

markets; there are always some sectors that perform well. As anexample, in 2004 the S & P 500 gained 8.99%, the Dow 3.5%and the NASDAQ 8.59%. Market sectors such as naturalresources gained 28.4%, and real estate gained 28.7%. Mid-capValue stocks gained 12% and Small Cap Value stocks gained21%. During the bear market of 2001 and 2002 the overallmarket was down each year by double digits but small cap valuestocks were up each year by about 20%.

Since the best investment minds have not demonstratedover long periods of time that any market timing modelconsistently predicts stock market behavior, and we have onlyone lifetime to invest, my choice is to be fully invested at all timesin the right market sectors.

My investment decisions will continue to be based on myinvestment principles and on the investment environment. I do

not want to miss the surges in the market, which historically haveaccounted for most of the long-term gains. I am not going to besitting on the sidelines waiting for the precise moment to play thegame and risk missing the season.

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Chapter 5

Patience

Many successful investors have demonstrated with theirlong-term returns that investing is not a game with a lot of dailyactivity.

As a young teenager I worked for my father in his smallmanufacturing business. He would always remind me that

visible activity, or what he referred to as asses and elbows, wasa sign that you were being productive. If there was not a lot ofactivity then you were not productive. Thinking and planning didnot count as productive activity in his world.

That may be true in a production business, but it has notbeen proven to be true in the investment business. Investmentresults are not necessarily a function of the number of stocksthat are bought and sold in a given year, but rather buying the

right stocks at the right price and selling them when they reachtheir full market value.

A lot of trading activity may be a sign of poor stockselection, as the value of a stock normally does not changesignificantly in short periods of time. The more trading activity,the higher the transaction costs, which also lowers returns.Frequent trading activity is appropriate if you are a stock trader,

momentum investor or dealing in commodities, but notappropriate if you are a long-term investor.

In todays fast-paced, instant results and informationoverload world, it is easy to understand why it is difficult to havepatience with investing. There is excitement in buying andselling stocks and watching them go up and down on a dailybasis. There is not a lot of excitement in spending timeanalyzing the financial performance of a company, meeting with

its management, talking to their suppliers, customers andcompetitors to determine if their stock is a good long-terminvestment. This takes time and patience.

It is also not very exciting to buy a good stock that hasbeen recently discounted by Wall Street and waiting several

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years until it reaches its full market value. This is what goodlong-term investors do. The portfolio turnover of many of thebest long-term performing mutual funds ranges from 20-25% per

year. This means that their average holding period for a stock isfour to five years. The average portfolio turnover of all mutualfunds ranges from 50-80% and in some cases is 100% per year.

Patient investing does pay off. The Longleaf PartnersFund, a mid-cap value fund, is a good example. They reportedin their June 30, 2004 semi-annual report that they were havingdifficulty finding any stocks that were selling at low valuations.For the first six months of the year their total activity was to addno new holdings and sell two stocks that had reached full marketvalue. The funds performance for the past twelve months was20.33%, for the past five years 7.38%, and for the past ten years14.65%. The S & P 500 lost 2.2% per year during the same five-year period.

The Oakmark Select fund, managed by Bill Nygren andHenry Berghoef, reported in the September 30, 2004 Annual

Report, that no new stock positions were added and no holdingswere eliminated during the past quarter. They reported a13.64% return for the past year, 14.29% for the past 5 years and20.21% per year since the fund was started in November 1996. Ilike the returns from boring patient investing.

Peter Lynch reported in his book Beating the Street, thatduring the last market boom individual investors, on average,gained one third or less of the market returns due to excess

trading. Many sold their good performing mutual funds or stockswhen they suffered a temporary downturn and bought others asthey hit their peaks and then headed down.

A further example of the importance of patience is shownin a study published in 1992 by Tweedy, Browne Company, LL.C.The firm has managed individual investments and mutual fundssince 1920. In their work titled What Has Worked in Investing:

Studies of Investment Approaches and Characteristics Associated with Exceptional Returns, they use the returns ofindividual stocks from 1968 through 1990 to compare relativeperformance for different holding periods.

