P/Es for the Smart Money

If you'd like to be a more successful investor, one way to do it is to start thinking like a corporate acquirer. And corporate acquirers assess stocks using enterprise multiples.

We've all been taught that one of the first things to look at is the Price/Earnings ratio of any stock you are considering for purchase. And while hugely helpful, the P/E ratio does not take debt into account. In order to capture this part of the financial picture, you need another ratio - the enterprise multiple.

This number compares the hypothetical price tag on an enterprise - debt as well as equity - to the operating income from the business... Whenever Warren Buffett considers any company for possible purchase, do you suppose he is looking at its P/E?... I don't think so!

The enterprise multiple concept assesses a company as an acquirer would - with debt included in the purchase price.

Think about buying a house: If you put $200,000 down and assume a $500,000 mortgage, your purchase price for the real estate is $700,000, not $200,000. And if you were buying the entire company, you'd certainly worry about debt. So why should we as investors ignore it because we're just buying a few shares?... Does that make any sense?

Here's how to get the enterprise number. First, find the company's enterprise value, which reflects its entire capital structure. Then add stock market cap to liabilities and liquidating value of preferred, then subtract cash and equivalents. This is the net cost to a hypothetical buyer of all the business assets, including factories, inventory, software and brand values.

Next, divide enterprise value by operating income, in the sense of earnings before interest, taxes, depreciation and amortization.

By itself, an enterprise multiple of 10 is not bad. But it's a tip-off to the weakness of the balance sheet whenever this ratio is higher than the P/E of the company you are evaluating.

If you are going to use enterprise multiples, put them in context. Compare a company's multiple with that of its peers. You'd expect high multiples in industries with high growth (like pharmaceuticals) and low depreciation charges (like software or broadcasting). You'd expect lower multiples in industries with slow growth (cement) or big needs for maintenance-level capital expenditures (cement, railcar leasing). After all, the owner of a cement factory has to divert a large piece of his operating income to replacing worn-out machinery.

Finally, the enterprise multiple can also be useful for digging up hidden values. It is especially adept at turning a spotlight on cash-rich companies with no debt. And one of the best features of enterprise multiples is the way they allow you to see the value of a company that's losing money or has seen a horrendous profit dip.

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How to Beat the Pros at Investing

Most people will probably have neither the time nor the inclination to go through with this. And while the five items below are not all that earth-shattering, if you do have the time and if you will stick with these five important things to do, then you can beat practically everyone when it comes to investing!

The Five Keys To Beating Everyone At Investing:

1. Commitment. The key here is that among two equally skilled competitors, the one with deeper commitment usually wins.

2. Homework. You need to know more than your competition. This means educating yourself by reading, and by crunching the numbers yourself.

3. Experience. Even with all the skills and commitment, you're not going to win big your first year as an investor. But you at least need to be in the game initially. All the reading about investing isn't going to make you a good investor if you're not in the game. But if you keep paying your dues by investing, by taking personal responsibility for any losses, and trying to learn from your mistakes, then eventually the big profits will come.

4. Thinking for yourself. It's amazing to realize that there are only a very few investors who really think for themselves. Names like Warren Buffett, Bill Gross, Peter Lynch, and John Templeton come to mind. But it is an amazingly short list. So in order to succeed as an investor, you must be able to think for yourself. And thinking is the toughest task you could ever undertake, which is why so few persons choose to do so!

5. Avoiding major mistakes. The "catastrophic loss" is what kills you. You cannot afford to lose it all, so cut your losses early. Use trailing stops, or do whatever it takes to keep your downside limited and your upside unlimited. And one day that unlimited upside will show up in your account.

There are ways to do okay in 30 minutes a year. There are even ways to do well in just 30 minutes per week. But what I've been talking about here is becoming a superstar - the best full-time investor possible.

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Some Thoughts on the Game of Investing

Making money in stocks is not rocket science. It requires a little knowledge, a little courage, the right tools, plus a healthy dose of skepticism.

First, as far as knowledge goes, every investment you make teaches you about the rules of the game. And the more often you invest, the more you're likely to read and absorb.

