How To Read Barron's

There are several good daily financial newspapers that any investor can read such as The Wall Street Journal, The Financial Times, or Investors Business Daily, but these can often be more distracting than helpful.

Reason: Daily newspapers explain why the Dow Jones Industrial Average (DJIA) went up or down the day before. They study the daily fluctuations so closely that the average investor may overlook a more important week long or month long trend.

This is why I believe that the average investor can benefit greatly by reading Barron's, the weekly financial newspaper that comes out every Saturday morning. Here are the things to look for in Barron's...

Stock market trends. First, there is a wealth of data contained in the section called Market Laboratory. Here you can focus on the relative performances of the DJIA...the S&P 500 Index...the NASDAQ composite index...and the Russell 2000 Index, which comprises the best-known small-cap companies. This is where you may be able to spot some market trends early - such as when one index suddenly begins to outperform the others.

Mutual fund track records. The Lipper Mutual Fund Performance Averages pages in Barron's can be especially helpful. They track performance by mutual fund type for several different periods.

Looking at the mutual fund tables, an investor can quickly gauge how his/her funds are performing relative to their peers as well as to funds in other categories.

Money market fund yields. This table helps you see how the funds you own compare with industry averages. You can also see how the rate of the average tax exempt fund compares with the after-tax yield of the average taxable fund.

Insights and analyses. Columns on the stock market, bonds, international markets and real estate help to give you the big picture, as well as a sense of what long-term trends may be unfolding.

Opinions of great minds in interviews. Barron's has access to the best investors around, and you should want to know what they're thinking. If two great investors like Mario Gabelli and Peter Lynch suddenly begin seeing the same emerging theme, then investors should take notice and start tracking the trend.

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Don't Over-Diversify!

Warren Buffett has been quoted as saying this about diversification. "The only people who diversify are those who really don't know what they are doing."

What Buffett is telling us with that statement is this: You can't be a Tiger Woods in investing. When you spread your energies and your capital too many ways, you are courting disaster!

If you have really taken your time and only picked stocks that are bona-fide winners, then there's no need to diversify for safety.

If you're not supremely confident about each stock in your small portfolio, then perhaps you should have never invested in them in the first place.

Remember, the fewer stocks you have, the more time you can spend becoming an expert on them.

Buffett rarely owns more than ten, and much of his capital is tied to just two or three.

Now that's focus!

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A Growth Spurt That Won't Quit

A strong run by the U.S. economy is helping to push equities back near record levels, while some economists, including new Fed Chairman Ben Bernanke, expect growth will begin to decelerate over the course of the year, while indicators both in the U.S. and abroad remain bullish for stocks.

The U.S. economy is expected to grow 3.4% this year, according to Blue Chip Economic Indicators, down fractionally from the 3.5% rise in 2005, in spite of a cooling down in the housing market and skyrocketing energy prices. The economy will keep up its good performance because key fundamentals for solid growth are still in place: Businesses are drawing on their hoards of cash to hire more workers, buy new equipment, and build new plants.

Equities stand to benefit from all this activity, especially the stocks of capital- goods makers. Production of business equipment is growing at a double-digit pace, and overall business investment should post another strong year.

Idle production capacity in the U.S. is quickly disappearing, and robust global economic growth is forecast to remain above 4.6% both this year and next by the International Monetary Fund. But all that growth also raises concerns.

Demand for metals and oils is not easing. Indeed, U.S. consumption of gasoline has exceeded year-ago levels despite the price surge. That will likely keep commodity prices elevated and inflation concerns front and center. Tighter labor markets are also producing faster wage growth. The combination has the potential to eat into corporate earnings, especially in a more competitive global economy.

So far, U.S. companies have overcome higher costs by getting more productivity out of their workers, but that will be hard to sustain if both hiring and wages follow current trends. Average hourly wages rose 3.8% from a year ago in April, the fastest pace since mid-2001. Companies that don't find a way to raise prices may see margins slip.

Recent inflation figures show that businesses may be gaining some pricing power -- one reason why the Fed isn't ruling out more rate hikes. Investors are concerned that the Fed could go too far with them and hurt economic prospects. But economists still believe the central bank will pause soon, if just temporarily, to assess the effects of prior hikes. If and when the Fed does take a break, it would be yet another reason to expect stocks to keep on climbing.

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Where's the Top?

The May 29, 2006 edition of Business Week is out and on page 97, it talks about the fact that while stocks may be high, an examination of them from three angles shows they're likely to stay aloft.

Only 30 out of thousands of stocks make up the Dow Jones Industrial Average (DJIA), but in the public's mind, it is the stock market. So when the DJIA flirts with a new high, people take notice.

