5 Traits of Great Stocks

5 Traits of Great Stocks
By Jeff Fischer
June 15, 2009

A recent study revealed that three of four stocks on the U.S. markets lost value between 1980 and 2008, despite the S&P 500 returning 10.4% annualized. What this means is the winning stocks won big, thereby compensating for the overwhelming number of losing stocks. However, if you hope to be invested in the winners, you need to choose carefully.

More than two decades of investing experience has helped us at Motley Fool Pro zero in on what makes for a winning business. Here are five of the key traits we seek in each stock before we buy it.

1. Sustainable competitive advantage
Healthy profits in a business attract competition -- everyone wants a piece of the profit pie. The only way a company can maintain profit margins and grow is to have a sustainable competitive advantage that serves as a protective moat around the business. You hear this quality talked about often, from Warren Buffett on down, but many investors still fail to buy companies that sustainably meet the bill. That's because it's the rare company that truly has lasting advantages -- but they are out there.

They're usually midsized or larger, have a long history of steady growth, and own assets or market share that provide enduring advantages over all others. Think Cameco (NYSE: CCJ), the largest uranium owner on the planet (the world isn't producing more uranium anytime soon); or Intel (Nasdaq: INTC), which enjoys 80% market share in computer CPUs. eBay (Nasdaq: EBAY) has sustainable competitive advantages, but it hasn't evolved quickly enough to keep all of its customers happy. However, network effects and market share -- competitive advantages -- are buying it time to right the ship.

2. Diverse customer base
A competitive advantage isn't worth much if the business is dependent on only a few customers. We like our businesses to have widely diverse and growing customer bases. This way, when some customers are lost, the business is not in peril and will continue to grow. We shy away from buying companies where just one or two customers account for 10% -- or more -- of annual sales.

3. Pricing power
With a lasting competitive edge and a broad customer base, a company usually enjoys some degree of pricing power. When costs rise, the company can pass them on to customers rather than suffering them itself. The strongest companies can implement modest price increases every few years without losing or alienating customers. Pricing power gives a company one more important arrow in its quiver as it hunts for long-term annualized growth.

4. Significant recurring revenue
If a business enjoys our first three criteria and also has significant recurring revenue, we become even more interested. By recurring revenue, we mean sales that repeat all but automatically, often with the same customers again and again, and usually without the company needing to spend more on marketing or reinventing itself or its products.

Revenue at the largest electronic exchange in the world, Nasdaq OMX (Nasdaq: NDAQ), recurs whenever someone makes a stock or option trade on its exchanges. Elsewhere, insurance companies enjoy recurring revenue every time a policy is auto-renewed, which happens more than 80% of the time at the best providers. Software companies have also gotten wise and sell annual subscriptions to their wares.

As General Motors collapsed in the first major recession in years, we're reminded that automakers are an example of anything but easy recurring revenue. They need to advertise continually to drive each sale, making for an expensive business that's vulnerable when the economy stumbles.

Easily or "naturally" recurring revenue results in more predictable and more profitable results, and helps maintain a business even during recessions. Some of the stocks we buy in Pro won't have naturally recurring revenue, but when it drives at least 30% of annual sales, the company gets a close second look from us.

5. Expanding free cash flow
The qualities we've mentioned so far will usually lead to strong free cash flow, which is the lifeblood of any company. By definition, free cash flow is cash from operations minus capital expenditures and any other nonoperational cash income, such as tax benefits from stock options. Much more reliable than mere earnings per share numbers, we're looking for free cash flow that's growing at least 8% to 10% annualized over the long term.

No company grows in a straight line, but over time we want expanding free cash flow to drive the value of the businesses we own. Strong free cash flow growers over recent years include software provider Oracle (Nasdaq: ORCL) and credit card giant MasterCard (NYSE: MA). Meanwhile, a rebound in free cash flow can revitalize a company, as has happened with BMC Software (NYSE: BMC) since 2004, more than doubling its share price. All three companies, incidentally, also enjoy all of the four traits above.



http://www.fool.com/investing/general/2009/06/15/five-traits-of-great-stocks.aspx

How to value this stock?

Wednesday June 24, 2009
John Master’s ‘retirement’ an eye-opener
Comment by Jagdev Singh Sidhu



THE circumstances in which a company proposes to sell its assets, distribute all the cash to shareholders and eventually remove itself from the stock exchange are usually done when conditions are dire.

It’s either that the company is financially haemorrhaging or affected by some cataclysmic event that has destroyed its balance sheet.

Rarely would that scenario be pictured of a still healthy albeit marginally profitable listed company that has basically decided to call it a day on the stock exchange.

When John Master Industries Bhd (JMI) said it wanted to “retire” as a listed company, the motive itself was a little perplexing. In its latest annual report, John Master did not sound like it was preparing to throw in the towel. Nor did it indicate such a desire in its latest quarterly announcement.

Yes, low trading volumes are an indication of investor interest and JMI said its average trading volume of just 7,300 shares a day over the past 12 months shows how illiquid and thinly traded its stock is.

Meagre volumes might be a reflection of investor interest but is that sufficient reason to exit the exchange? Based on yesterday’s trading on Bursa Malaysia, there were 317 companies on the stock exchange with fewer shares traded.

Financially, JMI has hinted that it was treading on water. It says its financial future is uncertain and the prospects for the industry it operates in are tough.

Competition in this business is fierce and there will always be places where it’s cheaper to produce a piece of garment than Malaysia. Economics and profitability will rule and the directors might feel that the company is fighting a losing battle on that front.

It argues those conditions make any future dividend payments doubtful. Even though business conditions are tough and outlook uncertain, there is an offer to bid for the assets of JMI from three directors of the company related to the founder of the company who retired in May last year.

Nobody knows whether shareholders would get full value of the company’s net tangible assets which was RM1.07. The company’s last traded share price was 49 sen a share.

The company is relatively debt free with only RM5.5mil in short-term borrowings. It has RM43mil in cash, or a cash backing of 35 sen a share.

Most of its assets are in the form of inventories (RM67mil) and receivables (RM39.7mil). Plant and machinery carries a value of RM2.8mil on the balance sheet and land for development is another RM2.4mil.

The company, however, has promised that its assets would be sold via an open tender and under the watchful eye of Ferrier Hodgson MH Sdn Bhd.

Cashing out of JMI would give shareholders of the company the financial flexibility to decide on what to do with their money. It’s also an avenue for shareholders to maybe realise the value of their current investment in a thinly traded counter with over 122 million shares.

The entire exercise might be a quasi privatisation process of JMI but whatever it is, the entire exercise would be a test case for other companies on Bursa.

It’s for the directors, who act as custodians of a company, to advice and recommend the best course of action to be taken by a company. And in this case, they have decided that the latest proposal is in the best interest of the listed company.