Second, your success as an investor will be directly proportional to your courage - most importantly, the courage to make your own decisions rather than listening to all those know-nothing gurus out there.

Third, are the tools, particularly the Internet, which has empowered all of us by placing a plethora of investment tools at our disposal.

Finally, skepticism is an absolute requirement, which allows you to filter recommendations through your own analysis and homework. As you watch those "experts" on CNBC, do you often get a nauseous feeling while listening to them talk about 15 percent annual returns on individual stocks?

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The BusinessWeek Fifty

The special annual issue of BusinessWeek magazine (April 3, 2006) is now available and features the fifty top-performing companies over the past year.

While we've provided this complete listing for you, it still is highly recommended that you obtain a copy of this issue to read all of the fascinating details about these various outstanding companies for yourself. And incidentally, it should come as no surprise that APPLE COMPUTER heads this list!

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The Importance of Dividends

Whenever a company pays you a dividend, that's cash in your pocket - from the company that you own, to you. And if a stock has to pay you dividends in cash, the company must actually have that cash in order to pay you because cash dividends don't lie.

Dividends are critically important and to understand why, you need to understand what it means to be an investor as well as exactly what we as investors are entitled to whenever we invest.

If we loan $10,000 to a friend, and we get in writing that he will pay us back $11,000 in one year's time, what we are entitled to in a year is our $11,000. And what is our risk? Our risk is that he doesn't pay us. But it is a binding contract and we are entitled to our $1,000 in interest, which means that we are being paid 10% per year for taking on this risk.

If you invested that same $10,000 in any stock, what's at risk? Quite a lot, because that stock is normally trading at a given number times sales. And what exactly are we entitled to whenever we invest in any stock? The answer is absolutely, positively, unequivocally nothing!

The only thing you are entitled to as a stock investor is dividends!

So before you make an investment in anything, you should ask yourself this question: What's in it for me? The bottom line is that you want to know what you are entitled to whenever you invest in something. And making sure you get paid is quite often the difference between investing and speculating.

When considering your next investment, understand exactly what it is that you're entitled to. No matter how good the investment may seem, if what's in it for you is not clear, then what are you doing? So regardless of the story, make sure you know what's in it for you up front. And one simple way to tilt the scales in your favor is to make certain that you get paid!

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Surviving the Over-the-Counter Stock Market

Over-the-counter stocks, being small and often not well-followed by many analysts, are especially susceptible to rumors and false reports. Stockbrokers and underwriters flourish on heavy trading and are ususally themselves the source of misleading reports. Basic wisdom applies here: Whenever a company sounds too good to be true - watch out - because it probably is!

Rule of thumb: If you don't know why you own a stock - or why you're buying - then you're in someone else's hands. This makes you more vulnerable to the whims of the market.

Over-the-counter stocks, particularly new issues, are usually short-term plays. And one should never buy any OTC stock without first having a sell target in mind.

If the selling price is reached, even within a week of buying, stick to your predetermined sell decision - unless there is some major extenuating factor you hadn't considered before.

About 80% of all the new issues will be selling below their issue price within 18 months time. Reason: Most new issues are overpriced in relation to existing companies; but they themselves are all destined to become just another existing company within a year of being issued..

Whenever you are evaluating a new issue, find out who are the people involved. If the underwriter is, or has been, the target of the Securities and Exchange Commission's investigations, this is often mentioned in the prospectus. The SEC prints a manual of all past violators. So avoid underwriters that have had a lot of SEC problems. The strong companies rarely use them when going public.

Check out the auditors of a new-issue company. They will be named in the prospectus. If the auditor is not well-known or is itself in trouble with the SEC, question the numbers in the financial reports.

Another danger in over-the-counter stocks is a key market maker who mixes buy and sell orders in amongst its own brokerage customers so that the market price is artificial. If such a broker collapses, so too will its main stocks. This illustrates the danger of buying a stock dependent on only a single market maker. To avoid such a problem, invest in stocks quoted on NASDAQ where, by definition, there are at least two strong market makers, and hopefully a lot more.

