The Single Best Investment by Lowell Miller

The Single Best Investment Book Review

I loved reading The Single Best Investment: Creating Wealth with Dividend Growth written by Lowell Miller.

The biggest challenge in stock investing is not knowledge, stock selection or analysis, but investor behaviour. The behavioural challenge is how to ignore the huge amount of information that investors drown in, the daily stock prices provided by Benjamin Graham’s Mr. Market and the sales machine of the finance and banking industry.

The book provides a Do-It-Yourself (DIY) guide to stock investing. It is one of the most down-to-earth books written on stock investing.

The dividend growth strategy outlined can, over a longish period, creating a spectacular compounding machine with a high probability of providing not only the best return on investment, but also handsomely beating the market. All of this without having to bother about the daily changes in stock prices.

In the author’s words:

This book is for savers and builders, for people who understand (or who want to understand) that the forces of time, modest and reliable growth, and compounding are on their side.

In this book Iʼll detail a simple and straightforward way to earn solid returns on your investments over the long term, with the lowest possible risk.

Itʼs an approach that can get you off the hook of information addiction, free you from the need to constantly keep up with the latest developments and the opinions of a million pundits.

In effect, you can invest in stocks without “playing the market.”

The author calls the amount invested in stocks as a Bouncing Principal and I have decided to adopt it – the words are spot on.

Given my finance and accounting background, I have been a strong advocate of dividend yield investing for a number of reasons. Naturally the book appealed to me. However, I still had excellent takeaways on bonds, on using charts/technical analysis (being a proponent of fundamental analysis I had completely ignored it; but planning to fix the gap now!) and many other nuggets of information spread throughout the book.

The book is a must read for all investors.

There is no excuse to not read the book – it is available as a free download on the author’s website here.

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The Single Best Investment Book Summary

Note: This summary is made up of my notes, thoughts and highlights of important passages while reading the book. I keep updating the summary when I revisit it, and occasionally may edit it to reduce summary length. Don’t be surprised if it has changed between visits. The author’s words are in normal font, while my interpretations are in italics.

INTRODUCTION

Where investment was in the past the province of the rich and an afterthought for the middle class, now it is everyoneʼs hobby. Business fandom is as large as the crowd for sports results, the weather, or news of the latest presidential scandal.

Whom to believe? What to believe? Whereʼs the best place to put your money? Does the answer vary with each investorʼs situation? By a lot? By a little? Do you have to change where you put your money all the time, depending on conditions in the market? Do you have to be able to guess where interest rates are going in order to succeed in the markets?

Should you be in Growth Stocks? Value Stocks? Small Stocks? Mid-Caps? International? Emerging Markets? IPOʼs? Vulture Funds? REITs? High Tech? Low Tech? No Tech? Bonds? Mutual Funds? Managed Accounts? The question comes up again and again: What to do? What to do?

There should be some way to have a simple investment program that makes sense, thatʼs easy to implement, and that has a high chance of succeeding in meeting your long-term investment goals at the end of the road.

This book is for savers and builders, for people who understand (or who want to understand) that the forces of time, modest and reliable growth, and compounding are on their side.

Investing isnʼt some athletic event where agility and flashes of virtuosity are the secrets of success. Rather, investing really is investing— the methodical accumulation of capital through a sensible and disciplined plan which recognizes that “shares” are not little numbers that jump around in the paper every day. They represent a partnership interest in a real and going business. Your plan, very simply, must recognize that you will manage your investments by actually being an investor—a passive partner in a real and going business.

The Goal of This Book

In this book Iʼll detail a simple and straightforward way to earn solid returns on your investments over the long term, with the lowest possible risk. Itʼs an approach that can get you off the hook of information addiction, free you from the need to constantly keep up with the latest developments and the opinions of a million pundits. In effect, you can invest in stocks without “playing the market.”

Youʼll have this high confidence, as well as a high comfort level—two requirements for long-term success—because the strategy is based on impeccable common sense.

No investor can hope to succeed without having the ability to stick to a plan.

Only if youʼre comfortable with what youʼre doing will you be able to stick to your plan. And comfort (peace within and a cool head) in the frequently volatile world of investments is only achieved, I believe, when you are able to stand on the calm bedrock of common sense.

Common sense

Common sense in investing means employing a strategy thatʼs inextricably linked to the actual corporations in which youʼve invested.

Common sense means your strategy needs to be effective in virtually all market conditions.

Common sense means having reasonable, achievable goals. Common sense means never trying to hit a home run, and never berating yourself with remorse for a situation that doesnʼt work out.

Common sense means spreading out your risks, but not so much that you lose control over your portfolio.

Comfort Level

The instant you deviate from a common sense approach, falling under the sway of a newsletter guru or a slick TV expert, or playing some “system” thatʼs had a good record for a few years, youʼll lose your comfort level because youʼre no longer grounded in the reality of being a part-owner of a real business.

And when you lose your comfort level you become fearful, greedy, superstitious, “intuitive,” prayerful, victimized—you enter into all the emotional states that ultimately provoke investing mistakes.

Unlike other aspects of life, price changes canʼt be explained away, or rationalized, or denied. They just are.

Prices, and therefore the market, are immutable and beyond our control. Iʼll be frank: Iʼve never been able to wish a stock to a higher price. Prices make us feel powerless; itʼs no wonder that emotional comfort as an investor is hard to achieve.

Investor Behavior

Successful investors have known since time began: itʼs not the vehicle that crashes, itʼs the nut behind the wheel.

1. Duration is as important as magnitude. Years ago Harvard psychology researchers showed that subjects could endure great levels of pain if they knew the pain would be gone in a short time. But if the subjects were made aware that the pain would last a long time, they suffered more and “gave up” much more quickly even if the actual pain level inflicted was quite modest.
2. Investors donʼt want to experience losses. One reason investors are always waiting to get out even, is that they donʼt like to experience losses, which are a form of pain.

Economist Richard Thaler of the University of Chicago found that losing $1 makes investors feel two to two-and-a-half times as bad as winning $1 makes them feel good.

But when the loss is actually taken, a discrete event has occurred which cannot be pushed away from the investorʼs consciousness. The loss itself makes the investor feel quite literally like a loser, whereas in holding to “get even” the investor can travel a kind of self-deluded heroic route.

Amos Tversky of Stanford University commented that “Loss aversion—the greater impact of the downside than the upside—is a fundamental principle of the human pleasure machine.”

As Frank Campanale, former CEO of Smith Barney Consulting Group, put it, “The fears of the client drive the investment process more than the knowledge of the financial adviser.”

The pain of regret is more powerful than greed, he says. Investors with winning positions sell early in order to avoid the imagined regret they will have if they fail to realize the profits that they currently have.

3. People compartmentalize their money issues. Imagine that upon arriving at a Broadway theater you discover youʼve lost your $50 ticket. Would you pay another $50 for another ticket? Now letʼs say you arrive at the theater ready to buy a ticket and discover youʼve lost $50 in cash. It should be clear that in both cases youʼre out $50. But of subjects questioned only 46% said theyʼd buy another ticket if theyʼd lost the first one, while 88% said theyʼd still buy a ticket if they had just lost the cash. To buy a second ticket “doubles” the cost of the play in the mind of the buyer, while lost cash is in a more abstract compartment of the mind, and hasnʼt yet been “invested” in the play.

Daniel Kahneman, of Princeton University, suggests that in the compartmentalizing process, “Investors focus on the risk of individual securities. As a result, they tend to fret over the short-term performance of each investment, often leading to excessive trading and bad decisions.”

4. Investors lack self-control. In an unusual display of common sense for an economist, Thaler points out that in life we eat too much, we have a terrible time kicking old habits, we donʼt exercise enough, in general we arenʼt able to take control of ourselves as much as weʼd like. Why should it be any different when it comes to investing?
5. Narcissism plays a role. Thaler notes that investors, risk-averse as they may be, are also in some sense over-confident. Even amateur investors somehow believe their opinions are worth more than a cup of coffee, and most investors will continue to buy mutual funds, though most funds underperform, because they persist in believing they can pick winners.

Investors are arrogant and rarely show the humility and respect that the markets deserve.

Open your inner eyes

Emotions influence investment decisions like the moon directs the tides, and to succeed over the long term youʼve got to do more than open a brokerage account and keep your records. Youʼve got to tune in to who you are, what you want, how you behave in various conditions, the kinds of change you might be capable of and the kinds you are not.

Awareness and control of the inner life is extremely important to successful investment.

Yet investing can be solid and comfortable, like a well-made old wool blanket, if you approach it sensibly. Part and parcel of a sensible approach, a commonsense approach, is to understand just who you are and the kinds of emotional reactions to investing that you experience—as well as how those reactions influence your decisions.

The strategy you use must be a sound one. But no strategy exists in a vacuum, it is always implemented, for better or worse, by a human being.

Investors, Listen Up

You will not succeed if you trade a lot. You can only win the investment game by actually being an investor.

You will not succeed if you pick ten different stocks for ten different reasons, or ten different stocks because ten different “advisors” or brokers say they are good ones.

You will not be successful if you constantly dream of larger profits than the market can reasonably be expected to provide.

Youʼll only succeed by gluing your eyes firmly to the long-term future, and by making long-term commitments within the structure of a strategy thatʼs founded on reason and common sense, supported by historical evidence that the strategy has performed well in the past.

Summing Up:

1. Weʼre drowning in information.
2. The goal: a simple and straightforward way to earn solid returns with the least possible risk.
3. Investor psychology is always at work behind the scenes, for each of us. Common sense and an approach that inspires high confidence are the antidotes.
4. The vehicle is important, but so is the driver.

Chapter 1 – THE FIRST HURDLE: SAY GOODBYE TO BONDS AND HELLO TO BOUNCING PRINCIPAL

The First Step The first step for any successful investor is to understand the environment in which all investors must live.

The Silent March of Inflation Perhaps because the monthly bill never arrives in the mail, most investors pay far too little heed to the basic underlying context in which their investments exist.

Inflation marches on, quietly, rarely making headlines, and static dollars fall further and further behind. Put simply, if prices double, the value of your investment must double merely to stay the same in terms of purchasing power—and that doesnʼt even begin to address the issue of having your money “go to work” for you, of getting a true investment return above the rate of inflation.

So inflation is the context in which your investments exist, the starting point, the minimum benchmark against which investment performance must be measured. The inflation rate is the first hurdle you must overcome.

Since we know that inflation exists, and since we know that bonds do not rise along with inflation, we know that bonds are actually riskier in the long term than investments which can increase in value.