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One example they site is the market drop of 27.9% in1974. If you had held a group of low price-to-book value stocks,the return after one year would have been 5.0% better than the

market, after 3 years 62.2% better, and after 5 years 172.6%better. This is pretty strong evidence that doing the properresearch on companies before buying, buying at the right price,and holding for a long period of time is an effective strategy forachieving superior market returns. Its boring but effective.

Being a patient investor takes discipline and courage tostay the course, particularly during temporary storms, day-to-daymarket movements, and the barrage of news.

If thorough research is done before buying a stock,fluctuations in the market should be ignored, as they occureveryday and for a variety of different reasons, most of the timeunrelated to the underlying value of the stock.

Stocks should be sold when they reach full market valueor if the fundamentals of the company change in a way that

reduces their long-term potential.

Patient investing is boring but historically has gottenmore consistent results in the long run when compared to manyother investing approaches.

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Chapter 6

Markets Are Not Rational

Every day the major market indexes such as the DowJones Industrial Average, the S & P 500 or the NASDAQ go upor down as a reflection of how investors feel about stocks. Ifinvestors are positive, they are buying, and the averages go up.If they are negative, they are selling and the averages go down.

The daily buying and selling of stocks does not appear tobe a rational process but rather one based more on the emotionsof fear and greed. If investors fear that stocks may go down,they sell. If they see opportunities for the market to go up theybuy, as they do not want to miss out. To demonstrate how thisworks lets look at a few typical days in the market.

On Monday December 6, 2004 the Dow Jones IndustrialAverage went down by 45.15 points or 0.43%.

After the markets closed on Monday it was reported inthe financial press that the market on Tuesday, December 8,2004 should go higher as reports that oil prices continued todecline, productivity in the U.S. was higher than expected, andholiday shopping looked stronger than anticipated.

What actually happened on Tuesday was that the Dow

dropped 106.5 points for a loss of 1.01%. It was interesting toread one of the technical market analysts on Wednesdaymorning explain why the market declined on Tuesday. Hereported that the weak jobs report released the prior week nowhad traders questioning just how strong the economy was andthey therefore had difficulty pushing stocks higher on Tuesday.

Overnight we went from a view that stocks were worthmore and the market should go up, to the view that perhaps they

were overpriced. This pattern is repeated each day in the stockmarket where in excess of one billion shares of stock are tradeddaily on just the New York Stock Exchange.

This process does not seem to me to be very rational. Itdoes not appear that investors are looking at the valuation of

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each companys stock price based on the fundamentals of thecompany before they buy or sell. Perhaps that is why buyingand selling of stocks on a daily basis is referred to as trading

rather than investing.

One of the classic examples of irrationality in the stockmarket is Monday, October 27, 1987. On that one day the Dowdropped 508 points or 22.7%. What happened that day to makethe value of the thirty biggest and best companies in the U.Sworth billions of dollars less than they were just twenty-fourhours earlier?

It was fear, which led to panic selling. Fear that some ofthe domestic and global issues that we were facing at the timemight lead to a major slow down in the economy. There was nological reason or fundamental factors that changed the value ofthese companies in one day. They were doing what they weredoing the day before when they were valued on average 22.7%higher.

As we experience the daily ups and downs of themarket, the financial press and market analysts report reasonsfor the changes. When the market goes up, the headlines in theWall Street Journal might read strong jobs report fuels marketor better than expected profit report from Intel pushes market upor market analysts upgrade of G.E. spurs market rally. Whenthe market goes down, the headlines might read inflation fearsspooks market or factory utilization for March drops by 1%causing concerns on Wall Street; or terrorists attack in Spain

sparks sell off. There are always reasons presented by themarket experts that try to explain why the market acted the way itdid. Many times they sound very convincing.

The reality is that each day the market reacts to what isperceived either as good or bad for stock investing.

Ben Graham expressed it best when he said that Mr.

Market, the stock market, in the short term is a voting machineand not a weighing machine. He meant that everyday, investors,traders and professional money managers, decide by theirbuying and selling of stocks, which ones are the most popular.The most popular, or hottest stocks are the ones that are beingbought and therefore their price goes up. The stocks that are not

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very popular are being sold and therefore go down in price. Inthe short term stocks are often valued based on popularity.