Ultimately it will be a decision for the company’s shareholders to make.


JMI : [Stock Watch] [News]


http://biz.thestar.com.my/news/story.asp?file=/2009/6/24/business/4182449&sec=business


Ref: Asset valuation approach in liquidation


Company Name: JOHN MASTER INDUSTRIES BERHAD
Stock Name: JMI
Date Announced: 29/05/2009
Financial Year End: 31/03/2009
Quarter: 4
Announce - 0309(Ann).xls
Announce - 0309 (Ann).doc

When valuing a business for liquidation, most assets are marked down and the liabilities treated at face value.

• Cash and securities are taken at face value.
  
• Receivables require a small discount (perhaps 15 percent to 25 percent off).
  
• Inventory a larger discount (perhaps 50 percent to 75 percent off).
  
• Fixed assets at least as much as inventory.
  
• Any goodwill should probably be ignored.
  
• Most intangible assets and prepaid expenses should be ignored.

Applying the following to the latest balance sheet of JMI:

• a 50% discount to fixed assets and inventories,
• 25% discount to receivables, and
• all liabilities are at face value,

I deduced a liquidation NTA value of $ 0.70 per share (equivalent to net worth for the whole company of $ 110.5 m).

http://spreadsheets.google.com/pub?key=rMg4CdEMPdLx-jOwZM-ecKA&output=html

This contrast with the reported NTA of $ 1.0754 per share in its latest quarterly report.

Today, the market price per share of JMI is $ 0.60 giving a market capitalization of $ 73.70 m. Therefore there is little potential upside here.

Always buy, hold or sell based on fundamentals.

To summarise:

We should buy, hold or sell based on fundamentals.

The basic premise behind our "buy" strategy - over the long term, investors gravitate toward stocks with strong fundamentals because those are the strongest companies, and that causes those stocks' prices to rise over time.

If you're buying stocks based on the above basic premise, that is, they have strong fundamentals, and over the long term, stocks with strong fundamentals tend to rise, you should hold on to a stock as long as it continues to meet the fundamental criteria you used to select it.

It's time to sell and replace the stock with another stock that does meet your criteria (and one that thereby has better prospects of rising in value), if the stock's fundamentals have slipped, so that it no longer meets the criteria you used to buy it. Also consider selling, if the stock is grossly overpriced, not justifiable even by the good fundamentals of the company.


Price should always be related to the fundamentals.

We should NOT buy, hold or sell based solely on the price is low or high or rising or falling


Related posts:
Why we buy? Because of the fundamentals
Why we hold? Because of the fundamentals
Why we sell? Because of the fundamentals
Always buy, hold or sell based on fundamentals.


Because the goal is always:

• look closely at what to hold and what to sell now
• to maximize return on capital and
• to take advantage of the time value of money,

One must look forward at future prospects rather than backward at now-irrelevant old (higher or lower) prices.

Also read:
To guide you on holding or selling a stock in your portfolio.
To guide you in re-balancing and re-weighting of your portfolio.
Weathering a Panic
Stock Selling Guide - Gain/Loss Worksheet (Part 1 of 5)
Stock Sale Considerations (Part 2 of 5)
Evaluating Changing Fundamentals (Part 3 of 5)
To Sell or to Hold Checklist (Part 4 of 5)
Selling and Holding mistakes Checklist (Part 5 of 5)

Why we sell? Because of the fundamentals

When you're building your portfolio, then, you want to pick the stocks that have the best fundamentals - because (sorry again) over the long run, investors gravitate toward stocks with strong fundamentals because they are the strongest companies.

If the stock's fundamentals have slipped, however, so that it no longer meets the criteria you used to buy it, it's time to sell and replace it with another stock that does meet your criteria(and one that thereby has better prospects of rising in value).



Your selling is based on ongoing re-evaluation of portfolio at regular intervals

The selling assessment is thus an ongoing re-evaluation of where a stock stands right now. You must continually reassess what the stock's prospects are going forward - not what they were a month ago, six months ago, or whenever you bought it.

On average, using monthly rebalancing period produce the highest raw return.

The important point here, whether you use a one-month rebalancing or a different time frame that works for you, is this - you need to re-examine your portfolio at set intervals, to assess how your holdings stand relative to the reasons you bought them. If they no longer meet the criteria you used to pick them, you should consider replacing them with new stocks that do make the grade.

By sticking to a firm rebalancing and reweighting plan, you keep emotion and hype from impacting your selling decisions. You sell at regular intervals, and you sell based on fundamentals. Just as with buying stocks, there's no place for hunch-playing or knee-jerk reactions here.



Price matters in how it is related to fundamentals

Whether the stock price has dropped sharply since you bought it or whether it has skyrocketed is no matter; what matters is where the stock's fundamentals stand right now.

Price - just as with buying - matters only in terms of how it relates to the fundamentals (what the stock's PE or P/S ratios are, for example).

Many investors will sell a stock:

• because its price has fallen and they think they need to cut their losses, or
  
• because the price has risen and they think the "smart" thing to do is to take the profits rather than risk the stock coming back down.

But those are arbitrary, emotional decisions.




When stock should be sold immediately

There are a couple rare occasions, however, when you should sell a stock without waiting for the rebalancing date to arrive.

• If a firm is involved or allegedly involved in a major accounting or earnings scandal, you should sell the stock immediately, because you can no longer trust its publicly disclosed financial data.
  
• In addition, if a firm has become a serious bankruptcy risk since the last rebalancing, you should also sell its stock immediately.

So with all of these challenges, how do you stave off emotion and make good, sensible "sell" decisions? The same way that you keep emotion at bay when deciding what stocks to buy: By using a disciplined system that makes sell decisions based on cold, hard fundamentals - not emotion-driven hunches, or arbitrary price targets.

Making good sell decisions is another reason for better returns in your investment portfolio.


Related posts:
Why we buy? Because of the fundamentals
Why we hold? Because of the fundamentals
Why we sell? Because of the fundamentals
Always buy, hold or sell based on fundamentals.

Why we hold? Because of the fundamentals

When you're building your portfolio, then, you want to pick the stocks that have the best fundamentals - because (sorry to repeat) over the long run, investors gravitate toward stocks with strong fundamentals because they are the strongest companies.

If you're buying stocks because they have strong fundamentals, and (everyone now), over the long term, stocks with strong fundamentals tend to rise, you should hold on to a stock as long as it continues to meet the fundamental criteria you used to select it.

Whether the stock price has dropped sharply since you bought it or whether it has skyrocketed is no matter; what matters is where the stock's fundamentals stand right now.