On May 10, the index closed to 11,643, a shade below its all-time high of 11,723, only to give back 223 points in the next four sessions.

As the DJIA reaches for the heights, investors face that age-old conundrum: Is the stock market hitting a ceiling or is it building a new floor?

Analysis shows the market has sturdy economic and valuation underpinnings, but the technicians who study trading patterns and volume expect headwinds. In other words, use pullbacks as buying opportunities.

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The Case For Owning Gold

China's four largest banks: the Bank of China, the Industrial and Commercial Bank of China, the China Construction Bank, and the Agricultural Bank of China are planning to introduce a new gold ETF on mainland China some time during the next three months.

These are huge institutions, and when China's new gold ETF debuts, there will likely be a mad rush by millions of Chinese investors who could find it difficult for them to buy the needed gold all at once and thus have a tremendous impact both on the price of gold as well as its availability in the marketplace.

So what does all this mean to you if a portion of your portfolio is invested in gold such as in GLD, the gold ETF? It means that your investment in gold is doing just fine, and if anything, this is going to be a time to buy even more!

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A Number That Warren Buffett Cares Very Much About

If you leave $10,000 in a bank savings account for ten years, you may have $10,500 by the end of that time period. It's hardly worth doing. But give that same $10,000 to Warren Buffett to invest (he has averaged 22.2% per year since 1965) and you would end up after ten years with about $42,000, which is $31,000+ more than you would have received by leaving that money in the bank.

Wouldn't it be nice to know exactly how Buffett does it? Perhaps Warren is privy to some trick or maybe there's a secret to investing that makes the process a whole lot easier but that the average investor has yet to learn?

I'm not suggesting that it's easy to earn large investment returns. But the basic process that Warren Buffett uses is a single, time-tested method that is very simple to understand.

Warren Buffett is able to produce high returns year after year by focusing on one aspect of any business he invests in: the business's ability to generate free cash flow.

There are different definitions for free cash flow but they basically all come to mean the same thing. Free cash flow is money that a company makes by doing business. It isn't money that comes from selling off assets, or getting a loan. Free cash flow is money that comes from doing business. And it's called "free" because it's money that management is free to do with as it pleases after it pays all the bills.

The method for calculating free cash flow is very easy to understand. You take a company's net income, and add back certain non-cash charges like depreciation and amortization. Then you subtract how much capital spending the company must do in order to stay in business. The resultant number is the free cash flow.

Knowing one year's worth of free cash flow is just the beginning of the process. To do what Warren Buffett does with the information, you'd have to make an estimate of free cash flow for each of the next seven to ten years. And then you have to account for the fact that a dollar ten years from now isn't worth as much today as a dollar two years from now.

The process is simple to understand, but actually doing it can be very complicated. So perhaps the best approach would be to just buy the Berkshire Hathaway B-shares, and let Warren Buffett do it for you!

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Numbers Can Be Dangerous

Measures of risk and return should be carefully selected to match investment objectives and to allow for any unique constraints inherent in the account. They must also be interpreted with great care. And once established, they should simply inform an investor as a gauge of his progress and relative performance.

Although "benchmarking" is a useful tool to keep investors on track, it is ironic that benchmarks can also suggest to uneducated investors that they should chase the latest pipe dream. It is all too common for investors, tantalized by claims of extraordinary returns, to lose sight of the fundamental purpose of saving and investing, which is to meet some future financial outlay. One can spend only dollars, not short-term relative performance. It requires discipline to ignore the acute disappointment that can result when short-term results are compared to a benchmark. It is a mistake to throw in the towel by abandoning a sound investment plan and chasing the latest "hot" manager.

Perhaps it is part of our culture to believe that there is an equivalent of a Michael Jordan or a Tiger Woods of investment management. There are none. It seems that we are predisposed to think that talent and hard work will lead to success in stock picking, as it does in so many other areas of life. But alas, markets simply work too well to allow this. There will always be a manager who will outperform your portfolio over the short-term. These money managers have simply been dealt a lucky hand. And rest assured they will trumpet their good fortune. However, we hope that common sense will allow you to avoid these distractions.

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On The Lighter Side

The trouble with the rat race is that even if you win, you're still a rat!

-Lily Tomlin


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The Portfolio Pyramid: How to Diversify Your Portfolio

Remember the food pyramid for building a balanced diet? The portfolio pyramid covers the essential elements of a healthy, balanced portfolio.