After all, investments in stocks are, theoretically at least, investments in something that grows, that gets larger.

Investments in fixed income are investments in something that is intended to stay the same, something thatʼs “fixed.”

Bouncing Principal

If you want the gains that stocks can provide, youʼve got to pay the toll. The toll is fluctuations.

Youʼve got to accept it deeply, in your heart. Youʼve got to embrace it—or your investment process will fall apart, done in by bad decisions and inadequate returns.

Itʼs often said that everyone wants to get to heaven but no one wants to die. Investors, like everyone else who wants to reach a goal, have to pay a price. Itʼs really not that difficult, once you realize that fluctuations are just a natural part of the process, a process that leads in laddered stair-steps to the heaven of solid investment returns.

Let me put it bluntly, bonds are a bad investment. And they donʼt even do what most people think they do, which is provide a decent return with low volatility.

Bonds, Bad

Bonds arenʼt investments, theyʼre savings.

Investors all too frequently buy bonds because they are “afraid” of the “market.” This would be fine if bonds gave back a return that at least exceeded inflation, but not only do bonds underperform stocks, the chances are high that in any given period bonds will not beat inflation.

The path to a better way starts with the acceptance of the “bouncing principal” principle. You need to accept some risk—but that doesnʼt mean that you need to assume that risk is equal to loss. Itʼs not.

Learning to Love Fluctuations

With the correct perspective, one can learn to appreciate—and eventually seek out—investments that fluctuate (at least a little!).

In most reasonable investments, we might say, the notion of risk is really more precisely a notion of volatility. That is, the value of the investment will fluctuate up and down—this is a given, based on the premise of an investment and the fact that an investment with no fluctuations canʼt be expected to generate an equal return to one that fluctuates.

In theory, if “risk” is actually fluctuation, the greater return you get for investing in something with higher fluctuation is actually a kind of payment for tolerating the fact that the value of your principal may bounce up and down.

The return you earn is a “payment” for accepting the “bouncing principal,” and it is also a payment for accepting the fact that you might need the money at a time of downward fluctuations.

The right understanding of risk is an assessment of how often and how deeply the value of your investments will fluctuate, and whether you will be paid enough to accept that bouncing, compared to how much you get paid to accept the fluctuations in other investments.

The Risk/Confidence Equation

Obviously, the right investment is going to have a moderate magnitude of fluctuations relative to the return you can expect to get.

The best long-term investment is going to be one where you have the fullest faith and confidence that it will fluctuate back up after it fluctuates down. That it will become more valuable over time.

One test of how good an investment is in terms of the ease of holding it, is to consider how attractive it may be to purchase or add more when its value has been decreasing.

When your understanding of your investment is sufficiently great to overcome the natural fear that declining prices will persist forever, then youʼre no longer just a pawn of the great industry dedicated to selling investment products, you are actually an investor.

Easy to Hold, Easy to Buy Declines

The opportunity to add more to your investment becomes as attractive as the actual gains you are seeking. From a psychological standpoint this will always be the best investment or investment strategy, because a strong holder and one who can buy declines will always stand a better chance of success than one whose investment life is governed by the fear of loss. Put another way, a good investment is one in which paper losses are tolerable.

So the best long-term investment is one that is easy to hold, and easy to buy in moments of decline.

We donʼt need to get more than we need in an investment, and we certainly donʼt need to try to get more than the historical average. Reasonable goals are attainable. Fantasies are not.

Summing Up:

1. The first step in investing is to understand the environment, and the environment always includes inflation.
2. Over any extended period, prices rise and the value of a dollar declines. The inflation bill never arrives in the mail.
3. “Safe” investments such as T-Bills, Bonds, C.D.s, and money market funds are poor investments because what they give is less than inflation takes away.
4. History has shown that stocks are the right investment for an environment that includes inflation. Reason supports the historical record, since an investment in a business is an investment in something that grows.
5. Part of the “price” of having an investment that succeeds in our world is that it will fluctuate; we need to learn to tolerate the fluctuations. Invest- ments, as opposed to “riskless” T-bills and C.D.s, will, as Bernard Baruch flatly noted, tend to fluctuate.
6. The true long-term investor will accept these fluctuations, and decide just how much “bouncing principal” is emotionally acceptable.
7. Conservative investors will seek investments that have an acceptable level of fluctuations, and are easy to hold or buy more of during periods of decline.
8. Your emotional relation—or, better yet, your lack of emotional relation—to your investment will make all the difference between good and bad decisions.

Chapter 2 – THE EIGHTH WONDER: A FIRST LOOK AT COMPOUNDING

Th Single Best Investment strategy is not about “playing the market.” Itʼs about being a partner in an enterprise, and beyond that itʼs really about creating a kind of compounding machine that sits quietly off in the corner working for you while you go about your business.

Compounding is the money that money makes, added to the money that money has already made. And each time money makes money, it becomes capable of making even more money than it could before! This is called a virtuous circle, and itʼs what we want to get working for us.

Whatʼs intriguing about Single Best Investment stocks, though, is that you can still harness the power of compounding, even if you need to spend your income, because the stocks themselves benefit from compounding processes in the real world, and your capital can increase even if youʼre unable to reap all the benefits that reinvesting can bring.

The magic of compounding can be felt on the income side of the ledger as well as in its effect upon principal.

If you think of your capital as “working” for you, you can easily see that in a compounding situation you also get to have your capitalʼs children working for you (and the childrenʼs children, and their children after that). Only in the world of pure investment, there are no child labor laws. You can work those little fellas twenty-four hours a day, and you should.

Even if youʼre only concerned with income, you can wind up seeing your principal grow mightily, almost inadvertently, merely by focusing on investments that offer compounding income, income that rises.

In 1626 Peter Minuit bought all of Manhattan for about $24 in gold and trinkets from the Native Americans who lived there. This sounds cheap, but the Indians [sic] may have gotten the better end of the deal. To see why, suppose the Indians had sold the goods and invested the $24 at 10%. How much would it be worth today, 365 years later? The future value is . . . roughly 31.2 quadrillion dollars. Well $31.2 quadrillion is a lot of money. How much? If you had it, you could buy the United States. All of it. Cash. With money left over to buy Canada, Mexico, and the rest of the world for that matter. This example is something of an exaggeration. In 1626 it would not have been easy to locate an investment that would pay 10% every year without fail for the next 365 years.

Compounding has nearly turned staid men into chirping poets:

• Baron Rothschild said “I donʼt know what the seven wonders of the world are, but I know the eighth, compound interest.”
• Albert Einstein found in compounding the same kind of almost mysterious universal energy that he had sought in relativity physics, calling it, “the greatest mathematical discovery of all time.”
• And as Benjamin Franklinʼs famous Poor Richard aptly put it, “I never saw an oft removed tree/ That throve so well as those that settled be.”

Balancing Compound Returns and Volatility

All investments that make use of compounding returns and the compounding principle are not created equal, though sometimes the distinctions are not easy to make.

Be sure to note that the long-term return numbers for stocks or mutual funds that you hear bandied about are compounded average annualized returns.

No investment that fluctuates has the same return each year over a long period.

The return is not the average of the simple returns over a period, either. It is the cumulative total return (the growth of a dollar, in other words) for the period divided by a factor which tells you what the annual return would have been had it been the same each year, in order to reach the same cumulative return.

Standard deviation is basically a number that tells you if the investment is more bouncy or less bouncy, on its way to the final cumulative return.

The game, then, for all but the greediest investors, is simple: find the best return with the lowest standard deviation. Find the best risk-adjusted compound average annual returns.

Time, Patience, and the Right Kind of Stock

Whatʼs needed is a total investment process that harnesses the power of compounding in a positive way, thatʼs pervaded by compounding, that uses the compounding principle to create value in a multi-dimensional way.

Time is a crucial element. Every successful investor will sooner or later come to the eternal verity that in this area of life, “time is your friend.” In a sense, when you understand the impact of time on compounding, you understand that investing is a kind of discipline, a kind of spiritual path (ironically enough) to teach you patience.

Compounding is a quiet process, and it needs time to incubate.

Time is on your side in the right investment situations.

The corollary is obvious: you must give a compounding program time to do its job.

If the notion of compounding holds only one lesson it is this: the first prerequisite for successful investing is patience.

Think of anything youʼve done over a long period of time, whether itʼs a skill or a relationship or a hobby or even just living. Youʼre probably a lot better at it and you probably know a lot more than you did when you started. This is the effect of compounding. This is the cumulative return.

The real difference is that you must learn to be passive. That is, after all, the definition of an investor: a passive partowner of a business, a shareholder.

The trick is simple: find a business with reliable growth that will share that growth with its owners, be patient and watch it grow.

Fast growth is not the goal, for fast growth is not reliable growth and isnʼt worthy of your patience.

Summing Up:

1. Itʼs not about playing the market, itʼs about becoming a partner in a business.
2. Compounding is a building with bricks which themselves make bricks.
3. Even annual returns of 10% can produce gains of nearly 600% in twenty years.
4. Time is all you need. Time and a sensible investment that makes maximum use of compounding.

Chapter 3 – THE SINGLE BEST INVESTMENT: CREATING YOUR OWN PRIVATE COMPOUNDING MACHINE

Build your own private compounding machine.

You build it using good “parts” that are in fine working order, you maintain it as needed with an occasional lube and oil change, and you leave it alone—you let the machine do its job.

Components of the Machine

First, we looked at the personal, emotional situation of the investor, the “operator” of any system or strategy. Any strategy (or “machine”) must include in its design a recognition of humanness, and try to provide a kind of exclusion of the self.

Second, we reviewed the notion that in the long-term economic environment which faces all investors, growth of both principal and income are essential.

Fixed income cannot be a part in the machine.

Fixed income simply doesnʼt provide good enough returns to overcome inflation plus provide additional solid real returns to justify the inherent risks and volatility.

Third, the compounding machine must really focus on the miracle that compounding truly is.

That means income is reinvested whenever possible (as youʼll see, you can still have a compounding machine and withdraw income, it just wonʼt be as effective as one that reinvests), and it also means that an investorʼs most powerful tools are time and patience.

A broad, panoramic view is needed: an obsession with monthly or quarterly returns will simply gum up the gears.

Fourth, the compounding machine should make use of the investment areas that show the highest risk-adjusted returns, the biggest return per unit of risk. Historic results combined with reason have shown us the path to the right stocks for use in building our machine. These “right” stocks must also be easy to hold, for we know that the biggest pitfall for investors are the problems and bad decisions that arise from the anxiety of holding stocks through the ups and downs of “bouncing principal.”

Dividend Growth Is the Hidden Key.

