Cash Comes in Three Flavors

Believe it or not, there are different types of income. Just as there's different types of stocks, bonds, and mutual funds, so too there are different types of income - three to be exact.

First is Fluctuating Income - which is effectively the "rent" you receive for letting someone else use your money. And this type of income goes up and down right along with the ups and downs of the economy. If interest rates rise then your income rises. If interest rates fall then your income falls. Because of this flexibility you, the owner, can move and withdraw your money with relative ease. The drawback is, just like a renter at a week-by-week flop house, you get bounced around quite a bit. Common examples here are Money Market Funds, Short-Term CD's, and Treasury Bills.

The next flavor is Fixed (or sometimes called Flat). Here you lock in a given rate for a given period. Three, five, ten, or even thirty years. With this type of income, what you are literally doing is signing a long-term "lease" for the use of your money. The benefit to you is obvious. You get a higher rate than the previous flavor, and you know what and when - and for how long you're going to get it. Common examples here are long-term CD's, Corporate, Municipal & Government Bonds.

The third flavor is Rising. Here you get cost of living raises on your money. Every year or so you get a raise. Not because you're such a superstar but because you're still breathing! Common examples here are Utilities, high-dividend-paying Blue-Chip Stocks, income oriented real estate and REIT's.

Now this is important. Make doubly sure you get it: The first two flavors (Fluctuating and Fixed) will not and cannot maintain your standard of living or keep your purchasing power stable. Only the third flavor can do that.

And another important point: In order to keep pace with inflation, the highest yield is not the answer. Rather, the answer is: What is the yield's growth rate? If the yield actually grows, then you have a Riser. If not, then good luck, because you'll need it!

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Balanced Diet Investing

Your grandmother may have told you to "eat a balanced diet if you want to be healthy." Well, "healthy" investing works in much the same way although the "diet" consists of stocks, bonds, ETFs, commodities, mutual funds, options, limited partnerships, derivitives, and unit trusts among others. The list of investment choices is virtually endless and their permutations run into the zillions.

As if this isn't enough of a problem, the literature on each choice makes it look like the virtual paragon of investments. They're touted as perfect, safe, inflation-proof, secure, and flexible.

Take mutual funds for example. According to each fund's literature, its three-, five- and 10-year track record always looks great. You're inundated with Lipper and Morningstar reports proving whatever point the fund wants to make.

Limited partnership literature and stock research reports do the same. When have you ever received a tip on a bad stock?

Next in line is how great the trendy asset-management strategies are. Sweep accounts, asset allocation accounts, wrap accounts, index accounts and others all receive the same hype. So what's an investor to do?

Well grandma's "balanced diet" comprises four basic food groups. In investment and portfolio management, whether it's for your personal account or your retirement account, there are also four basic "food groups." If you know them and how to use them, you're halfway home. These groups (not the component ingredients, which are stocks, bonds, mutual funds, etc.) are capital preservation, income preservation, capital appreciation, and income appreciation.

The most easily understood group is capital appreciation. With this one, we can all take the Will Rogers attitude of not being as concerned with the "return on our principle but with the return of our principle." Common examples are certificates of deposit, short-term government bonds and money markets.

With income preservation, we want a stable return on our investment for long periods of time. We don't want our savings to take any pay cuts. Examples here are long-term bonds and annuities, which allow us to lock in long-term rates.

We want our core savings to increase in absolute dollars in capital appreciation. This can be achieved by investing in things like quality "blue chips," growth stocks and real estate.

Income appreciation is the last and least understood group. Here, we want our cash income to increase in absolute dollars, by making investments that have proven track records of consistent dividend or income increases. We might use utilities, real estate or high-dividend-paying "blue-chip" stocks for this purpose. The goal here is cash pay raises in absolute dollars (not just compounding, which is "simply" re-investing).