Price - just as with buying - matters only in terms of how it relates to the fundamentals (what the stock's PE or P/S ratios are, for example). Many invetors will sell a stock because its price has fallen and they think they need to cut their losses, or because the price has risen and they think the "smart" thing to do is to take the profits rather than risk the stock coming back down. But those are arbitrary, emotional decisions.

Remember, you bought the stock because its strong fundamentals made it a good bet to gain value; if its fundamentals are still strong, why wouldn't it still be a good bet to gain more value?

Related posts:
Why we buy? Because of the fundamentals
Why we hold? Because of the fundamentals
Why we sell? Because of the fundamentals
Always buy, hold or sell based on fundamentals.

Why we buy? Because of the fundamentals

Let us examine the basic premise behind our "buy" strategy - over the long term, investors gravitate toward stocks with strong fundamentals because those are the strongest companies, and that causes those stocks' prices to rise over time.

We buy because of the fundamentals - not just because the price is high or low or rising or falling.

Remember, the only way price comes into the decision to buy is in how it relates to the stock's fundamentals - that is, in the form of such variables as the price-sales ratio or price-earnings ratio.

When you're building your portfolio, then, you want to pick the stocks that have the best fundamentals - because (sorry to repeat) over the long run, investors gravitate toward stocks with strong fundamentals because they are the strongest companies.



Related posts:
Why we buy? Because of the fundamentals
Why we hold? Because of the fundamentals
Why we sell? Because of the fundamentals
Always buy, hold or sell based on fundamentals.

Determining When to Sell

While a lot of strategies out there tell you how to buy stocks that will make nice gains, there are few that address the second half of the stock investing equation: when to sell.

• For many investors, deciding when to sell is a harder decision than deciding what to buy.
• Cabot Research, a behavioural finance consulting firm, has found that even top-performing mutual fund managers may be missing out on 100 to 200 basis points per year because of poor sell decisions.
• Seeing as how amateur investors tend to do much worse than the professionals, it is likely that the average, nonprofessional investor suffers even greater losses because of poor sell decisions.

Why are investors struggling with selling?

• Advice on this topic is somewhat lacking in the investment world. A survey found that more than 70% of professionals investors used a selling approach that was not highly disciplined or driven by research and objective criteria. So it seems most of the pros aren't offering a whole lot of guidance here.
• Just as our brains tell us to avoid unpopular stocks and jump on hot stocks when we're buying, they also cause havoc when we're trying to figure out when we should sell a stock.

A few phenomena make selling - and sticking to a selling plan - a difficult task.

- There's the 'fear of regret."

When we make an error of judgment, we feel badly; which is never pleasant. This is certainly true when we take a loss on a stock. Hindsight is always 20/20, and we end up thinking that we could have easily avoided what turned out to be a bad move.

• Because of the unpleasantness of those feelings, the investor avoid selling stocks that have lost value, instinctively wanting to postpone those feelings of pain and regret - even if those stocks now have little prospect of rebounding.
• Loss aversion refers "to the observed tendency for decision makers to weigh losses more heavily than gains; losses hurt roughly twice as much as gains feel good."
• As locking in losses hurts a lot, investors avoid selling stocks for a loss even after they no longer have good prospects, to delay that hurt.

- Another common mistake many investors make is holding on to winners too long.

Growth fund managers often do just that "because they are encouraged to do so by all the good news regarding companies prospects."

• A perfect example would seem to be the tech stock boom of the late 1990s.
• Many investors - professional and amateur, made a fortune as the Internet bubble grew. The problem was that the bubble kept growing, long, long after these stocks had risen above reasonable values.
• Still the buzzs was that the "Internet Era" had arrived, and would fundamentally change the stock market; when it came to the World Wide Web, the theory went, there were limitless possibilities - and thus limitless returns.
• Blinded by the hype, most of those people who had made huge sums of money ignored logic and held on to their stocks too long, only to see them come crashing down.

To try to avoid some of these problems, some people will set price targets for stocks they buy.

• They'll determine ahead of time that, if the stock gains, say 30%, they will sell it and take the profits. This sounds good on the surface, but really it's just another problem.
• All gaining stocks were not created equal; one stock may gain 30% and then drops, but another may gain 30% and then gain another 200%.
• Setting arbitrary selling targets like this can hurt just as much as they help, if not more.

The most difficult decision - when to sell

The most difficult decision for an investor isn't deciding which stock to buy, but deciding when to sell.

"You can be right about a stock's potential, but if you hold on too long, you may end up with nothing."

Many experts give detailed advice on how to buy stocks, few give advice about when to sell, despite the importance of that decision.



Discipline plays a key role in any selling strategy.

- One problem investors run into is that they fall in love with a winning stock and hold onto it too long.

- Many investors also fear that they will sell winners too soon and miss out on even greater gains.

• "Instead of groping for the last dollar, you should gladly leave some upside on the table. Catching market tops is not your game. This is preferable to getting caught in a subsequent downdraft."

There are two main reasons to sell stocks:

• deterioration in the stock's fundamentals (particular in its earnings estimates or five-year growth rates), or
• the stock's price approached the firm's expectations. You can devel0p these price expectations for each stock you own, using earnings estimates, and the projected expansion of the stock's PE ratio. These targets should also be adjsuted based on market climate.

One of the most important things an investor can do is stick to a firm selling strategy - whatever the details of that strategy may be.

Low Price-Earnings Investor

What does PE ratio signifies?

1. One of the common explanations of the PE ratio is that it tells you how much investors are willing to pay for every dollar in earnings that a company is generating.
2. However, PE ratio is also a measure of what kind of growth, investors are expecting from a company in the future.

• For example, take two stocks, one with a PE of 50 and the other with a PE of 10. Earnings drive stock prices, so if investors are willing to pay 5 x as much for one company's dollar of current earnings as they are for the other company's dollar in current earnings, they must be expecting that the first company will grow earnings much more rapidly than the second.

This idea of expectation was key.

• High-flying growth stocks with high PEs had so much expectation built into them that they often fell at the slightest sign of disappointment.
• Low PE stocks, however, have little anticipation or expectation built into their price. Therefore, any improvement in performance is likely to boost the attention they get, while they suffer little if their results don't meet the Market's already low expectation.

Low PE Investing

John Neff wrote, "Indifferent financial performance by low PE companies seldom exacts a penalty. Hints of improved prospects trigger fresh interest. If you buy stocks when they are out of favour and unloved, and sell them into strength when other investors recognize their merits, you'll often go home with handsome gains."

Neff continuously searched the newspapers for companies with low PE ratios (i.e. the least popular stocks in the market), also keeping tabs on those that had just posted new lows or were getting hammered in the press. From these shunned firms, he used a series of quantitative measures to identify those that were good bets to rebound.

