Real Returns

Beyond official mutual fund returns are "investor returns," which factor in the timing of investors' purchases and sales. Thus, investor returns depict the return earned by a fund's typical investor.

In every diversified stock fund category, investor returns for the last 10 years have lagged total returns. This was especially true for growth funds. What's more, for every category, the investor return of the low-volatility quartile trounced the high-volatility quartile.

NOTE: Mutual fund investors likely will post better long-term returns with low-volatility funds, which tend to be those that led their categories during the 2000-2002 bear market.

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Deal or No Deal

Investors hoping to cash in on the merger and acquisition frenzy should look for stocks that are both attractive on their own and have characteristics that might appeal to corporate raiders.

Such companies have rich levels of free cash flow and steady, sustainable cash flow growth. You should consider the EV/EBITDA ratio. EV is enterprise value (market cap plus debt, minus cash). EBITDA is earnings before interest, taxes, depreciation and amortization.

NOTE: A low EV/EBITDA ratio indicates that a company might be undervalued, and thus a good investment.

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Drugs At A Discount

Over the past 10 years, leading drug stocks traded at an average price/earnings ratio of 25. Today, their average P/E ratio is just 16.6, and some large pharmaceutical stocks pay substantial dividends.

The industry's current problem is that companies don't have enough blockbuster drugs in development to replace all the important drugs that will be losing patent protection over the next few years. However, thanks to the aging Baby Boomers, we can expect total spending on prescription pharmaceuticals to grow faster than the overall economy.

A well-diversified portfolio should include drug stocks, and you might want to shore up your holdings now while they trade at relatively low prices.

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Falling Fees

Commissions at some brokerages have fallen so far - to zero, in some cases. Leading the brokerage pack is Zecco.com, which offers up to 40 free trades a month.

Others offering free trades are Wells Fargo and Bank of America. The latter two firms each require a minimum account balance of $25,000 to get free trades, while the Zecco minimum is only $2,500.

No-commission trades will make it practical to DRIP into the high-fee DRIP companies through a broker instead of through the DRIP.

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Words of Wisdom

"The more that you read, the more things you will know. The more that you learn, the more places you'll go."

-Dr. Seuss

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Who's Kidding Who Concerning Inflation?

Inflation is currently running at a little under 3% annually - so we're told - OR, at over 14%, depending on which calculation you use.

The latest official U.S. government figure is 2.9%. But if you recalculate inflation using pre-Reagan (1980) methodologies, when inflation was seen as a real threat to the economy, the annual inflation rate in May was about 10.3%.

These are "core" numbers discounting both food and energy. In total, food and beverage costs are up nearly 4% since May of 2006.

Therefore, the real inflation rate is 14%!

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Separate Ways

With separately managed accounts (SMAs), investors hold individual securities - stocks as a rule - selected by esteemed money managers.

Historically, SMA minimums were in the $500,000 to $1 million range, but some now are as low as $25,000 and might drop even further.

Advocates insist that investors have more tax control with SMAs, compared with investing in mutual funds. With SMAs, you know the tax basis of your investments. If a mutual fund sells appreciated holdings, relatively new investors may wind up paying tax on profits enjoyed by longer-term shareholders. SMAs allow investors to avoid these unwanted taxes.

With SMAs, no one else is deciding when to jump in and out of your securities, a process that can trigger capital gains for mutual fund investors - or simply unwanted sales based on management needs and not necessarily yours.

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Stock Up

This is the first time in modern history that we've seen a prolonged worldwide interval - 56 months - of equity arbitrage. This results when the earnings yield on equities (earnings divided by price) is more than the after-tax cost of money.

Today's equity arbitrage comes in three forms: (1) corporate acquisitions; (2) share buybacks; and (3) leveraged private equity buyouts of public companies. Altogether, the global equity supply will shrink by 5% this year, which will boost earnings of the remaining shares.

Shrinking equity supply and higher earnings per share may help stocks register a fifth straight winning year.

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NEXT MEETING: Thursday - July 19, 2007

This month, as the result of comments that were voiced at last month's meeting, we'll devote our meeting to a serious effort at reinstating the Portfolio. It was an excellent idea to begin with, but met with an untimely demise, in part, due to the way in which we employed the trailing stop method. So please feel free to offer suggestions as to how we might "fine tune" the Portfolio so as to achieve a more successful result on the second time around. One thought that I will offer is to incorporate the two most powerful secrets of the world's greatest investors into any new Portfolio... This could turn out to be a most fascinating discussion!


We meet at DePaul University, located at 150 West Warrenville Road in Naperville, Illinois. The meeting begins at 7:00 PM and ends at 9:00 PM. And the room number will be posted on the easel which stands near the reception desk in the main lobby. Our meetings are always open to anybody who shares our interest in learning and talking about investing. You need not be a member of AAII in order to attend.

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The Wisdom of Warren Buffett

To many on Wall Street, both companies and stocks are seen only as raw materials for trades.


Professional money managers tend not to see companies and stocks as businesses, but as bouncing numbers on a screen on which they can place bets. Warren makes his money off these gamblers when they oversell a business and drive down a company's share price to the point that it is cheap relative to the long-term value of the underlying business.

The casino aspect of the stock market has been in place since its conception; people simply like to gamble, it makes things exciting. With stocks you can borrow money, lots of money, to place your bets, which is great if things go your way, but real bad if they go against you. This explains why there are such wild price swings -- sometimes money managers have to get out regardless of the price of the shares.

