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Rational Investing

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by Clark Davis

Befuddled by the market's near parabolic rise? Wondering if and when it will correct? Welcome to the club.

I continue to be amazed at the strength of the markets. It reminds me that we must be mindful of the distinction between investors' markets and buyers' markets. And that some of our old, favorite anecdotal indicators bear revisiting.

First, the buyer vs. investor differentiation.

Whether in the stock market or in the normal course of business and family life, a buyer buys because he wants to own something. Oftentimes price is not a consideration and imaginative rationalizing can take place. (Men, especially young men, are particularly good at this when it comes to cars and hobbies. I know I was when I was much younger.)

Investors, on the other hand, acquire assets because of their value, and are disciplined to measure value in terms of certain guidelines. If the price is above the value they assign to the asset, they don't invest. One value measurement often used is the P/E ratio, the price of a stock divided by its earnings. The ratio asks the question, "How many dollars am I paying for a dollar's worth of earnings?"

Taken a step farther, it can be compared to the earnings growth rate of the company, in which case it is referred to as a PEG, or the price earnings ratio divided by the earnings growth rate. For example, a company is growing earnings at 30 percent and its price earnings ratio is 15 times earnings; dividing 15 by 30 produces a PEG of 0.50.

Many value investors use the PEG as an initial screen for undervalued (below 1) or overvalued issues (generally 1.25 to 1.50). Bear in mind that no single screen is perfect. Our work over the years has shown that multiple screens with specific weightings greatly enhance the evaluation results. That's why we use the PEG in combination with several other proprietary screens each week when we analyze the 12,000 issues in our database.

By almost every historic measurement, there are many companies, especially in the Dow Jones Industrial Average, trading at levels unrelated to their underlying values. It is a market in which buyers have chased Internet issues, drug companies and numerous large company stocks to levels no longer attractive to investors.

It doesn't take a heck of a lot of common sense to know that if everyone is buying the same "story" stocks at any price someone will be left holding the bag. We refer to it as "the greater fool" theory, which is, "buyers will pay any price in hopes that a greater fool will come along and offer them an even higher price."

(For an intriguing and very informative look at how this has occurred throughout history, we recommend a classic book, "Extraordinary Popular Delusions & Madness of Crowds." Written in 1841, and spiced with humor and some interesting archaic words, it chronicles human nature at some of its greediest and most illogical times, including the Tulip mania of 1634-1637 when a single "special" bulb sold for 8,000 pounds of wheat, 16,000 pounds of rye, four fat oxen, eight fat swine, 12 fat sheep, two hogsheads of wine, 1,000 gallons of beer, 500 gallons of butter, 1,000 pounds of cheese, a complete bed, a suit of clothes, and silver drinking cups.)

Anecdotal evidence of investors getting carried away can sometimes be found in a number of ordinary-appearing occurrences. Examples of signs that market mania is rearing its head include:

The cover of Business Week, Fortune, Time, or Newsweek showing a bull on Wall Street or pronouncing that stocks are the only place to invest. The more of these, the stronger the mania.

Two or more books about stock-market investing on The New York Times Best Seller list. Paperbacks are a minor indicator. When people shell out big bucks for hard copy guru books, look out below.

An especially powerful indicator is any title by an unheard of author that has in it the words "How I" or "How To," as in "How I Turned $1,000 Into $1,000,000 in Growth Stocks" or "How To Double Your Money In The Market."

When, at social gatherings, more people are talking about their investments than their kids.

When your barber/stylist/hairdresser/beautician tells you about the mutual fund he is buying.

When your dumbest relative or friend, who has never before mentioned investing, tells you he bought, or is going to buy, stock. (Trust me, if you own what he is buying or the barber is buying or what the majority of the party conversationalists are buying -sell. When the man on the street is buying, who is left to buy from him?)

There are other signs, which I will discuss in future columns. Right now I have to leave to keep my appointment at the barbershop.

(Clark Davis is a 30-year investment veteran and CEO of Saint Louis Investment Advisors, a specialized money management company. Questions or comments can be directed to him by mail via The Springfield Business Journal, 313 Park Central West, 65806 or by e-mail at clark@slia. com.)

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