He explained, "Swept up by flavours of the moment, prevailing wisdom frequently undervalues good companies. Many - but not all - that languish out of favour deserve better treatment. Despite their solid earnings, they are rejected and ignored by investors caught in the clutch of groupthink."

The challenge of course, is separating the stocks that are unfairly being beaten down because of overreaction from those that deserve their low prices.

What is 'low' PE ratio?

"You should look for stocks with a low PE ratio." What is 'low'?
Depending on your point of view, low PE ratios could mean:

• PE of 5 or below
• PE of 15 or below
• anything less than the median PE of the S&P 500 industrials
• PE in the bottom 20% of the market
• PE that is less than the annual EPS growth rate of the company (PE/EPSGR ratio less than 1)

All the above precise definitions of 'low' PE have been used by various investors.

Why the P/E Ratio Is Dangerous

Why the P/E Ratio Is Dangerous
By Rex Moore
June 19, 2009


I have no doubt that the most widely used valuation tool by individual investors is the price-to-earnings ratio (P/E). Unfortunately, it may also be the most dangerous tool, because it's so misunderstood. Today, I'll talk (well, type) a little about what the P/E's problems are and how you can overcome them.

What it is
On the surface, this is a very simple and informative ratio -- a company's stock price divided by its last 12 months of earnings per share. So we can look and see that Monsanto earned $4.10 per share over the past year. At today's price around $81.30, its P/E ratio is $81.30 / $4.10 = 20. You might also hear the hip Wall Street crowd say "Monsanto has a multiple of 20" -- because it sounds so cool.

Because you obviously want more earnings for every dollar you invest, a lower P/E is considered more attractive. After all, you'd rather be paying $40.65 per share for Monsanto's $4.10 in earnings (P/E = 10) than $81.30 (P/E = 20), right?

Yes, absolutely -- why wouldn't you want to pay less for the exact same earnings stream? The same principle also applies when comparing different businesses, as long as they are equal in all other respects.

What it isn't
Of course, things are never equal in the investing world (you didn't need me to tell you that), and this is where problems creep in. It's also why the P/E ratio should never be the only tool you use to value a business, for several reasons. Let's look at three of them.

1. Forward to the future
A glance at most any financial data provider tells us that Cisco Systems (Nasdaq: CSCO) is trading at a P/E of 16. Juniper Networks (Nasdaq: JNPR) has a multiple of 31. So Cisco must be a better value, right?

Well … maybe. It's rare to find two businesses that are exactly alike, and these two certainly have their differences. Also, analysts estimate Juniper will grow earnings about 18% annually over the next five years, while Cisco is only projected to grow at around 10% per year. So there you run into a big problem with the P/E -- it's a short-sighted, usually backward-looking tool. If one company is able to double its earnings in a few short years while another remains stagnant, the former could be a much better value despite a higher multiple. Yet you wouldn't know it from the single-snapshot picture the P/E provides.

The "forward P/E" published by some sources is a better tool, because it uses the next year's estimated earnings for the "E" part of the equation, instead of the previous year's earnings. But that still provides only a very limited snapshot. This chart illustrates just how tough it is to get a handle on this simple ratio.

Company
Estimated 2-Year Growth Rate
Trailing P/E
Forward P/E*

Apollo Group (Nasdaq: APOL)
69%
16
15

USEC (NYSE: USU)
91%
17
15

Visa (NYSE: V)
49%
41
20

Baidu.com (Nasdaq: BIDU)
77%
65
44


Data provided by Capital IQ, a division of Standard & Poor's. *Using next 12 months' earnings estimate.


The first two companies look like bargains compared to their growth rates, but you should question just how likely they are to achieve this future growth. The second two appear expensive looking backward, but much more reasonable looking forward. But how much growth will there be after the next couple of years? So many variables!

2. Focus on fundamentals
As the previous example shows, the P/E becomes more useful if you can get a grasp on just how much in earnings a company will be able to achieve over the coming years. But in order to do this, you'll need to study the underlying business and understand its margins, scalability, competitive position within the industry, etc. This fundamental analysis goes a long way toward putting the P/E in its proper perspective.

3. The fiction of accounting
Another problem comes in defining "earnings," the denominator in our equation. Like Donald Trump's hair color, it isn't always what it seems. In fact, unlike Donald's hair, it's so easy to massage and manipulate the earnings number that it's a wonder the Street still hangs on every penny. While one company may report a largely honest number, its competitor may be padding the EPS in order to "meet estimates." In the end, stuff like that usually catches up to these companies -- and, in turn, their shareholders.

My story
The best way to think about the P/E ratio reinforces what Motley Fool co-founders Tom and David Gardner tell members of their Stock Advisor investing service: You must understand that you're buying a business when you buy a stock. I'd heard that often enough, but it took a real-life example to drive the point home.

Several years ago, a friend and I considered buying a sporting goods store. It was a family-run business, with virtually no debt -- or cash -- on the balance sheet. The owner wanted $100,000 for it.

What's the most important thing you'd want to know if you'd been in our situation? Right: how much money we could reasonably expect to earn over the next few years. We didn't care about the fiction of accounting earnings (point No. 3 above) -- we wanted to know how much in real cash profits the business could pull in.

If it were $10,000 per year, we'd be getting the company at a P/E of 10 ($100,000 / $10,000 = 10). If it were $5,000, that's a much less attractive multiple of 20.

We dived into the fundamental analysis to figure out the real earning power of the company (point No. 2). The short story is, we thought we could make the business much more efficient (improving the margins), but future revenue and earnings growth (point No. 1) seemed very limited due to several well-financed competitors in the area.

In assessing whether this was a smart purchase, we used the three points to come up with our decision. In the end, we passed on the purchase because the P/E we calculated was over 20. Using that number hand-in-hand with our analysis, we knew it would have taken too long for us to even recoup our original investment. But the exercise itself was a lesson I'll never forget.

The lesson
Using P/E as a standalone valuation tool could cost you big-time. Isolating on any single metric, for that matter, is a recipe for disaster.

When David recommended Amazon.com (Nasdaq: AMZN) in September 2002, he acknowledged that its P/E of 75 carried risks. But his fundamental analysis convinced him the company deserved that multiple, and the stock is up more than 400% since.


Rex Moore is a Fool analyst who's been cleared to operate heavy machinery. He owns no companies mentioned in this article. Amazon.com is a Motley Fool Stock Advisor selection. Baidu is a Rule Breakers pick. The Fool has a disclosure policy.



http://www.fool.com/investing/general/2009/06/19/why-the-pe-ratio-is-dangerous.aspx

Valuing a business using PE

The best way to think about the P/E ratio: You must understand that you're buying a business when you buy a stock. Here is a real-life example to drive the point home.