For example, on December 6, 2004 a share ofCaterpillar stock dropped in value by $0.35, from $90.92 pershare to $90.57 per share. This represented a reduction in valueof 0.4%. When multiplied by the total number of sharesoutstanding, Caterpillars value dropped by millions of dollars inone day.

What happened within the Caterpillar organization inless than twenty-four hours to cause it loose millions of dollars inmarket value? The answer is most likely nothing. The companymost likely ran on Monday December 7, 2004, as it had theprevious day. They got orders, produced and shipped productsand made money just like they had been doing when theircompany was valued at $90.92 per share the day before.

On Tuesday, December 7, 2004 Caterpillar stock closedat $90.82, up $0.25 per share from Monday or 0.3%. It is hard to

imagine what happened in less that twenty-four hours to makeCaterpillar more valuable than the day before. Perhaps thebuyers and sellers on Monday made a mistake when they soldshares for less and changed their minds on Tuesday. In anyevent, Caterpillar went on making and selling equipment andservices around the world and making money, just like everyother day.

There are times when something does change to reduce

the value of a specific companys stock, such as the loss ofleadership or a scandal, but this happens infrequently comparedto the daily changes in a stocks price. That is what Ben Grahammeant when he referred to Mr. Market as a voting machine.Every day the most popular stocks get more votes and the priceof their shares go up. The unpopular stocks get the boot andtheir price goes down

Historical research has taught us that the daily pricefluctuations of stocks are primarily reactionary and driven by fearand greed.

Because of the somewhat irrational approach to the dailychanges in stock prices, there is an opportunity for the astute

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investor to gain an advantage. When a stock is selling at a pricebelow its intrinsic value, the market presents a good buyingopportunity. When a stock becomes priced at or above its fair

market value, it is a good opportunity to sell and harvest profits.Since the market does not consistently price stocks at their truevalue, the patient and analytical investor can capitalize. Thisapproach to buying stocks when they are undervalued andselling when they reach full value is referred to as valueinvesting.

I have grown to accept that todays price for a particularstock or todays level for the Dow, S & P 500, or NASDAQ mayhave little to do with the value of that company or the value of theoverall market. Even though the investment professionals andthe press have reasons as to why the market did what it did, thereality is that the psychology of the traders and institutionalinvestors who control most of the daily transactions in themarket, were either a bit fearful that day or a bit greedy.

When someone asks me where the Dow will be next

month or next year, I say I have no idea. If they ask me where itmight be in five or ten years, I say most likely higher. Historically,over long periods of time, stocks have always increased in value,but never in a straight line. Use the ups and downs along theway to your advantage. Capitalize on the mis-pricing in themarket to buy if under priced, and sell if overpriced.

Dont spend time trying to predict where the markets aregoing to be in the short term, unless you are good at predicting

irrational behavior. Markets do not behave rationally much of thetime.

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Chapter 7

Think Beyond U.S. Stocks and Bonds

U.S. stocks and bonds are not the only investments thatare available to us today, nor are they always the bestperforming. Alternatives such as foreign stocks and bonds,commodities, energy, precious metals, natural resources andreal estate are all available through mutual funds and ETFs, andshould be considered as part of an overall investment strategy.

The U.S. stock market has had a long-term upward trendfor the past two hundred years. There have, however, beenperiods when the U.S. market has gone down or has been flat.From 1965 to 1982 the U.S. market was flat for the entireeighteen-year period, with some ups and downs in between.From 1973 through 1974 the U.S. stock market was down by27.2% in 1973 and 27.9% in 1974. In 1990 U.S. stocks sold offand ended up down 13.8% for the year. From 2000 through 2002

when the technology bubble burst, technology stocks lost 78% oftheir value.

During these flat and down market periods, there wereother markets that were up. In 1987 international stocks gained24.63%. During the 1993-1994 U.S. market downturn,international stocks gained 32.56% in 1993 and 7.78% in 1994.During 2001 and 2002 when the U.S. stock market was still

suffering from the technology bubble bursting, U.S. bonds gained8.42% in 2001 and 10.27% in 2002.

It is not always true that international stocks do wellwhen U.S. stocks are down, as the U.S. economy has a greatimpact on other economies around the world. However in anyyear there is generally a market or market sector someplace inthe world that is doing well.