Try to spot companies just before they decide to go onto NASDAQ. When they do, their price inevitably rises because of the increased attention. Very often the managements will simply tell you if they have NASDAQ plans or not. One very good tip-off: If they've just hired a new financial manager, it's often a sign of an imminent move to NASDAQ.

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The Power of Compounding

Making money entails more than merely predicting which way the stock or bond markets are heading, or trying to figure out which stock will double over the next few years. For a great majority of investors, making money requires a plan, self-discipline, and desire.

So in order for anyone to become successful as an investor, that person must have a plan.

One of the most important lessons we can learn about living in the modern world is that in order to survive, you've got to have money. But you'll never really know very much about money until you learn how to use and understand a set of the compounding interest tables.

Compounding is the royal road to riches. Compounding is the safe road, the sure road, and most importantly, anybody can do it. But in order to compound successfully, you need the following:

1. Perseverance - in order to keep you firmly on the savings path.

2. Intelligence - in order to understand what you are doing, and why.

3. Knowledge of the mathematics tables - in order to comprehend the amazing rewards that will come to you if you faithfully follow the compounding road.

4. Time - in order to allow the power of compounding to work for you.

However, there are two ironies associated with the compounding process. The first should be very obvious - compounding may involve sacrifice because you can't spend it and still save it. And secondly, compounding can be very boring - that is until you have been at it for several years and the passive money begins to flow in. Then at that point, compounding becomes very interesting!

You can work your compounding with a good money market fund, T-bills, or even with 5-year Treasury notes.

Something else to bear in mind. If you want to become wealthy, then you must never lose big money. Unfortunately, most people lose money in disastrous investments, or by gambling, engaging in risky business deals, and sometimes simply through greed or poor timing.

In the investment world, a wealthy investor has one major advantage over a small investor, or a stock market amateur. The advantage that the wealthy investor enjoys is that he doesn't need the markets. The wealthy investor doesn't need the markets because he already has all the income he needs. He has money coming in via bonds, T-bills, stocks, money market funds, and even real estate.

A wealthy investor tends to be an expert on values. When stocks are a bargain, and stock yields are attractive, he buys stocks. When bonds are cheap and bond yields are irresistibly high, he buys bonds. And when real estate is a great value, he buys real estate. In short, the wealthy investor puts his money where the great values are. And if no outstanding values are available, the wealthy investor waits. And he can afford to wait because he has money coming in daily, weekly, and monthly. The wealthy investor knows what he is looking for, and he doesn't mind waiting months, or even years for his next great investment.

But what about the typical small investor? This person always feels pressured to "make money." And in return, he's always pressuring the market to "do something" for him. But unfortunately, the market isn't interested. So when the small investor isn't buying stocks offering 1% or 2% yields, he's off to Las Vegas trying to beat some casino at the blackjack tables. Or he's spending $20 a week on lottery tickets.

The typical small investor doesn't understand values, so he constantly overpays. He doesn't understand the power of compounding and he also doesn't understand money. He also never heard the truism: "He who understands interest - earns it. He who doesn't understand interest - pays it." Thus, this explains why the typical American is a person who is deeply in debt!

But here's the ironic part of it. If from the beginning, the average person had adopted a policy of never spending more than he earned; if he had taken his extra savings and compounded it in intelligent, income-producing securities, then in due time he too would have money coming in daily, weekly, and monthly, just like the wealthy person.

The only time the average investor should stray outside the basic compounding system is when a given market offers outstanding value. And we define an investment to be a great value whenever it offers: safety, an attractive return, and a good chance of appreciating in price. At all other times, the compounding route is safer, and probably a lot more profitable, generally in the long run.

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Broad-Based Strength Bullish

Chuck Carlson, in his current market commentary, comments about how the Dow Jones Industrial Average recently went to its highest level in nearly five years. And the Dow Jones Transportation Average recently went to its highest level ever. Small-cap stocks continue to post new highs.

Clearly, the market is not being driven by gains in just a few groups. Take a look at the list of stocks making new highs. What you see are stocks from virtually every industry sector. From banks, REITs, and insurance companies to industrial stocks, health care, railroads, and consumer stocks - all doing well.

