Four Basic Rules for Investing in the Stock Market

Beating the S&P has become like a golf handicap: expressed in a number that gets bandied about, and maybe embellished a point or two, to impress any financial "mind" polite enough to listen.

The goal is simple, But for many, the attempt is futile and childish, grossly naïve in its fundamental premise. Most try, but few succeed.

Fifty years ago, keeping your head above water meant saving a dollar. Now, squeaking by has become the 13% annual return that nearly ruins a manager's financial career/reputation by narrowly clearing the S&P by a mere 50 basis points.

But there's a new American generation... an entitlement class of children playing children's games... a generation weaned on the bottle of instant gratification. They've been told to expect more for less... they've been assured that it's OK to spend more than they make... because in the end, the government will be there to brace their fall.

Unfortunately, mommy and daddy are broke. And so is Uncle Sam. But the American family keeps spending despite that the consumer savings rate for all of 2006 remained a negative 1%.

The 2006 figure proudly surpassed the negative 0.4% savings rate in 2005. These two years produced the most reckless lack of savings since the negative 1.5% savings rate in 1933, during the Great Depression.

So while most Americans woefully stare at double-digit Annual Percentage Rate (APR) as they cut another cheque for the minimum monthly payment, the debt continues to rise.

It won't be long before the notion of keeping your financial head above water will require more effort than signing your name on the back of yet another new credit card.

Hardly anyone beats the market for more than a few years, so why do we waste so much time and money trying? And more importantly, why do we deem our investing success relative to what a bunch of strangers are doing? It's comical when you stop and think for a second. As Jason Zweig cleverly points out in Ben Graham's The Intelligent Investor, no one's gravestone reads, "HE BEAT THE MARKET!"

Expectations today shun returns below double digits. Earning 9% won't cut it if someone else is earning 10%.

That type of thinking negates what Warren Buffett calls the very first rule of investing: "Don't lose money."

As investors, we're looking for a margin of safety... companies trading near or below their intrinsic value with an established earning power. That's basically it.

So here are four basic rules for investing in the stock market criteria I follow. You may recognise the thinking. Warren Buffett coined the parameters. It's a bit cliché, but we'll humbly concede that if the wheel ain't broke...well, you know the rest.

So let's begin. We always ask ourselves these four things:

1) Is the business easy to understand?
2) Does the business sell at a fair price?
3) Does the business operate with a long-term competitive advantage?
4) Does the foreign stock trade on a U.S. exchange?

For explanation's sake, we're going to lump the first two rules together in the following example.

Is the business easy to understand and does it sell for a fair price?

This is a fictional story of a small biotech company. We'll call the firm "CureAll Pharmaceuticals." CureAll currently holds patents on two mildly significant drugs that treat a rare blood disorder. Proceeds from those sales pay the rent, but the company continues to operate in the red. The company's immediate future rests on a breakthrough pipeline drug capable of curing prostate cancer.

Here is where our story begins.

One of the world's most respected financial newspapers reports that the small biotech company CureAll Pharmaceuticals, based in Raleigh, N.C., cleared Phase II clinical trials for a remarkable new drug that researchers suspect has a 90% probability of effectively curing early-stage prostate cancer.

The drug can be administered in pill form. Effective treatment will require one pill every three months. The FDA has signalled that passing Phase III trials seems likely. Anticipation builds.

Prostate cancer affects more men than any other form of cancer. The American Cancer Society estimates 220,900 new cases of prostate cancer were diagnosed in the U.S. in 2003 alone. No males are immune. The risks increase with age. Family history also increases the likelihood.

The breakthrough of such a drug would mean a great deal to a great many people. There's no way to quantify the benefits.

Even before Phase III clinical trials begin, the company's stock takes off. Investors are willing to forego 120 years of future earnings for a single share. Who could blame them? This is the miracle cancer drug we have all been hoping for.

Two years pass, and FDA approval looms even closer. The stock price continues to climb. The atmosphere around CureAll's stock feels strikingly similar to the sentiment for Internet search engines in the early 1990s.