In 2004, which closed with the DOW up 3.5% and theS & P 500 up 8.99%, there were a number of internationalmarkets that performed much better. Overall international stockswere up 11.79%. Countries or regions that performedexceptionally well included Brazil up 23.3%, Europe up 15.98%,Mexico up 51.1%, Canada up 12.2%, and Australia up 22.9%.

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In the twenty-one year period from 1982 through 2001,international stocks had better returns than U.S. large cap

growth stocks in ten of the years, and were the best performingcategory above all U.S. stocks and bond in five of the years.This period included the technology boom during which large capgrowth stocks led all markets for five years.

With the development of the mutual fund industry it iseasy to invest in both sector and broad based internationalstocks. There are a number of investment styles followed byinternational fund managers ranging from growth to value andfrom all cap to small cap and large cap. Some funds focus onemerging markets while others focus on developed countries.Some hedge against changes in the value of the U.S. dollarrelative to foreign currencies, others are unhedged.

When investing in foreign stock funds it is important tounderstand the fund managers investment approach as well asthe unique risks associated with international investing, such as

currency and political risks. Today, with the declining value of theU.S. dollar relative to other currencies, unhedged internationalfunds provide the investor the additional gains from the currencyappreciation. If the dollar begins to strengthen then thisbecomes a disadvantage.

Some of the no-load international mutual funds that Ihave used include Artisan International Fund, Oakmark GlobalFund, Third Avenue Value International Fund, Polaris Global

Value Fund, Tweedy Browne Global Value Fund, and Dodge andCox International Fund. Since my approach to investing has abent towards value, most of these funds have a value approachto investing. There are a number of other good internationalfunds as well.

Foreign stocks are also available through index mutualfunds and ETFs. Both invest in a basket of international stocks

that represent various international stock indexes. There is quitea variety available. Some represent all foreign stocks, othersrepresent geographical regions such as Europe, and still othersrepresent specific investment styles such as small cap value.

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Another international opportunity that is often overlooked by U.S.investors is the international bond market. As we have becomea more global economy and as many counties have developed

more stable currencies and financial institutions, this hasbecome a viable investment option.

Interest rates and currency values change over timebased on the economic conditions of a particular country orregion. Normally interest rates in developing countries such asChina, India or South Korea are higher than in developedcountries such as Germany, Canada or the United States.Political risk also increases a countrys interest rates. Interestrates in Russia or Venezuela would be higher than in the UnitedStates due to differences in political risks.

When interest rates in the U.S. are at the bottom of acycle and beginning to rise, investing in foreign bonds could be away to gain better-fixed income investment returns. As withinvesting in international stocks, there are additional risks withforeign bond investing, such as rising interest rates, political risk,

foreign currency risk as well as higher investment costs. Theseadditional risks need to be considered before making foreigninvestments. Buying a mutual fund whose management hasexperience and presence in the foreign market can helpminimize risks.

Some of the no-load foreign bond funds that I have usedinclude Loomis & Sayles Global Bond Fund, PIMCO EmergingInternational Bond Fund and American Century International

Bond Fund. There are a number of other good international bondfunds as well.

As an example of recent performance, over the pastthree years Loomis & Sayles Global Bond Fund returned 52.2%,PIMCO Emerging Market Bond Fund 78.1%, and AmericanCentury International Bond Fund 66.9%. Past performance isnever an indication of future performance. During this same

three-year period the U.S. stock market had a negative return.

A few other areas of investment outside of traditionalU.S. stocks and bonds include commodities, energy, preciousmetals, natural resources and real estate. These investment

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sectors present different but unique opportunities due to long-term world trends.

Gold has done nothing but lose value since it peaked atover $800 an ounce in 1980. It dropped to as low as $250 anounce, and then over the past three years rose to the $425-$450range. Still a long way from the $800 an ounce I paid in 1981. Abuy and hold gold investor has lost a lot of purchasing powersince 1980.

What has been driving gold up recently has been fear.Fear of terrorists activity and political instability around theworld. Fear of a worldwide recession. Fear of the high budgetand trade deficits in the U.S. Fear of the impact of the decliningvalue of the U.S. dollar. Fear of inflation.

Very little of the rise in the price of gold in the past fewyears has been due to an increase in the demand for gold. Someforeign central banks have taken the opportunity of golds risingprice and have sold some of their holdings.