The purpose of income appreciation-type investments is to keep us in pace with -- and hopefully ahead of -- inflation. Bonds, CDs and fixed-income investments can't do this. Lock in 10% on $10,000 today for 10 years and you obviously get $1,000 per year. This may be fine in 2006, but in 10 years, that same $1,000 per year won't look so fine. Even at the government's ficticious "only 3 percent simple inflation," you've lost 30 percent of your purchasing power (10 years times 3 percent). And just as your income stream lost 30 percent of its purchasing power, so did your principal!

Confusingly, of all these investing "food groups," there is no best choice. Focusing on one or two is like eating only steaks and potatoes. So your grandma was right about a balanced diet!

Here's a case analysis illustrating the best use of the four groups. Assume we have either a typical 40-year old or a typical company retirement plan. Their needs are remarkably alike. They both need and want a portfolio that provides various amounts of capital preservation, income preservation, capital appreciation and income apppreciation.

If the investor wants to follow just the income preservation and capital preservation routes, a core portfolio could consist of bonds that mature at different times. If, on the other hand, the goal is capital appreciation and income appreciation, the portfolio could possibly focus on blue-chip stocks and utilities. Or it's possible that an investor could adopt a middle-of-the-road approach and go with 25 percent in each group.

Finally, what we need to learn from all of this is that an investor has to understand that it's not only what you own but why you own it that really matters. He or she also needs to realize that virtually every investment falls into one of these four groups for analysis and applicability.

Managing your personal portfolio is an evolving, dynamic process. There is no one perfect system, but there are general guidelines that make life a lot easier. Obviously, nothing beats ongoing reviews of your portfolio, coupled with thoughtful examination of the actual selections that you place in your portfolio in the first place.

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How To Check Out A Hot Stock Tip

Putting your money where someone else's mouth is is far more likely to be risky than rewarding - unless you follow the tip up with some research. Here's the right way to do just that.

If you're like many investors, your first instinct upon hearing a plausible argument for a stock is to bounce the idea off your broker the next morning. But to make the conversation a more intelligent one, head for your public library first. Specifically, look up the company in the Value Line Investment Survey or Standard & Poor's Stock Guide.

Pay particular attention to how the share price has fared lately. If the stock is in the news, it may be a good time to look at it, but it's probably the wrong time to buy it, since the news may already be reflected in the price. In any event, steer clear of shares trading at a new 52-week high; instead, wait three to six months to see whether the stock retreats to a more reasonable level.

What follows are five frequent stock pitches you may be tempted to swing at, plus some advice that will help to give you a better batting average.


The New Product Scenario

While everyone wants to get in on the next biotech or software star, buying the stock of a new cutting-edge company can be especially risky. Not only is the business or product likely to be difficult to understand, but standard stock analysis is complicated if, as is often the case, the company has yet to earn a dime.

Still, investors are far from helpless, but researching the product or technology is not the way to start. Whatever business it's in, you can determine the value of a development-stage company by comparing its total market value (the number of shares outstanding times the price) with how much it has spent on research and development over the past five years, information that can be gleaned from company financial reports.

Stick with firms sporting a market capitalization/R&D ratio of less than 10 to 1. If it's higher than that, the stock is overpriced.


The Bargain Stock Story

The textbook way to see whether a stock is undervalued is to examine its price/earnings or price/book ratio. Any stock trading at less than one times its book value per share - that is, the per-share worth of the company's assets minus liabilities - or below the market's P/E ratio is a potential bargain. Underline potential.

Above all, don't make the beginner's mistake of merely comparing the company's P/E to the market's and concluding that the shares are cheap or too high priced. Instead, check out the stock's annual relative P/E ratio, available in Value Line, to see whether the company usually trades at a discount or premium to the market.

Then too, go beyond P/E ratios in researching a supposed value stock. Zero in on the strength of the company's finances. Start by looking at Standard & Poor's investment quality or Value Line's financial strength ratings and think twice before investing in a company with less than a B+ grade from either source. Then see how much debt the company has, and stick with outfits where debt is no more than 40% of capital. If the balance sheet is solid, then an undervalued stock you hear about is worth considering.