You may remember, back in 1994, Yahoo's search engine started as a simple directory for the then-small universe of Web sites. The stock price rose side by side with the market all the way to its peak in 2000. On the last day before the new millennium, Yahoo closed at USD$432.69. Its diluted earnings per share that year were 6 cents on the dollar. And investors and pundits were predicting that Yahoo was set to go even higher.

We termed the 1990s the "new economy." We said times had changed. Many considered earnings to be irrelevant. We all know how that story ends.

By the end of 2000, Yahoo closed at USD$25, down 94% in less than a year.

But it's now 2007. Times have changed.

Investors argue CureAll maintains a tangible revenue-producing product. The dot-com companies had nothing like this, they said. That is why speculators got burned. "It's different this time," they claim.

CNBC and the financial press jump on board. They interview a host of potential candidates for this cancer-curing drug. Even pundits left of the far left begin cheering capitalism's conquest. They jump on the business- minded bandwagon. They claim seed money from cutthroat VC firms is finally being put to good use. Society and Wall Street are meeting face to face for the very first time.

Soon, management announces a press conference. The greatest minds in medicine start making public statements. This looks to be the breakthrough society has been anxiously awaiting. The stock takes off. The share price now trades for 200 times earnings.

Among a host of reporters, doctors and investors, CureAll's management discloses final FDA approval. The room explodes with applause and cheering.

Wall Street wholeheartedly jumps on board. The stock climbs even higher...by the end of the trading day, CureAll's shares are going for 250 times future earnings.

Here's where our story takes a turn.

In all the hype, investors confused the tangible benefits of the drug for the tangible benefits of the stock.

Unfortunately for investors, the costs of producing this innovative drug are astronomical. Gross margins are less than 5%. Operating margins are then even half of that.

Critical inputs come from shaky supply sources. To make matters worse, CureAll's current blood disorder drugs are about to go off patent. The future pipeline contains the only high-margin, cash cow product that could effectively put the company firmly in the black. But FDA approval for that drug requires successful DNA rebuilding in the Jensen sarcoma as well as full atomic models with sugar phosphate nucleic acid structures of 25 different lab rats.

That's tough to read, much less to comprehend.

Like Yahoo, the hysteria surrounding CureAll's drug eventually surrenders to the financing and fundamental earning power behind it. Although cancer patients are rewarded, investors suffer. The stock falls 94% by the end of 2007.

The story of CureAll demonstrates two common traps that readers of The Offshore Speculator will be encouraged to avoid: First, steer clear of businesses you don't fundamentally understand. And second, never pay too much for an asset, regardless of how great that asset may be.

You see, all market bubbles eventually come to an end. There's no telling what triggers the retraction. Some average investor woke up one day and realised that he'd probably not recoup his investment on a company with an earnings multiple well above 200. It's really common sense.

Value investors like Benjamin Graham and Warren Buffett know that throughout history, the average price-to-earnings ratio of the stock market has been 15.3 - which means investors have traditionally been willing to pay $150,000 or so for $10,000 in earnings.

Yesterday it was Yahoo and today it appears to be Google.

Growth projections are large, and they're built on a very fragile assumption. They assume Google will be the leading search engine for years to come. They assume a competing programmer will fail to construct a better algorithm. They assume real competition will not enter the market. In an industry with little to no switching costs, that's a pretty risky assumption.

As value investor Christopher Browne points out, there is nothing wrong with owning a great business that grows at fantastic rates... it's a matter of paying the right price for that business.

Browne goes on to say that investors should determine an intrinsic value, wait for someone to overreact or under-react to news and buy the stock when the market prices the shares for less than they're worth.

In the case of CureAll Pharmaceuticals, investors would have been wise to short the stock the day after the cancer-fighting drug received FDA approval.

But so it goes.

Google is just another name for the same story. It's a story whose message is focused on hubris and greed. Regardless, investors today are singing the same historical tune: "It's different this time."

It's never different this time.

Regards,

Christopher Hancock
for The Daily Reckoning Australia

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