As long as the high level of uncertainty exists in theworld around economic and political stability, the price of gold willcontinue to rise.

When the uncertainties are resolved in positive ways,the price of gold will revert to more historical values. If they areresolved in negative ways, such as a recession, then gold maycontinue its upward trend until the economy recovers. Gold is a

short-term investment opportunity but brings with it a lot of riskand needs to be followed very closely for changes in the worldoutlook.

Other precious metals such as silver and platinum arepriced more on actual demand rather than as a hedge againstpolitical or economic stability. I would be cautious withinvestments in the gold and precious metals area. Both gold and

precious metals can be purchased through no-load managedmutual funds, index funds or ETFs, some of which hold goldbullion and others invest in gold or precious metal producingcompanies.

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Commodities, energy, and natural resources present aninteresting longer-term investment opportunity.

There is a worldwide long-term shortage of energyincluding oil, natural gas, and coal. There are also shortages ofcommodities such as timber, steel, and copper.

With the industrialization of China and other emergingcountries, we are more rapidly depleting our natural resources.In 2004, China consumed 25% of the worlds cooper, 32% of theworlds coal production, 25% of the worlds aluminum, 50% ofthe worlds cement, and 40% of the worlds steel.

As many of these resources are not renewable andothers take a long time to replace, costs will continue to rise untilsubstitute products are found or additional capacity added. Thisupward trend in prices may be interrupted by a temporaryrecession. Besides China, countries like India and others arealso accelerating their rates of industrialization.

Commodities and natural resources should beconsidered in an investment strategy with a full understanding ofboth the opportunity as well as the risk.

Some of the no-load mutual funds that I use thatspecialize in these sectors include; RS Natural Resources, U.S.Global Resources, PIMCO Commodity Real Return, ICONEnergy, and Excelsior Energy & Natural Resources. There arealso index funds as well as ETFs to consider.

Real estate has been one of the best performing sectorsin the U.S. for the past one, three and five years. In 2004 it wasthe best performing of all sectors returning 28.7%. Many nowthink since U.S. real estate has done so well over the past fiveyears, that a bubble has been formed and will burst within thenext several years. This is difficult to judge but real estateinvestments through no-load mutual funds are also worth

consideration.

When putting together your investment strategy considerother investments besides U.S. stocks and bonds. Considerforeign stocks and bonds, precious metals, commodities, energy,natural resources and real estate as they at times present unique

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investment opportunities. Consider the additional risksassociated with each one before investing.

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Chapter 8

Be Where Markets Are

Over the past 200 years the U.S. stock market has gonethrough various cycles. Some were short, such as the 1973-1974 market downturn. Some were long such as the 1982-2000technology market boom. Some were positive with good marketgains; others were negative with severe losses, such as the2000-2002 technology bubble burst, where technology stocks

lost over 70% of their value.

If we stayed invested in technology stocks through theentire downturn, it will be many years and perhaps my nextlifetime before we would regain our losses.

If we had invested in an index fund representing the Dowand held it for the period from 1965 through 1982, we wouldhave had no net gain. For this entire eighteen-year period the

Dow ended at about the same level in 1982 as where it started in1965. In terms of the purchasing power, our money would havelost value, as the inflation rate during this period averaged 3.5%per year.

Within each down market cycle there are opportunities toavoid losses and make positive gains, if we understand wherethat markets are and what the trend is. Often we try to either

hang on during a down cycle in the hope that the cycle willreverse soon, or bail out of the market all together and missopportunities.

During the 2000-2002 downturn, the market suffered a47% loss and technology stocks dropped by 78%. Some hungon and are still trying to recover their losses. Others acceptedthe reality that technology stocks had gotten extremelyoverpriced. They took some losses and then looked for

investment opportunities in other markets.

We found that many small cap stocks were undervaluedrelative to large cap and technology stocks, and that thisappeared to be a good area for investment during the recoveryperiod. In 2000 small cap value stocks gained a 22.83% return

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and in 2001 they gained 14.03% when the NASDAQ lost 39.2%and 21.0%.