Mature companies pay dividends from their earnings. Every quarter the company sends a check to investors, sharing a small fraction of the profits, and many investors love those checks. The feature that few have heeded, though, is that a significant number of companies raise their dividend every year (or nearly every year).

Dividend growth is the critical piece in the puzzle for creating a portfolio that will serve you over the years.

Pay attention. This is a simple idea, but it is also the single most important idea for long-term investors.

The reason it is so important is that dividend growth drives the compounding principle for individual stocks in a way that is certain and inevitable. It is an authoritative force that compels higher returns regardless of the other factors affecting the stock market.

An instrument that produces income is valued based on the amount of income it produces.

What makes rising income that comes from a growing dividend so attractive in a yield stock?

You not only receive greater income as the years go by, you also get a rising stock price—because the instrument producing the income (the stock) is worth more as the income it produces increases.

You get the income that increases to meet or surpass inflation, and you get the effect of that rising income on the stock price, which is to force the stock price higher.

You get rising income, and the increasing income makes the stock thatʼs producing that income increasingly valuable.

Dividends Tell the Truth

Dividends and dividend growth are the real-life signal that a company has the wherewithal to pay you dividends, that it has your interests at heart in the fact that it pays you dividends, and that it is experiencing real growth as proven by the real growth in its real dividends.

Dividends are a kind of acid test or litmus paper that reveals the true state of a companyʼs finances. As Geraldine Weiss so aptly observed, “dividends donʼt lie.” In order for a company to pay a dividend, it must have the money to pay it with.

A company can tell you about its earnings, but there is always a certain “flexibility.” There is no flexibility when it comes to paying and increasing dividends. The company must have the cash to pay to you.

What you see is what you get. Through the dividend, a company can show you how well itʼs doing.

Dividend Growth as a “Part” in the Machine

One yearʼs dividend growth doesnʼt ring the investorsʼ greed bell.

If youʼd like to have an annual income equal to your investment capital, all you have to do is buy the right stocks and sit on them. Compounding dividends will do the rest.

In a hurry? We might be able to speed up the process a bit through buying stocks especially selected to play an active part in the compounding machine.

Rising Dividends Create Rising Prices

The stock will rise as much as its dividend income rises. If the income doubles, the stock should double, roughly speaking.

Compounding in stocks has an amazing effect when given some time to work. But compounding with reinvested dividends has an astronomical effect over time.

It is the reinvestment of income that really powers up long-term returns. Because you reinvest, everything increases exponentially.

The reinvestment plan works so well because you are continually buying more shares, and those shares themselves reap both income and capital gains.

The Single Best Investment approach—a conservative and easygoing strategy—harnesses a hidden power that is far more effective than the prognostications of any market guru or short-term stockpicker. If all goes according to plan, it is possible for you to equal or exceed the returns of even the best investors. But as you can also see, time and patience are the keys.

The Single Best Investment approach is probably the most conservative and risk-averse strategy that you can possibly use to invest in the long-term growth of the economy and the corporate stocks within that economy. It is an approach thatʼs easy to comprehend and easy to stay with—once you comprehend that youʼre a partner in a business and that all good things take time to develop.

Long-term compounding of the companyʼs profits, manifested to you through rising dividends, is the key principle that will translate into long-term compounding of your returns as an investor.

Summing Up:

1. Create a compounding machine, donʼt play the market.
2. The operator is just as important as the machine.
3. Dividend growth is the energy that drives the compounding machine.
4. Dividend growth is the true signal of a prospering company.
5. Dividend growth pushes up the price of a stock.
6. Stock prices should theoretically rise in a percentage increment equal to the amount of dividend growth (applies to stocks with above-average yields).
7. Reinvestment brings you more and more shares, each of which earns dividends and is subject to the effects of dividend growth.

Chapter 4 – THE SINGLE BEST INVESTMENT STRATEGY APPLIED

The Single Best Investment approach relies on a simple formula, so simple it almost seems impossibly simple:

High quality

+ High current dividend

+ High growth of dividend

= High total returns

THE COMPONENTS OF HIGH QUALITY

Whatʼs high quality? High quality stocks have superior financial strength, as signaled by

• low debt,
• strong cash flow, and
• overall creditworthiness.

High quality companies have proven

• their staying power through good and bad times,
• with strong and creative management,
• proven products, and
• a proven market for those products.

Financial Strength

Low Debt

Interest payments have a higher priority than dividends, and if cash flow declines to the point where dividends canʼt be raised, or have to be cut or eliminated (perish the thought!), youʼve got a wrench in the gears of your compounding machine instead of a smoothly functioning “part.”

Half debt and half equity would give you a debt/capitalization of 50%. Except in specific cases weʼll be discussing later, your company should not have a ratio of more than 50%. In other words, it should not have—unless there is a compelling reason to make an exception—more debt than equity.

The cash flow of the company after taxes is at least three times the amount of interest it pays.

Strong Cash Flow

When times are tough, the financially strong and financially flexible companies (strong companies have the flexibility to take advantage of opportunities that arise) actually grow stronger. Theyʼre able to buy competitors that falter, choked by excessive financing and inadequate cash flow. Theyʼre able to take market share by beefing up marketing just when their competitors are forced to retrench. They can afford to buy the best talent if thatʼs whatʼs needed. They can develop new products that will make a long-term difference.

Cash flow should be strong enough to fund both dividends and the investment necessary to keep the company growing and lively. Earnings should progress on a steady uptrend—earnings growth need not be fabulous, but it should be at least as great as the dividend growth that you expect. In other words, for our purposes annual earnings growth should be consistent, and it should be in the 5%–10% range, at a minimum.

Dividends are paid from earnings, so you should be sure that dividends are a modest percentage of earnings (this is known as the payout ratio, earnings divided by dividends). The payout ratio should be less than 60%.

Creditworthiness

For our purposes, in the Standard and Poorʼs ranking system, a stock must have a minimum credit rating of BBB+ to qualify. Among bond mavens, thatʼs known as “investment grade,” and weʼd rather be on the next step up in the “A” range.

The greatest credit rating in the world is not going to impress us unless the company is also a dividend-increaser.

Management Quality

Integrity. Does management ever lie?

Performance. How has the company performed in difficult times?

Past is not always prologue, but past performance in difficult times can at least give you some rational indication about how well a company will do in the next difficult period—which is sure to arrive sooner or later.

Periods of weakness give well-managed companies an opportunity to expand—as opposed to companies that go chasing acquisitions merely because their own stock price is high.

Acquisitions. How well does the company absorb and integrate acquisitions? To my mind, this is one of the truest marks of outstanding management. First of all, it is a mark of good management to make acquisitions that can be easily absorbed and integrated. The choice of the target and the price paid are key factors, as well as the culture of the target and its distribution channels. But beware of the mega-deal, the “transformative” acquisition.

Brand Extension. Good managements tend to find ways to extend their brands, their services, their franchise, their strengths.

Franchise. Every company worth investing in has some kind of a franchise or niche.

Quality Business. The nature of the business itself should be good quality, in a market capable of delivering moderate and consistent growth. Avoid fads and “new” goods or services like the plague. Sure, youʼll miss a hot number or two, but new isnʼt what you want in a Single Best Investment.

You want a company that can deliver long-term consistent moderate growth, long-term dividend yields, long-term growth of yield. These characteristics arenʼt apparent in either new companies or companies that are relying on new goods and services.

It sounds like a fatherʼs advice in an old movie: focus on real companies that make real things (or services) that real people need. The sleazier the basic underlying business, the more likely is the investor to wind up slimed.

High Current Yield

One might think that this part of the equation for picking an SBI stock is a no-brainer. However, current dividends have to be weighed against dividend growth to have real meaning.

Low current yield with high growth doesnʼt serve the SBI strategy, nor does a stock with a very high current yield but little or no growth.

Letʼs say you have a Single Best Investment pick that yields 4% today and shows a projected growth of yield at 10%. Compare that to a growth company with a 1% current yield and projected growth of yield at 20%. In three and a half years, the second stock will have a yield on original investment of 2%. In seven years, it will be 4%, in a little more than ten years it will be 8%. But our SBI turtle, with income growing at half the rate, will be at 8% in seven years, and 12% in about ten years.

The first goal for a compounding program ought to be to reach the average annualized return expectable from stock market investing—about 10% per year—from income alone as quickly as possible.

Youʼll get there much more quickly if you start from a higher base level of income than if you only seek the maximum income growth each year.

And, most important of all, if you use mature, financially secure, reliable companies, youʼll insure that you actually get to your goal.

The essence of what weʼre about in this strategy is uncovering the high yielding stocks that arenʼt risky. So thereʼs always a balance to be drawn between high current income and projected growth of income.

High Growth of Yield

How high should dividend growth be? How do you know what it will be? How can you project yield-growth? First of all, you want growth of yield to be as high as you can get it. Bear in mind that very high recent growth of yield in a company doesnʼt necessarily imply future growth of yield at the same level.

In general, you want to see a dividend growth rate that is at least higher than inflation, and with a margin of safety.

So a minimum growth rate for dividends should be about 4% (utilities and others with a higher current yield might be a tad less). But, understanding the dynamics of an equity compounding machine built on high current yield enhanced by high growth of yield, you should really aim for a 10% growth of yield on your portfolio.

If you can get that, your yield will double about every seven years, and so, according to our model, should the price of your stocks.

The need to establish a projection for dividend growth is the best argument for working with mature, reliable companies whoʼve proven their mettle in the past and whose earnings going forward are going to be the most reliable.

The strategy whose outlines weʼve been drawing for identifying Single Best Investment stocks does not require you to be a clever equity analyst. Stocks for projected high total returns merely have to fulfill the three parts of our formula: high quality + high current yield + high growth of yield. As Keats said of the Grecian Urn, thatʼs all we know and all we need to know. The compounding machine that you create, driven slowly but inexorably higher by rising dividends, will bring you solid total returns over time.

Summing Up:

Itʼs a simple formula:

High quality

+ High current yield

+ High growth of yield

= High total returns

1. High quality starts with high financial strength, and the ability and willingness to pay a rising dividend.
2. High quality includes managementʼs honesty and managementʼs ability to face challenges such as tough conditions or acquisitions, as well as to expand their niche.
3. High current dividend yield is always relative, but twice the current market average is a reasonable goal. 150% of the average is the minimum.
4. High growth of yield—income should rise at least as fast as inflation, the faster the better. Past may be prologue for dividend levels, but pro- jected earnings growth must support projected dividend growth. The “simple formula” is going to provide a group of candidates, most of which will prove to be reasonable holdings. In the next chapter weʼll begin to look at some of the traditional tools investors have used to winnow out the biggest winners from the pool of contenders.