Several years ago, a friend and I considered buying a sporting goods store. It was a family-run business, with virtually no debt -- or cash -- on the balance sheet. The owner wanted $100,000 for it.

What's the most important thing you'd want to know if you'd been in our situation? Right: how much money we could reasonably expect to earn over the next few years. We didn't care about the fiction of accounting earnings (point No. 1) -- we wanted to know how much in real cash profits the business could pull in.

If it were $10,000 per year, we'd be getting the company at a P/E of 10 ($100,000 / $10,000 = 10). If it were $5,000, that's a much less attractive multiple of 20.

We dived into the fundamental analysis to figure out the real earning power of the company (point No. 2). The short story is, we thought we could make the business much more efficient (improving the margins), but future revenue and earnings growth (point No. 3) seemed very limited due to several well-financed competitors in the area.

In assessing whether this was a smart purchase, we used the three points to come up with our decision. In the end, we passed on the purchase because the P/E we calculated was over 20. Using that number hand-in-hand with our analysis, we knew it would have taken too long for us to even recoup our original investment. But the exercise itself was a lesson I'll never forget.

http://www.fool.com/investing/general/2009/06/19/why-the-pe-ratio-is-dangerous.aspx

To recap:

When buying a small business:

Point 1: Past accounting earnings are a guide, but can be manipulated. More importantly is to conservatively assess the real earning power or cash profits of this company over the next few years.

Point 2: Can you increase this real earning power through improving its efficiency - the profit margins?

Point 3: Assess its future revenue growth and earnings growth. Are these sustainable?

Having assessed the quality of the business and its management, the other decisions one has to make are:

Point 4: Would you like to own or run the business of this company?

• If the answer is no, walk away.
• If the answer is yes, proceed on to next step.

Point 5: Is the seller's price attractive for you to own this company? Given your target of a certain return on your investment, what is the 'maximum' price (akin to intrinsic value) you are willing to pay to own this company?

Point 6: Can you buy this company at a discount to your price? Ask for a discount from the seller? Maybe 'wait' for a discount from the seller? Also remember, it is also alright to buy at a fair price, especially if it is a good business with good fundamentals, up for sale for various reasons.


Essentially, this is not dissimilar to our use of QVM method in assessing which companys' stocks to invest in. (Q=Quality, V=Value, M=Management)

Market turns down again

We need to prepare ourselves to “fish” good quality stocks at reasonable price levels if the market turns down again.

An Interesting Comeback Calculator

http://www.nytimes.com/interactive/2009/01/06/business/20090106-comeback-graphic.html


Calculate Your Financial Comeback
Has your portfolio plummeted? So has ours. Use our Comeback CalculatorSM to calculate when your investments could return to their peak levels.


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June 20, 2009
Your Money
For Older Investors, Old Rules May Not Apply
By TARA SIEGEL BERNARD
The stock market’s damage has already been done. And if you’re one of those people near or already in retirement, you already know you’re going to have to work longer, save more or spend less.

But what should you do right now with the money you have left? Should you wade back into the stock market, if you bailed out when the market was plunging? Or if you watched your investments drop and then recover a little in the last few months, should you just hold on? What happens if the market doesn’t fully recover for a long time? (That happened in Japan in the ’90s.)

This economic downturn has been steep enough and frightening enough to undermine the idea that the stock market, over time, will always deliver. So a lot of investors have retreated to a more conservative stance.

The wisdom of that move is debatable. The investment industry warns that becoming too defensive is costly in the long run. Its argument goes something like this: People are living longer, retirement may last 25 or 30 years and stocks are supposed to protect you from the ravages of inflation. And since stocks tend to outpace most investments over long periods of time, the industry says, your savings will do all right in the end.

But some people are no longer comfortable with that logic. There’s even a new study that contends holding stocks over long periods of time may be riskier than previously thought. Robert F. Stambaugh, a finance professor at the Wharton School at the University of Pennsylvania and a co-author of the report, said most investment research only accounted for the risk of short-term market swings around the stock market’s average gain over time. It doesn’t factor in the fact, he said, that the average itself is subject to change.

So what should retirees and pre-retirees make of all of this?

“If another decline in the market is going to bankrupt you or put you out of business or destroy your retirement account, you should not go back into the stock market,” said John C. Bogle, the founder of Vanguard and viewed by many as the father of index investing. “It’s not complicated. The stock market can go up and down a lot and nobody really knows how much and when.”

What’s worked for Mr. Bogle may not work for you, but his method isn’t a bad place to start. “I have this threadbare rule that has worked very well for me,” he said in an interview this week. “Your bond position should equal your age.” Mr. Bogle, by the way, is 80 years old.

That’s a rather conservative recommendation, by many financial planners’ standards. In fact, Vanguard itself offers products that are more aggressive. Its target-date funds — whose investment mix grows more conservative as retirement nears — recommend that people retiring in 2010 (generally, people who are 65) should split their savings evenly between stock and bonds.

Charles Schwab, by contrast, has recently reduced the risk for its target-date funds. The company’s 2010 fund will allocate about 40 percent to stock funds next year, down from 50 percent in the past. “It’s a reflection that our clients’ appetite for risk has changed,” said Peter Crawford, a senior vice president at Charles Schwab Investment Management.

But you shouldn’t simply view your investments through the lens of how much you allocate to different investments (though you will need to come up with a plan). Instead, you should work your way backward. First, consider how much you will need to live when you’re retired and then figure out how you’ll pay for it.

Nearing Retirement

Ideally, you should have started to slowly shrink your stock position over your working career. But some financial planners have become more conservative about that. Before the market’s sharp downturn, Warren McIntyre, a financial planner in Troy, Mich., typically reduced his clients’ stock allocations by about 1 percent each year. Now, for older investors, he ratchets down their stocks by 2 percent each year once they reach 60. So a 65-year-old’s investments would be evenly split between stocks and bonds.

Other planners are taking even more defensive positions. “We are still very concerned about the status of the economic recovery and remain quite defensive as a result,” said Chip Addis, a financial planner in Wayne, Pa., who invests his clients’ portfolios in only 40 percent stocks.

Of course, there’s no one formula. Milo Benningfield, a fee-only planner in San Francisco, for instance, said he put a 61-year-old client in a portfolio with 60 percent in diversified stocks and alternatives (like real estate) and 40 percent in fixed-income (largely split among high-quality, short-term and intermediate-term bonds and cash). But this client can afford to take that risk — the client owns a house, rental property and has other holdings outside the portfolio.

The picture may change for pre-retirees who are 61 and close to meeting their savings goals, but can’t afford to lose any money. “We would ask ourselves to what degree, if any, can you afford equities,” Mr. Benningfield said. If inflation was their only concern, he might invest their money across a ladder of Treasury Inflation-Protected Securities, or TIPS, which are backed by the government and keep pace with inflation.