During this period the Federal Reserve was reducinginterest rates to stimulate the economy. Therefore U.S. bondfunds were a good place to invest as they appreciated in valueas interest rates went down. In 2000 U.S. bond funds went up11.6%, in 2001 they went up 8.4% and in 2002 they went up 10.3%.

Another example of the risk of buying and holdingthrough a long down cycle was the market crash of 1929. If aninvestor had stayed invested through the 1929 crash, it wouldhave taken 65 years to recover the losses.

Based on an analysis of the history of market returnsover a long period of time, stocks are the best long-terminvestment when compared to alternatives such as bonds. Todemonstrate this, Jeremy Siegel in Stocks for the Long Runpresents the historical returns of the market for the past two

hundred years.

This analysis assumes that we all have a very long timehorizon in which to stay fully invested in the market to recoverfrom inevitable down market periods. As history has shown,down markets can last for a long time and be quite devastating.

The long-term returns of the market have averagedabout 10-12% per year; however there have been many years

when returns have been negative. There have also been yearswhen they have been in excess of 20%, such as the late 1990s.The range of market returns from the period of 1952 through1994 has been -27.9%, and +55.9%.

If we had about fifty years before retirement, we couldinvest in market index funds, ride out the up and down cycles,and expect by our 70th birthday to have earned on average 10-

12% per year. The only risk is that we retire at seventy when themarket is in an up cycle and not a down cycle.

The reality is that most of us are not 30, or 40 or 50years from needing some of our retirement funds.

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We have recently experienced the greatest bull marketin our lifetimes. It is unlikely that many of us will experienceanother one of similar length and magnitude.

This leaves most of us with the necessity of following themarket cycles, and structuring our investment strategy to takeadvantage of them. To maximize our potential returns and avoidmajor losses, we need to keep abreast of the changing globalenvironment and move our investments as the environment andthe markets change.

When large cap growth stocks are overpriced, dont holdlarge cap growth stocks. When small cap value stocks are underpriced, buy good small cap stocks. When interest rates are in aperiod of long-term decline, consider buying U.S. bond funds.When the world economy is growing rapidly, considercommodities and natural resources.

Sticking with an investment for a long period of timethrough down market cycles is a risky strategy when your time

horizon to recover losses is limited. It is always easier to rowwith the tide than against it.

Portfolio changes should be made very thoughtfully andbased on long-term trends, not on a reaction to todays drop inthe Dow or the S & P 500.

Most major trend changes in the economy or the worldenvironment occur over periods of months or years, not days or

weeks. Make sure the change represents a trend that hasdeveloped or is developing.

As Charles Ellis puts it in Winning the Losers Game, Asan investor you must adapt to the market. The market wontadapt to you. Be where the market is, not where it was orwhere you would like it to be. This approach should increaseyour odds of avoiding major losses and getting positive gains.

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Chapter 9

Dont Follow the Crowd

Robert Shiller in Irrational Exuberance explains howinvestors get caught up in the mass psychology of the marketsand abandon rational thinking. We are reminded of this when weexamine how investment decisions were made during thetechnology boom. As Shiller points out, investors behavior thenwas no different than in the early 1920s before the 1929 market

crash.

As we look back at the 1990s technology boom, it ishard to understand why we paid over 100 times projectedearnings per share for companies that had only been in businessa year or two. It is also hard to understand why we paid ever-increasing amounts for shares of start-up Internet companiesthat had no earnings.

Many new technology and Internet companies braggedabout how fast they could spend cash. The executives of thesecompanies would report not on profits but on how much theywere spending on marketing and promotion. A new term burnrate came into being as a measure of how much cash acompany was spending. In Internet companies a measure ofbusiness success was how many sets of eyeballs a websitecould attract per day. During this time the belief was that profits

did not matter anymore. This was a new era for business, or sowe were led to believe as we followed the crowd.

Ken Fisher, an investment manager and author has afavored expression that captures the essence of following thecrowd. He says, When everyone knows or believes something,it generally is not true. This certainly turned out to be the caseduring the technology boom. Many of the things that we came tobelieve about technology companies and the new business era

turned out not to be true. We experienced this in March of 2000when the bubble began to burst.

Ken demonstrates his point about common knowledgeand crowd following by reviewing the annual forecasts ofinvestment managers. Each year he gathers data on what

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investment professionals around the country think the marketswill do in the next year.