The High-Dividend Dazzler

In truth, to wise investors an ultra-high yield can be a sign of financial trouble, and always merits further study. Compare the yield with other companies in the same industry. If it's two or three percentage points higher than the industry benchmark, figure that the dividend is ripe for pruning.

To find out whether the dividend will get the axe anytime soon, scrutinize the so-called payout ratio, or dividends as a percent of earnings. You can find it in Value Line or calculate it by dividing the annual dividend by the past 12-months' earnings per share. The lower the payout ratio, the more cushion the company has to maintain the dividend if earnings drop. For an industrial company, conservative investors should look for a ratio of 50% or less (70% is okay in the case of a utility). But if the dividend is more than earnings and profits are on a downtrend, there's a serious risk the dividend will be cut.


The earnings-Growth Grabber

Since stock prices tend to track prospects for earnings growth, everyone loves a company capable of 20% profit increases year after year. Two telltales can help you judge how profitable a business is: An above-average return on equity (ROE) - basically a look at what the company is earning on the shareholders' stake - and high, and expanding profit margins.

Coupled with low debt, a high ROE can predict above-average earnings, assuming the company reinvests profits in the business. An ROE above 12% merits your attention; above 15% suggests a solid grower; and 20% or more means you have a potential scorcher. But since an ROE is merely a snapshot of a company's profitability, look for signs that the company can sustain such a torrid return. Growing profit margins indicate that the concern maintains pricing flexibility or is reducing its costs. Either way, it's doing something right.


The Turnaround Tempter

Before swallowing the hook, search newspaper articles for reports of executive changes or consult the company's latest annual reports. Also look in Value Line to see whether cash flow (how much net cash the business generates) has moved into the plus column. Such a turnaround can be a sign that earnings will follow suit, and Wall Street simply loves positive earnings reversals. Then too, check whether company insiders are really optimistic about their firm. Look up insider buying behavior in Value Line. Just as more insider selling than buying over recent months could signal a problem, increased buying may be a sign that the stock is poised to take off.

However compelling a stock tip sounds, don't feel you have to swing at the first pitch. No matter how good the story, there's always time to check it out. And what's more, there's always going to be another good stock pitch come along!

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When Wishing Beats Investing

This is the title of an article appearing on Page 22 of the November, 2006 edition of Smart Money: The Wall Street Journal Magazine. It reminds us of a fact which is known to most investors, but one which we tend to lose sight of - the fact that patience is a virtue - with a payoff.

Some of the best investors spend most of their time not buying stock. Instead, they isolate superior companies and study them day in and day out. Then, they wait. Eventually, a spike in oil prices or an earnings miss will drive the stock price down - only then do they buy.

"Everyone does the opposite," says Jeff Auxier of the Auxier Focus fund. "They focus on the ticks and let the market move them instead of letting the market serve them."

So what this tells us is the fact that if you want to develop into a superior investor, you should be creating a "wish list" of potentially good long-term holdings, and then wait and seek for situations like headwinds developing in the housing market or in consumer spending and the overall economy to increase the likelihood of short-term drops that can provide an opportunity to invest in candidates that you have been watching on your "wish List."

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Designing The Perfect Portfolio

Believe it or not, the overall strategy is no more complex than any well-thought-out business plan. When you get to the plan's "fine tuning," the waters can get a little muddy, but the master plan is something anyone can do. It consists of three phases, and when you complete each phase in order, you may find yourself pleasantly surprised.

The first phase is top-down asset allocation. In this phase, you take a step back and you need to analyze who you are, where you are and where you want to be. Once you have this base, you then need to analyze your current portfolio to see if it fits with your goals. Do you need more or less growth? More or less income? More or less liquidity? More or less tax relief? By answering these questions, you can then prepare an ideal portfolio -- on paper.

