June 2011

Extreme Value
The Extreme Value Owners Manual

Contents
Welcome to The Owners Manual ................................................................................1 The One Investment Idea That Always Makes Money ................................................5 The No. 1 All-Time, Greatest Secret of Investing ........................................................8 How to Participate in One of the Worlds Best Income Invetment Strategy ..............11 Jim Rogers and Warren Buffett on How to Manage Your Money..............................13 The Old Man and the Dog..........................................................................................16 Find the Few Stocks That Will Make You Rich, and Forget About the Rest ..............20 Getting Rich in Stocks Means Doing Nothing at All for Years ..................................23 Make 10 Times Your Money without Taking Big Risks..............................................25 The Three Things Rich People Do All Day ................................................................27 What No One Ever Tells You About Selling Stocks ....................................................30 Why Its So Easy to Get Rich in Stocks, And Why So Few People Do It ..................32 Steak Tastes Better When Its on Sale, and Other Thoughts About Risk ..................35 The Secret to Getting Rich in Stocks ........................................................................38 Use This Simple Secret to Find the Best Socks ........................................................40 The Best Foreign Stocks Are Right Here at Home ....................................................42 Its When You Get Paid That Counts..........................................................................45 What Youve Got Wrong About Value Investing ........................................................47 The Secret to Horse Racing... and Stock Investing ..................................................49 The Greatest Mutual Fund in the World ....................................................................51 The Secret of World-Dominating Dividend Stocks ....................................................54 Where to Find Extraordinary Income Streams That Always Go Up ..........................57 Know This and Youll Never Have to Worry About the Markets Next Move ..............60 New Study Reveals Worlds Greatest InvestmentStrategy ........................................62 Four Must-Reads That Will Radically Change Your View of Stocks ..........................64

Welcome to The Owners Manual

Im Dan Ferris, the editor of Extreme Value. The first thing you should know about me is, unlike many newsletter writers, I dont write Extreme Value on the side. Doing financial research for each monthly issue of Extreme Value is how I spend the majority of my time each and every day. It is the singular focus of my career. I graduated from college in 1987. I had a brief stint as a junior executive with the Electronic Data Interchange Association in Alexandria, Virginia. It was a boring, stifling, bureaucratic place for a young guy to be. I quickly realized I wanted to figure out how to get rich by making my money work at least as hard as I was working. So I spent much of the 1990s trying to find what really worked in investing. Over about 12 years, I read every investment book I could get my hands on, took a mail-order course on commodities trading, asked questions of every professional investor I met, subscribed to half a dozen newsletters, lost some money trading commodity futures, and finally made some money in gold stocks in mid-1995. In 1997, I wrote a letter to Bill Bonner, the founder of Stansberry & Associates parent company. I told him exactly what I just told you and that I believed I could write effectively about investing. His secretary normally throws away such letters, but on a hunch, she forwarded mine to Bill. He normally doesnt give such letters the time of day, but somehow, my words got through to him. Bill Bonner and I met in November 1997. We talked for 15 minutes and he hired me on December 8, to serve as the editor of a publication then called Real Asset Investor. The two best things I ever did as the editor of Real Asset Investor
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were: 1) recommending Waste Management shares in December 1999, after theyd been decimated by an accounting scandal that summer, and 2) recommending shares of Consol Energy in July 2000, just before coal prices went up. Both stocks looked like questionable investments when I found them. But they both doubled in a year or so. Both experiences, as well as many others I had while researching stocks for Real Asset Investor, taught me you cant throw stock picks around like playing cards at a blackjack table. You have to be careful and thorough. And if you cant find anything to buy, then you have to write to your readers and tell them you cant find anything to buy. In the fall of 2002, my current publisher, Porter Stansberry, decided to create a newsletter focused on the cheapest, safest stocks in the market. He wanted thorough reporting and careful investment selections. He asked me to be the editor, and Ive been researching, picking stocks, and writing Extreme Value since September 2002. Im careful and thorough, and I only recommend a stock when it is safe and cheap enough to be called an Extreme Value. In the following pages, Ive collected a series of essays that Ive written on my investment philosophy and other important ideas about putting your money into the stock market. If youre a serious investor, this is a great resource to keep on hand to consult any time you come across a stock and wonder if its a good investment or not. The One Investment Idea That Always Makes Money, for example, on page 5, explains the basic guidelines for value investing. I also discuss in more depth the kind of cheap and unappealing (but valuable) stocks I look for in Extreme Value. I tell you what the perfect investment would be like if it existed, how to use this information to select stocks that do exist, and how important it is to treat investing just like you would your own business. Youll find out about the most important qualities to look for when evaluating stocks. Youll learn how to use Warren Buffetts methods for finding undervalued stocks, how to earn money while you sleep, when to sell

value stocks, and the most important secret there is to investing. As a subscriber to Extreme Value, youll receive my specific recommendations about when to buy and sell particular stocks. But this manual offers a more general understanding of how I see the markets and the best ways to invest. If you use it with the monthly newsletters, I guarantee your investment returns will improve. Good investing,

Dan Ferris

The One Investment Idea That Always Makes Money

If you look up a group of top money managers with 20-year records, youll find a disproportionate number of those managers are value guys. ~ Christopher Browne, CEO of Tweedy, Browne Company.
Chris Browne had just finished his junior year at the University of Pennsylvania in the summer of 1968. One day, after a few weeks of training with an Army reserve unit, Browne rode the subway to his fathers office, the offices of Tweedy, Browne Company. He wanted to hit up the old man for the $5 train fare so he could head back home to New Jersey. Ed Anderson, a former student of value-investing legend Benjamin Graham, was also a partner at Tweedy, Browne. He cornered young Chris and talked to him about investing for two hours straight. Chris had no idea what he was planning to do for the summer or the rest of his life, for that matter. So, it was relatively easy for Anderson to convince the young man to work at his fathers firm until he went back to school in the fall. At the age of 21, having lived with a father who never discussed his work as an investor at home, Chris summer job was to pick Tweedy, Brownes next winning stocks. Chris sat with the big, blue Standard & Poors book, which contained financial data for all the publicly traded companies at that time. Browne made one simple calculation for each stock listed in the giant book. He subtracted all liabilities (long- and short-term debt, preferred stock) from each companys current assets (cash, short-term investments, inventory, receivables). The number he arrived at was called the net current asset value. Chris then looked at the price of each company. If a stock was sell-

ing for two-thirds of its net current asset value or less, hed fill out an IBM punch card, complete with the firms bid price, and send it to the National Quotation Bureau. Chris Browne was also appointed as the companys bank analyst that summer. He calculated book value for each banking company. Then he looked to see which companies traded at two-thirds or less of book value. Again, he filled out the cards and sent them in. Describing the atmosphere at Tweedy, Browne Company in his early days with the firm, Browne remarked, No one worked really hard in this organization. It was strictly a 9-to-5 job. But they had plenty of business. Over the next 15 years, the firm made a phenomenal 20% a year, multiplying investors money 15 times. Every $10,000 invested in 1968 became $154,000 by 1983. Chris Browne still uses the same techniques he learned at his fathers firm back in 1968. Today, he runs the firm. Browne says he looks for 10 things in an investment, all of which he learned from his fathers firm as a young man. 1. Buy stocks with price-to-earnings or price-to-book ratios cheaper than 80%-90% of all stocks. 2. Buy stocks of all sizes, never segmenting them by market cap. 3. Carefully research each company, including interviews with management. 4. Dont try to mimic the indexes (i.e., S&P 500 or Nasdaq). 5. Stay as fully vested as possible, since 80% of investment returns occur during 2%-7% of total holding time. 6. Keep turnover (trading) to a minimum, which keeps commission costs low. 7. Keep all transaction costs as low as possible. 8. Think of yourself as a business owner and act like one. 9. Invest all of your money using a value approach.

10. Become an avid student of investing, and constantly work to improve. What Ben Graham was doing from the 1920s to the 1950s, what Warren Buffett has been doing since 1956, what Tweedy, Browne has been doing since 1920, and what were doing in the pages of Extreme Value today, are all based on the same principles. We all buy stocks for less than their real value, just like Chris Browne learned to do in the 1960s. Value investing is the one investment idea that never changes and always works. If you want a great, easy-to-read book on Chris Brownes ideas, pick up a copy of The Little Book of Value Investing. Itll take you two hours to read, and itll serve you well for a lifetime.