If the majority of the investment professionals forecastthat the market will go up by 6-8%, Ken believes that there is alikelihood that the market will either go down or go up muchhigher. Ken looks either at the minority view or at what theexperts did not forecast to get the best indication of what themarket will do during the next year.

Kens track record in using this approach to predict howthe market will perform has been quite good. In the majority ofthe years, the consensus of the professional investors has beenwrong. Yet this is what most of us follow. Following the crowd iseasy, as everyone is agreeing. Going against the crowd takescourage and there is often little support.

Robert Shiller further explains that as mass hysteriabuilds, as it did in the early 1920s, again it the late 1950s, andin the 1990s, business writers and analysts try to help us justify

our beliefs and keep the momentum going. Do you recall all ofthe articles and broadcasts about the era of the 1990s being anew and different time?

During the 1990s, there was a lot of talk about theimpact the baby boom generation would have on the continuedgrowth of the economy. This time we believed we had a neweconomy and had licked the business cycle. Technology wasgoing to contribute to unprecedented growth in productivity; and

our declining interest rates would continue to stimulate bothpersonal and business spending.

We even heard that profits did not matter any more. Thetechnology boom and its benefits were changing forever theeconomy of the U.S. Anyone that did not invest in it would loseout. Many technology companies were forecasting growth ratesof 60, 70, and 80% to continue for many years.

During the technology boom, the number of familiesinvesting in the stock market grew from about 40% to about65%. There was no way we thought that any technologyinvestment was a bad bet. We did not want to miss out so wedove in and drove stock prices even higher.

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Reality hit in March of 2000 when the house of cardsbegan to fall.

During this time, most of us abandoned rational thinkingas we got caught up in the momentum of the crowd. We weretempted by the rewards of instant gains and feared being left out.We did not take time to analyze what was happening to thevaluations of stocks we were buying.

There were a few investment professionals who weresaying in 1998 and 1999 that the market was over priced, thefree-for-all spending could not go on forever, companies had tomake a profit if they were going to survive, and the marketalways returns to historical valuations.

A few got out of the market in 1998 and 1999 only to beseverely criticized as the market continued to rise. In March of2000 they became instant geniuses as the market began itsdecline. The few lone wolves in the crowd were right as

rationality began to return to the market.

The lesson learned from this experience is to understandwhat makes sense, what is rational, and what is not. Eventhough the market reacts somewhat irrationally every day,means that its valuation may have little to do with reality.

Dont get caught up in the hysteria of the crowd. Stickwith investment fundamentals. Make your own assessment

based on your investment principles and your view of the currenteconomic environment.

In the long run the fundamentals of a company and thehealth of the U.S. economy determine what a fair value is for acompanys stock and for the entire market. When these valuesget out of touch with reality, as they have for periods of time, theyhave always returned to fair value and reality.

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Chapter 10

Have a Plan and Stick to It

As we reviewed in the introduction, there are manydifferent ways to invest. They range from momentum investing,such as the CANSLIM system that William ONeil developed,to index investing, asset allocation, value investing, hedge fundsand many others. One common characteristic of all successfulinvestment approaches is they have a set of rules or principles,

which define how they will invest, what they will invest in, andunder what conditions.

William ONeil in his book 24 Essential Lessons forInvestment Success outlines the specific conditions under whicha stock should be purchased and when it should be sold. Whenthe system is followed, in certain market environments, goodinvestment returns can be achieved, as many followers of hissystem have demonstrated.

Ben Graham and David Dodd, in Security Analysis,present a method for determining the intrinsic value of acompany, which they believe is the price at which the stockshould be purchased. The fair market value then defines at whatprice to sell. Their method of value investing clearly defines howthey invest, what they invest in, and under what conditions.

Proponents of traditional asset allocation havedeveloped models that define how an investment portfolio shouldbe structured so that assets are invested in all the major sectorsof the market, and rebalanced each year to maintain prescribedallocations.

Technical analysts have built computer models that trackboth short-term changes in stock prices and long-term pricetrends. These models are used to take advantage of small

changes in the price of a stock as well as determine when to beinvested in the market, and when to be on the sidelines.