But since retirees generally spend money on entertainment, health care and food — whose costs often exceed the general rate of inflation — he said he might invest 40 to 50 percent of their money in a portfolio of diversified stock funds (with at least 30 percent of that in international stock funds). But, he added, “Cash is risky, stocks and bonds are risky, life is risky.”

As to those investors who got out of stocks, Mr. Bogle said it might be time for some of them to get back in. “But I would take two years to do it,” he said. “Maybe average in over eight quarters, and do an eighth each quarter. I am just not in favor of doing things in a hurry or emotionally.”

And then? “Don’t touch it,” he said, emphatically. “One of my rules is don’t do something. Just stand there.”

Retirement

Several planners recommended different variations on a similar strategy for retirees. Set aside anywhere from eight to 15 years of your expected expenses — that includes food, utilities, housing, insurance — in bonds and cash. That way, you’ll never have to tap your stock holdings at the worst possible moment.

“Once you have that in place, you feel like you can weather any economic storm,” said Chip Simon, a financial planner in Poughkeepsie, N.Y.

When you have figured out how much it costs to live each year, the next step is to see how much Social Security will cover. Whatever is left needs to be financed by your retirement portfolio. And the general rule of thumb is that you shouldn’t withdraw more than 4 percent of your portfolio (adjusted for inflation) each year.

There are different ways to invest your cash and bond holdings.

Rick Rodgers, a financial planner in Lancaster, Pa., invests 10 years of annual expenses in a bond ladder, with an equal amount coming due every six months. The ladder can include high-quality corporate bonds, Treasury notes, certificates of deposit or municipal bonds, depending on the retiree’s tax bracket. Mr. Simon takes a similar approach using a 15-year ladder of zero-coupon bonds. He says that investors can start building the ladder in their 50s, with the first rung coming due the year they retire.

Some advisers also say you can guarantee you’ll be able to cover your basic expenses by purchasing an immediate annuity from an insurance company. The annuity pays you a stream of income until you die. “You can buy four small ones from four insurers if you are worried about insolvency risk,” said Dallas L. Salisbury, president of the Employee Benefit Research Institute. “And if you are just worried about inflation protection, you can do TIPS.”

But you should probably delay any annuity purchases because payouts rise with interest rates. With current rates so low, and the possibility of inflation later, advisers said it’s best to wait a few years. You can also research inflation-adjusted annuities, but you’ll receive lower payouts in the beginning, Mr. Benningfield said, adding: “Less than most people can stomach.”

Learn from the Worst: Summary

We have learned that we have a lot going against us when it comes to investing in the stock market -

• our brains,
• our emotions,
• timing, and even,
• the mutual fund industry itself.

We've also learned that if we want to grow our money by any substantial margin over the long run, the market is the best place to be.

Therefore, it is important to have good philosophy and strategy on how to stay in the market and avoid these pitfalls.


Summary

While the stock market is unpredictable in the short term, it becomes predictable - and predictably good - over the long term. In fact, it has proven to be far and away the best long-term investment vehicle of all-time, especially when inflation is factored in.

Despite that fact, the vast majority of individual investors, mutual fund managers, and stock recommendation newsletters fail to beat the market over the long run, often underperforming by wide margins.

The reason for most underperformance is that investors' emotions lead them astray, causing them to react to short-term price movements and the interpretation of those movements by experts featured in the media. This leads to selling low and buying high.

Much of the stock market's gains come on a limited number of days - and no one knows exactly when those big days will occur; if you jump in and out of the market, you risk missing them.

In order to make money by timing the market, you need to be right on about 75% of your market calls - and research shows that most investors, even so-called experts don't come closee to that success rate.

Learn from the Worst: The Best Way Not to Miss the Boat - Don't Get Off in the First Place

Many investors, however, either don't expect or just plain cannot tolerate the short-term discomfort of the stock market, and they'll do just about anything to try to avoid it.

Some will ignore stocks altogether, not wanting to deal with the short-term risk involved. Instead, they will put their money into bonds, Treasury bills, or even just keep it in a CD or savings account. After all, while those options don't have nearly the upside of stocks, you can't lose money with them. Or can you?

There are flaws in this logic. The reason: inflation. If, for example, all of your money is in a savings account that is earninng 2% interest per year but inflation is at 3% per year, the relative worth of your money isn't increasing by 2% annually; it's actually declining.

Since, World War II, the threat of infaltion to fixed-income investments has been very real. In his book Contrarian Investment Strategies, Dreman notes that:

• when adjusted for inflation, stocks returned an average of 7.5% from 1946 to 1996;
• when also adjusted for inflation, however, bonds had an average annual return of just 0.86%, gold actually declined by 0.13% per year, and T-bills returned just 0.42% annually.

Looked at another way, the average annual T-bill return before inflation was 4.8% during that period, about 2.5 x less than what stocks returned before inflation - not great, but not bad considering that T-bills are essentially risk-free; after inflation is factored in, however, stocks returned about 18x as much as T-bills per year.

Based on information like that, Dreman concluded that inflation was a far greater risk to long-term investors than short-term stock market volatility.

While some will try to avoid short-term market discomfort by avoiding stocks altogether, others, of course, believe they can skirt the stock market's short-term anxiety and still reap the long-term rewards. But much more often than not, they will end up with all the short-term discomfort and none of the long-term gains.

Part of the reason is that, most investors who try to time the market end up buying high and selling low. But there's also another important reason that is critical to understand - the nature of when and how the stock market makes its gains. In a 2007 article for CNNMoney, Jeanne Sahadi touched on this concept.

Citing data from Ibbotson Associates, Sahadi said tha if you had invested $100 in the S&P 500 in 1926, you would have had $307,700 in 2006 - a pretty staggering gain. But if you had been out of the market for the best-performing 40 months of that lengthy 972-month period, you would have had just $1,923 in 2006. That means that 99% of the gains over that 81-year period came in just 4 percent of the months.

The principle holds over shorter periods, as well. If you invested $100 in 1987, you'd have had $931 by the end of 2006, Sahadi noted. But if you were out of the market for the 17 best trading months of that 240-month period, you'd have ended up with just $232. In this case, 84% of the gains came in 7% of the months.

The bottom line: While the market rises substantially over time, much of its increases come on a relatively small portion of trading days - and no one knows for sure when they're going to come. If you jump in and out of the market based on short-term fluctuations you're bound to miss some of those big days - and you can't get them back.

Another point to note. In a market where the vast majority of gains come on a small number of days, you don't just have to be right more than you're wrong if you want to make money timing the market - you have to be right a whole lot more than you're wrong. That's what the research of William Sharpe shows. Sharpe found that in order to make money with a market-timing approach, you need to be right in your timing decisions at least 74% of the time - not just 51% , as many assume. Consider that statistic showed that the most accurate human forecasters were right about 20% of the time - and you see that most market timers won't even come close to succeeding.