Chapter 5 – TRADITIONAL VALUATION TOOLS

Many studies have shown that stocks that are lower-priced based on traditional valuation measures outperform more expensive stocks in the long term.

As many scholars have pointed out, investors appear to overpay for apparently superior growth prospects and underpay for assets.

If investors overpay for growth, they have already discounted that growth in present prices.

Price/Sales Ratio.

Take price per share and divide by sales per share. For example, a company has $40 in sales per share, and the stock sells at $20. The price/sales ratio is .50. If it has $60 in sales, the ratio is 20/60, or .33. If it has $20 in sales, the ratio is 20/20, or 1.0. The idea here is that you are trying to establish value by determining how many dollars of sales you can get for one dollar of share price.

Why is low price/sales a useful figure? The key concept here is that revenues are the raw material of profit. Itʼs true that some businesses have high sales and low margins, always have and always will (grocery stores, for example), but the very first prerequisite for a business is revenues.

When a companyʼs stock sells at a low price/sales ratio, the stock price in effect demonstrates investor pessimism about rising margins. When margins are improved even a bit, the effort goes straight to the bottom line, often surprising investors with the magnitude of earnings gains (earnings which are now available to pay dividend increases, of course!).

Companies with low price/sales ratios are prime targets for acquirers and other improvers of the breed, for obvious reasons.

According to OʼShaunessey, you should look for a price/sales ratio below 1.5. You should also modify this threshold depending on the industry youʼre looking at.

Price/Earnings Ratio.

Divide the price per share by the earnings per share.

What the P/E does is give you an idea of how quickly youʼd get your money back if you owned the entire company, and the cash flow that wasnʼt represented by earnings was needed to run the business.

At 10 P/E youʼd get your money back in ten years if there was no earnings growth. To the extent that there is earnings growth, youʼll get your money back sooner.

Thatʼs why higher growth stocks normally have higher P/Es, even though the level of their growth, or even sometimes the fact of their growth, is often uncertain. Itʼs also why interest rates affect stocks so strongly. The higher the interest rate, the more quickly Iʼll get my money back from bonds with little or no risk of ultimate loss. When the interest rate gets high enough, an investors sees, theoretically, that sheʼll get her money back so quickly from bonds that she doesnʼt want to take the risk of owning stocks.

The P/E ratios that investors “assign” to stocks derive from this “competition” with fixed income and are responsible for the bulk of equity price movements.

P/E is a rather slippery concept, since a P/E is awarded by investors, not earned by the company. It provides a good constant marker for dividing the high volatility stocks from the low volatility stocks—since as a general rule the lower P/E stocks are also the lower volatility stocks.

In practice P/E provides a very good marker for determining which stocks are in favor and which are out of favor.

Interpreting P/Es

Most value experts use P/E as a guide to determining this shunned quality that holds within it the potential for reaping outsized profits when a company comes back into favor. Note that Iʼm not calling the stock “undervalued,” merely out-of-favor.

One thing is certain: it is a lot easier for a stockʼs P/E to go from 10 to 20 than for its earnings to double!

Unless a stock has had an “excusable” year of poor earnings recently, the minimum requirement for a Single Best Investment stock is that it have a P/E of less than the market.

The P/E must be, at a minimum, less than the reciprocal of the long-term bond rate. That is, if the bond rate is 5%, the reciprocal (5% divided into 100%) is 20. The reciprocal of the bond rate is a fair P/E for the stock market when inflation is historically low or moderate.

P/Es on SBI stocks are normally much lower than the market as well as the “fair rate,” since high-yielding stocks normally occupy the lower deciles of the P/E universe. But we need to establish a higher limit (i.e., the market P/E) in case you encounter.

Too, sometimes you can find a P/E thatʼs out of line because the growth or momentum constituency has abandoned a stock with expected high growth—leaving stranded a stock that has evolved into a moderate growth item priced low relative to its real and uninflated prospects. As always, though, the prospects must “come true,” and cheapness is only a quality thatʼs affirmed in hindsight.

P/Es and “Undervalued” Stocks

The best way to determine if a low P/E stock is out of favor is to check its historical relative P/E – relative to the market, and then relative to its own historic premium or discount to the market P/E.

The academic literature does not universally view P/E favorably as a decisive factor among successful stocks.

The real lesson to take away from this, though, is that many so-called experts will use analytic tools to come to a conclusion regarding the value of a stock despite the fact that the effectiveness of the tools is shown to be arguable. No wonder stock prices jump around all the time!

Book Value Theoretically, at least, book value is the rough market value of the companyʼs assets. I like to think of book value as the 5:00 a.m. value; what everythingʼs worth before all the employees arrive and the machines start humming.

In general, the closer a stock price to the companyʼs book value per share the better (though, since we live in the real world which isnʼt always neat, there are certainly some exceptions. Weʼll discuss these later on). Book value is another analytic tools of debatable merit, though there is certainly a rational basis for looking at it and there is a body of academic work supporting at least a moderate level of usefulness.

As with P/E, there are extremes of high value and low value which do have at least some rough meaning, particularly as applied to an individual situation. A company selling at less than book value is selling at less than the value of its tangible assets. Whether itʼs a bargain or not even at that price remains to be seen from looking at the whole picture, but on its face such a company has got to be seen as selling at a “low” value.

The Market/Book Ratio

The in-between realm of market-to-book is harder to pin down. (The ratio is found by dividing market price by book value).

Most studies show that a low market/book valuation is a favorable factor, though how favorable is open to question.

The best approach is to take a kind of real-estate attitude and look for comparables. Look to see whatʼs normal in the industry in question. Look especially at any recent takeovers in the industry. These give you the best sense of all regarding what market/book “should” be, since there was at least one buyer willing to buy the whole caboodle at a given book/market.

In general, we want the market/book ratio to be substantially lower than the average stock, and as close to book as possible. The closer you are to book value, the more “margin of safety,” as Benjamin Graham put it.

Cash Flow and Cash Growth

All too often investors become enamored of the “names” in their portfolio, and forget that the real business of a company is to make money.

The purpose of the company is to “make a profit.” Thatʼs what a company is, when all is said and done. Itʼs a thing that makes a profit, or not. Just as a Single Best Investment stock is a thing that plays a part in an investorʼs compounding machine, or not. In both cases, if itʼs “not,” then the thing will soon be gone.

Most value investors pay more attention to cash flow than to reported earnings. Itʼs a better measure, because the nature of many businesses means that earnings may be relatively small compared to the overall cash generated, and not necessarily due to low margins.

The depreciation charges that reduce cash flow before the earnings number appears donʼt actually cost the company anything today; theyʼre noncash charges. The company is actually “making” all the money it earns, but earnings appear lower due to the depreciation deductions.

OʼShaughnessy also provides the most recent testing of price/cash flow ratios as an investment variable. Results were similar to those with price/sales ratios, though not as strong. Low price/cash ratio stocks far outperformed their high ratio (high-priced) brethren. For reasons unknown, however, he found stocks with a low price/cash flow ratio to be rather more volatile than the average issue.

Cash Growth

My favorite indicator of a healthy and secure mature company is wonderful, in my mind, because itʼs so simple and dumb. Even a kid with a lemonade stand can understand this one.

I want a companyʼs cash and cash equivalents to be higher than last year at this time.

That means, in a manner of speaking, that it has more cash in the bank than it did last year (cash includes stocks, bonds, T-bills, etc.).

How did it get that cash? Plain and simple: by taking in more than it spent.

There are plenty of perfectly good reasons why a company might not show up well on this measure: a capital expansion might be draining cash, or a restructuring, or an acquisition, or a huge marketing push. But thereʼs only one reason why a company will show more cash this year than last (unless it has done a stock offering or sold a substantial asset)—it actually earned the money. In reality, as opposed to “on the books.”

Not only does growth of cash tell you real things about a companyʼs operations, it also gives you material for the dreams an investor dreams.

Cash that builds up often leads to a stock buy-back—which is the next best thing to a dividend increase, because it reduces the number of shares outstanding, thus raising earnings per share, and, once again, the cash per share thatʼs available to pay dividends.

Basically, cash growth is a measure of success, just as you feel more successful in your own life if you have more savings at the end of this year than you did at the end of last year.

A Takeover

When deciding between two Single Best Investment candidates, for example, the features that make a company takeover bait are also normally features which point to more attractive valuation. So this is another “litmus” test that can be used, as long as you donʼt go wild dreaming of deals that no oneʼs thinking of doing or may ever do. Lots of cash thatʼs not put to use relatively quickly might single out a company as a takeover candidate.

When stocks were much cheaper, in the 1970s and 1980s, corporate cash was exactly what the LBO specialists looked for. And when they found it theyʼd just go out and borrow the money to do the deal—since the cash would quickly pay down a good portion of the debt, and the “cash machine” being acquired would take care of the rest.

Insiders Insiders can give you insight into the merits of an investment. There are two aspects to consider: how much of an interest do insiders (management and board members) hold in the companyʼs stock, and what have they been doing with their shares lately?

There are many companies, including many of the largest, in which insiders own a very small percentage of the stock outstanding. Often, less than 5% of shares are held by insiders. This means that the company winds up being run for the benefit of managers rather than shareholders.

Insiders often have proven to be quite “lucky” in timing the buys and sells of their own company stock (using, say, a one-year time horizon). While thereʼs no reason to expect that a corporate insider has any better idea about what the overall market will do than anyone else, extraordinary activity among insiders on the buy or sell side is often associated with subsequent positive or negative company fundamental development.

Summing Up:

The traditional valuation measures which can be helpful are:

1. Price/sales ratio below 1.5.
2. Price/earnings ratio less than the average and less than the reciprocal of the bond interest rate.
3. Price/book value lower than the market, the lower the better.
4. Seek cash greater this year than last year.
5. Takeover possibility—based on financials or strategic fit.
6. Insider activity—increased buying is more important than selling. More relevant to small stocks than large ones.

Chapter 6 – DOES UNDERVALUATION EXIST? THE STORY OF THE STOCK

If thereʼs one universal constant in the market, itʼs the claim of money managers and brokers that they seek only “undervalued” stocks.

What would lead an average individual investor to believe—for that matter what would lead a professional investor with a team of assistants to believe—that the investor can recognize an “undervalued” stock whereas all the rest of the world, all the trillions of dollars of brain and computing power, all the armies of researchers and global profit- seekers, cannot? When you think about it, the view that a particular stock is undervalued can only be seen as sheer arrogance.

