Using the Web to Enhance your Investment Return
Ted Williams, PhD

List of Sections

1. Introduction
2. Roth IRA Contribution limits
3. Overview
4. Method 0 - Low Cost Mutual Funds
5. Method 1 - Peter Lynch's Strategy
6. Method 2 - Motley Fool's Strategy
7. Method 3 - Valueline Portfolio I
8. Method 4 - Value Investing
9. Options
10. Summary
11. References
12. Summary of Links
13. Glossary of Investment Terms

Introduction

Some caveats:

• I do not recommend or endorse any security, product, or company mentioned here. I am describing my own experiences which may, or may not, be applicable to your situation.
• I do not provide investment advice. Never accept any advice or recommendation, including the information provided here, without first performing your own independent verification.
• The opinions expressed here are not necessarily those of NOCCC or of my employer.
• I am not an expert on investing. I invite you to add your own insights to this discussion.

In case you have occasion to refer to any information provided here, this presentation is available on my web site, www.tlwilliams.net, article 0106pInvesting.

In the February presentation we covered several basic investing topics listed below. In case you missed that presentation, you can view the presentation at www.tlwilliams.net, article 0102pInvesting.

• How much money do I need in order to retire?
• Definitions of stocks, bonds, certificates of deposit, money market funds.
• Using asset allocation to control risk.
• How taxes reduces your return from stocks and from mutual funds.
• Criteria for selecting a mutual fund.
• Stock brokers, market makers, and financial advisers - pitfalls and hidden costs.
• Buying and selling stocks on-line. Selling stocks short.
• Buying and selling bonds and treasuries on-line.
• The benefits of a ROTH IRA.
• How to avoid transaction fees via direct investing.
• Social investing.
• Annuities and life insurance.
• References

This discussion does not emphasize the importance of asset allocation in controlling the level of your risk. For more on this topic, please consult the article 0107b Asset Strategy on my web site, www.tlwilliams.net.

Roth IRA Contribution Limits

The table below is off-topic, but it notes the latest contribution limits for the Roth IRA as per the Tax Reduction Act signed into law on May 28, 2001. These new laws may be changed, depending upon future legislation. Check out the latest developments at www.rothira.com.

To qualify you must have earned income equal to or greater than your Roth IRA contribution. Further, the maximum allowed contribution starts to decline (depending upon your filing status) if your modified adjusted gross income exceeds $95,000 in the year that your contribution applies. The rules are too complicated to spell out in detail here.

Overview

We build on the February presentation by discussing some more aggressive investment strategies that you can implement with the help of the internet. We start by reviewing the long-term strategy presented earlier and then we describe four new strategies:

• Method 0 - Low-cost mutual funds. Regular investments in low-cost mutual funds using a Roth IRA to reduce taxes.
• Method 1 - Peter Lynch's strategy. Invest in companies that produce products and services that you use and understand.
• Method 2 - Motley Fool. Invest in emerging companies that dominate an industry.
• Method 3 - Valueline. Invest in a portfolio suggested by Valueline. Their Portfolio I has a long-term track record that surpasses the S&P 500 index.
• Method 4 - Hedging. Use stock screening to pick 10 stocks for purchase and 15-20 stocks to sell short. At the end of every quarter, reevaluate your portfolio. Replace any poor performers by repeating the stock screening process.

Method 0 - Low Cost Mutual Funds

This tried and true method for successful investing involves the following steps in the order shown:

• Eliminate debt, especially unsecured debt.
• Participate in tax-sheltered retirement plans (401Ks, Roth IRAs) to the extent allowed by law. By 2004, you will be able to invest $5,000 of earned income per year in a Roth IRA.
• Set aside $400 every month for your Roth IRA.
• Invest part of your money in a low-cost index fund, such as one of the Vanguard Index Funds
• Invest part of your money in a low-cost bond fund.
• To reduce risk (but with lower gain), place a portion of your investment in short-term bond funds, money market funds (MMFs), or certificates of deposit (CDs).
• If you have a long time horizon and/or you are willing to assume more risk, increase the portion in stock funds.

Just invest regularly in a low-cost mutual fund and forget about it. As the time that you plan to spend some of your investment approaches, move a portion of your investments into CDs, MMFs, or short-term bond funds. For more information on this method, see my February presentation 0102pInvesting.