Warren Buffet, the most successful long-term investor ofour time has a strict set of criteria, which define under what

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conditions he will buy a company for his portfolio. Often he waitsyears until the conditions are right.

These and other approaches have worked because theinvestor also has an understanding of how markets act. Theyunderstand that markets are influenced by both economic trends,and irrational reactions. To effectively follow any system ofinvesting, a good understanding of the markets, the economicsof business, global trends, as well as the psychology of themarket are required.

The most important reason many systems of investinghave worked is that they have a defined process and set ofdecision rules. They are documented and always followed. Thisunemotional and disciplined following of sound investmentdecision rules separates the successful investors from the rest.

The investment model for decision-making might be rightbut if not followed all the time, the results will not be consistent.If the model is flawed, then the results will also be inconsistent. I

have found approaches to investing that did not pass the test oftime as they were based on specific market conditions. When theconditions changed, the system no longer delivered results.

Every investment system may not be effective under allmarket conditions. As we have shown earlier, investing in sectorstocks such as technology may have been an effectiveinvestment model to follow during the 1990s. It has been a verypoor investment model so far in the 2000s.

Changing this model to a broader sector rotation modelmay be a good alternative as other market sectors such asenergy, transportation, and natural resources have been strongin the early 2000s. This change might broaden the model so thatit works in all markets.

The model used for making investment decisions must

be one that is good for all seasons and must pass the test of anumber of different markets cycles.

My model for investing consists of investing with goodmutual fund managers, to be fully invested at all times in theappropriate investments based on the world economic and

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political trends, to consider not only U.S. stocks and bonds butalso foreign and specialty investments, to be where the marketsare, to make my own informed investment decisions and not

follow the crowd, and to re-evaluate the market environment andmake gradual changes to my portfolio to reflect any changes inlong-term trends.

This is not the only way to invest. As I have shown, thereare many other investment approaches. What is important is tofind a defined investment process that has worked under avariety of market conditions. Make sure that it is consistent withyour own individual values and stick with it all the time, not justwhen it seems to be working.

Your individual approach to investing needs to fit whoyou are or you will not stick with it. I am somewhat conservativeand could not be a momentum investor since I focus more onpaying the right price than following a stocks price up beyond itsfair value. I also could not invest by following an event drivenhedge fund strategy, as I am not a big gambler. George Soros

and Julian Robertson have done extremely well using thisstrategy. They have often taken what appeared to me as greatrisks and have gotten great rewards much of the time.

Develop an investment plan and stick with it. Goodinvesting takes knowledge of the markets, discipline, patienceand often courage. If you do not have an investment plan, findan independent investment advisor who has an investmentapproach that you can understand and are comfortable with. He

will make sure that you stick with the plan and help prevent youfrom making emotional investment decisions or following thecrowd.

It may be difficult to find independent investmentadvisors, as many are associated with selling a particularinvestment product, which can color their view and limit yourinvestment options. Remember that every investment approach

must define how you will make investment decisions, what youwill invest in, and under what conditions.

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Chapter 11

Issues and Outlook for U.S. Economy

As part of my investment process I review each year themajor issues and trends facing the U.S. and the world, andaccess how they might affect the investment environment overthe next few years.

I believe that long-term investment returns are impacted

by major world economic and political trends. A review of theinvestment environment is like looking at a long-range weatherforecast. They both help prepare us for the upcoming season.

I see a number of major issues facing the U.S. as well astrends in the world that should be considered when makinginvestment decisions. I will cover some of the significant onesthat might influence investment decisions for 2005 through 2008.

Aging Population and Declining Workforce

Harry Dent, in The Next Great Bubble Boom, presentsprojections for the retirement age population and the number ofentrants into the work force. In 2005 there will be 3.5 millionAmericans reaching retirement age. This compares to anaverage of 2.6 to 3.25 million per year for the period 1988-1995.This increase is occurring at a time when the number of new

entrants into the work force is declining.

During the 1980s there were 2.5 million new entrants tothe work force each year. In 2005 there will be 2.0 million. Overthe next twenty years the projections are:

Reaching Retirement Age(Per Year)

New Work Force Entrants(Per Year)

2005 3.5 million 2.0 million2009 4.25 million 1.0 million2015 4.5 million 750,0002020 5.0 million 350,000

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Common Sense Investing