Youʼre not alone with your information today. No investor is.

No one knows more than anyone else at this point, save company management.

Investors come to different opinions based on the same set of facts, and the weight of their decisions is what determines the price of a stock.

“Undervaluation” is really, consciously or unconsciously, a code word. Whatʼs really meant is the belief:

1. That the company will do better in the future and investors will re- cognize this through a willingness to pay higher prices in the future for those still-to-come improvements, or
2. That investors are being overly emotional about a companyʼs problems or changes, and over time investors will come to see the errors of their ways, come to see that the company has more power as a business than theyʼd given it credit for and are currently willing to pay for it.

But both these possible beliefs are only beliefs, the truth of which will only be known when times has passed.

“Companies that have done well in the past are likely to do well in the future. Let me try to buy them at a reasonable price, since no oneʼs going to let me walk off with them on the cheap.”

The inarticulate, hidden meaning of “undervalued” is that a stock has a proposed story, and the believer in undervaluation believes that the story will come true. As in the movies, thereʼs not just one story. There are millions of stories, each one a little different, each with different characters and plot twists.

Whatever the story, itʼs always about the future, and the future is always ultimately unknowable. There are only probabilities. And there are factors, influences.

No stock is undervalued today, for today it is “worth” what investors are willing to pay for it, no more and no less.

Will it be worth more tomorrow, a year from now, ten years from now? That depends on whether or not its story comes true.

Look for a Stable Marketplace Looking at the business position of the company—how it fits in the economy of the world, what its role is, what its environment is—we want to see first and foremost that the business of the company involves repeating sales.

The “normal” Single Best Investment stock is not, unless there is some special and unique value consideration, going to be the kind of company that makes washing machines or toys or swimming pools or hammers or sunglasses. It will not be a miner of copper or a producer of movies, not a dress manufacturer, not a lingerie catalog retailer, not a vacation home developer.

It will be companies with a predictable stream of cash flow that has been proven over the years, companies with reliable repeating sales, companies that do not hit a black hole when the economy goes soft.

A Growth Kicker

The growth kicker is built on a solid base of reliable cash flow from the parent, so it has the three things most new businesses lack: management skills, financial resources, and an important first customer—the parent.

Restructuring. There may also be a kicker in a kind of reverse form, when a company restructures to get rid of a money-losing or low-return subsidiary or division.

Consolidation. On the other hand, great “consolidators,” or companies that have been effective at making acquisitions in fragmented industries composed of many smaller competitors, have often achieved their “growth kicker” in this somewhat riskier fashion.

Buybacks. Another “growth kicker” is a stock buyback. When a company buys back, say, 5% of its shares, earnings per share on the remaining shares instantly go up by five percent, as does their equity interest in the companyʼs assets.

A Tailwind. Still another growth kicker occurs when a company happens to have raised its sails just where the wind is blowing. Remember the famous scene in The Graduate where Dustin Hoffman is advised that the key word in his future is “plastics”? The subtext, of course, is that even a passive young man can do well if he gets involved in a business with huge intrinsic growth.

Bargains? Iʼve already made clear, I think, my view of the concept of undervaluation. A stock is always priced at its correct value today, for how can a stock have a value other than what investors are willing to buy and sell it for? But that statement does include situations where investors have become emotional about a stock, or even apathetic about a stock. The story of the stock, in effect, becomes the fact that, in the eyes of an investor, other investors are viewing the stock irrationally.

In the normal course of events, there is no undervaluation, there are only stories which may or may not come true.

For us, a good story means finding solid companies with good yields whose long-term prospects feature moderate reliable growth, growth which will be sufficient to boost the dividend, steadily increasing our current income and thereby creating upward pressure on the price of the stock. Itʼs a boring story, but it works.

Summing Up:

1. Those who assert “undervaluation” are either arrogant or uncom- prehending.
2. Information is everywhere; how could a stock be undervalued?
3. The idea of value is really an idea of narrative, of imagining what will happen in the future, in a story.
4. The story of the stock should include:

a. Reliable and repeating sales with moderate increases.

b. Some kind of growth kicker.

c. Management that has shown concern for shareholder value through its actions (dividend increases, share buybacks). d. A real-world operating environment supportive of the notion that a companyʼs past record of excellence wonʼt be inhibited and will likely be enhanced in the future by visible economic trends. 5. Bargains may sometimes appear under special circumstances, but in general there are only stories with one degree or another of credibility. 6. The “normal” story is that the company has well defined long-term prospects, including the high probability of dividend increases which will eventually boost the value of the stock.

Chapter 7 – CHARTS CAN HELP YOU

A number of academicians undertook studies to show the valuelessness of technical analysis.

Yet, ignored in these proofs was the Nobel prize winning work of Markowitz and Sharpe, which included the “mystery” of stocks with high “alpha”— high returns that could not be explained away merely on grounds that the stocks were more volatile, or that the market was volatile—which was basically the mystery of relative performance.

Despite all the talk of market efficiency and roughly perfect pricing based on available information, certain stocks that exhibited high alpha for one year (high relative strength for one year) tended to outperform the market in the subsequent year.

Since then numerous studies have confirmed the value of excess relative strength as an attractive feature of a stock.

Fundamental Analysis Isnʼt the Last Word

I found the attitude hard to understand, since all investment strategies are ways of quantifying presumed or tested probabilities.

Since all the information about stocks is known to investors (now more than ever), thereʼs little or no real explanation for the fact that prices change—though prices are changing all the time.

It seems to me that if ideas that stocks are always “correctly” priced are going to hold water they have to somehow account for the fact that prices are changing all the time.

Investor feelings are the most underrated factor in determining stock prices, certainly in determining short-term prices. But they are real and present at all times.

Uncovering Investor Sentiment Through Technical Analysis

The premise of technical analysis, the art and science of evaluating price charts, is that the subjective position of investors can be inferred from the manner in which investors are behaving, from the manner in which stocks are trading.

While there is plenty of “noise” or trading that has no special meaning (perhaps most trading is noise), extraordinary trading reflected in price and volume patterns will, according to technical theory, enable you to predict performance—or at least performance relative to the average stock—for the future, and will lead to consequently extraordinary returns.

One thing we knew for certain: stocks exhibit the characteristic of serial autocorrelation. Is that a fancy enough phrase?

Autocorrelation—a thing is similar to itself.

Serial—having the quality of existing in a series or repeating pattern.

Translation: there are trends. Prices of individual stocks and the market clearly go in trends of three to eight months before reversing, we found, and individual stocks show similar patterns relative to the market average, over- or underperforming for three- to eight- months at a stretch.

If we were right about serial auto- correlation, and if the Modern Portfolio Theorists were correct that “alpha” (another way of stating relative strength) persisted for more than one year, then it might be possible to identify, at any given point in time, a universe of stocks most likely to outperform on purely technical grounds.

What we found, more than four trillion calculations and many months of processing time later, was that when you tested the known technical approaches carefully by computer, requiring the computer to make buys and sells each and every time the requirements of a signal were fulfilled, there was very little that offered promise of outperforming the market—and we could find no strategy or signal which actually did outperform.

We tried again, this time attempting to employ a principle that had become a staple in software development at IBM: information is more valuable when it is reinforced by the same conclusion emerging from different algorithms. With our usual penchant for grandiose jargon, we coined the phrase “multiple simultaneity” to describe the moment we were seeking, the moment in which multiple signals all come to the same conclusion and all arrive at the same time.

The Best Chart Patterns

Charts help, but theyʼre only one more tool: useful when employed as part of an array of analytic tools which include, primarily, fundamental factors affecting each individual stock.

The key item is not breakouts or moving average crossings or penetrations or support or resistance or cycles or any of the other terms technical analysts are wont to sling about.

The key item is relative strength.

Relative strength is, simply, how a stock has performed relative to the overall market (or any relevant index). It is calculated by dividing the price of a stock each day by the price of the index on that day.

When companies are doing the right things and/or conditions in the market are right for them, investors tend to move in their direction, generating higher relative strength.

Pay less attention to actual price change in a stock and more attention to relative strength.

Six-Month Relative Weakness

One of the most intriguing things we found in our testing is that among the most powerful predictors for future price performance is at least six months of relative weakness, followed by a notable increase in relative strength.

This is especially useful for our purposes, since as a stock goes down, its current yield, based on the dividend, increases.

Buying stocks after a period of relative weakness has apparently ended gives you a much higher probability of superior future performance. But what does “apparently ended” mean? There are a variety of patterns that can indicate the termination of relative weakness; the easiest and simplest for most investors to use is a conventional trend line break.

A trend is first defined as a series (thereʼs that word again!) of declining highs. It is broken when the most recent high is surpassed.

While the “formula” of requiring at least six months of underperformance coupled with a present indication of higher relative strength is the single most preferred pattern for buying the kind of stock weʼre after, reality is not always so neat that it will present you with ideal situations just when youʼre ready to invest.

When All Is in Concert

Bearing in mind that the fundamental formula of high quality, high current yield, and high growth of yield, is far more important than any technical pattern could ever be, and that technical “maps” are useful but not near as useful as a well-tuned analytic brain, the other type of pattern to look for when buying SBI stocks is one in which everything is in concert.

Short term price trends should be moving higher, short term moving averages should be moving higher, longer-term prices trends should be rising, longer-term moving averages should be rising, and both short- and long-term relative strength should show an upward push.

The trends should be mild, not sharp.

Quality is always a bargain.

Better to attach yourself to a quality company in mid-move than to fret over whether or not you paid the lowest price in the history of the world.

Do the two kinds of technical patterns to favor seem to contradict each other?

The first, recall, seeks a stock that has been in a general long-term up trend (which is nearly always going to be the case with our high-quality universe) but has recently suffered from a relative price decline (for whatever reason) before beginning to show strength again.

The second requires no prior decline at all.

But if you are faced with a market thatʼs been rising for a year, or a yearlong strong market for the kinds of stocks we buy, and you have money that needs to be invested, you wonʼt find the ideal technical pattern, and you need a pattern that works under the conditions presented.

The Selling Climax

Hereʼs another technical moment that we found to be of statistical value, and itʼs of particular interest to purchasers of Single Best Investment stocks.

We found that volume of trading—a key ingredient in many a technicianʼs arsenal of techniques—had almost no value in predicting future price change. But there was one key exception, and it is known as the “selling climax.”

Like an earthquake, there can sometimes be minor aftershocks, but, nearly all the time, the volume climax marks a bottom. You need to watch a stock for a bit and not go diving into the turbulence to buy (thereʼs usually ample time before it starts back up again); still, the selling climax marks the entrance of a stock onto your list of buy candidates.