Such broad-based strength is generally a positive for the market, especially when it comes to assessing the sustainability of the current rally.

What is especially impressive is that stocks from industry sectors seen as vulnerable due to high interest rates - most notably financials - have posted strong gains so far this year.

That interest-rate-sensitive stocks are doing well may indicate that perhaps interest rates won't be tending much higher at least in the near term.

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How to Become A World Class Investor

Most people who think of themselves as investors don't really understand the important differences between stock selection, asset allocation, and position sizing. And this is unfortunate because there are statistics to prove that over time, as much as 90% of the money you make in the market will be generated by HOW you buy stocks, and not by which stocks you buy!

One of the most important differences between "World-Class" investors and everyone else is that world-class investors do three things that you probably don't:

1. They sell stocks.

2. They manage their asset allocation carefully against a benchmark.

3. They have a position-sizing discipline which they never break.

Most average investors won't sell stocks. They simply won't cut their losses, no matter how many times they tell themselves that in the future they will. Maybe it's because they don't like to admit they've been wrong about a stock.

World-class investors manage their asset allocation very carefully. Asset allocation is how much money you place into different asset classes like stocks, bonds, cash and/or real estate. Believe it or not, these choices are the most important parts of your investing.

Finally, the last difference between world-class investors and everyone else is that most people regularly break their own position sizing rules. They will get excited about one or two stocks and then invest too heavily in those few stocks. This almost always results in large losses.

You can improve your investment results and also sleep better at night if you institute a little discipline into your investing activities. Make sure that you use a trailing stop with any stock you buy and follow the position at least weekly. Also, adjust your asset allocation for market conditions, but don't get either 100% invested in stocks or 100% out of stocks. And lastly, don't go overboard for any one stock - not ever. The best advice is to never place more than 5% of your total portfolio value into any one stock.

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March 16, 2006 - MEETING UPDATE

I just received word that our scheduled speaker for this meeting, Mr. Cory Riedberger of Power Shares Capital Management, has been sent to St. Louis on company business, and therefore will be unable to speak to us this evening. However, we have rescheduled him for our meeting on May 18th, and he has assured me that there should not be any problem keeping that May meeting date.

So we will continue in our accustomed manner, and our topic for the evening will be, "The Craft of Investing." And why do I call it a craft? Because a craft is a skill that can be learned and perfected, which is exactly what one does in order to become a better investor!

And this also means we shall have more time to discuss our Phantom Portfolio, and decide what, if anything, we want to do further with it at this point in time.

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Desperately Seeking Income

In this interest-rate environment, it's not difficult to find dividend yields of 3% to 5% on blue-chip companies. Megabanks such as Citigroup, Inc. and Bank of America Corp. have yields well above the S&P 500's 1.78% average. Battered pharmaceutical stocks also look appealing. On top of their yields, their low prices mean many of them have the potential for decent capital appreciation - giving them a heftier overall return. Pfizer, for instance, yields better than 3% and recently even raised its dividend by 26%.

A good way to get a diversified portfolio of dividend payers is through an exchange traded fund (ETF). The iShares Dow Jones Select Dividend Index Fund (DVY) owns roughly 100 of the market's biggest payers, with a heavy dose of financials, pharmaceuticals, and utilities. And the brand new SPDR Dividend ETF owns top-paying companies that have consistently increased their payouts. It tracks the S&P High Yield Dividend Aristocrats index, which yields approximately 3.3%.

And here's another up-and-coming investment idea. Income Deposit Securities (IDSs) which offer yields of up to 14%. An IDS is part stock and part bond. That means roughly half the yield comes from the stock dividend, which is taxed at the maximum tax rate of 15%. The remaining portion comes from bond payments, taxed at your regular income tax rate.

Right now, most Income Deposit Securities are issued by small but cash-rich companies. The yield on OTELCO, Inc., a rural phone company, is just north of 10%. Another small firm, CENTERPLATE, Inc., which runs concession stands at sports stadiums and other venues, is paying around 13%.