The portfolio pyramid is a way of looking at your portfolio to determine if it's truly diversified both across and within asset classes. As you can see below, the pyramid breaks down a portfolio into manageable layers, making it easy to uncover any unhealthy symptoms.




Asset allocation: the foundation of your portfolio

The foundation of the pyramid is asset allocation. Your asset allocation determines the broad risk level of your portfolio, which should match your risk profile. Then once you've diversified across asset classes, you can start diversifying within asset classes.


Market capitalization

The size of a company is often measured by its market capitalization - the company's stock price multiplied by the number of outstanding shares. On the pyramid, market cap denotes the percentage of large vs. small companies in the stock portion of your portfolio.

Small-cap stocks tend to be riskier than large-caps, but have the potential for more upside. A sound diversification plan includes both, because nobody knows which of these two asset classes will be in favor at any particular time. For example, in 1998, domestic large-caps outperformed small-caps by 31 percentage points. But in 2003, small-caps outperformed by 19 percentage points.

Style

Next up is style, or the balance between growth and value investing. A mix of both is recommended, and the difference in performance can be dramatic. For example, in 1999, small-cap growth outperformed small-cap value by 44 percentage points. But in 2000, that was reversed and small-cap value outperformed by 44 percentage points. And styles also respond to markets differently.

Sector

Every stock is in an industry, and every industry is in a market sector. Holding too many investments in the same sector can be risky.

Industry

Jumping up to the next layer in the pyramid, the 10 sectors comprise 59 industries and 123 sub-industries. Even when a sector's performance is up, not all industries within that sector will perform identically.

In 2005, the consumer discretionary sector was down 7%. Yet if we look closer at this sector we find it contained 27 different sub-industries which had a mixed performance. Two notable examples are the 49% loss in automobile manufacturers and the 26% gain in homebuilding. Depending on what industry you held within the sector, your return could have been quite different.

The lesson? For a balanced diet, after you diversify across sectors, diversify across the industries within a given sector.

Geography

Over the past 36 years, the U.S. has a 0-36 record as the best performing market in a single year. This shows that you should look at investment opportunities outside the U.S..As with sectors and industries, your portfolio should include a mix of different countries.

Manager

Next comes managing your managers. It can be risky to have all your actively managed mutual funds with the same portfolio manager. Suppose the portfolio manager leaves the firm? Or the fund company goes through a disruptive restructuring? How might changes like these affect your portfolio? Hence, it makes sense to diversify across managers, as well.

Stock

Finally, at the top of the pyramid we have the individual stock level. This is where your greatest risk likely resides. As you create your portfolio, be watchful of inadvertently concentrating your position in a single firm.

Remember the tragic headlines of Enron employees who suffered great losses in their retirement plans? That's because they were over-concentrated in Enron stock. Enron is not an isolated incident. Many supposed "blue chip" companies have imploded in their day -- Conseco, Kmart, WorldCom, and United Airlines to name a few.

To reduce the risk of that type of portfolio meltdown, diversify your stock holdings so that no more than 5% of your portfolio is represented by any one stock. And if you have less than $50,000 to invest, then you may want to consider mutual funds, until such time as your pool of investment capital has grown sufficiently to warrant investing in individual stocks.

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The Long View

David Dreman, a regular columnist for Forbes magazine and well-known for his contrarian views on investing, is the subject of an interesting article appearing in the June, 2006 edition of Smart Money magazine, starting on page 46.

According to Dreman, investors tend to make the same mistakes again and again and when they do, he stands ready to profit.

He talks about heuristics, which are simple guidelines that we use without thinking. We need them to operate and they work very well most of the time. Heuristics allow people to concentrate on what's important at that moment, but they don't work when people aren't good statistical processors.

Then he talks about the base rate and the case rate. For stocks, the base rate is the long view - the 10 percent the stock market has returned on average over decades. The case rate is what the market's been doing for a few weeks or months or even a couple of years. So when we get a bubble like we had in the late 1990s, people immediately go over to the case rate - the short-term return - and project that into the future forever. So they end up paying too much for their stocks.

There is a second part to this. Mistaking the case rate for the base rate is a processing error. But there's another piece to it, and that's affect. Affect is based on likes and dislikes. The more we like [a stock], the more we're willing to pay for it. The less we like it, obviously, the less we're willing to pay for it. Research has shown that if we like something, we can overvalue it by as much as 100 times its true worth. And bingo - there's your bubble!

...There is more to the article and I highly recommend getting your hands on this issue of Smart Money and paying attention to the wisdom of David Dreman.