Where the stock fits our criteria on all other grounds—high quality, high current yield, high growth of yield—the selling climax indicates a draining of risk. And, since the yield increases for a stock as the price declines, selling climaxes often point out yield peaks in high-dividend-paying stocks.

Not every selling climax will have a happy ending. But the rewards are great enough to absorb some losers in the process. Certainly, when earnings and dividends are unharmed by whatever history is unfolding, SBI investors want to get very interested. Even when there are real troubles, however, selling climax stocks are worth a look if the company has had a long history and if it has a franchise of some kind, a business position difficult to re-create. If it was once an SBI with “all in concert,” the question becomes: can it become so once again? Position yourself three or five years hence, looking back on todayʼs events. Will they pass?

Look for the Turn

Technical analysis is most useful as a timing tool—and it is never more than a timing tool—in helping you to identify “the turn.”

No matter how short or how long a time frame you are using when looking at charts, always try to buy when the price turns up. Remember, stocks exhibit the characteristic of “serial autocorrelation.” They go in trends.

When the trend has been against the stock, use technical analysis to see when it might have changed in favor of the stock. If you donʼt see a turn, donʼt buy.

Whether youʼre looking for a long-term bottom or a short-term entry point, as the old saying goes, “let someone elseʼs money make the bottom.”

This couldnʼt be more apt when dealing with SBI stocks. After all, youʼre going to be involved with each investment for a long, long, time. Why not be patient enough to wait for the best, or at least the better, moment to begin your relationship?

Technicals for Selling

First, the statistical profile of comparable signals for selling, as opposed to buying, is not a mirror image. The selling signals arenʼt nearly as accurate in terms of predicting direction or magnitude of a trend move. Second, and more important, we donʼt want to sell these stocks, weʼre not seeking to sell these stocks.

Whereas the technical picture may be helpful in delaying a buy decision on a candidate stock, or speeding up a decision to buy, once weʼre “in” we donʼt really own a stock any more—we own a part of a compounding machine.

Summing Up:

1. Many reject technical analysis, but both academic and practical quantitative studies indicate it can be helpful.
2. The most important single factor is relative strength, the performance of an issue relative to a benchmark such as the market, or its industry group.
3. You should see short-term relative strength, but a prior period of relative weakness is not only acceptable, it is a plus.
4. Examine massive selling to determine if a “climax” has occurred.
5. Let there be a turn. Let the stock show at least some hints of good near- term performance before buying.
6. Technicals arenʼt so well adapted for selling, especially in the case of stocks that you intend to hold many years. Selling a stock based on a chart is hardly the same thing as choosing a stock from a list of qualifying candidates because its technicals cause the stock to stand out from the pack.

Chapter 8 – A GALLERY OF SINGLE BEST INVESTMENT STOCKS

Primary goal is to function without the influence of another partyʼs criteria. So if you use the data from this or another service, try to ignore their evaluations.

If you hold a stock and the market gets scary, or the price softens up a bit, all you need to do is view the historic data array, roll over, and go back to sleep.

Noted investor Warren Buffet often appears to think that “franchise,” the monopolistic characteristics that accrue from geographic advantage, or brand name, or industry dominance, is an investment variable which can almost determine the appeal of an investment all by itself.

We need more, we need dividends and dividend growth to create our compounding machine, but a great “franchise” can be a thing of investment beauty—and it can definitely help ensure the durability of the machine.

Investors should take note when a stock with the wind to its back—in the form of great demographics—makes substantial increases in dividends.

Not every stock can be among the highest yielding companies. Sometimes you have to pay up for a company that is simply a juggernaut in its field, and whose financial and operational safety is so strong that a lower current yield is acceptable—especially if you believe you can count on a rising yield during the term of your holding.

As I write the market is rather richly valued. Iʼd pay more heed now to high current yield with a bit of modest growth—since a high yield can provide a cushion against downside volatility—than to any promises of great future growth.

At a time when the market has been in a tailspin, however, one might want to pay more attention to stocks that have continued to grow well as companies, despite a falling stock price.

Chapter 9 – HOW TO HOLD AND WHEN TO SELL: ATTITUDE IS EVERYTHING

Long-term investing is about character, about depth of vision and the cultivation of patience, about who you are and who youʼve made yourself to be.

For all good things come from having the vision to see how a companyʼs story will unfold in the future, having the patience to let it unfold, having the generosity of spirit to have faith in management to do the job for you, the passive investor.

Having the good sense to understand that you are a passive investor, an investor in a company with factories or facilities, workers, decision makers, financiers, other shareholders—an investor in all this, not an investor in a name with a number that bounces up and down in the newspaper each day.

The Single Best Investment strategy is an antidote. For what ails investors is not so much a lack of the necessary intelligence to identify a company that might do well in the future (although I must confess that the majority of stocks often make me wonder, who owns this junk?), but an inability to see the far horizon of compounded growth, and a consequent inability to have a really comfortable and satisfying relationship with a particular investment.

Too Many Stimuli

The emotional odds are stacked against the shareholder. There are constant voices attempting to seduce you from your path and take you onto another. There is the voice of insecurity about your view of the long-term strategy of a company.

The emotions of a holder can be your undoing. The rules for picking a Single Best Investment stock arenʼt that hard. Whatʼs hard is keeping your mind on your wife when youʼre a judge at the Miss Universe pageant.

Easy In, Easy Out

But the worst thing isnʼt just the ecosystem of information, opinion, and the Three Sirens (greed, fear, conformity) that constitute our environment.

The worst thing is the almost infinite liquidity of the market, and constant transparency of prices.

The fabulous liquidity of our markets means you can get in or out of a stock in literally thirty seconds. It becomes terribly easy to act on a passing emotion or an incorrect and hasty reaction to a piece of corporate news.

Imagine if divorce just required filling out a two-line form and dropping it off at Town Hall. How many intact marriages do you think weʼd have? Imagine if selling a house was as easy as selling a thousand shares of Microsoft. Wouldnʼt houses turn over much faster?

Liquidity permits you to float, unfocused, like a cork among the lily pads, tossing this way and that with every passing breeze. It focuses your mind on the possible—since, after all, with total liquidity any move is possible to make—and distracts you from the disciplined commitment youʼve made to the principal of compounding.

To Have and to Hold

The hard part in investing is holding, and learning to tolerate the myriad and relentless swings of greed and fear to which an investment holder is inevitably subject.

And your ultimate goals are simple, as weʼve defined them many times in this book: to get an excellent return on your invested capital with as little anxiety as possible by making maximum use of the principal of compounding, and by investing in stocks whose chief appeal is as vehicles in a compounding process, or “parts” of a compounding machine.

Holding successfully requires a kind of spartan attitude, a kind of warrior attitude, in which you hold your ground, never tromping away, through thick and thin, through storms and sun, never becoming excessively excited or happy by profitable rallies, never sinking into gloom or depression or second thoughts when prices are on the wane.

As a warrior you understand that there are many ways to win the battle of investing, there are many ways to come out on top in the end. But some ways are wiser than others, designed to maintain sanity in a chaotic world.

The warrior attitude says: this is my strategy. It is a good one. It will work. I will not deviate from it no matter what the seeming success in the moment of some other strategy or approach. I will see to the other side; I will recognize that the candle which burns the brightest also burns away the quickest.

Over and over he remembers: “rising income will ultimately produce rising prices commensurate with the rising income. If the income doubles, the stock will double. Often it will more than double, as the stock comes back into investorsʼ favor. But logic says it will double at least.. Even if a stockʼs price were to remain unchanged for decades, the rising income would ultimately give me annual returns from income alone that are higher than the historic average returns expectable from the stock indices.”

Itʼs the logic of compounding and the unfolding of history thatʼs your “bet” when you invest in high-quality high-yield high-growth-of-yield stocks. Itʼs time that youʼre investing in, really, time and the notion that over time the economy and the companies that serve the economy will grow at least modestly.

Even the famous speculator Jesse Livermore said, “I made all my money from sitting.” How does Warren Buffet make his money? “While Iʼm snoring,” he says.

The Right Way to Monitor Your Stocks

Focus on your compounding machine, not the constantly fluctuating prices of things.

Your job as a holder is to monitor your positions quarterly to determine whether each stock is performing its function as a part in a compounding machine.

Youʼll want to look at the companyʼs quarterly reports for this. Youʼll want to see that earnings are roughly whatʼs necessary for the company to both pay the current dividend and to increase it when appropriate.

Youʼll want to see that revenues are rising.

If the “story” was steady growth based on good demographic trends, be sure you see that growth is present, and not a perpetual promise for the future. If the story involved an exciting diversification built on top of good cash flow, make sure that both elements are showing progress. Did the company miss analystsʼ earnings targets by a penny or two? Forget about it. The analystsʼ projections are notoriously unstable and inaccurate.

Dividends: Always the Key

However, as a holder you do need to be especially alert to the state of the dividend. As you surely know by now, we consider the dividend to be the litmus test for a dividend-paying company. It is like a cardiogram image of the heartbeat, or breath on the mirror.

We donʼt care if its chairman makes the cover of Time, or if management gets the national Award of Excellence, or if company headquarters are designed by the worldʼs greatest architect or a local building contractor (actually, the latter is to be favored in most cases). What we care about is that the company can participate as a “part” in a portfolio that is a long-term compounding machine. We never want to take our eyes off that one-and-only concept.

There are three questions regarding the dividend:

1. Is the dividend in jeopardy? This is basically the payout ratio question.
2. Has the company changed its dividend policy? Most companies maintain a policy of paying out, say, 30% or 40% of earnings in dividends.
3. Has the company failed to raise its dividend for one year? Sometimes, as noted above, thereʼs an excuse. It might be a capital construction. Generally, we will not hold a stock more than two years without a dividend increase, unless there are clear and articulated mitigating circumstances.
4. Has the company cut its dividend? Dividend cuts are the kiss of death for stock pricing generally, and are a direct contradiction of the principles that guide a Single Best Investment portfolio generally. You should really never get to the point where your stock cuts the dividend by surprise (rising payout ratios, falling earnings accompanied by falling revenues, company statements, all should key you in to the possibility of a cut long before it happens). If the dividend is a flag signaling company health, a cut is a flag at half-mast.

Youʼre a passive investor. When all is going as you planned it, above all, stay passive! If the dividend is at risk, or it doesnʼt grow and thereʼs no excuse, then you may make use of that infinite liquidity in our markets, pick up the phone, and sell.