The No. 1 All-Time, Greatest Secret of Investing

I dont know if I should tell you this. I should be afraid you might use what Im about to tell you. Youll use it against me in the market. What Im about to tell you is the only real edge I possess as an analyst and as an investor. But Ive pledged to serve you, dear reader, and serve you I must, to the utmost of my ability. So it is that I must reveal the greatest single secret of investing as I have learned it. Before I tell you what the greatest single secret of investing is, though, I want to tell you why Im going to give it to you. Im going to tell you this secret because its hiding in plain sight. I bet going public with it wont hurt me any, because knowing it doesnt change the fact that you still have to do lots of work to take advantage of it. So here it is, the No. 1 secret of investing. The secret is that fear is the dominant emotion in the market at all times. I know of several famous investors whose actions reflect a clear understanding of it. But even Warren Buffett the most successful investor in the world has misconstrued the secret. He once said something like, To make money, you have to be greedy when everyone else is fearful and fearful when everyone else is greedy. I think Buffett is wrong about that one, and I bet if I called him up and told him why, hed agree with me. If people were really greedy, theyd wait until stocks were in their
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darkest hour and therefore at their lowest prices to buy them. But most people dont do that. They wait to buy. Nobody wanted stocks in 1982, the perfect moment to be greedy. There was no reason to be afraid, no reason to wait. You dont wait to buy something thats priced right unless youre fearful. Period. Thats why I say fear is the dominant emotion in the market at all times. Instead of doing their own work and relying on the conclusions of their own thinking, most investors including most of Wall Street let the price action of the entire market, or even of a single stock, pinch hit for their own intellects. Maybe its not great insight to say everyone is afraid at market bottoms. But what about tops? Everyone is greedy at tops, right? Wrong. The reason so many people become involved in stocks at market tops is because everyone else is buying. Thats what everyone is waiting for. When youre filled with fear, you wait for some sign that its safe to buy again. The sign investors choose most often is the actions of others. Crazy as it sounds, otherwise sensible people, though blessed with a perfectly good brain, often choose to substitute the product of someone elses brain for the product of their own brain. Somehow, if someone else is doing something, it makes it more legitimate than if they thought of it on their own. This serves various types of animals in the wild, who survive by moving in herds (though it doesnt seem to do the lemmings much good). But humans are different. They dont need to travel in herds, because each one has the ability to take care of himself. Here we are, the paragon of animals, and most of us dont get past the behavior of lemmings when it comes to investing. In order to make money, you have to stand on your own. You have to do your own thinking. You have to do your own research.

You have to make your own decisions, and handle the consequences every step of the way. Thats how you should invest your money. Thats what Extreme Value is about at its core.

How to Participate in the Worlds Best Income Investment Strategy

Today, Ill share with you what I believe is the worlds greatest income investing secret. While you can take advantage of this secret at any time, certain times are better to begin than others. The traditional ways of income investing like owning real estate stocks (REITs), oil trusts, or government bonds are worthless compared to this wealth-compounding strategy. The secret is buying shares of World Dominating stocks with large and growing dividends. World Dominators are the No. 1 companies in their industries. Theyre consistently profitable, year after year. They gush free cash flow. And they pay a lot of that cash out to their shareholders. Think WalMart, ExxonMobil, and Procter & Gamble. World Dominators dont have the highest current yields. The stocks above pay between 2.5% and 3.5%. But the best income stocks arent the ones with the highest current yields. Thats a common mistake among income investors. High yields come with high risk. Investors get sucked into risky REITs and energy trusts because they want to earn a high yield right away. But too often, the extra risk produces losses. Especially now, you need to keep your money safe. Thats why the best income strategy is to buy the safest stocks, the World Dominators. And they are perfect for long-term income investors because they pay dividends that go up every year. ExxonMobil has raised its dividend every year for nearly three decades. Wal-Mart has raised its dividend every year for more than three decades. And Procter & Gamble has raised its dividend every single year for nearly six decades.

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Thats over half a century of dividend raises. Best of all, you can count on these companies to raise their dividends year after year because they dominate their industries. Wal-Mart is the worlds biggest retailer. ExxonMobil is the No. 1 oil and gas company. And Procter & Gamble is the largest consumer-products company in the world (selling to half the worlds population). Heres what it means for long-term income investors: In 10 years, that 2.5%-and-growing yield can give you a 10% return on your original investment. Imagine owning a business like Wal-Mart and getting a 10% yield. Its an income investors dream come true. Being the No. 1 company in the industry is how these companies are able to crank out huge amounts of cash flow year after year and pay higher and higher dividends. They dont have to grow in order to keep paying out big dividends, year after year. Obviously, everyone knows about these companies. But what most people dont realize is how important it is to buy them when they get cheap. World Dominators are the most valuable companies in the world. Most of them are easily worth anywhere from 20 times earnings to as much as 30 times earnings. Ive been writing newsletters for almost 14 years and Ive never found as sure a thing in the stock market as buying cheap World Dominators. These stocks are like bonds with interest payments that grow. Theyre ideal for income investors, because over time, theyll pay you more and more income as each year passes. Bonds cant do that. World Dominators can.

Jim Rogers and Warren Buffett on How to Manage Your Money

Managing your own money is much simpler than most people think it is. The reason people think its complicated is Wall Street wants it that way. If managing your own money werent complicated, Wall Street firms would go out of business. It would be hard to imagine your broker, for example, calling you up and saying, Hey, listen. You dont need to do all this buying and selling all the time. All you need to do is let your money sit in cash most of the time. Then, when you find something really great, something that you know is a good, safe bet to make plenty of money whether its 10 days or 10 years from now call me up and Ill buy it for you. Likewise, youre not going to see anyone on TV saying, You really dont need our mutual funds. Most of them arent that great and never will be. You really just need to sit around and wait for something thats so good, itll make you rich without taking unnecessary risks. OK, so dont ask mutual fund managers or brokers about managing money. Ask millionaires and billionaires who made their money buying and selling stocks, bonds, and real estate. Theyll tell you what to do. And itll actually work. This is what Warren Buffett says about managing money: Your default position should always be short-term instruments. And whenever you see anything intelligent to do, you should do it. Buffett also said that asset allocation, a Wall Street obsession, is pure nonsense. Asset allocation is Wall Street BS, but people actually pay a lot of money for that kind of advice. Educated people. People who would otherwise impress us with their connections and money and power. God only knows why they cant see that asset allocation is a total scam. Its

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completely and totally unnecessary. If you want to know what to do instead of worrying about asset allocation, remember this: The best way to minimize risk, says Buffett, is to think. As usual, he cuts through all the crap, and gives advice that makes sense. Jim Rogers is somebody else you ought to listen to on the subject of managing your own money. He used to work with George Soros. Rogers drove around the world twice, once on a motorcycle and once in a car, and wrote a book about each trip. Rogers told author John Train in 1989 that you should take your money, put it in Treasury bills or a money-market fund. Just sit back, go to the beach, go to the movies, play checkers, do whatever you want to. Then something will come along where you know its right. Take all your money out of the money-market fund, put it in whatever it happens to be, and stay with it for three or four or five or 10 years, whatever it is. Youll know when to sell again, because youll know more about it than anybody else. Take your money out, put it back in the moneymarket fund, and wait for the next thing to come along. When it does, youll make a whole lot of money. The only problem with this simple strategy of sitting in cash and investing only when circumstances are ideal is human nature. Nobody wants to do it. Nobody wants to be patient. Everybody wants to buy and sell quickly and make a fortune overnight. Judging from the results most people get, they really just want to buy and sell quickly, whether they make a fortune or not! Of course, the average investors impatience is just another easy way for us Extreme Value types to get an advantage. We can sit in cash, wait for something that is too good to pass up, then buy it and hold on. What could be simpler than that?

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The Old Man and the Dog

Dont ask me no questions, and I wont tell you no lies. ~ Lynyrd Skynyrd
Once there was a man. The man found himself in a new town and wanted to get to know the people. So he went to the town square to see what he could see. He soon came upon an old man. The old man was whittling, turning a stick into a smaller stick. On the ground near the old mans feet sat a German shepherd. The dog bared his teeth and made a low noise from deep inside his solid frame as the new man approached. The new man stopped and looked down at the dog with some trepidation. He asked the old man, Does your dog bite? The old man kept whittling, and never looking up, replied, Nope. The new man in town was relieved. He reached down to pet the animal. The dog lunged at him and would have taken a chunk of flesh out of the arm of a slower man. As it was, the new man recoiled quickly enough that his coat sleeve was the only casualty. Examining the shredded coat, the new man said with emphasis on each word, I thought you said your dog doesnt bite. The old man stopped his whittling. He looked up for the first time, wearing a toothless, wizened grin. The old man said with just as much emphasis on each word, Thats what I said. My dog doesnt bite, and returned to his whittling.

Taken aback, the new man motioned to his torn coat and said, Well? The old man stopped whittling again, looked up, motioned to the dog with his knife, and said, That aint my dog. The moral of the story: Ask the right questions. If you want to make money in stocks, you should get satisfactory answers to the right questions, or refrain from investing. The Extreme Value list of the right questions to ask before investing is identical to that of Marty Whitman, founder of Third Avenue Value Funds. 1. Is the stock cheap? 2. Is the stock safe? Warren Buffett and Charlie Munger of Berkshire Hathaway have decided on their list of the right questions to ask before investing. The following is from a Buffett interview I discovered. Interviewer: Could you please explain the filter process you go through in making an investment? Buffett: Look, it is just this simple there are four things we look for. Can we understand it? Does it have a sustainable long-term competitive advantage? Are the management people we admire and trust? And do we think its selling at an attractive price? It is as simple as that. If it gets through all four filters, then I sign my name to the check. Phil Fisher is the man who did the most to change Warren Buffett and Charlie Munger from hard-core devotees of Ben Graham to investors who are obsessed with owning only the best businesses run by the best people. Fisher wrote a list of 15 questions to ask before investing. Theyre in his landmark book, Common Stocks and Uncommon Profits.