Naturally, what works on paper may not work in reality. So you will need to massage the portfolio, still staying with major asset classifications and strategies, until the overall portfolio's master plan works for you. And perhaps more importantly, until you can sleep with it.

Phase Two is the bottom-up asset allocation phase. You now know, for example, that you wish to have 20 percent of your assets in conservative growth. Of this 20 percent, half is to be in proven stock funds (managed growth) and the other half in individually selected stocks (self-directed growth).

Now for the difficult part. Of the more than 10,000 different mutual funds and/or ETFs available, which one or ones are best for your particular goals in this portfolio? And of the 50,000-plus stocks, which show the most promise for the least amount of relative risks?

Needless to say, this same bottom-up analysis needs to be applied to all other asset classifications (bonds, annuities, hard assets, etc.) and tax-management strategies (tax shelters, annuities, individual retirement accounts, etc.).

Phase Three involves ongoing reviews. There is no one approach or investment that is perfect for all times. If whole mountain ranges can be destroyed by blowing grains of sand, then so can the best-designed portfolios.

Reviews need to be complete and frequent, at least twice a year. And we don't mean cursory reviews but rather, a full and complete review of each asset from both the top-down and the bottom-up points of view.

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Preferred Stock As An Investment

To begin to see if preferred stocks are right for you, we need to do a brief recap of a publicly traded corporation's financial structure. As you should be aware, corporations need money in order to buy plants and equipment, and to get this money they issue both stocks and bonds. Stocks are for those investors who are willing to take ownership risks for ownership rewards; bonds for those willing to accept creditor risks for creditor rewards.

Smack in the middle and a hybrid of these two is a lesser-known entity called a preferred stock. Simply put, it's like a bond in that it typically, but not always, pays a fixed, non-adjusting rate. However, it differs from a bond in two key areas: It effectively never matures and it is junior to bonds in the corporation's chain of liabilities (bond holders eat first, then preferred stock holders and lastly, the leftovers go to the common stock holders).

Preferred stocks are like their common stock cousins in that the dividends can only be paid from company profits. If there are no profits, there are no dividends. But they differ from common stocks in two key areas: First, the dividends are typically cumulative. In other words, if the company misses a payment, it owes the preferred stock shareholder, it cannot pay any dividends to the common stockholders until all preferred stockholders are paid. Second, the preferred stock dividend is typically much greater than the common stock dividend.

Another benefit of the preferred stock is that its yield is often greater than that of the bond. Yes, you read that right! Thus, income-wise, a preferred stock is "safer" than a common stock and can pay more than a bond. When you buy a preferred, you are effectively locking into that day's yield. No more wild interest rate rides.

But before you decide to run off and load up on thousands of shares of preferred stocks, you should do your homework and also bear in mind a caveat or two.

You need to remember that preferred stocks are interest-rate-sensitive. In this case, it simply means that whenever rates go up, the prices of preferred stocks go down - and vice versa.

Currently, rates are relatively high. This means that the potential investor in preferreds has a double opportunity. First, with high rates, you obviously get the opportunity to lock in high rates. Secondly, when rates start to go back down, preferred prices will go up. So you can get high yields and capital appreciation in one package. But a preferred stock is only as good as its corporation so you should stick with "A" -rated firms or better. And also make sure you understand any call provisions.

Thirdly, as always, spread your eggs around a bunch of baskets. And since there are very few mutual funds or ETFs that specialize in preferreds, you will most likely have to design and select your own portfolio.

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Ten Tips For Improving Returns

Here are 10 ideas for making an intelligent review of your portfolio and doing some tinkering that might improve your returns without raising your risk level.


1. Eliminate Stub Positions

A "stub position" by definition, is a holding that accounts for less than 1 percent of your portfolio. Stub positions tend to drain your profits. For example, if a 0.5 percent stub position triples, it increases the value of your portfolio by a mere 1 percent - which is a terrible waste of a triple!