There's also another opportunity to pick up yields higher than 10% up north with Canadian Income Trusts. These trusts pay out a large chunk of their earnings, usually on the order of 60% to 80%. Like an IDS, income or royalty trusts tend to be from cash cows, typically in the natural resources sector. For example, ARC Energy has a dividend of 8.84%, while NAL Oil & Gas pays 12.2%. You can also find some outside of energy, including beermaker Big Rock Brewery (7% yield) and trucking and logistics company TransForce (7.73%). In today's yield-starved market, companies like these certainly fill the bill!

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Pop Quiz Time

An assistant professor at the Massachusetts Institute of Technology, has developed a 90-second test that seems to predict whether you will be good at things like managing money. The test consists of the following three questions.

(1) A bat and a ball cost $1.10 in total. The bat costs $1 more than the ball. How much does the ball cost?

(2) If it takes five machines five minutes to make five widgets, how long would it take 100 machines to make 100 widgets?

(3) In a lake, there is a patch of lily pads. Every day, the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long would it take for the patch to cover half the lake?

Answers can be found at the end of this post.




Each question has an intuitive - and wrong - response. Most people need a moment's reflection to get the right answer. Thus, the questions test a certain type of intelligence - "cognitive reflection."

Besides being fun, the cognitive reflection test (CRT) has an amazing correlation with people's ability to evaluate risky propositions and to sort out the time value of money. (A dollar today is worth more than a dollar in the future because today's dollar earns interest.)

Respondents were also asked to choose between various pairs of economic alternatives. Many of the decisions involved temporal choices. For instance, would you rather receive $3,400 this month or $3.800 next month?

The second choice is better: it's equivalent to getting 12 percent interest in just a month. Of the people who scored a perfect 3 on the CRT, 60 percent preferred to wait a month. Of the people who got zero on the CRT, only 35 percent did.

People with high scores also showed more tolerance for risk when the odds were in their favor. For instance, people were asked which they would prefer: (a) $500 for sure, or (b) a gamble in which they had a 15 percent chance of winning $1 million and an 85 percent chance of receiving nothing.

Of people who scored zero on the CRT, the overwhelming majority took the sure $500. Of people who got a perfect 3, 60 percent preferred to roll the dice. Intuitively, they understood the concept of the gamble's "expected value," which is the sum of possible values, each multiplied by its probability (15 percent of $1 million plus 85 percent of zero equals $150,000). Clearly, this beats $500. Indeed, it's interesting how few people were willing to take the risk.

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Correct answers are (1) 5 cents; (2) 5 minutes; and (3) 47 days.


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Words of Wisdom

Chance is always powerful. Let your hook be always cast; in the pool where you least expect it, there will be fish.

-Ovid


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Hopscotching The Investment Media

The March 6, 2006 edition of Kiplinger's Personal Finance reveals the fact that adjustable-rate mortgages (ARMs) accounted for one-third of all mortgages last year, a huge jump from historic levels. The vast majority were interest-only loans or loans where borrowers paid even less than the stated rate. Such unusual terms are losing favor because regulators are urging lenders to do a better job of explaining the risks involved.

NOTE: if you pay interest only, and prices have fallen when it comes time to sell, you may have to come up with cash to pay off your loan. The allure of all types of ARMs is disappearing because they now have interest rates that are barely lower than fixed-rate loans.
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In the February 27, 2006 issue of Forbes, we read that many investors believe that countries with expected rapid growth rates are the best places to invest. However, in 2005, the highest growth rates were registered by China and Venezuela, yet their equity markets were the only ones in the emerging market universe to register losses. One study of 53 national stock markets, going as far back as 105 years, found no statistical link between previous economic growth and investor returns.
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Smart Money, in its March 6, 2006 issue reveals that closing some of your credit card accounts probably will do you more harm than good. If you've had those cards for a long time, they might represent the oldest credit you have. Shutting them down would shorten your credit history and likely lower your credit score. If you're carrying balances on other credit cards, canceling dormant cards could hurt your score further by increasing your ratio of outstanding debt to available credit. For the best results, use each of your cards at least once or twice a year and pay the full balance on time.