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1. Does the company have products or services with sufficient market potential to make possible a sizeable increase in sales for at least several years? 2. Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited? 3. How effective are the companys research and development efforts in relation to size? 4. Does the company have an above-average sales organization? 5. Does the company have a worthwhile profit margin? 6. What is the company doing to maintain or improve profit margins? 7. Does the company have outstanding labor and personnel relations? 8. Does the company have outstanding executive relations? 9. Does the company have depth to its management? 10. How good are the companys cost analysis and accounting controls? 11. Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition? 12. Does the company have a short-range or long-range outlook in regard to its profits? 13. In the foreseeable future will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stock18

holders benefit from this anticipated growth? 14. Does the management talk freely to investors about its affairs when things are going well but clam up when troubles and disappointments occur? 15. Does the company have a management of unquestionable integrity? If all you do from this day forward is demand a good answer to Whitmans, Buffetts, and Fishers questions for every stock youre considering, odds are three things will happen to you: Youll buy far fewer stocks, lose far less money, and make far more money on the ones you do buy. If you stick with me here at Extreme Value, I can promise you I wont ever recommend a stock unless we get the right answers to the right questions.

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Find the Few Stocks That Will Make You Rich and Forget About the Rest
There are two requirements for success in Wall Street. One, you have to think correctly; and secondly, you have to think independently. ~ Ben Graham
Fifteen stocks. According to a columnist in Forbes magazine, thats what it took to make Warren Buffett one of the richest men in the world. Forbes columnist Mark Hulbert did a study a few years back. He looked at all of Warren Buffetts investment decisions over the years. Hulbert concluded 15 stocks made Buffett rich beyond anyones wildest dreams, turning him into a modern investment legend. Without those 15, Hulbert says, Buffetts returns would have been mediocre. Im not sure exactly which 15 stocks they were, but you and I both know some of them: Coca-Cola, Gillette, GEICO, Washington Post, Wells Fargo, and American Express, to name the most famous examples. When Buffett decided to get into those stocks, he bought as much as he could, knowing he was planning to hold them indefinitely. Buffett has done that since the beginning of his investment career, no matter how much money he had. He put half his net worth into GEICO at age 20. How did Buffett find those 15 stocks that were worthy of big chunks of his investment capital? Good question. Simple answer, too. He focused only on companies 1) whose businesses he understood, 2) with good management teams, 3) with a competitive advantage sufficient to produce high returns on capital for many years to come, and 4) priced to make him rich. Thats what Buffett is looking for in an investment. And, as Yogi

Berra might say, if you dont know what youre looking for, youre never going to find it. In our monthly Extreme Value service, were looking for companies trading at a discount to their intrinsic value, as measured by net assets and/or earnings power. Simple as that. Whatever your criteria are, you need to know them cold. Thats the only way youll be able to make really big money in stocks. You cant, for example, expect to own 50 different stocks and manage your own portfolio as a part-time endeavor. Like Buffett said, I cant be involved in 50 or 75 things. Thats a Noahs Ark way of investing you end up with a zoo that way. In Janet Lowes book, Warren Buffett Speaks, she quotes a key passage describing Buffetts advice on how to find and focus on those few gems that will make you rich: Draw a circle around the businesses you understand, and then eliminate those that qualify on the basis of value, good management, and limited exposure to hard times. The circle Buffett mentions is the circle of competence hes spoken of many times. He can only get rich on those few stocks whose businesses he understands. Period. If a stock is outside that zone, it might go up, but itll go up without Buffett on board. Here are a few words from Buffett on how to work within your circle of competence to find great investments: I would take one industry at a time and develop some expertise in half a dozen [companies]. I would not take the conventional wisdom now about any industries as meaning a damn thing. I would try to think it through. If I were looking at an insurance company or a paper company, I would put myself in the frame of mind that I had just inherited that company, and it was the only asset my family was ever going to own. What would I do with it? What am I thinking about? What am I

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worried about? Who are my competitors? Who are my customers? Go out and talk to them. Find out the strengths and weaknesses of this particular company versus other ones. If youve done that, you may understand the business better than the management. If you think your circle of competence is small, and would never fit your 15 stocks, Buffett has some advice for you about that, too: If we cant find things within our circle of competence, we wont expand our circle. Well wait. I wonder what your own stock portfolio would look like if you looked at each stock and asked, Is this company within my circle of competence? If you cant answer with an emphatic yes, it would be better for the stock to go up without you than to keep your money in something you dont understand. If you dont understand the business, then youll have to admit that either event (going up or down) will come to you as a surprise. And when it comes to your money, surprises are something you dont need. Avoid them by knowing your circle of competence and staying inside it.

Getting Rich in Stocks Means Doing Nothing at All for Years

A fair amount of my wealth is the product of boredom and illiquidity. A wealthy friend told me that once. Hes in the securities business. Hes made a fortune buying little stocks no ones ever heard of. And he also happens to be a reader of Extreme Value. My wealthy friends comment points out something most investors have a great deal of difficulty doing with their money: nothing. People hate doing nothing with their money. Most investors are way too active. They want to buy and sell constantly. They want the latest, hottest idea. They want it to be 1999 again, so they can buy Amazon at $300 and watch it go to $400 (presplit prices). And yet, absolutely everyone Ive ever met who has actually gotten rich in stocks, bonds, or real estate (including the traders!) they all say the same thing. They all say getting rich investing is a long-term proposition, period. Every now and then you buy. You rarely sell. And you spend most of your time just waiting: doing nothing. But thats not what most people expect. They expect to get rich quick. What they dont understand is the very desire to get rich quick will bankrupt them. If you want to make real money in stocks, bonds, real estate, or any other investment vehicle, find a way to do it long term. Even if its commodity futures, find a way to be a long-term trader, not a get-richquick scheme.

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Besides giving your money time to grow, youll also keep the negative effects of taxes and commissions to a minimum. Tweedy, Browne Company has a great little paper about taxes, and the advantages of holding long-term versus holding short-term. Due to the effect of taxes alone, long-term holding is far superior to short-term holding. The difference between the long term and the short term can mean the difference between making eight times your money or 16 times your money. Thats the difference between making 15% a year for 20 years and selling at the end of every year, versus making 15% a year for 20 years and not selling until the end of the 20th year. If you want to get rich in stocks, its doable, but you have to be willing to buy cheap, play it safe, and hold for the long term. As Warren Buffett once put it, Inactivity strikes us as intelligent behavior. Its intelligent because thats how you really get rich in stocks. You buy, then you do nothing for a good, long time.

Make 10 Times Your Money without Taking Big Risks

Investing is like tennis. Its a losers game. Think of the difference between professional and amateur tennis players. Professionals win points. Amateurs lose them. When weekend warriors play tennis, the losers determine who wins. They hit the ball into the net. They whack it out of bounds. And they routinely doublefault on their serves. That doesnt happen nearly as much in pro tennis, with its long rallies and pinpoint shots. Most investors are like amateur tennis players. They lose money in stocks because of their own behavior. Theres no opponent outplaying them. They beat themselves. DALBAR, a Boston-based research firm, compared the returns from market index funds with returns real investors earned in equity mutual funds... From 1989 to 2009, market index funds returned 8.3% per year. If you compound $10,000 at that rate for 20 years, youll wind up with just under $50,000 five times your money. For buying an index fund and doing nothing else, thats a great return. No research necessary. No thinking required. Just buy and wait. It couldnt be easier, and you get five times your money, pretax. The only problem with that 20-year, five-times-your-money return is that almost nobody earned it. Real, flesh-and-blood investors investing their own real, hardearned money made significantly less than 8.3% per year over that time. On average, individual investors in U.S. equity funds earned just 3.3% per year. At that rate, $10,000 grew to just $19,150 in 20 years. They didnt even double their money in 20 years! Most investors just cant hit the ball back over the net.

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Most real investors investing their own real money perform even worse relative to the overall market in bull markets. During the great bull market to end all bull markets from 1984 to 2000, DALBAR found equity mutual fund investors made 2.57% per year, with market index funds compounding at 12.22% per year. The age of the daytrader treated investors worse than most periods. Investors ran around the court faster than ever, swinging like mad, only to hit more balls out of bounds and into the net than ever, turning a $10,000 investment into just $15,000 during the biggest bull market in history. Had they simply failed to lose, theyd have turned $10,000 into just over $100,000. Investors could have made 10 times their money in 16 years by refusing to overmanage their own money by letting stocks do the work for them. A large dose of humility would help most investors make more money in stocks. For starters, most investors just shouldnt buy individual stocks. They should buy index funds and plan to hold for decades. Almost everyone else should build a diversified portfolio of only the highest-quality names and plan to hold them for at least 10 years. If you cant hold on for a long time, be prepared to take losses. World Dominators and stocks like them are an excellent start on a diversified portfolio that could earn you 10 times your money remember, thats 12.22% per year for 16 years. Most stocks like this will compound your money at single-digit rates. But one or two could produce enormous returns. You dont need to take on big risks to earn that kind of return. All you need to do is wait. To master the losers game, you must be patient. You must master time itself.