Some people tend to spend roughly the same amount of time studying each of their stocks. For them, a stub position may take away time and energy better spent elsewhere. Other people virtually ignore their stub positions - but that can lead to nasty surprises.

So check your portfolio for stub positions and either increase them to at least 1 percent or else get rid of them.


2. Own from 20 to 40 Investments in Your Portfolio

If you own fewer than 20 stocks, your portfolio may not be diversified enough - though you can solve that problem by including some ETFs and/or mutual funds in the mix. If you own more than 40 investments, chances are you're not going to be able to spend enough time keeping track of each.

One benefit of having a diversified portfolio is that any single stock cannot lose you more than 100 percent of your initial stake, but it can gain you more than 100 percent. If you only own a handful of stocks, you have less chance to take advantage of that fact.


3. Have a Cooling-off Period

At the moment you decide that buying a certain stock would be a good idea, start your mental stopwatch. Wait at least 24 hours and perhaps as much as a week. Then reassess to see if the buy rationale still seems compelling. Otherwise, you will wind up with a portfolio full of impulse purchases.

If a waiting period is a good idea for the purchase of handguns, it's an equally good idea for the purchase of common stocks.


4. Own Some Non-U.S. Stocks

It's easier today than in the past for Americans to own stocks of companies outside the U.S.. An increasing number of major European and Asian companies trade in the U.S. in the form of American Depository Receipts.

If your portfolio is too all-American, you are tied to the fortunes of a U.S. stock market that is somewhat high at the moment. You also miss some major values that may be available abroad. Because the U.S. has a relatively mature economy, you may be able to pick up some faster growth by investing in stocks in Asia, Latin America and Europe. This raises the risk level of your portfolio, but that risk is at least partially offset by the fact that you are no longer putting all your eggs in one basket.


5. Be Ambitious

Don't buy stocks hoping for a 15 percent or 25 percent gain. That's a game that brokerage houses like you to play - because it makes you trade more often - but it's really foolish.


6. Stick With Your Asset Allocation

Decide on a mix of stocks, bonds and cash that suits your temperament, age, health status, timing of expenditures such as college tuition, and need for current income. Then try to stick with that mix, making adjustments once or twice a year. This makes you buy a little more of assets that have declined and take a few chips off the table for assets that have risen. In most market conditions, that will enhance your returns.


7. Be Patient

Don't trade too much, don't sell too soon, and don't buy too fast. John Templeton, one of the great value investors, liked to say that he wouldn't sell a stock unless he had spotted another stock that was twice as good a bargain.

For many individual investors, it costs 1 percent to 3 percent of your money to buy a stock and another 1 percent to 3 percent to sell. So the in-and-out cost ranges from 2 percent to 6 percent. In almost every sense of the word, the stock market is a game of percentages.

The cost of trading is one major reason so few investors manage to beat the market averages.


8. Keep A Source File

Try to write down where you got the idea for purchasing each stock in your portfolio. If you have time, also do this for stocks you've owned in the past. Then evaluate how the stocks from each source did. Soon you'll be paying more attention to the sources - brokers, magazines, Web sites, or whatever - that served you well, and less attention to those that have served you poorly.


9. Check On Custody

Frauds come and go, but they never totally go away. So take just a moment to see that your holdings have a proper custody arrangement. If you choose, an individual broker, money manager or financial planner may have the ability to trade your account. But he or she should never actually have control of your money. It should be in custody of a third party, such as a bank or major brokerage house.


<10. Buy What's Unpopular

You rarely get rich buying what everybody else already loves. But you sometimes get rich buying what everybody else hates. But if you want to buy low and sell high, you often need to buy stocks when there is some danger present. Then you do your best to evaluate the danger to see how lethal and how long-lasting it is likely to be. If it's a passing thunderstorm, it may be a buying opportunity.

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