Popular vs. Unknown Stocks

Beautiful New Orleans -- they don't call it the Big Easy for nothing. Even the cab drivers are relaxed and happy. Ah, palm trees, and a September break from the humidity.

That's where I was last week, a guest of the National Association of Mutual Insurance Companies (NAMIC). I doff my Foolish jester cap to NAMIC for inviting me to their great convention. It was a privilege to speak to their members on the question, "What to do with your money now?"

Here's a quick tour of the speech about how to secure your finances -- especially stock investments -- in times of economic uncertainty.

Uncertainty? So what's new?
First, there is always economic uncertainty. As good or bad as times may seem, confidence can change swiftly. So let's be like Binkley in the classic Bloom County comic strip, and take today's economic fears out of the anxiety closet. How scary are they, really?

The Federal Reserve has dropped the federal funds and discount rate to historic lows, yet unemployment has not dropped. It may seem low historically, but tell that to any recent graduate.

Interest rate and tax cuts have stimulated the economy, but is anyone feeling sanguine? And all the Fed-induced liquidity almost certainly means inflation again someday. Or... do China's low labor and manufacturing costs provide a deflationary threat?

According to The Economist's recent world economic survey, the U.S. current account balance is negative 5% of GDP, way beyond its prior high of 3% under President Reagan before the next boom. Will this precipitate a massive run on the dollar, instead of an orderly fall that fuels our exports?

In discouraging signs reminiscent of Smoot-Hawley and other trade protectionism in the Great Depression, nations walked out of the World Trade Organization meeting in Cancun amid signs worldwide of possible increases in trade barriers.

In the three-engine theory of economic growth, U.S. consumers solely keep the train running, with a combination of bulging personal debt and withdrawals of home equity. Personal bankruptcies are on the rise.

Facing this parade of horribles, we nod to Dorothy Parker and say, "We might as well... live!"

Blithe spirit
What if every single one of these spells D-O-O-M? What if they lead to, oh, the worst economic decline of the last 100 years? If a run on the dollar or protectionism or deflation or inflation brought us another Great Depression, how bad would it be?

Most importantly, would it change the way we should invest?

First, my parents lived through the Depression and provided a backdrop familiar to all that era's children -- a fear that somehow, somewhere, things will blow up again and we will lose everything. But my father also hammered into me (in the kindest of ways) that even in the darkest days of the 1930s, if you had a job, you were OK. You could keep a roof over your head, and feed, clothe, and educate your children. Unfortunately, unemployment hit levels three to four times greater than today, and today's graduates face a terrible job market, but it does put things in some perspective. Education and the willingness to work hard are the best insurance against disaster.

Second, if you stayed the course -- weren't scared away, kept investing -- you had profits long before the Dow Jones Industrial Average and the S&P 500 returned to their pre-Crash of '29 levels in 1954 and the early 1940s, respectively. They didn't just regain their losses in a decade or 25 years if they stayed invested, they made a very decent compound annual return for those deflationary times. Behavioral economists correctly caution that people don't stay the course. Rather, they stay away.

This psychology endangers us more than any macroeconomic climate.

Stock market psychology
Yes, our psychology hurts us. Investors pile into stocks at times of maximum market enthusiasm and desert in droves at maximum pessimism. Buying high and selling low, investors over time impoverish themselves.

It has happened most seriously three times in the last 100 years, about every 30 to 40 years from the Roaring Twenties to the Go-Go Years of the late 1960s to the last stampeding bull in the late 1990s. But it also happens less dramatically as the markets swing up and down in their normal overreaction, which they do all the time, because there is no such thing as an orderly and calm stock market rise that reflects some calm, rational measure of corporate profits.

It's happening again now, with the Nasdaq rocketing almost 80% from its October 2002 low. You read that investors "regain enthusiasm for the market," and of increasing money flows into stock mutual funds. Help!

And at the same time, with the decline of the traditional pension and three years of falling major market averages, there has never been a greater need for personal savings and profitable long-term investment. Disciplined and steady savings and investment may sound boring, but it's the best way to deal with economic uncertainty.

It's the ancient Greeks advising moderation in all things, the Buddhist Middle Way. It's not the easy money siren song or the fear mongers, but the Sexy Middle.

What about stocks?
After starting with a low-expense stock index fund, such as one that attempts to match the S&P 500, the best advice on stocks for all seasons comes from Benjamin Graham, Berkshire Hathaway (NYSE: BRK.A  ) CEO Warren Buffett's legendary teacher at the Columbia Business School and author of The Intelligent Investor and, along with David Dodd, the classic Security Analysis. Ruined by the Crash and saved by a relative, money manager Graham resolved not to lose money again. I will in this short space do no justice to Graham's extensive learning and simple, clear explanations -- learning that many spend a lifetime savoring -- but I will summarize a finding that means a great deal today.

Graham basically found that the stocks of the companies everyone knows and wants -- the popular companies -- are almost always overvalued. Everyone wants them, driving up the price. By definition, they offer little upside.

In Graham's time, they included railroads and other heavy industrial companies. Today, they might comprise stocks such as Citigroup (NYSE: C  ) , General Electric (NYSE: GE  ) , Coca-Cola (NYSE: KO  ) , PepsiCo (Nasdaq: PEP  ) , Johnson & Johnson (NYSE: JNJ  ) , Wal-Mart (NYSE: WMT  ) , or Pfizer (NYSE: PFE  ) . And on the techie side, Microsoft (Nasdaq: MSFT  ) , Intel (Nasdaq: INTC  ) , or Cisco Systems (Nasdaq: CSCO  ) . (For a list of the 20 most widely held stocks, see Jeff Fischer's recent look.)