The Three Things Rich People Do All Day

Johann Sebastian Bach (1685-1750) taught me something about picking stocks. I studied music in college. I was a classical guitarist. When I first started studying, I was familiar with Bachs work, but I thought it was terribly boring. For me, listening to Bach was like taking an infallible sleeping pill. When they played Bach in my music classes, I would begin to nod off in a few short minutes, almost without fail. But one day I remember it vividly I was in the hallway of the music building. That day in the hall, I decided that, if all these experts and music teachers thought Bach was great, Id just keep listening to the music and try to stay awake. Id try to hear what they heard. I consciously decided to expand my horizons. And it worked. Today, I am a huge fan of Bachs music. When I hear it, it doesnt put me to sleep. On the contrary, it actually energizes me. I have recommended Bachs works as energizing background music to several people. Its hard to say what caused me to go from bored student to passionate advocate on the subject of Bach. All I know for sure is that I willingly suspended judgment and immersed myself in the music. I just played it day after day after day. One day, I realized I loved it. I was bored at first. But then I just couldnt get enough of it. The music did all the work. It got me. Ive done something similar with investing. There is possibly no piece of writing more sleep-inducing than a form 10-K, the financial report every public company must file with the SEC once a year. There are no stories. No pictures (except the odd graph here and there). Nothing visually stimulating in the least and

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everything reads like it was written by lawyers and accountants. When I started reading these documents about 10 years ago, I couldnt make it through them. Id fall dead asleep, with my head on my desk. But I decided there must be something to reading them, since thats how investors with real money spent their time. So Id wake up and keep reading. Sometimes, Id fall asleep again. Then Id wake up again and keep reading. No kidding. That really happened. Part of the reason I persisted is because I had read somewhere that people who are going through something emotionally frustrating or difficult will often say, Im tired, as a kind of defense mechanism, an excuse for not being up to the task at hand. I took my boredom with SEC filings as a sign of my ignorance. I didnt want to be ignorant, so I pressed on. With Bach, I submitted to the apparent wisdom of my teachers, and I learned to love that which I had previously disliked. With investing, I have submitted to the proven wisdom of the great investors, especially Warren Buffett. As usual, Id suggest you dont take it from me, but from someone with more money and brains than I may ever have. On page 217 of J. Pardoes collection of quotations, Warren Buffett Has Spoken, Buffett says, I spend an inordinate amount of time reading. I probably read at least six hours a day, maybe more. Next time anyone criticizes you for having your nose stuck in a book, just tell him youll never get rich if he doesnt stop talking. So what does Buffett do besides read? The quote from the Pardoe book continues, I spend an hour or two on the telephone If Buffett were talking to Elvis, perhaps you could broadcast the conversation over TV, radio, and Internet, and most people would be interested in listening in. But its probably just the CEOs of the companies he owns, maybe his partner Charlie Munger, and a bunch of folks in the financial world. I doubt most people would understand as much as half the conversation, given that Buffetts largest money-making ven28

ture is the somewhat esoteric world of insurance, with a focus on the even more esoteric world of reinsurance. Again, nothing to watch. Just one side of a boring conversation about statistics and money. After reading and talking on the phone, then the activity level really kicks into overdrive. and then the rest of the time, says Buffett, I think. Reading, conversing with people who know what youd like to know, and thinking. Those are the three things rich people do all day. If you think theres a secret out there, one thats going to help you hit the jackpot, I wish you luck finding it. As for me, Im just going to get back to reading, conversing with people who know more than I do, and thinking.

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What No One Ever Tells You About Selling Stocks

Nobody knows anything about selling stocks. Nobody. If you wonder what Warren Buffett himself has to say on this subject, you need only read his 2003 annual letter, in which he admitted, I made a big mistake in not selling several of our larger holdings during The Great Bubble. If these stocks are fully priced now, you may wonder what I was thinking four years ago when their intrinsic value was lower and their prices far higher. So do I. No matter what Buffett says, I think his ignorance about selling has been one of the true secrets of his success. Since he knows its an extremely difficult subject, he simply avoids it. He holds stocks for the longest possible term and he buys whole companies, which he intends never to sell. Buffett isnt the only great, rich investor who admits that selling is a thorny issue. Marty Whitman told Grants Interest Rate Observer, Ive been in this business 50 years. I have had a lot of experience holding stocks for three years, [doubling them], and [selling them] to somebody else for whom it tripled in six months. You make more money sitting on your ass. Whitman also admitted, Were just not that smart on the sell side. Never have been. Of course, Buffett and Whitman are both rich, and continue to make plenty of money for themselves and their shareholders. Not knowing anything about selling hasnt hurt them any. As for me, for every 20 stocks I recommend in the pages of Extreme Value, I recommended selling about six of them. Half the time, I sell too early. Holding on longer, then, is the easiest way to get an advantage over
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the vast majority of investors. The average holding period for a stock traded on the New York Stock Exchange peaked at about eight years in the 1960s, down to about 6 months today. How hard is it to figure out that, if you can hold on for a year, youre going to do better than most of the people who are presently holding NYSE stocks? And if you hold on to stocks for three years, youre really flying up in the thin air. Its been much harder to lose money than to make it over any three-year period since 1952. Thats true of stocks, as represented by the S&P 500 and also of long-term government bonds. I found out that investing legend and Buffett confidant Phil Fisher used a three-year rule for his performance. He told his clients that, if he hadnt produced a good result in three years, he should be fired. Phil Fisher knew that long-term performance kicks in by the third year. So when do you sell? I dont know. Ive been wrong about how to do it about half the time. Please try not to hold it against me, because no one else seems to know either.

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Why Its So Easy to Get Rich in Stocks, And Why So Few People Do It
Albert Einstein called it the greatest mathematical discovery of all time, and, the greatest creator of wealth known to mankind. Baron Nathan Rothschild called it the eighth wonder of the world. Both men were talking about the power of compounding. Its easy to understand how compounding works. Just look at this simple example. Say you invest $100,000 for 40 years. During that time, you make 12% per year. At 12%, itll take you until year 22 before you have $1 million, but only another six years until you cross the $2 million mark. If you can hold on until year 40, youll wind up with more than $9 million. YEAR 0 $100,000 YEAR 1 $112,000 YEAR 2 $125,440 YEAR 3 $140,493 YEAR 4 $157,352 YEAR 5 $176,234 YEAR 6 $197,382 YEAR 7 $221,068 YEAR 8 $247,596 YEAR 9 $277,308 YEAR 10 $310,585 YEAR 11 $347,855 YEAR 12 $389,598 YEAR 13 $436,349 YEAR 14 $488,711 YEAR 15 $547,357 YEAR 16 $613,039 YEAR 17 $686,604 YEAR 18 $768,997 YEAR 19 $861,276 YEAR 21 $1,080,385 YEAR 22 $1,210,031 YEAR 23 $1,355,235 YEAR 24 $1,517,863 YEAR 25 $1,700,006 YEAR 26 $1,904,007 YEAR 27 $2,132,488 YEAR 28 $2,388,387 YEAR 29 $2,674,993 YEAR 30 $2,995,992 YEAR 31 $3,355,511 YEAR 32 $3,758,173 YEAR 33 $4,209,153 YEAR 34 $4,714,252 YEAR 35 $5,279,962 YEAR 36 $5,913,557 YEAR 37 $6,623,184 YEAR 38 $7,417,966 YEAR 39 $8,308,122 YEAR 40 $9,305,097