Other Reasons to Sell, All or Part

The only other time to sell would be when a stock spikes upward in price— perhaps on takeover rumors—to the point where its current yield is small in relation to other available stocks. Sophisticated investors may want to consider selling when a stock gets “ahead of itself,” but this is a tricky area indeed. How high is too high for a great company over the long term.

Consider a partial sale if your stock gets out of hand, bringing it back down to an equal dollar weight with your other stocks. What if you find an overwhelmingly fine qualifying candidate that you donʼt own. That might be a reason sell all or part of a holding, to raise cash for the purchase. But, basically, the goal of this program is to try to hold your stocks indefinitely. These are not stocks that are bought to be sold.

Summing Up:

1. The strategy provides a framework, but true success depends upon maintaining a calm and passive attitude.
2. Emotions and unnecessary decisions are the undoing of most investors.
3. Liquidity, which enables you to make instant decisions, can be a threat to your circumspection.
4. Hold your stocks with a cold, objective eye, an eye fixed on the far horizon.
5. Hold as you would hold real estate.
6. Sell if it appears the dividend may not be increased, or if too much time passes without an increase and thereʼs no legitimate excuse for a failure to increase.

Chapter 10 – BUILDING YOUR PORTFOLIO

In a way, knowing which SBI stocks we want to buy and hold is just an intermediate step. The next step, and one thatʼs as important as knowing what stocks to buy, is understanding how to put them together.

Asset Allocation

Itʼs two words, actually, but two words typically spoken as one and with a reverence seen otherwise only in discussions of utmost theological urgency: “asset allocation.”

One of the things that really undermines the concept here is that most asset allocators include fixed income as an asset class—presumably, the fact that it exists means it should be included.

You donʼt make any money in bonds, and in many if not most periods your returns are actually negative after adjusting for inflation. Unless the world turns upside down in the next fifty years and all becomes its opposite, you should not have any bonds in your portfolio.

The SBI portfolio can do everything that a full-blown asset allocation portfolio can do, and it can do it all in one portfolio.

To the extent that you include fixed income, you are almost guaranteeing that the portfolio will underperform the market over the long term, because the long-term returns from fixed income are so far below those of equities.

Bonds are still a bit less volatile than stocks, but not by much. And their returns are impoverished relative to stocks. Too, most people ignore the fact that the most normal state of affairs in the markets is for bonds and stocks to be moving higher or lower in tandem.

How Many Stocks? In our portfolios for individuals and institutions we tend to carry thirty to forty stocks (except for one high-income strategy). That may be a large number for an individual investor to both identify and track, though itʼs about the smallest number of stocks that Iʼm personally comfortable with in terms of a portfolio thatʼs not going to fluctuate as much as the overall market.

The rule on this is simple, and itʼs the rule that underlies Modern Portfolio Theory: the fewer stocks you have the more likely you are to experience greater volatility than the market, and the more stocks you have the less likely you are to experience greater volatility.

Since smaller stocks tend to be more volatile, youʼll need more than thirty stocks in a portfolio to approximate market volatility, unless the stocks you choose tend to be individually less volatile, which is the case with SBI stocks.

If you want to hold a smaller portfolio but you still want to have volatility thatʼs less than the market, the stocks you hold in a smaller portfolio need to be less volatile and more conservative than the average of all the stocks in the index. The smaller your portfolio, the more conservative should your stocks be, if you want to maintain low volatility.

Fifteen to twenty carefully chosen stocks will probably provide enough diversification to achieve the goals of an SBI strategy.

Weighting

Weʼve found that equal dollar weighting is the appropriate way to run a portfolio, no matter how many stocks are held. If you want to hold fifty stocks, each will be weighted at 2% of the total dollars.

What About Cash?

“Full investment” (more than 90% of the portfolio) should be the policy of your portfolio.

Partners are partners, like mates in a marriage. To get the full benefit of the intimacy, wisdom, and depth that the years bring, the partners have to stay together. Obviously, in the investment world polygamy is both acceptable and beneficial, but to each mate you must make a real commitment if you want to see the good things that time, and only time, can bring.

What About Higher Income? Thereʼs a saying in the investment world that may likely be as old as civilization itself: “thereʼs room in business for bulls and bears, but hogs eventually get slaughtered.” The investor commonly known as a “yield hog” typically comes to a bad end.

The construction of a portfolio involves a constant interplay between the need for yield (or the security that yield provides) and the need for inflation-beating appreciation. In most cases thereʼs a “trade-off” between yield and growth.

You do not use stocks with a yield thatʼs close to the market or only, say, twice the market, even though they may exhibit great valuation extras and strong dividend growth. You stick with the highest yielding elements that also qualify as high quality stocks with dividend growth.

You need to bear in mind that stocks with high yields are often out of favor and better valued than others.

Remember the principle: higher income generally means less risk and less total return. Lower income generally means greater growth but also greater uncertainty.

The bottom line is that your tilt on an SBI portfolio is an analogue to a conventional asset allocation, without the “flaw” of fixed income. Your stocks in the conventional “stock” portion are basically yield-oriented value stocks with perhaps a few beaten-down but still high-quality growth issues, and include small-cap and foreign items.

Instead of fixed income you use the higher-yield breed of SBI stocks. The more income you want, or the safer you want to be, the more of this latter type you use. Itʼs that simple.

The following paragraph appeared in the first edition of this book (1999). For obvious reasons, Iʼve left it in: As I write, the overall stock market is at valuation levels among the highest ever seen. Investors believe this can last forever, just as Japanese investors believed in the 1980s. I doubt that it can— though no one ever really knows for sure. If you share that doubt youʼll take the high yield road for now, possibly adding in more growth potential at some point when the market has declined and values are more reasonable. In any event, the likelihood of higher- yielding stocks outperforming lower-yielding stocks is higher when the market is more risky and vulnerable, as it is today.

Summing Up:

1. A Single Best Investment portfolio is intended to replace a balanced or asset allocation portfolio, and shows nearly identical risk characteristics—but without the performance drag of fixed income.
2. Diversify among as many sectors and industries as you can, as long as each stock qualifies under the rules.
3. Try to include at least thirty positions. There is some academic and real world evidence that half that many may be acceptable.
4. All positions should be at equal dollar weighting.
5. You can tilt the portfolio toward higher current income depending on your needs. You may give up some capital appreciation, but in many markets you will not.

Chapter 11 – “THE RULES”

There are only twelve rules to follow in buying and holding a Single Best Investment stock.

For all but the most sophisticated investors the rules should be seen as rules, not guidelines. If a stock doesnʼt fit for some reason, go find another one that does. Thatʼs one of the grand things about the markets—if the shoe doesnʼt fit . . . thereʼs always another shoe.

The Rules

1. The company must be financially strong. A quick rule of thumb is that it must rate at least B+ on the Value Line stock ranking system, or BBB+ in the Standard and Poorʼs credit ranking system.
2. The company must offer a relatively high current yield. The yield should be at least 150% of the current average yield of the S&P 500, and higher is better if all other criteria are met. We prefer yields that are double the average of the broad market, or better.
3. The yield must be expected to grow substantially in the future. Various data services including Value Line offer expected dividend growth rates. The expected dividend growth rate should normally be lower than or equal to the expected earnings growth rate. The higher the expected dividend growth the better, but it should be at least 5% to assure growth in excess of inflation. The dividend payout ratio should be less than 50% (except utilities and REITs and limited partnerships). The past dividend growth rate canʼt be mindlessly extrapolated into the future, though it can provide a guide to the attitude of the company.
4. The company should offer at least moderate consistent historic and prospective earnings growth. Earnings growth in the range of 5%–10% is sustainable for a large number of companies.
5. Management must be excellent. A long record of success is one mark of good management. Expansion during poor economic or industry periods is a plus. Ownership of shares by management— at least one yearʼs salary worth of shares for each top officer—is another plus. Seek management whose public statements have proven factual. New management in a “slow” company can be a major attraction—but investigate new managementʼs past record.
6. Give weight to valuation measures. Price/sales ratio should be less than 1.5, and ideally less than 1.0. P/E and Book Value ratios should be less than market. Growth of cash is a big plus.
7. Consider the “story.” Number one or number two market share in the companyʼs industry is a positive. Restructurings are normally a positive. A price decline after an announcement to acquire another company is generally a positive, if the acquisition is not monumen- tally large. A tailwind in the form of substantial industry growth or favorable demographics is a positive. There should always be a “growth kicker” if possible, built on a structure of reliable cash flow. Favor companies with repeating sales. Consider price trends of relevant commodities.
8. Use charts to help your buying. Thereʼs much thatʼs useless in technical analysis, but evaluating relative strength is useful. Prior six months of underperformance followed by notably rising relative strength is a positive. A high volume selling climax is a positive. In the short term, “look for the turn.” Technicals arenʼt too useful for selling, but can help you sort from among candidates to buy and help in trimming your position.
9. Picture the future. Does the company provide a necessity of life, and execute well? Is it likely to continue to be needed in society twenty or forty years from now? Has it defeated challengers to its market in the past? Are margins improving? Is the size of its market growing? Does it dominate?
10. Hold with equanimity. Successful investing is about the cultivation of rational patience. Focus on the unfolding story, not quarterly earnings reports or brokerage recommendations. Keep your eyes on the far horizon of compounded growth and rising income. Avoid checking prices too often. Do everything possible to immunize yourself against “holding anxiety.” Consider taking a long trip to a faraway land.
11. Sell when the dividend is in jeopardy, when the dividend has not been increased in the past twelve months without an excuse, or when the “story” has changed.
12. Diversify among many stocks that qualify as Single Best Investment stocks. If your account is large enough, use about thirty stocks, with equal dollar amounts in each stock. To the extent that you use fewer stocks, each should be among the most conservative in the universe. The highest income stocks can still provide outstanding appreciation and total return.

Choose the Obvious Stock

All the statements below (except the last one) should continue to be true as long as you hold the stock, and you need not sell as long as they remain descriptive of your investment:

The stock has a high credit rating. The dividend is high compared to other stocks. The dividend has recently been increased. The company has reliable earnings from repeating sales and it serves a proven marketplace. Earnings are expected to rise in coming years. Margins and other financial performance measures are increasing. Management has proven itself in good times, and never been revealed to be dishonest. The company has dominance in its industry or in its geographic area. There is some kind of growth “kicker”; a new product, an acquisition, demographic trends, takeover potential—atop the base of solid cash flow. The stock fits within standard valuation measures, and may also offer some valuation “extras.” Relative strength is rising in an orderly manner, ideally emerging from a prior period of relative weakness.