Note: Having a high credit score not only enhances your ability to get a mortgage at a good price, it also may help you pay less for things such as auto and homeowner's insurance.
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An Easier Way to Research Mutual Funds

For any person who invests in mutual funds, picking the right ones can be as tough as trying to understand the tax code. But now the National Association of Securities Dealers (NASD) is helping investors understand how to pick a mutual fund.

Last November, the NASD unveiled its new-and-improved Mutual Fund Expense Analyzer. This online tool enables investors to determine quickly and easily the expenses associated with more than 18,000 mutual funds and 160 exchange traded funds (ETFs).

It also will estimate and graph a fund's value over time - for any holding period specified by the user, as well as over a 20-year period - providing a running total of expenses the investor would pay during each period.

The tool also will compare the expenses of up to three ETFs, mutual funds, or share classes of the same mutual fund simultaneously. Users simply enter a ticker symbol or select a fund, share class, or fund family from a drop-down menu, and the tool automatically displays a screen with expense and fee information.

The new Mutual Fund Expense Analyzer also provides details about the fund or funds selected well beyond fee and expense information, such as investment objective and minimum purchase information.

You can access the Mutual Fund Expense Analyzer by clicking on "NASD" in our "Links" section. Then on the NASD home page, click on "Mutual Funds," and then scroll down on the right side of the screen to "Tools & Resources" where you will find the Mutual Fund Expense Analyzer listed.

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All About Spinoffs

The current edition of Barron's features a cover story (beginning on page 27) on Spinoffs, and how they can offer one of the most reliable routes to profit in the stock market.

It goes on to highlight nine (9) coming spinoffs including: Tyco International; Cendant; Sprint Nextel; Wendy's; First Data; Time Warner; Alltel; Liberty Media; Agilent Tech.; & Halliburton.

While this subject is basically the "stuff" of more serious investing, still in all the article has something of value for any investor and therefore I recommend reading it very definitely.

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Ben Bernanke - The "Prince of Paper"

It's no coincidence that on January 31, 2006 - the same day that Ben Bernanke succeeded Alan Greenspan as Federal Reserve Chairman - the price of gold also hit a 25 year high!

That spike in gold is hardly surprising to those who are familiar with Ben Bernanke. As Morgan Reynolds, former chief economist at the U.S. Department of Labor recently stated, "Bernanke has the power to screw things up royally, and he is off to a fast start: gold has gone up nearly $100 an ounce since Bush nominated him."

Ben Bernanke has a renowned fondness for crisp new greenbacks. In his own words, "The U.S. government has a technology called a printing press, that allows it to produce as many dollars as it wishes at essentially no cost."

Now while it may be true that it may not cost the government much, as anyone who studied Economics 101 in college knows, whenever the government cranks up the money machine, it costs you and me plenty because it devalues every single dollar we make and every single dollar we scrape together to invest.

The Fed's problem is that it's facing government deficits in excess of $8 trillion. That's about $27,000 for every man, woman and child living in the United States. And what's worse, Treasury Secretary John Snow has just asked Congress to raise the national debt ceiling, which 14 months ago, was set at $8.1 trillion. (The only other option is for the federal government to declare bankruptcy, and that's unlikely to happen).

So what does a fed chairman do in order to get control of the largest debt in all of history? Simple: if you devalue the currency then you also devalue the debt.

Several experts are in agreement that Bernanke will have no problem in turning on the printing press. Peter D. Schiff, President of Euro Capital Pacific, Inc, has stated: "Bernanke's finger will...be on the printing press: and he seems to be itching to crank it up."

Richard Russell, publisher of the Dow Theory Letters, believes the Fed is on course to add one trillion dollars to the banking system within a year.

According to James Turk, author of The Coming Collapse of the Dollar and How to Profit From It, "Bernanke will attempt to lessen the burden arising from the growing mountain of debt in this country as well as to maintain the illusion that the economy is on solid footing. This action will build the growing pool of liquidity, which in reality is excess dollars."

To top it all off, the Fed has quit publishing its M3 report, which to date has been the only way for investors to monitor the incredible growth in the money supply. If this lack of transparency sounds a bit fishy, that's only because it is!