YEAR 20 $964,629 The numbers above show what 40 years of compounding at 12% looks like. In year one, you make $12,000. In year 22, you make about $130,000 more than 10 times what you made in year one. Of course, theres one little problem here. Nobody but nobody wants to hold on and wait for 40 years. (I know I dont!) Everybody wants fast action. Everybody wants to buy a 50-cent stock on Monday and sell it for $5 on Friday. Unfortunately, most people are mathematically illiterate, so they dont understand that the odds are way against big, fast gains in stocks. That ignorance, in turn, makes it easy to be overcome by our natural tendency toward impatience. And that is why an understanding of the great power of compounding the single greatest tool an investor can possess remains, and is likely to remain, unexploited by the vast majority of investors. Proof that impatience is why nobody exploits the power of compounding is easy to come by. In the early 1960s, the average holding period for an NYSE stock was at its peak, about eight years. Today, the average holding period for an NYSE stock is about 6 months. Less than 12 months. That means the average company could hold two shareholder meetings a year, and the CEO would never see the same people twice. These people arent investing. Theyre looking to hit the lottery. By the way, the mathematics of the lottery dictate youll lose about 50 cents of every $1 invested over the long haul. If you dont overcome odds of more than 1 million-to-one very quickly, youre virtually guaranteed to lose half your money playing the lottery over many years. For the insightful and patient investors, the short average holding period for NYSE stocks is wonderful news. Once you know nobody wants to hold stocks for 12 months, its incredibly easy to gain an advantage over nearly every other player in the market. All you have to do is find an undervalued stock and hold it for at least one year, and you instantly put the odds of success in your favor.
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I imagine this insight doesnt get you very excited. After all, excitement is usually accompanied by a sense of urgency, some impending peril or reward. And this reward is decades away. Im the one whos telling you about time and compounding and even I have to admit that, while Im happy to know about it, it cant hold my attention for very long. I have to constantly remind myself, for example, not to sell a stock thats gone up 70% in a few months and theres the rub. Its human nature to want results right away. Its human nature to want to put your hands on something and affect it immediately. Its not human nature to delay gratification. Nor is it human nature to want to spend time studying material so impenetrably boring that it puts you to sleep, like SEC filings, generally accepted accounting principles, income tax rules, and securities laws. I remember when I was in my 20s, looking for the meaning of life in every nook and cranny of existence, reading all of kinds of stuff, including all of Nathaniel Brandens self-help books. Branden said something to the effect that human beings are the only creatures that can persevere in their quest to discover the right thing to do, succeed in that quest to find the right thing, believe its the right thing, tell everyone its the right thing and then go and do the opposite. Well, once you know what weve learned today about compounding and time, you can use Brandens insight to get rich. Once you realize that doing your own research on accounting, securities laws, and income taxes, combined with a bias toward holding good stocks for the longer term, wont give you the instant gratification of lottery tickets and slot machines you can still decide to go ahead and do the right thing.

Steak Tastes Better When Its on Sale, and Other Thoughts About Risk
Lets think about beta today. Not the fish. The number. Beta is a number enshrined by Wall Street. What it tells you is very simple. The S&P 500 has a beta of 1. If a stock has a beta of 0.5, it means that, historically, its price has gone up and down half as much as the S&P 500. Beta, then, measures the volatility of stock price movements relative to some broader universe of stocks, usually an index thats recognized as a proxy for the entire market. According to modern financial theory, and the Wall Street analysts whove swallowed it whole, if you know the beta, you know how much risk there is in owning a particular stock, or a particular portfolio, or a particular index fund. Stocks whose prices have moved up and down more than the S&P 500 are seen as containing more risk for investors. Stocks that move up and down less than the S&P 500 are seen as containing less risk. The modern theory of beta says, in effect, if a stock is worth $40, and its trading at $35, a fall to $30 means theres more risk in owning the stock than before it fell, provided the index didnt fall, or fall as much. So, if the business is still worth $40, getting it at a much bigger discount means absolutely nothing to the followers of beta. In his 1993 shareholder letter, Warren Buffett asked, Would that description [of risk] have then made any sense to someone who was offered the entire company at a vastly reduced price? Two paragraphs later, Buffett asks, We dont need a daily quote on our 100% position in Sees [Candies] or H.H. Brown to validate our well-being. Why then should we need a quote on our 7% interest in Coke?

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To a serious investor, the flaw in beta is obvious. The value of the business is absolutely nowhere. Whether the company was Coca-Cola or an XYZ commodity producer wouldnt matter to the followers (true believers!) of beta. I cant imagine such an important consideration being meaningless to anyone with real money to invest. (Well I can imagine it, but I cant make sense of it.) Accepting beta as an accurate measure of risk is like saying steak doesnt taste as good when its on sale. Au contraire. The cheaper it gets, the better it tastes, as far as Im concerned. The basic mistake that beta followers make is thinking the market is there to make decisions for them. Thats wrong. Stock prices dont really contain all the special information that analysts maintain they do. They just tell you what price somebodys paying right now (and what somebody else is receiving). The stock market is there to serve you, not tell you what to do. Most serious value-oriented investors do nothing to mitigate market risk. In fact, they openly acknowledge that they welcome volatility as a source of opportunity. Marty Whitman of Third Avenue, Bill Nygren of Oakmark, and Mason Hawkins of Longleaf have all made comments to that effect. I asked Staley Cates, Mason Hawkins co-manager at Longleaf, about this once, and he said the only thing he does to mitigate market risk is buy 50-cent dollars, i.e., stocks selling for 50% of fair value. Buffett says investment risk cant be calculated with the feigned precision of the beta purist, but that you can achieve a useful degree of accuracy. As he told a Wall Street Journal reporter, I deplore false precision in math. He names five criteria by which one might evaluate risk: 1. The certainty with which the long-term economic characteristics of the business can be evaluated 2. The certainty with which management can be evaluated 3. The certainty with which management can be counted on to channel rewards from the business to the shareholders

4. The purchase price of the business 5. The levels of taxation and inflation that will be experienced It sounds like more work than just looking up the beta. But then again, it tells you something useful, and that usually requires effort. Its not impossible to minimize risk, but you cant rely on a single number to get the job done. Ignore beta and think about every investment you make in light of the five criteria above, and your money will be a lot safer.

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The Secret to Getting Rich in Stocks

Its simple to say but hard to do. Im talking about the secret. The secret to getting rich in stocks. The secret isnt any of the things most people think it is. For example, its not value investing, or even Extreme Value-style investing. I know a smart guy who has been trading stocks and stock options for decades. He rarely holds on for more than a few days. Hes made himself and his clients quite wealthy. I know another fellow who became extraordinarily wealthy speculating on commodity prices But I dont trade options or speculate on commodity prices. Not in Extreme Value, and not with real money. Ive tried those strategies. They didnt work for me. So now I buy safe, I buy cheap, and I hang on for the long term. Well, if buying cheap, safe investments isnt the secret to building wealth in stocks, then what is? The problem with just blurting out the secret is it might not have the impact on you that it had on me when I discovered it. Secrets are funny like that. They sit in front of you for years, like that little girl with pigtails and braces back in grade school. Then one day, the pigtails are let down, the braces come off, and its Wow, never saw that coming. The secret to getting rich in stocks is not to get scared out of them. Not exactly a flowering debutante, but its true. The secret might even sound familiar to you. Its a close paraphrase of the Peter Lynch quote: The key to making money in stocks is not getting scared out of them in dieting, as in stocks, it is the gut and not the head that determines the results.

When the markets behave badly, I bet most people think not getting scared out of stocks feels about as natural as proposing to your daughter. And, well, theres a small problem with the secret. Lynch made his bones managing the Fidelity Magellan Fund to a 29% annual return over 13 years. The fund owned as many as 1,400 stocks at any given time. Lynch would buy practically a whole sector, sell the laggards, and keep the ones that went up. You and I cant do that. Nor can we afford to give too much money away in mutual fund fees, commissions, and trading friction. To truly exploit the secret, you need to know that the stocks you buy are worth hanging on to worth not getting scared out of. Thats the business were in. Were looking for investments that make it possible to use the secret without losing sleep (or needing a clean pair of shorts every hour). An Extreme Value stock ought to be one thats safe enough not to get scared out of.

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Use this Simple Secret to Find the Best Stocks

One of the secrets to finding the very best investments is so simple and so obvious, most people dont pay attention to it... If youd known about this secret back in 1994, you could have bought Colgate-Palmolive for less than $10 a share and made more than seven times your money. If youd known about this secret back in early 1995, you could have bought Microsoft for $4 and made more than six times your money. If youd known about this secret back in 2003, you could have bought McDonalds for $13 a share and made more than six times your money, including a growing stream of dividends. When you take into account the crashes of 2000-2002 and 20082009, its especially amazing investors are up this much. Whats their secret? They look for companies with the highest sales in their industry. I realize this sounds so obvious its almost laughable. Thats just because the real secrets to successful investing arent complex, like they are in science. Theyre so simple, anyone can understand them. For example, Buy low, sell high is laughably obvious. Its just that almost nobody has the discipline to actually do it. Selling the most is the definition of success in business. Microsoft Windows runs about 90% of the worlds personal computers. Intel sells about 80% of the worlds microprocessors. Campbells sells more than 70% of the worlds packaged soup. More than 60% of the worlds credit and debit cards say Visa on them. Colgate-Palmolive sells more than 40% of the worlds toothpaste. These are all excellent businesses with huge, consistent profits. Once a business sells more than any other company in its industry,
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it becomes incredibly difficult to compete with. Imagine trying to build a home-improvement business today. Youd have to compete with Home Depot and Lowes. Imagine trying to build the worlds most popular retailer. Youd have to try to compete with Wal-Mart. Wal-Mart has put dozens of grocery chains and mom-and-pop shops out of business. Imagine trying to make better french fries and sell more of them than McDonalds. Never gonna happen. Theres no substitute for being No. 1. Think about Amazon. It used the Internet to sell more books to more customers than any bricks-and-mortar bookstore chain ever could. Borders and Barnes & Noble are in terrible shape today because they failed to do that. They cant compete with Amazon, because Amazon will always be able to sell more books than them. If youd bought Amazon shares in 2006, when they were less than $30 each, youd have made nearly five times your money during a time when most stock market investors lost money. Even during the lowest point of the financial crisis, in March 2009, youd never have lost money. Buying the company that sells the most was all you needed to know. If you sell a product people like and want and figure out how to sell it to more customers than any other company, you will rule your industry. If investors are smart enough to know what youre doing, they can make a fortune owning your stock. Whether its burgers, bandages, or books, investors owe it to themselves to know about the company that sells the most. In most cases, if the stock is cheap enough, the top seller is the best investment you can make in that industry. Not all the worlds best businesses sell more products than their competitors, but many of them do. And these companies should be on your investment radar screen if theyre not already in your portfolio.