Appendix A – PERFORMANCE: ACADEMIC STUDIES, HISTORICAL BACKTESTS, AND REAL-TIME PERFORMANCE

In one of a well-known series of articles in the Journal of Finance (6/92), professors Fama and French concluded that “firms that the market judges to have poor prospects, signaled by low stock prices and low price/book ratios, have higher expected stock returns . . . than firms with strong prospects.”

As Lakonishok, Shleifer, and Vishny put it, also in the Journal of Finance (12/94), “value strategies yield higher returns because these strategies exploit the suboptimal behavior of the typical investor and not because these strategies are fundamentally riskier.

Lakonishok showed that under “laboratory” conditions (no real-time market decisions to make, no TV shows to watch or magazines or read) stocks with a low book value/market value ratio (value stocks) outperformed stocks with a high book/market by 19.8% versus 9.3%. Stocks with high cash flow per share returned 20.1%, while stocks with low cash flow per share returned 9.1%. Low P/E stocks beat high P/E stocks 19.0% to 11.4%.

As the authors put it, “A test of the extrapolation model (expectational errors made by investors) showed that while value stocks have much higher dividends and better fundamental ratios to price, investors still prefer glamour stocks due to unreasonably optimistic views on the future growth of glamour stocks. Investorsʼ mistakes are often confirmed in the short run but then disconfirmed in the longer run.”

During the test period value consistently outperformed glamour in the strategies, with value stocks improving with longer time horizons (value outperformed glamour over every five-year time period). In plain English, the tortoise beats the hare. This is not some moral value that academics would like the peasants to hold. This is the factual result

Yield Stocks

Recall the startling numbers from Ibbotson cited in Chapter 3 regarding the impact of dividends and their reinvestment: $1 invested in stocks in 1926 grew to $76.07, while $1 with dividends reinvested grew to $1,828.33.

OʼShaunesseyʼs studies published in What Works on Wall Street (McGraw- Hill, 1996) update and confirm the earlier academic work. “Itʼs impossible to monkey with a dividend yield,” he notes, “since a company must pay, defer, or cancel it.” The author found that high yield was a much more effective factor in stock price performance when what he calls “large” stocks are studied. Among large stocks, he found that the highest yielding stocks outperformed the overall universe 91% of the time over all rolling ten-year periods. He also found that when other criteria such as excellent (low) price/sales ratios and price/cashflow ratios and high liquidity are included, “large stocks with high dividend yields offer the best risk-adjusted returns available.”

Interestingly, OʼShaughnessyʼs yield strategy showed a maximum loss that was only half the worst loss of the overall universe (a large group whose diversity “should” have mitigated risk).

Dividend Growth

Brush and Spare found that there was a direct performance correlation for yield-change: “the first deciles of yield-change models . . . are more successful than lower-ranked deciles in identifying positive excess return stocks . . . . In general, increasing the holding period, or increasing the change interval [time used to measure changes in yield] leads to improved first decile returns.” “This result,” they noted, “is surprising in several respects. First, it is unusual to find a strategy that, even with zero transaction costs, shows increasing excess annualized returns as the holding periods get longer. Second, longer change intervals show higher excess returns than shorter intervals up to a surprising four or five years.” In plain English, this latter statement means that the longer and stronger a companyʼs dividend record, the more likely it is to provide excess returns in the future.

Next Brush and Spare combined current dividend yield with dividend yield change, which is the essential step in the Single Best Investment strategy. They concluded, “Holding stocks in the second, third, and fourth deciles as measured by current dividend yield, which are simultaneously in the first decile of four-year yield change [change over the past four years] for the next three years [holding period of three years], generates more excess return” than either yield or yield-change alone. When the authors combined some standard fundamental factors of the sort that weʼve reviewed earlier in the book, they found that “A range of combinations of fundamentals with four-year dividend change shows that long-term dividend-yield improvement used in low-turnover strategies does indeed reduce volatility, apparently faster than excess return drops.” “We conclude that dividend change, appropriately measured, does serve as an independent measure of value, providing information not found in the six [fundamental factors used in the Combo model]. The main contribution of dividend change is a marked reduction in volatility of return.”

Dividend Increase as a Signal

Denis, Denis, and Sarin sought to examine the information content of dividend changes; what do dividend changes tell you about a company? They sought to find an appropriate explanation for the well-documented association between dividend change announcements and stock price changes. The authors found that changes in dividends proved to be intended or unintended signaling by management regarding cash flows at the company.

Companies that increase their dividends are more likely to increase their reinvestment in the business, and companies that decrease their dividends are more likely to reduce capital expenditures. The conclusion is inescapable: companies that increase their dividends are companies that are making money—enough to run a thriving business and enough to share with stockholders in the here and now as well.

In any event, you donʼt have to be a professor of finance to know that if a company increases its dividend, management is saying good things about the future.

Appendix B – THE CATEGORIES OF SINGLE BEST INVESTMENT STOCKS

Utilities

In the utility sector, then, look for the following:

1. Bond credit rating at least BBB.
2. Five-year dividend growth in top two deciles of utility universe.
3. Projected five-year dividend growth and earnings in top decile of utilities.
4. Payout ratio under 70%.
5. A growth “kicker” in the form of sensible diversification or excellent growth demographics in the geographic area served.
6. Good management as demonstrated by a low cost of production and proven successful diversification ventures.

Real Estate Investment Trusts (REITs)

Hereʼs what to look for in a REIT:

1. The stock price should not be much higher than the net asset value of the properties the REIT owns. If it has ten dollars in real estate per share, the stock price shouldnʼt be much higher than ten dollars. Obviously, if the stock price is lower than the real estate owned per share itʼs a plus, since the company may well be a takeover candidate. A price slightly higher than real estate owned per share isnʼt terrible: one can make an argument that investors should be willing to pay extra for good management and good prospects as well as the liquidity REIT ownership makes possible in real estate.
2. The local economy should be in good shape. You donʼt have to be a financial genius to know that real estate tends to rise in value when the economy is strong, and rents remain buoyant. Of course everyone else in the world knows which local or regional economies have been strong as well, so you may find better buys in areas that have been depressed but are beginning to recover. In such areas youʼll often find the added bonus of little new construction in progress, meaning less competition for the space thatʼs available.
3. Debt should not be more than 30% of total capital. This is a fairly conservative level for a real estate operation, but conservative is where we want to be. The last thing you want to own is property whose income canʼt cover its debt obligations, and the same is true of a REIT.
4. Seek a moderate multiplier of FFO. FFO is an acronym for “funds from operations,” and it is the appropriate way of looking at a REITʼs cash flow; itʼs the equivalent of earnings for an industrial company. Earnings arenʼt really a fair measure here, since so much income is offset by depreciation in real estate. Generally, ten or eleven times current FFO is a reasonable price for an average REIT, twelve or thirteen times for a rapidly growing REIT.
5. Yield should be middle of the road or even on the low side for the REIT universe. While very high yields are often available, thereʼs less likely to be an element of growth present when the yield is substantially higher than average.
6. Seek growth in both FFO and yield. REITs can offer some of the highest dividend growth prospects in the entire equity universe, and can be among the most important parts for your compounding machine. Donʼt buy just for yield, then, but for growth of yield. In my view, REITs are typically undervalued based on potential dividend growth, though not necessarily on other factors. Conveniently, this is the factor weʼre most interested in.
7. Make sure there is substantial ownership of shares by management.

Banks

In the banking universe, look for a return on equity better than 12.0, a return on assets in excess of .8, and a declining level of bad debt reserves (you can be sure the market will have priced in a given level of bad debts, but it may not have priced in improvement in this measure, as investors often turn elsewhere when a bank is having troubles). The most important factor, in this area of many investment possibilities, is improvement. This will be revealed in improving numbers on various measures, but, most of all, it will be revealed in rising dividends.

The mere fact that a bank has diversified isnʼt enough. Like utilities, many banks have built management staffs that are better suited to postal work than finance. So make them prove their mettle in the marketplace.

Bad Odours

Here are some features that should cross a stock off your candidate list or should provoke serious thought about selling if you hold it:

• Quarrels with the company auditor, or firing the auditor during a time of controversy over earnings.
• Federal investigations.
• Questions by anyone in an official capacity regarding the timing of recording revenues and expenses.
• Successful and legal sales by insiders just prior to announcements of bad news or earnings shortfalls (itʼs never too late to flee a sinking ship).
• Great sales of a new product at the wholesale level, but with questionable sell-through at retail.
• Claims of mineral or energy resources unverified by objective third parties.
• Breech of loan covenants (this should never happen in your portfolio, since we screen out companies with high debt loads).
• Changes in governmental rules or programs from which the company has previously benefited.
• Profits that are highly correlated with changes in currency values.
• Dividend yields that are just too high, compared to other companies in the industry and the companyʼs earnings.

Earnings that rise when revenues are not (assuming that the company has not sold or closed divisions).

A FINAL WORD: THE HUMAN FACE OF DIVIDENDS

While most observers consider dividend changes to be an information cue about the future prospects of a company, Koch and Sun take a different tack, one which is quite timely in this age of a general culinary approach to corporate bookkeeping (most recently it has turned out that Fannie Mae was lying all along). Rather than focus on dividend increases as a message from management about the future (Healy and Palepu, 1988), they have determined that dividend changes are a kind of certification of previously reported earnings changes—just as valuable for investors, though the focus is more on the past than the future. Dividends become a tool for investors to determine the persistence of earnings changes, which is, said differently, all about the credibility of past reporting.

To quote their abstract, “We examine whether the market interprets changes in dividends as a signal about the persistence of past earnings changes. Prior to observing this signal, investors may believe that past earnings changes are not necessarily indicative of future earnings levels. . . . Results confirm the hypothesis that changes in dividends cause investors to revise their expectations about the persistence of past earnings changes. This effect varies predictably with the magnitude of the dividend change and the sign of the past earnings change.” In other words, the authors are suggesting, and we agree, that investors are in a perpetual state of anxiety about the reliability of the information theyʼve already received from management, and that when a dividend change confirms earlier reports investors are willing to reduce the necessary skepticism that is always a conscious or unconscious factor in their valuation equation.

To bring this down to earth, which we find necessary after parsing the authorsʼ formulas (which often run a full two lines including much decoration with Greek letters in a simulacrum of algebra), if youʼre getting cash that means the company actually made the cash. Whether you as an investor look at it as a certification of the past or a message about the future isnʼt that important. What matters is that youʼve been given some proof of the “statements,” and though there have been a few scam dividends in the past, handing out cash isnʼt usually the way crooked or self-serving managers operate.

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