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July, 2003: 5 11 31

Disclaimer - IMPORTANT - Read this first!

Investor's Journal is a diary focused strictly on investments and personal finance issues, primarily from a contrarian and retiree point of view. Follow along with an average guy's failures and successes as he learns, by trial and error, the fine art of value investing.

One of the systems with which we've had success in this period is a quite simple strategy touted by Robert Sheard (of The Motley Fool) in The Unemotional Investor.

He calls this technique "Unemotional Value 2."

The web site "Backtest Hall of Fame" helpfully provides the easy steps needed to select stocks using this method:

1. Find the 10 highest yielding stocks in the Dow Jones Industrial Average and rank them in order of their dividend percentages, highest at the top, lowest at the bottom. The convenient web site, Dogs of the Dow, does this for you.

2. Keep that list handy and create a new one by ordering the same 10 stocks according to their prices per share, lowest on top, highest on the bottom.

3. If the top (first) stock in both lists is the same, discard it from the second list. If not, retain it.

4. Purchase equal dollar amounts of the top (lowest priced) two remaining stocks from the step 2 list.

5. Hold these for one year (neither selling them nor buying more, regardless of how they or the equity markets in general are doing over the intervening period). Then, using the same steps, select the best two stocks again. If either or both of the stocks previously held are not selected by the system this time, replace it or them with the new one(s). Otherwise, keep the original holdings until the review the following year, and so on.

As of the close of trading on 7/3/03, the two stocks to be purchased using this method are:

By this technique one may, in an hour or less a year, obtain relatively high-yielding assets in an approach that, over the long-term, has good prospects of beating the major market averages. It is also a strategy that takes most of the guesswork and stress of indecision out of stock investing. One knows precisely when and what to buy and sell.

A big disadvantage is its volatility. With just two selections, if something goes seriously wrong with even one of them, much can be lost. Say you begin with $25,000. After five years the portfolio might be up to $65,000. Then, in the sixth year, one of your selection companies declares bankruptcy (as rarely but sometimes occurs) and you lose 100% of your investment in that security, perhaps reducing the portfolio by about $32,500. So it is not an approach for the fainthearted.

Offsetting this, though, is the prospect of performance that over the long haul averages much better than, say, the S. & P. 500 index. (Per R. Sheard, the annualized return of this method from 1961 through 1997, just before The Unemotional Investor was published, was 21.67%. Even considering that the compound annual returns since then have undoubtedly been lower, the strategy seems likely in the long run to be superior to investing in any of the major market averages.)

For Fran and me, this technique is not one we'll use exclusively or even with most of our liquid holdings. But for 5 -10% of our nest egg it seems ideal.

We invested $25,000 on 12/30/02, half in Honeywell and half in J.P. Morgan Chase. As of 7/3/03, including dividends, they are up on average just over 30%.

7/11/03-Have rediscovered Benchmark Investing (BI). We had bad luck with it a number of years ago, buying a lot of BI selection, Fruit of the Loom, stock just before its price plummeted almost to zero and then the company declared bankruptcy, so that all remaining common shares did in fact eventually become worthless. Even though the system had earlier helped us pick Intel, with which we had a much better experience, I have thus for some time been leery of this mechanical and complicated approach to value investing. Now, however, I have researched it further with help from the Trouncing the Dow web site, a new reading of the book of the same title, by Kenneth Lee, and a check into the record of this technique, at least as back tested, which turns out to have averaged over 26.5% compounded over the last 29½ years! At their reported rate of total return in that period, a mere $1000 investment in 1973 would be worth over $1,000,000 today (assuming one followed the approach throughout that period and that the tax consequences of trades were limited by a tax-deferred brokerage account).

Armed with my new interest and information, I labored this past week through the complicated calculations for all thirty of the Dow Jones Industrial Average stocks, preferring to do them myself rather than paying the $200 a year charged by the web site, which I'd want to double-check anyway. It happened that only one of the Dow 30 currently meets the criteria, if I did the math right: Home Depot (HD), with a recent price of $33½. It's current low and high price targets are $42 and $82, respectively. So, I'm buying a few thousand dollars worth of HD shares.

Given that I now know how to select the current BI winners, can determine when it is best to sell them, and the system's record is so terrific, I anticipate limiting my purchases of large-cap equities other than REITs to only those which, as a minimum, meet the BI criteria. I'll also, except for mid-cap, small-cap, and micro-cap stock purchases, suspend my usual restrictive personal selection criteria, such as that debt to equity must be no higher than .33 or price to book value no greater than 2.

Incidentally, the two stocks cited in the above entry as meeting the present Unemotional Investor 2 criteria, AT&T and SBC Communications, do not make the cut as current BI bargains.

7/31/03-Purchased 1200 shares of Parlux Fragrances (PARL) this morning. PARL has a price of $3.12, a market-cap of $26.7 million, a P/E ratio of 6.1, zero dividend, a price to book value of 0.54, and a debt to equity ratio of 0.10. It meets two Benjamin Graham value criteria (P/E and P/BK) and two safety criteria (D/E and current ratio [3.83]). Per AAII, its price to sales ratio is 0.43. The company's price to cash flow is 4.56. Return on shareholder equity is 10.83%.

This year our micro-cap value stocks, such as this, have generally done quite well. We have high hopes for PARL as well.

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