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The Best Foreign Stocks Are Right Here at Home

China, India, and Brazil were poor, Third World countries not long ago. Today, theyre making investors rich. Indias Sensex index has risen 20%, just since last November. And the iShares MSCI Brazil fund is up more than 100% since early 2009. The China Shanghai index rose from 1,100 to 5,900 in just two years, 2005 to 2007. Thats more than five times your money. Theres definitely money to be made in growing foreign markets. But you should be very, very careful about betting on a whole countrys stock market. In this essay, Ill show you a much safer way to profit over the long term from these hyper-growth situations, rather than blindly buying hot foreign story stocks, like most folks do. Stock markets that shoot up quickly can, and usually do, fall just as quickly. Buying a whole stock market isnt really investing, anyway. Youre just betting on the direction of a whole countrys stocks and theres no way one person can know enough to invest in every one of those stocks. Its not really investing. Its more like gambling. But its still a good idea to invest in foreign stocks. You dont want all your investments in one country. If the U.S. economy continues to suffer, all of your investments could suffer, too. Its better to spread your money around, so you can take advantage of good things happening in other countries. Fortunately, its easy to make safe, liquid investments in foreign countries. Its just as easy as investing in the U.S. You dont have to open a special account or deal with a foreign broker. You dont have to worry about foreign laws or taxes. Heres why...

Some of the worlds biggest, safest, most profitable businesses get more than half their sales from outside the United States. Theyre the easiest and best foreign investments you can make. Here are five companies from a list of elite companies I follow... Company Colgate-Palmolive (CL) Coca-Cola (KO) McDonalds (MCD) Procter & Gamble (PG) 3M (MMM) % of sales outside the U.S. 75% 74% 65% 62% 63%

You can invest in foreign markets and still get the peace of mind of buying safe blue-chip stocks. When the market crashed in 2008, investors in stocks like these had nothing to worry about. They made a safe 6% return on McDonalds... even though the stock market fell almost 40% by the end of the year. Now that you know McDonalds gets 65% of its sales outside the U.S., wont you sleep better as a McDonalds shareholder, even if the U.S. dollar gets worse? Foreigners will be able to buy more McDonalds products, and McDonalds loyal customers and strong brand name will allow it to raise prices in the U.S. to adjust for a weaker currency. When you buy great companies with high foreign sales, you often get a growing stream of dividends, too. Procter & Gamble has raised its dividend every year for nearly six decades in a row. Colgate-Palmolives dividend has increased more than 11% per year from 2001 to 2011. It can be complicated and difficult to buy stocks in foreign markets. You and I arent allowed to invest in stocks in India, for example. We have to go through complicated and expensive legal procedures to do it. Other countries have all kinds of taxes. A subscriber told me theres a 25% withholding tax on some of his foreign stocks, even in his IRA. His broker says theres nothing he can do about it. Theres little need to invest in foreign stocks. Its much easier to
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stick to the best-quality U.S.-traded stocks and find the ones that have more than half their sales outside the U.S. If you know nothing else about investing in foreign stocks except this simple, powerful idea, youll outperform 99% of investors who spend their time trying to find the next hot foreign stocks.

Its When You Get Paid That Counts

Imagine investing in a friends business. You invest $10,000. Since its not a charitable contribution, you want to know two things: when youre going to get your money back, and how much youll make in profit. Your friend answers: I dont really know when youll get paid. It might be some time in the next six months, but it could be as long as five or 10 years As to how much, I dont really know that, either. I think theres a chance Ill pay you about $10,000 over and above your initial investment. I hope itll be more like $1 million, though! But if things dont work out, Ill probably just give you back your $10,000, minus a few thousand to cover my losses. If things really go poorly, youll never get any of your money back. Youd laugh in his face. You would never go into business under such terms. No serious or semiserious businessman would offer you such vague terms. Yet, every day, millions of investors are offered such terms, and take them. They buy stocks not knowing when or if theyre ever going to get paid or how much. As if they were buying lottery tickets. I think people buy stocks this way because they dont know how to figure out when and how much theyre going to get paid from their investments. But its not really that complicated. If youre a bondholder, you know exactly when youre going to get paid: Four quarterly interest payments for some specified length of time, at the end of which you get back your principal. In stocks, its hard to predict when youll get paid. But theres an easy way to calculate how much youll earn. If you buy a stock for 50% of what its worth, you can expect to

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make double your initial investment some day. If you buy at a 75% discount, you can expect to make four times your money. At a 33% discount, youll make about 50%, and so on. The idea is always the same. Once you know the value of a stock, the price you pay determines roughly how much you can expect to make. An obvious question is, What if youre wrong about your estimated value? Bill Nygren at the Oakmark fund once provided me with a good answer. He insists on paying 40% less than his estimate of a companys value so that hell have a sizeable enough margin for error. When a stock reaches your estimate of its value, thats when you sell. Few brokers or other investment advisers will ever tell you to sell. Many of them are content to take advantage of their clients ignorance. If you sell at a profit and the stock goes higher, theyre afraid theyll look dumb. If you sell at a loss and the stock comes back, your broker or adviser is probably afraid youll be furious. As long as youre holding, your hope is alive. The incentive of brokers and advisers is to keep you holding and hoping at all times. Obviously, youre never going to make any money holding and hoping. You have to know when to sell. To know when to sell really know, and not just guess you have to determine value. Thats what we do in the pages of Extreme Value each month. If you were in any other business, youd demand at least that much. Investing should be no different.

What Youve Got Wrong About Value Investing

Over the course of my career, Ive received letters from investors criticizing the art of value investing. Many people think value investing is simply trying to time the market trying to pick the bottom in a stock. Thats not true. Every financial advisor or broker worth knowing will tell you nobody can time the market. Nobody can pick bottoms. Given the enormous opportunity that exists right now for investors who understand value how much a great business is worth to a private investor I need to take this opportunity to clear up the difference. Value investing is not an attempt to pick bottoms. Picking bottoms isnt a skill. Its like buying lottery tickets, another good way to lose money. I cant time the market. You cant time the market. No one can. You can only buy terrific values when you find them. I dont buy stocks because the market is down. The markets can always go lower. I buy when stocks are cheap. Most investors are mesmerized by that irresistible shiny object the modern, real-time price quote. Theyre members of the Q culture, as Lawrence Cunningham calls it in the introduction to his book, How to Think Like Benjamin Graham and Invest Like Warren Buffett. Cunningham writes, Quotes of prices command instant attention in the mad, modern market where buyers and sellers of stocks have no idea of the business behind the paper they swap but precisely what the price is. Its easy to know the price, which is why so many people are obsessed with it. Its much harder to know the value, which is why almost no one has any idea what value is or what it means.

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But since value investing has absolutely nothing whatsoever to do with market price quotations, it cant possibly have anything to do with choosing the perfect price quotation. Imagine paying two times earnings for a stock worth 20 times earnings. If it rose 200%, it would still be a great bargain and you should still buy it. If the same stock traded for four times earnings and fell 50%, it was still a great bargain back at four times earnings. Its merely a better bargain at two times earnings. If the same stock sells for 60 times earnings, then falls 50% to 30 times earnings, its not a bargain at all, even though it has fallen substantially. Thats how value works. It starts with business value, and only then does it make sense to check the price quote. Before worrying about the price quote, investors need to learn the assets, earnings, dividend history, expenses, profit margins, interest expense, management, the overall size of the industry, and who the competitors are. So I dont try to time the market. I buy stocks and recommend my readers buy stocks when stocks are very cheap in relation to their intrinsic values, no matter what happens tomorrow. Value isnt about hoping share prices go up, and it certainly isnt about attempting to predict the lowest share price. Its about knowing what a business is worth and paying a substantially lower amount than that.

The Secret to Horse Racing... and Stock Investing

One night in 1994, Berkshire Hathaway Vice Chairman Charlie Munger found himself at dinner with the president of Santa Anita, a horse racing track in southern California. Mungers dinner companion told him about bettors who wagered so much that they had lines of credit with the racetrack. Naturally, the great majority of those bettors were just like the hordes of smaller bettors: net losers over time. The few times when they managed to win, they never won enough to take care of their losses, plus pay for the racetracks cut. These are the whales, the high rollers, the people who gamble big, lose big, and provide a good living for the gambling industry. But a tiny few bettors, over the long term, really did manage to make a little money gambling on the horse races at Santa Anita. Munger was impressed that these few were shrewd about something with as much unpredictability as horse racing. Munger wanted to get to the bottom of the bettors success. That night, he learned the one thing that all those winning bettors in the whole history of people whove beaten the pari-mutuel system have is quite simple. They bet very seldom. Munger reasoned, Its not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it who look and sift the world for a mispriced bet that they can occasionally find one. And the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they dont. Its just that simple. First, bet seldom. Then, when you bet, bet big. Replace the word

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bet, with the word buy, and theres your formula for investing in stocks. Most people just dont have the patience for it. They dont want to bet seldom. They want to trade, to bet often, taking many small losses and small profits. They dont want to bet big, either. They want to diversify, to make many small bets. Once youve placed your bet, you must then do something else no one wants to do. As Joel Greenblatt put it at the Value Investing Congress in New York City in 2006, Nobody wants to wait three years. And because nobody wants to wait three years, an enormous opportunity exists for those who will.