As Warren said, "Think about a burning theater. The only way to leave your seat in a burning financial market is to find someone to take your seat, which isn't easy." This, of course, creates all kinds of buying opportunities for those who know the true long-term value of a business.

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Mutual Fund Quarterly

The current (July 9, 2007) edition of Barron's contains the quarterly Lipper Mutual Fund summary. This is the most complete listing of results for mutual funds available, and must reading for serious mutual fund investors!

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No More Funny Money

Aaron Russo is the producer of a new controversial documentary film with the title, America: Freedom to Fascism. This is a frightening examination of the real power that makes the world go around, the Federal Reserve Bank and the central banking and credit system.

The film, which premiered at the Cannes Film Festival, explores the legality of the 1913 Federal Reserve Act and the 16th Amendment, which provides for the graduated income tax.

Russo and an eccentric cadre of Libertarian "tax protesters" claim this is the largest hoax ever perpetrated on the American people. The New York Times disagrees with them but Russo says they are all wrong.

In any event, you can find out much more about the sinister beginnings of the Federal Reserve by reading the book: The Creature From Jekyll Island by G. Edward Griffin.

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Happy Birthday America!

Today, as we celebrate the 231st "birthday" of the most wonderful country that the mind of man has ever conceived, it would be good to set aside the celebrating just long enough to take a good hard look at the present crop of deceitful politicians of both political parties, and read the words of the Roman statesman, Cicero.


A nation can survive its fools, and even the ambitious. But it cannot survive treason from within. An enemy at the gates is less formidable, for he is known and carries his banner openly. But the traitor moves amongst those within the gates freely, his sly whispers rustling through all the alleys, heard in the very halls of government itself.

For the traitor appears not as a traitor; he speaks in accents familiar to his victims, and he wears their face and their arguments, he appeals to the baseness that lies deep in the hearts of all men. He rots the soul of a nation, he works secretly and unknown in the night to undermine the pillars of the city, he infects the body politic so that it can no longer resist. A murderer is less to fear.

-Marcus Tullius Cicero
Roman orator, statesman 42 B.C.

Ed. Note: Do Cicero's words tend to describe anyone that you know?... Think about it!

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What's Next?

The July, 2007 issue of BUSINESS 2.0 magazine is out and it carries a very interesting article on the next generation of Internet connectivity, called Wi-Max.

You may currently be connecting to the Internet via DSL or cable, or even with Wi-Fi (that is if you happen to be located within 300 feet of its transmitter), but with Wi-Max, just one tower will service a five square mile region.

The new service will be provided by Sprint-Nextel and it will "go live" later this year in three cities including Chicago, Washington, D.C., and Baltimore.

Among the benefits of Wi-Max is its speed. While DSL-based Wi-Fi usually transmits 2.5 megabits per second, Wi-Max can handle up to 5 Mbps. And the better Wi-Max can be used for voice, Internet, and video services, and multiple users won't slow it down as is the case with cable.

Of interest to investors is the fact that Sprint is working with heavyweights like Intel, Motorola, Nokia, and Samsung. And PC cards will be available when the new service launches, followed by gaming devices, laptops, cameras, and even phones with built-in Wi-Max by the end of 2008.

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The 25% Solution

In the 25% Federal tax bracket (taxable income up to $128,500 on a joint return), municipal bonds are not especially attractive. You might earn 3.6% on a five-year tax-exempt bond.

You could buy a five-year Treasury note and earn 4.8%; in a 25% tax bracket you'd lose 1/4 of your yield (1.2%) to taxes and wind up with 3.6%, the same as from a muni.

For the same yield, you're better off with the safe credit risk that Treasuries offer. With greater taxable income, though, you would be in a higher tax bracket and thus net more with municipal bonds.

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What Is Style Analysis?

Asset allocation is a strategy for dividing your portfolio among investments in different asset classes - typically a range of stocks, bonds and cash - to help you achieve your financial goals. Each of the individual investments within those classes puts your money to work in different ways, performs differently in different economic climates, and carries a different level of investment risk.

However, choosing the right mix of investments to produce the return you want, at the level of risk you are willing to take, is usually more difficult than determining the allocation model to follow. So how do you know which investments to buy? That's where style analysis comes in.

The part style analysis plays

Each individual investment within an asset class has a distinctive style, or pattern of behavior, which explains much of the return it produces. A mutual fund's style, for example, is determined primarily by its particular asset allocation, or the diversified portfolio of investments that make up the fund. Since no two funds own exactly the same investments in exactly the same proportions, no two produce exactly the same return.

What style analysis can tell you

As an example, a stock fund might describe itself as a domestic stock fund, and you might specifically select the fund to cover that segment of the msrket. Based on that classification, you would expect the fund to produce a return that reflected the performance of US companies during a particular time period.

The question, however, is whether the fund actually performs like a domestic stock fund or, has the fund actually allocated a significant portion of its portfolio to stock in companies doing business overseas? In that case, return-based style analysis would show that a segment of the fund's actual performance was more like that of an international stock fund during the time period in question.

Conclusion

The advantages of style analysis in identifying investments that are suited to your portfolio are its efficiency and impartiality. The only data needed are historical returns, and the method provides an assessment of the investment's behavior independent of its stated objective. Its results therefore let you make an informed decision about the role that investment can play in your portfolio.

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