Learn from the Worst: Our Emotions - Need for an Emotional Rescue

If we don't succeed at it, why do we keep trying to time the market? Given the short-term unpredictability of the stock market, it's pretty much inevitable that we'll fail if we try to time our participation in stocks, yet we always think we can learn to do it.

• "Man, it was so obvious that I should have done last time; now that I've learned my lesson, I'll be able to time things right next time." We tell ourseleves, even though it wasn't obvious what we should have done last time, and it won't be obvious whenit comes to future market-timing decisions (hindsight bias).


• "And time and time again, when one of our stocks starts declining, we jump off of it and onto the latest "hot" stock, only to watch our old stock rise and our new, flashy stock fall."

Our emotions

We are emotional creatures, and in many cases throughout life, that's a good thing. When we are in danger, for example, we feel fear, and our brains interpret this feeling as a signal to flee for safety's sake.

In the stock market, however, emotion is one of our greatest enemies. Our intstincts tell us to flee when we see danger, and danger is what we see when our investments start losing value -

• danger of losing our money,
• danger of not being able to afford to send our children to college,
• danger of not being able to afford to retire when we want to retire.

And, just as with other dangers we perceive, our first reaction is to flee - or, in this case, sell.

Now, when it comes to being attacked by an animal or a mugger who is trying to hurt you, fleeing from harm is a good instinct to have. But in the stock market, fleeing can, in fact, lead to great harm. That's because the danger we often sense in the stock market is false danger.

Perfectly good stocks fluctuate over the short-term (there's typically a 40 to 50% difference between a stock's high and the low for the previous 12 months), and sometimes it's due to factors that have nothing to do with their real value. (Think of the example in which one company is negatively impacted when another company in its industry posts a bad earnings report.) Because of the array of factors that go into its day-to-day movements, we just can't predict what the market's or an individual stock's short-term fluctuations will be with any degree of accuracy.

Nevertheless, we still act on them, and a big reason is emotion.

Peter Lynch once explained this phenomenon in an interview.

• "As the market starts going down, you say, 'Oh, it'll be fine."
• Then "it starts going down more and people get laid off, a friend of yours loses their job or a company has 10,000 employees and they lay off 200. The other 9.800 people start to worry, or somebody says their house price just went down. These are little thoughts that start to creep to the front of your brain."
• People even start thinking about past financial disasters, bringing thoughts of such calamities as the Great Depression to the front of their minds, even if the current situation is nowhere near as bad.

In today's world of nonstop media hype and sensational headlines, it's very difficult to keep those thoughts from entering our minds. And the more they do, the more likely we are to make bad investment decisions.

Dallbar's study of investor behaviour shows that the percentage of investors who correctly predict the direction of the market is much lower during down markets than it is during rising markets.

During falling markets, when people have already been losing money, the fear of losing even more can cause many to cash out, even if the downturn is just one of Wall Street's periodic short-term hiccups. (Behavioural finance referes to this a myopic loss aversion.) Often, investors are then slow to jump back in when the market turns around, so they miss out on the bounce-back gains.

And it's important to remember that the market does bounce back, even when your fears and worries are telling you that "this time is different, this time the market won't recover." In fact, over time, the market climbs higher than any other investment vehicles.

According to reserach performed by Roger Ibbotson, Rex Sinquefield, and Ibbotson Associates, in the 20-year period that ended at the end of 2006, the S&P averaged an 11.8% annual compound return, beating long-term corporate bonds (8.6%), long-term government bonds (8.6%), and Treasury bills (4.5%).

While unpredictable in the short term, the performance of the stock market becomes quite predictable - and predictably good - when looked at over the long term.

Imagine, for a moment, that the market is a helium-filled balloon that you set loose outside on a gusty day. From moment to moment, it's hard to tell where the balloon is headed. It gets pushed around from side to side by the wind - that is, earnings reports, economic data, analysts' ratings, pundits' predictions - and sometimes even gets knocked downward. From moment to moment, you'd be foolish to bet someone exactly which way the balloon will go, since there's no way predict which way the wind will blow. But it's almost a sure bet that, over a longer period of time, it will end up a lot higher than it started.

In his book Stocks for the Long Run, Jeremy Seigel states that the market has averaged an annual compound return of 11.2% in the period 1946 to 2006. Siegel also examines those returns for their standard deviations. This is a statistical measure to show the rangee of returns in a "normal" year during a particular period.

If a stock has returned an average of 10% annually over a particular period with a standard deviation of 5%, for example, that means that about 2/3 rds of the time, its returns have been between 5% (the average return minus the standard deviation) and 15% (the average plus the standard deviation).

According to Siegel, the annual standard deviation of the market has been about 17% in the 1946 - 2006 period, which means that about 2/3rds of the time during the 60-year time frame, returns were between -5.8% and 28.2% , a huge potential year-to-year difference. (And that's the range returns fell into about 2/3 rd of the time; in other years they were even further from the average.)

The fact that such major year-to-year fluctuations can - and many times do - occur in the stock market makes for a lot of anxious times in the short term, but that anxiety is simply the price you pay for the excellent long-term returns that the stock market gives you. If stocks earned 10 or 12 % per year and were a smooth ride, why would anyone ever invest in anything else? This concept is known as the equity risk premium.

The bottom line: There are no free lunches in the stock market. If you want the long-term benefits of stocks, you've got to pay the price of short-term discomfort.

Ref: The Guru Investor by John P. Reese

Learn from the Worst: Market Timing - The Most Dangerous Game

Every day, millions of investors, try to discern where the market will head tomorrow, next week, or next month.

Market timing occurs when people move in and out of the stock market with the intent of taking advantage of anticipated short-term price movements.

Market timing can be

• as simple as you want it - maybe you've heard from a friend that the market is about to take off, so you invest in stocks - or
• as complex as you want it - perhaps you've developed an elaborate model that uses various economic indicators to predict which way the market will go in the next month.

Whatever way you go about it, though, it's not likely to end well, because the market is simply too complex and irrational in the short-term for anyone to correctly and reliably predict its movements.

Want proof that market timing doesn't work?

1. Research performed by Dalbar, Inc (in its 2007 Quantitative Analysis of Investor Behaviour): The firm notes that the S&P has grown an average of 11.8% per year from 1987 through 2006, an impressive gain. During this period, however, the average equity investor averaged a return of just 4.3%.

• The reason? As markets rise, the data shows that investors "pour cash" into mutual funds, and when a decline starts, a "selling frenzy" begins.
• In other words, the research shows that investors tend to do the opposite of the old stock market adage, "Buy low, sell high."