The Greatest Mutual Fund in the World

If you want to make big returns on your investments year after year for many years, listen to David Swensen. Swensen is the widely respected chief investment officer of the Yale Endowment Fund. He made Yale more than 16% per year for two decades. That kind of compounding gives you 20 times your money in about 21 years. Imagine retiring with 20 times what you have right now. Making that kind of money as an investor is a rare achievement. Mutual fund investors know this better than anyone... On the subject of mutual funds, Swensen says, A miniscule 4 percent of funds produce market-beating after-tax results with a scant 0.6 percent (annual) margin of gain. The 96 percent of funds that fail to meet or beat the Vanguard 500 Index Fund lose by a wealth-destroying margin of 4.8 percent per annum. Wow. Ninety-six percent of all mutual fund managers make less money than a simple index fund... and charge you fees for doing so. The obvious lesson from all this is to be very picky about whos managing your money. You only get one shot at compounding your wealth over decades... so every single percentage point you can earn is worth millions. In this essay, Im going to show you how to avoid garbage funds. And Im going to tell you how to find the perfect mutual fund. If you know what to look for, you can save yourself a lot of money and headaches over the coming years. The perfect mutual fund has five key attributes that tell you its safe enough for your retirement savings and will earn enough money on your investment. Take a look at the funds you own this weekend. If they dont meet the following high standards, consider selling them and

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switching to the small handful of funds that do. First of all, management should act in the shareholders best interest at all times, even if it means closing the fund. One of my favorite funds stayed closed for more than two decades, during which time it could have grown many times its current size. That would have earned more fees for the funds management. But it also would have made it much harder for management to produce the kind of returns that multiply your investment by a factor of 200. Its almost impossible to produce outstanding gains when youre trying to put a huge amount of money to work. Second, management should not be in business to soak investors by charging high fees. Some of the best mutual funds in the world charge just 1% of assets under management. If youre paying over 1.5% in expenses to your fund manager, youre overpaying. Third, the best mutual funds only buy the very best companies on Earth. There arent 200 truly exceptional companies in the world worth buying. Probably less than 100. The best mutual funds focus their attention (and your money) on their very best ideas. The ideal mutual fund holds 15-30 stocks. Somewhere in that range is the perfect balance of diversification and focus. Fourth, the perfect mutual fund holds stocks for the long term. When you buy the best companies and hold large positions, it makes no sense to trade in and out quickly. The average large-cap blend mutual fund holds stocks for an average of about 17 months. Not even two years. Many mutual funds hold hundreds of stocks, and turn over their entire portfolios every year. They dont know what to buy, and they dont know what to sell, so theyre constantly buying and selling. Finally, you want to invest in a mutual fund whose managers invest their own money right alongside yours. This is a no-brainer. Its also hard to find. But why would you ever give your money to a fund man52

ager whose interests werent exactly the same as your own? Do yourself a favor next week. Print off this list. Call your mutual fund managers and go over it with them. If they dont meet these requirements, they should have a good explanation for why not. If youre not happy with the explanation, dump them.

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The Secret of World-Dominating Dividend Stocks

Investors who know what theyre doing will recognize this secret as soon as they hear it. But I bet if you try to tell your friends about this secret, they wont get it (and theyll continue to get killed in the stock market). The thing is, its not really a secret. Ive seen it in Forbes, the Wall Street Journal, and Barrons. Cohen & Steers fund manager Rick Helm has repeated the simple secret on how to avoid risky income stocks and earn a steady stream of high and growing dividends: The best income stocks are the ones that consistently raise their dividends, even though these stocks tend to have low current yields. Helm has spent his entire career looking for the very best dividendpaying stocks, and his fund owns Procter & Gamble, Microsoft, and Wal-Mart (all of which yield under 3%). But just look at how their dividends have grown in the last several years: Annual Dividend Company Growth Rate Microsoft 11% Wal-Mart 19% Procter & Gamble 12% Since... 2003 1998 1998

through good times and bad. Microsoft has so much money, it doesnt know what to do with it all. So its paying it out to shareholders. Its buying back shares and paying the fastest-growing dividend Ive seen among World Dominators. Wal-Marts growth has slowed, but its still bringing in plenty of cash. So instead of using it to grow the business, its using cash to grow the dividend. Procter & Gamble has raised its dividend every year for more than 50 years in a row. A recent annual report was crystal clear: Our first discretionary use of cash is dividend payments. Dividend payments come out of free cash flow. Free cash flow determines bonuses for P&G executives, giving them a great incentive to treat shareholders to a growing stream of income. With World Dominators like these, a low but rapidly growing current yield eventually becomes a large and growing yield. Let me show you an example... You could have bought Wal-Mart in 1997 for less than $18 a share (split-adjusted). Back then, the quarterly dividend was $0.034. The current yield was tiny, below 1%. But if you bought Wal-Mart at that time and simply held on for a dozen years, you were earning $1.80 a year in dividends for a yield of 10% or more over your original cost. Imagine owning a business like Wal-Mart and getting a 10% yield. Its an income investors dream come true. (A stock price 200% higher doesnt hurt, either.) Most income-focused investors lust after stocks with high current yields. Big mistake. High current yields usually indicate high risk... leveraged balance sheets and commodity-oriented businesses. MLPs, REITs, and other stocks with high current yields must pay out a large portion of earnings in dividends or theyll lose their taxadvantaged status. Theyre not allowed to retain earnings for future growth. If they want to grow, they have to go to the capital markets and
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These stocks all are World Dominators. A World Dominator is generally the largest, most powerful company in its industry. It can raise prices to stay ahead of inflation and use its enormous size to keep costs low. Raising prices or being the lowest-cost provider means these World Dominators tend to crush the competition. So they often generate enormous amounts of cash. That cash can support dividends
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issue new debt and equity securities. World Dominators tend to be the most creditworthy institutions on Earth, so unlike high-yield REITs, theyre immune to capital-market problems. Even when times get tough, theyre not cutting their dividends. If a growing stream of income thats impervious to economic disaster is what you seek, World Dominators are what you need to own.

Where to Find Extraordinary Income Streams That Always Go Up

For years now, Ive been pounding the table on World Dominators. These companies are at the tops of their industries. They gush free cash flow and pay out ever-increasing dividends like clockwork. Some of these companies have grown their dividends for 40 years in a row. But I realize many of you doubt the wisdom of owning these stocks. So today, Im going to show you why dividend growth stocks are the closest to a sure thing that exists in the stock market. Theyre the only source of return you can count on to rise every year. Theyre unbeatable investments. Ive told you about this many times. But now Id like to show you... Lets start with retail dominator Wal-Mart (WMT). Take a look at Wal-Marts dividend growth from 2001 to 2011...

Its relentless. Wal-Marts dividend has grown every year, year after

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year, through the biggest housing boom and bust in history... the worst financial disaster in American history... Federal Reserve inflation... higher food prices... terrorist attacks... two recessions... $150 oil... and $1,500 gold. Through all of it, Wal-Mart has continued to grow its business and dividend payment by 18% per year. At that rate, if you buy today, youll earn a double-digit yield over your original cost within eight years. Now lets compare that to the performance of the S&P 500 as a whole. The chart below tracks the average dividend paid out by S&P 500 stocks over the same 10-year period...

Mart continued to raise its dividend by double digits every year. The bottom line is, the market cant promise you growing income. It cant even promise you steady income. Only the World Dominators can. Theyre the best investments around. And if youre investing for income, theyll beat the stock market, year after year.