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NEXT MEETING: Thursday - May 18, 2006

Our guest speaker for this meeting will be Mr. Cory Riedberger, of Power Shares Capital Management in Wheaton, Illinois. His topic: "All About ETFs."

Among the points that Mr. Riedberger will cover is the very important difference between Power Shares ETFs and most other ETFs that are currently available.

We'll also take time to check the progress of our Phantom Portfolio and discuss any possible further moves at this time.
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We meet at DePaul University, 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 have an annual membership fee of $15.00 - and non-members are always welcome for a $5.00 donation.

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Farewell, Louis Rukeyser!

Louis Rukeyser died this past Monday. The celebrated host of Wall $treet Week always conducted the program with a high intellect, wry humor, plus an occasionally irreverent commentary. His was both a refreshing as well as a very entertaining approach to investing that will be sorely missed!

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Stuck In The Middle

No good product can long escape Wall Street's tendency for abuse, and such is the case for exchange-traded funds (ETFs).

ETFs have grown exponentially in a very short period of time and have been seized by savvy marketers hawking ETFs based on various "groupings." These are intuitively appealing to investors, but have no place in a portfolio based on rational, asset class investing. Some are bizarre, such as ETFs based on initial public offerings, while others are more conventional, including ETFs based on specific industries and commodities.

With the exception of REIT and gold-based ETFs, there are no funds based on industries or commodities that represent legitimate asset classes.

So-called mid-cap ETFs have proven popular. And the American Institute of Economic Research (AIER) recently examined the returns on the middle three quintiles of U.S. common stocks ranked by market capitalization. They concluded that while small and large-cap stocks have unique and therefore desirable risk and return characteristics, mid-cap stocks do not.

During the years 1926-2005, the median difference between the returns on the largest quintile and the smallest quintile was more than 13 percentage points. During eight out of ten 12-month spans during those years, the returns on the middle quintiles were somewhere between those of the largest and smaller quintiles. The other 20 percent of the time (when the returns on the middle three quintiles were outside the range between the first and fifth quintile) the median difference from the closer of the two remaining quintiles was only about two percentage points.

This suggests that there is little point in holding a "mid-cap" fund, especially when the portfolio contains funds that hold companies further down the list of companies ranked by size. Asset class investing takes advantage of dissimilar price movements, and in this respect, investment vehicles based on mid-cap stocks offer little value.

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M3 Money Supply Figures

If you are disappointed by the Federal Reserve action last March in stopping the publication of the M3 money supply figures - which by the way makes no sense whatsoever - unless perhaps they are trying to hide something from us, then you will be pleased to know there is a Web site where this information is still available.

You can click on Economagic in our "Links" listing to access this Web site which is the best site for the latest statistics on interest rates, inflation, housing starts, GDP, and even the M3 Money Supply figures.

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ENOUGH IS ENOUGH!

When I began this Blog in 2004, I was determined to stick with the subject of investments and never allow politics or other topics to surface here. But today, I received an e-mail that really raised my blood pressure. It shows very clearly the contempt and disrespect that the illegal mexicans (Note: small "m" is intentional!) have for this great country of ours. And since you won't be seeing this photo in your CONTROLLED press, nor will any of our spineless fork-tongued politicians of either political party address this insult to our flag that took place at the Whittier High School in "The Peoples Republic of California" - I now post this disgusting photo for everyone to see what these ungrateful peons from south of the border really think of our great Nation.

Your House Is Guilty Until Proven Innocent

Are you aware that your house, car, or boat can be convicted of a crime? The entire concept sounds absurd, but it's absolutely true. If a crime is committed on your property, then the police (or the government) can seize it - whether that property is a house, czr, boat, or anything else you own. They can also empty your bank account, if they can prove that even one U.S. dollar has been earned through illegal means.

Get this: it doesn't matter whether you committed or are even suspected of these crimes, because only your property "is guilty." Sound unfair? Well, it's called civil forfeiture. It's been happening since the U.S. was founded nearly 230 years ago, and in 80% of civil forfeiture cases, the property owner is never convicted of a crime, but that still doesn't stop the police or the federal government from confiscating their property.

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A Potential Investment Opportunity

We read with interest in Business 2.0 magazine about a consortium of tech heavy hitters that thinks it has just the thing to bust open the market for student PCs: a speedy and durable little laptop that will sell for about $300.

Project Inkwell, backed by Intel, Microsoft, SanDisk, and others, says the machine will be roughly the size of a paperback book and will sport blazingly fast boot-up times, basic word processing, and Web connectivity. Design firm IDEO has already produced a prototype, dubbed Spark. Inkwell is courting school districts across the country and estimates the potential market at more than $20 billion.

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