2. A few years ago, the investment research company Morningstar began tracking mutual fund performance in a new way. Normally, mutual fund returns are reported as though an investor remained invested in the fund throughout the full reporting period. A fund's three-year return, for example, is reported as the percentage increase or decrease an investor would have seen if he had been invested in the fund for the entire three previous years.

In a methodology paper ('Morningstar Investor Return'), Morningstar says it found that this "total return" percentage doesn't accurately portray how well investors in a particular fund really fare.

• The reason: While the "total return" percentage measures how a fund does over a specific period, people often don't stick with the fund for that entire period; instead, they jump in and out of it.
• And, according to Morningstar, the returns that the typical investor in a particular fund actually realizes (the "investor returns") tend to be lower than the fund's total return - implying that people pick the wrong times to jump in and out of the fund (or the market).

3. While investors themselves deserve some of the blame for this, mutual funds sometimes don't help. In its investor returns methodology paper, Morningstar states that if firms encourage short-term trading and trendy funds, or if they advertise short-term returns and promote high-risk funds, they may not be looking out for their investors' long-term interests.

• Their investors' actual returns will likely be lower than the fund's total return.
• (The fees mutual funds charge also don't help, something Bogle stresses; those costs make it so that the fund manager has to beat the market just for his client to net market-matching returns.)

Learn from the Worst: Expert

With all the convoluted factors that drive the stock market, predicting which way it will go in the short term is just about impossible.

But wait. A certain group of people that the media refer to as "experts", how are their predictions? These self-assured sounding commentators that we find on TV, the Internet, or print news tell us that they know just what the latest round of earnings reports or economic figures will mean for stocks. After all, they're experts; don't they have to be at least pretty good at predicting economicand stock markt trends?

Unfortunately, research shows that they don't. Let's see how well the stock picks of most "experts" who appeared in the media actually did. Research on this showed there was no consistency or predictability in the performance of these pundits. The best performers in one week, one month, one quarter, six months, or one year were almost guaranteed to be entirely different in the next period; basically, you couldn't make money by picking a top performing expert as measured over a short period of time and following him or her.

"Experts" are far from infallible. A study found the best forecasters - even the "experts" - couldn't explain more than 20% of the toal variability in outcomes. "Consider what this means. On all sorts of questions you care about - Where will the Dow be in two years? Will the federal deficit balloon as baby-boomers retire? - your judgement is as good as the experts'. Not almost as good. Every bit as good." (This was from a 2006 article for Fortune, Geoffrey Colvin examined this concept by reviewing the book Expert Political Judgment: How Good Is It? How Can We Know?)

Colvin also noted that the study found that the experts' "awfulness" was pretty consistent regardless of their educational background, the duration of their experience, and whether or not they had access to classified materials. In fact, it found "but one consistent differentiator: fame. The more famous the experts, the worse they performed," Colvin said.

So, if that's the case, why do so-called "experts" still get so much publicity and air time? The reason is another result of our human nature. As humans, we want to believe the world " is not just a big game of dice and that things happen for good reasons and wise people can figure it all out." And since people like to hear from confident sounding experts who appear to be able to figure it all out, the media likes to give them air time - and the experts like to get that air time because it pays. This relationship was described as a "symbiotic triangle" - it is tempting to say "they need each other too much to terminate a relationship merely because it is based on an illusion."

The bottom line: Just because someone sits in front of a camera with a microphone and speaks confidently doesn't mean he or she has any sort of clairvoyant powers when it comes to the stock market. In fact, the odds are that four out of every five times, they'll be wrong!

Learn from the Worst: The Futility of Forecasting

Having established that most investors - professionals and amateur - underperform the market, the obvious question is, why?

How can so many smart people fare so poorly?

Perhaps, the greatest reason, is the fact that we are human. The way we think, the way we perceive things and feel emotions - has become a major topic in the investing world in recent years. Behavioural finance and neuroeconomics examine how psychology and physiology affect the way we deal with our money. And in general, the findings show that we humans are investing in the stock market with the deck stacked against us.

Zweig authored a book on neureconomics titled Your Money and Your Brain. One of the main points Zweig stressed is that human beings are excellent at quickly recognizing patterns in their environment. Being able to do so has been a key to our species' survival, enabling our ancestors to evade capture, find shelter, and learn how to plant the right crops in the right places. Those are all good, and often essential, things to know.

When it comes to investing, this ability ends up being a liability. "Our incorrigible search for patterns leads us to assume that order exists where it often doesn't. Almost everyone has an opinion about whether the Dow will go up or down from here, or whether a particular stock will continue to rise. And everyone wants to believe that the financial future can be foretold." But the truth, is that it can't - at least not in the day to day, short-term way that most investors think it can.

Everyday on Wall Street, something happens that makes people think they should invest more money in the stock market, or, conversely, makes them pull money out of the market. Earnings reports, analysts' rating changes, a report about how retail sales were last month - all o fthese things can send the market into a sudden surge or a precipitous decline. The reason: People view each of these items as a harbinger of what is to come, both for the economy and the stock market.

On the surface, it may sound reasonable to try to weigh each of these factors when considering which way the market will go. But when we look deeper, this line of thinking has a couple of major problems.

• It discounts the incredible complexity of the stock market. There are so many factors that go into the market's day-to-day machinations; the earnings reports, analysts' ratings, and retail sales figures mentioned above are just the tip of the iceberg. Inflation readings, consumer spending reports, economic growth figures, fuel prices, recommendations of well-known pundits, news about a company's new products, the decisions of institutions to buy and sell because they have hit an internal taget or need to free up cash for redemptions - all of these and much, much more can also impact how stocks mvoe from day to day, or even hour to hour or minute to minute. One stock can even move simply because another stock in its industry reports its quarterly earnings. Very large, prominent companies such as Wal-Mart or IBM are considered bellwethers in their industries, for example, and a good or bad earnings report from them is often interpreted - sometimes inaccurately - as a sign of how the rest of companies in their industries will perform.

• When it comes to the monthly, quarterly, or annual economic and earnings reports, the market doesn't just move on the raw data in the reports; quite often, it moves more on how that data compares to what analysts had projected it to be . A company can post horrible earnings for a quarter, and its stock price migh rise because the results actually exceeded analysts' expectations. Or conversely, it can announce earnings growth of 200%, but fall if analysts were expecting 225% growth.

Here is one more wrench: the fact that good economic news doesn't even always portend stock gains, just as bad economic news doesn't always precede stock market declines. In fact, according to the Wall Street Journal, the market performed better during the recessions of 1980, 1981-1982, 1990-1991, and 2001 than it did in the six months leading up to them. And in the first three of those examples, stocks actually gained ground during the recession.