Its not bad. The average dividend payment is up overall during the period. But when things got tough in 2008 and 2009, many companies slashed their dividends. The S&P 500 paid the same amount in 2011 as paid in 2006. Five years of dividend growth was wiped out of existence. If you were depending on dividends from the average stock as a source of income, you took a heavy pay cut. But while most companies cut or eliminated their dividends, Wal58 59

Know This and Youll Never Have to Worry About the Markets Next Move
Everybody wants to know what the overall stock market will do next. Will it rise more? Will it fall? If it falls, will it be a small dip... or a giant crash? Investors who think about questions like these too much arent investors at all. You dont get to know what the stock market will do next. No one does, at least not often enough to profit consistently from it. Over the short term, the stock market is a random walk. You never know which direction its next step will be. The antidote for the universal obsession with the markets ups and downs is learning how to think about its valuation. Here are the three numbers to watch... 1) Total stock market value as a percentage of GDP [If total stock market capitalization divided by GDP] falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200% as it did in 1999 and a part of 2000 you are playing with fire. Warren Buffett, in a 2001 Fortune article Buffett should have noted slam dunk buy territory on this ratio doesnt really kick in until you get down around 50% or 60%... Greater than 100% is once-an-eon, slam dunk sell territory. It rarely gets above 90% and has spent decades under 75%. 2) Earnings yields and price-to-earnings ratios for the big indexes To calculate earnings yield, divide 100 by the price-to-earnings level. At 20 times earnings, stocks have an earnings yield of 5%. A price-to-earnings ratio of 10 = 10% earnings yield.
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I look for an earnings yield of 9%-14% before I say stocks as a group are cheap. 3) Dividend yields for the big indexes Dividends are probably the most important thing most stock market participants completely ignore. In his excellent book, Behavioural Investing, James Montier showed that over the long term, dividends have provided more than half the returns from equities. A knowledgeable, rich investor only gets excited about the broad market when cash dividend yields are up around 5%-7%. In general, I dont worry what the market is up to. You dont have to either if youre just very careful what you buy and sell or avoid garbage. But if you must keep an eye on the market, these three numbers are the only ones that matter.

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New Study Reveals Worlds Greatest Investment Strategy

Its official: Buying the cheapest assets you can find is where you make the biggest, safest, easiest money as an investor. What made it official to me was a study by one of the greatest living investors. The investor is Jeremy Grantham. His firm Grantham, Mayo, Van Otterloo, manages over $100 billion. Grantham published the results of a 10-year forecast he made for the period from December 31, 1999, to December 31, 2009. In 1999, Grantham predicted the rank and return for 11 different asset classes. The actual rankings wound up correlating 93% with Granthams forecast. The probability of equaling or besting such a performance is about one in 550,000. How did he do it? As he wrote in his investor letter, We forecast [back in 1999] that the egregiously overpriced S&P would underperform cash and everything else what should you expect starting at 33 times earnings? and we assumed that emerging equities would do extremely well despite a 0.7 correlation with the S&P, because they were cheap. (Italics added.) Granthams forecasting feat confirms a thesis Ive believed for a long time: If you wait for asset prices to reach extremes of valuation, you have an excellent chance of outperforming most investors. Its difficult to wait for these extremes to come around, but its crucial to your success as an investor. Granthams track record for spotting valuation extremes goes beyond a single 10-year period. He and his clients successfully avoided every bubble of the last two decades (Japan in the 80s, tech stocks in the 90s, financials and housing in the 00s). He was bearish at the top of the most recent bubble, in 2007, and super bullish at the bottom, in late 2008/early 2009.

Granthams lessons are powerful and easy to understand. Avoid whats expensive. Buy whats cheap. Stocks were incredibly popular in 1999, when Grantham made his prediction. They crashed three months later. Emerging markets were very cheap. They produced excellent returns. In both cases, extremes of valuation trumped all else. If youre buying and selling businesses without knowing how to value them, and how to spot extremes of valuation in them, you cant possibly hope to make a dime in the stock market. If you fancy yourself a trend follower, be careful you dont follow your beloved trend straight off a cliff. Granthams forecasting success proves waiting for extremes of value to arrive makes long-term investing success much, much easier to achieve. And while I normally dont pay a bit of attention to predictions, its great to see such a common-sense forecast prove the case for value investing once again.

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Four Must-Reads That Will Radically Change Your View of Stocks

Most people view the stock market like a lottery game. They make short-term bets on businesses they know little or nothing about... and generally lose money. But theres another way to practically guarantee youll make money in stocks. It requires you to stop obsessing about the markets day-to-day fluctuations and learn something about the businesses youre buying and selling. You can learn about this method in a number of ways. But I think a great introduction is to read three short books, and one important chapter of another book. By the time youve read all four, a lightbulb ought to switch on in your head. You should be convinced theres a better way to buy stocks than making random guesses about short-term share price movements. At my publishers annual lifetime subscriber meeting, I was asked for a single book recommendation. I enthusiastically recommended Joe Ponzios F Wall Street, which I had just finished. F Wall Street teaches you to think about the value of a business first and forget about the price of it until you understand the value well enough. Thats what all the best investors say. Look past the noise. Look past the short term. Forget about market risk... F Wall Street! Focus on value. Be a business analyst, not a market follower. I probably shouldnt tell you any of this. If you gained expertise in valuing businesses, youd almost never buy stocks. Most public companies are simply too hard to value. Those that arent too hard to value spend most of their lives overvalued by Mr. Market. When I tell my readers Im having trouble finding cheap stocks, it goes without saying I mean cheap stocks I understand well enough to value. Ponzio also provides a reasonable shortcut method for armchair
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investors who see the value in stocks, want to stick with large, stable companies, and dont want to invest hundreds of hours of research each year. Ponzios final chapter is on patience, another hugely important concept. As I tell my Extreme Value subscribers, mastering time is the most important factor in any investment plan. If you cant learn to be patient, you simply cannot make money in stocks. If you can be patient enough, success is virtually guaranteed. Overall, F Wall Street is well-written and highly readable. Its also worth rereading. I keep it within arms reach at all times when Im at home. Most financial books stink. This one is great. Read it and learn from it. Another valuable investing book is Joel Greenblatts classic, The Little Book That Beats the Market. Using a simple story thats a joy to read, Greenblatt teaches the reader the ideas behind his Magic Formula investing concept. Magic Formula investing is a simple idea that says you should buy the best businesses when theyre trading at suitably cheap prices. Greenblatt offers simple metrics and guidelines so you can learn to identify a good business and know when its cheap enough. Greenblatts book, too, is worth rereading. Its next to Ponzios book on my shelf. Another book I often recommend is Frank Singers little 27-page masterpiece, How to Value a Business. Singers booklet provides a simple formula for valuing a business, which requires that you estimate the probability of a companys earnings occurring. Think about that. Most people take the earnings for granted. They dont bother wondering about the likelihood of earnings occurring. There are many highly cyclical businesses out there. Once you get real about the likelihood of a given level of earnings happening again, you start realizing a lot of stocks are just too risky to fool with. Singers book also prompts you to think about three different types of value: liquidation value, stock value (which is really IPO value), and ongoing business value. Liquidation value is not the subject of the book. And Singer admits there seems to be no sense or logic to IPO valuations.
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What Singer does is provide you with basic tools to understand the value of an ongoing business. He also shows you how ongoing business value can be much higher for a strategic acquirer than for an investor like you or me. A strategic acquirer is another company in the same business. Businesses are worth more to strategic acquirers because the key inputs, the earnings, and the probability of the earnings occurring are higher for the strategic buyer. He buys the business because he thinks he can wring more profit out of it. And he thinks higher profits are highly certain. So he pays more. Like Ponzio and Greenblatt, Singers book contains good examples and anecdotes. The other must-read I recommend most consistently is Chapter 20 of Benjamin Grahams The Intelligent Investor. The chapter is called Margin of Safety as the Central Concept of investment. I recommend you reread it once a month. Its that important. Once you learn about value, you have to keep in mind business values are inherently imprecise. You cant pinpoint them. You can only estimate them within a given range. Margin of safety is simply the margin for error investors need because its impossible to pinpoint business value. For example, if you think a companys stock is worth $100 a share and you buy it for $95 a share, you dont have a real margin of safety. If that $100 company is a World Dominator and you buy it for $75 a share, youre getting a margin of safety. Say the company is a riskier business, not a World Dominator. In that case, youll want a bigger margin of safety. You might want to wait until it sells for $60, or even $50, a share. If most investors learned to value a business, they might exit the stock market altogether. My guess is most stock investors who learn to value a business become very picky about the stocks theyll own. They buy less often, sell less often, and hold longer. And they make more money.

Published by Stansberry & Associates Investment Research. Stansberry & Associates welcomes comments or suggestions at feedback@stansberryresearch.com. This address is for feedback only. For questions about your account or to speak with customer service, call 888-261-2693 (U.S.) or 410895-7964 (international) Monday-Friday, 9 a.m.-5 p.m. Eastern time. Or e-mail info@stansberrycustomerservice.com. Please note: The law prohibits us from giving personalized investment advice. 2010 Stansberry & Associates Investment Research. All rights reserved. Any reproduction, copying, or redistribution, in whole or in part, is prohibited without written permission from Stansberry & Associates, 1217 Saint Paul Street, Baltimore, MD 21202 or www.stansberryresearch.com. Any brokers mentioned constitute a partial list of available brokers and is for your information only. Stansberry & Associates does not recommend or endorse any brokers, dealers, or investment advisors. Stansberry & Associates forbids its writers from having a financial interest in any security they recommend to our subscribers. All employees of Stansberry & Associates (and affiliated companies) must wait 24 hours after an investment recommendation is published online or 72 hours after a direct mail publication is sent before acting on that recommendation. This work is based on SEC filings, current events, interviews, corporate press releases, and what weve learned as financial journalists. It may contain errors, and you shouldnt make any investment decision based solely on what you read here. Its your money and your responsibility.

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