                 TTM Forward  EV/^
Company P/E^ P/E TTM FCF^ Yield
Cisco Systems 40 31 29 0.0%Citigroup 16 14 33* 3.1%Coca-Cola 25 23 28 2.0%General Electric 21 20 26 2.5%Intel 51 56 26 0.3%Johnson & Johnson 23 27 23 2.0%Microsoft 30 34 17 0.6%Pepsi 23 25 28 1.4%Pfizer 42 25 28 2.0%Wal-Mart 30 33 65 0.6%
*FCF less meaningful for a financial
services company.
^Key: P/E = price-to-earnings ratio
TTM = trailing-12-months
EV = enterprise value (market cap + debt - cash)
FCF = free cash flow

Valuation is relative, depending on growth and other factors, but the law of large numbers counsels that these huge companies are less likely to deliver investment returns at these annual rates with each passing year, so the potential upside is limited. But if you hold them a long time, reinvest dividends, and invest new cash regularly -- dollar-cost average -- there is less downside and more chance of closing in on the market's average returns. After all, these companies' gargantuan market capitalizations make them dominate the very broad-market averages and index funds you may buy, say, in your 401(k) plan, to track those averages.

And those average annual broad-market returns of 8% to 11% a year over 20-year periods (depending on whose stats you believe) are just fine.

Where the real upside is
But according to Graham, the greatest gains lie in smaller, lesser known and inherently less popular companies. Their lower popularity often means more inefficient stock pricing and more opportunities for value. But they also offer the greatest risks. Graham says financial analysis skills are required to determine whether "cheap" means undervalued -- or a just plain lousy business. Hence his founding, study, and teaching of the modern field of security analysis.

Institutions -- and the rest of us
Larger financial institutions can pay tens of thousands of dollars for their own analysts, and buy big-ticket research from independent research shops such as Sanford Bernstein and quality-of-earnings gurus like Howard Schilit's Center for Financial Research and Analysis and David Tice & Associates. These outfits aren't skewing their advice in the direction of potential investment banking clients, but they are beyond most individuals' wallets.

Individuals like you and me face a wild, wild West when searching for affordable independent advice. We know to avoid Wall Street sell-side analysts and often turn to the stock newsletter business, which offers a gazillion research products at affordable prices of $100 a year and up. The problem is that you have to hunt to find high-quality research among the email penny stock pumpers and direct mailers screaming the End of the World as We Know It.

For those of us who want the Sexy Middle, it can pay to subscribe to a good stock research newsletter that:

  • provides unconflicted and independent advice;
  • maintains a complete record of selections;
  • shows how selections have done versus a benchmark;
  • explains reasoning clearly both for buying and selling, using the language of business and financial analysis instead of appeals to emotion; and
  • acknowledges both successes and failures honestly and in plain view.

Examples of unknown small companies
When you find a trustworthy newsletter that researches Graham's world of unknown investments offering value, you may find companies that not only win blank stares from friends, but perhaps even derision. "That Breathe Right nasal strip company, CNS (Nasdaq: CNXS  ) ? Ha!" But you can be strong, knowing that it's minting free cash flow, buying back shares, starting a dividend, and expanding slowly and intelligently into complementary brands.

Yes, proudly wear your investor badge of funny little companies, like catalogue and online outdoor discount retailer Sportsmans Guide (Nasdaq: SGDE  ) , software maker Pegasystems (Nasdaq: PEGA  ) , and Hooker Furniture (Nasdaq: HOFT  ) -- all selections of Tom Gardner's Hidden Gems. Or Marvel Enterprises (NYSE: MVL  ) , which is up 348% since it was featured in the July 2002 issue of Motley Fool Stock Advisor. How's [insert your favorite large cap here] doing compared to that?

Our analysts find these companies through painstaking work. We screen, read, crunch numbers, call, and post, and we reject countless candidates for each one we take to the prom. That's what you want for quality, independent research.

The best investments?
Timeless investing rules don't change because of our economy, which is always uncertain. Save and invest regularly -- not just when "the markets" are allegedly "hot" or "cold." When you invest, do so where you are comfortable with dollars you don't need in the next five years. And no matter your stock investing choices, make sure that your biggest investments are in family and friends, because these will yield the greatest returns of all.

A personal note
I certainly felt that way this weekend, when more than half of the 43 members of the International School of (Nairobi) Kenya's class of 1983 held their 20th reunion here in Washington. Their senior year English teacher, I was pleased and privileged to catch up with the countless personal and professional accomplishments of this talented, warm, worldly, and special group. (Not to mention that when a Norwegian student recited Shakespeare he had memorized in the class, your Foolish analyst let loose the tears.) This weekend yielded more returns than any stock.

Have a most Foolish week, and thanks for reading.

If you would like Tom Jacobs to speak to your group, please contact Jamie Patten atJPatten@Fool.com. Tom is the guest analyst in the current issue of Tom Gardner'sHidden Gemsand owns shares of CNS, Sportsmans Guide, and other funny little companies disclosed publicly in hisprofile. We happy Motley Fools are investors writingfor investors.


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