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A Book Review

In Financial Intelligence, authors Karen Berman and Joe Knight present the essentials of finance in easy-to-read chapters that anyone can understand and put to use right away.

Written for business managers, but valuable for investors as well who want to understand what really goes into a company's financial statement. The authors not only teach you the fundamentals, but they also take you behind the scenes to show where the numbers come from.

Topics covered include: the basics of financial measurement; reading income statements, balance sheets, cash-flow statements, and more. The art of finance; separating hard data from assumptions and estimates; the mechanics of analysis; calculating ratios, return on investment, and working capital. Cash and profit and knowing the difference between them.

All in all, this book can definitely help you become a more confident and knowledgeable investor - provided that you are willing to make an effort to read it with understanding and then apply what you have learned!

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Investment Fallacies

There are widely-held investment notions that are in fact simplistic, and can cost investors dearly. Some of these have even been promoted in the media as sound practices.

1. Attempting to avoid the payment of capital gains taxes.

Not many people enjoy paying taxes, but sometimes tax-avoidance can entail greater risk and reduce overall returns. These investors lose sight of their objective - to maximize their risk-adjusted returns after taxes - and instead become fixated on avoiding taxes altogether, especially those levied on realized capital gains. An investor may be hung up on the fact that he will incur a 15 percent federal levy on the realized gain, while ignoring an uncertain but potentially enormous cost should the stock collapse.


2. An investor may decide to "wait for the stock to come back."


Investors all too often fret about the price they have paid for a security, and allow that concern to influence their immediate investment decisions. Investors often lament the fact that the value of a particular security had fallen from what they had originally paid for it, and that they would not sell it until it "came back" to that level.

This rationale is flawed. The cost of any asset is a sunk cost; it is irretrievable and therefore should not affect an investor's decision. The holder of any asset has two basic choices at any given time: he can continue to hold the asset, or he can sell it and invest the proceeds in some other asset. Each asset has some future value which is unknown, but the better outcome has nothing to do with what the investor paid for his security once upon a time.

3. The idea that one should never spend out of capital.

Some investors, especially those approaching retirement, are wed to the notion that they should live off of their investment income (dividends and interest) and avoid "dipping into capital" by selling securities in order to meet their spending needs. While this was at one time a reasonable maxim, it is now no longer a valid concept in financial planning.

At one time the U.S. dollar was defined as and redeemable on demand, in specific amounts of gold. High-grade bonds and similar instruments thus were even better than gold because they paid interest. The long-term stability of prices seemed assured, so bondholders were equally well-assured that the long-term value of their bonds would not deteriorate. Spending from capital was considered imprudent; only the interest income from such holdings should be used to meet living expenses.

But since that time the gold standard has been abandoned, and monetary inflating has become institutionalized. It is now a virtual certainty that when bondholders redeem their bonds seversl years hence, the purchasing power of their proceeds will have diminished since the time at which they purchased the bond. And the real value of the bond's interest payments will have eroded as well.

In this environment, investors are forced to consider supplementing their fixed-income holdings with common stocks and gold, which have historically outpaced price inflation. These provide returns largely through capital appreciation; they are purchased so that at some point they may be sold. Thus spending out of capital is no longer to be avoided, and is in fact an inherent part of a wise investment strategy.

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NEXT MEETING: Thursday - March 16, 2006

This month we begin our Spring Speaker Series with guest speaker, Mr. Cory Riedberger, from Power Shares Capital Management in Wheaton, IL - whose topic will be, "All About ETFs." One thing you will learn is a very important difference that sets Power Shares ETFs apart from others. And as usual, there will be ample time for questions.

We will also spend time discussing the phantom portfolio which we began to build at our last meeting in February.

Our meetings are held at DePaul University, which is located at 150 West Warrenville Road in Naperville, Illinois. Meetings begin at 7:00 PM and end at 9:00 PM. The room number will be posted on the easel standing near the reception desk in the main lobby.

We always welcome other serious investors to our meetings and AAII membership is not a requirement; however, we do have a $15 annual membership fee to cover twelve (12) monthly meetings throughout the year. And non-members may attend for a $5 donation.

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