Method 1 - Peter Lynch's Strategy

Peter Lynch is the famous manager of the Fidelity Magellan Fund in the 1970s. He reveals his secrets in the book One Up On Wall Street. His strategy is simple. Buy stocks of companies that provide services or products that you like and understand. A couple of examples are:

• L'Eggs. Peter's wife visited found that the grocery store had started to offer pantyhose in egg-shaped containers. Peter went to the store and found that the grocery store manager was unable to keep up with the demand. He found this investment very profitable.
• Starbase. I once worked for a company named Starbase Corporation. I knew a lot about the company and its prospects. When the stock price fell to $0.76 per share, I invested heavily. A few months later, I sold at $3.00 per share for a handsome profit (it rose briefly to $16.00 per share later in that same year).

Note a couple of things. Not every choice will be a winner, but a few big winners will more than compensate for a few small losers. You do not have to buy a stock at its absolute bottom or sell it at its historic high to make money.

Peter makes several important recommendations about investing:

• Think like an amateur.
• Buy bonds when interest rates are starting to rise, sell when rates are at the bottom.
• Stocks are most popular when the market is about to fall (e.g. Jan, 2000).
• Research before you buy.
• Stocks are a bet on the future earnings of the company.
• Choose stocks with a P/E less than growth rate.
• Choose stocks with an increasing dividend.
• Buy on a dip.

Method 2 - Motley Fool's "Rule Breaker" Strategy

The Motley Fool is run by the Gardiner brothers. They offer some good advice and some mediocre advice at their site on the web www.fool.com.. Their more aggressive portfolio, named "Rule Breaker" has earned 32% in the last year and has averaged 30% per year since its inception in 1994. Their philosophy is to identify the companies that are on their way to dominating an emerging market. For example, Wal-Mart in the 1970's or Microsoft in the 1980's. These companies went on to make huge fortunes for their investors. Consult their web site for more details on how they value a company's prospects.

Method 3 - Valueline Portfolio I

The Hulbert Financial Digest ranks the performance of hundreds of financial newsletters. Most do not do as well as the S&P 500 index. One exception is the Valueline Portfolio I which has outperformed the S&P 500 year after year. Although a Valueline subscription is expensive, they do offer extensive extensive financial information on over 1700 companies. They also offer a "Timeliness" rating on each stock. Their portfolio selects stocks using the following criteria:

• Timeliness rating of 1.
• Safety rank of 1-3.
• Financial strength of B+ or higher.

If you are a subscriber to Valueline, you can find weekly updates to this portfolio in the "Selection and Opinion" newsletter in the section " Selected Investments: Recent Developments". The performance of this portfolio is published a the end of each quarter.

Method 4 - Value Investing

Stock Screening
Have you wondered how most mutual fund managers select stocks? Most use "stock screening" to select stocks to buy. Stock screening is done by selecting a set of stocks that meet some criterion, such as a Valueline Timeliness rating of one. Then, this set of stocks is reduced further by selecting those stocks in this set that also meet another criterion, such as a Valueline Financial Strength of B+ or better. This process is continued until all of the desired criteria are met.

Selecting Stocks
Valueline offers a stock screening facility for its subscribers. The process is as follows. Select:

• Summary & Index
• Valueline Screens, Full database
• Tools, Filters
• For each criterion: Select field name, logic, value.
• Save filter
• Run filter

If there are too many stocks left, add more criteria. For example, you can add a criterion such as high yield. If there are too few stocks to pick from, allow a greater range of values. For example, allow a Valueline Timeliness rating of one or two. In addition, you may manually remove one or more stocks from the list.

This same process can also be used to select poorly performing stocks as candidates for short sales.

Selecting Columns
Valueline has over 256 columns, one for each piece of data, such as the Timeliness Rating, P/E ratio, Price, etc. Most of these columns are of no interest to us. We can restrict the number of columns displayed. In the above stock screen select the following:

• Select view from the menu at the top.
• Select Customize from the drop-down menu.
• Hide all columns.
• Select those columns you wish to display and then select show columns.

Bogle's Criteria.
Bogle in his book, Common Sense on Mutual Funds, suggests that the following factors determine the average stock market return over an extended period:

• Initial dividend yield.
• Rate of growth in earnings over the period.
• The change in the price-earnings ratio over the period.

Formula
Suppose that the dividend yield and the rate of growth are both zero. Further, suppose that the initial P/E ratio, PE1 is 15 and the final P/E ratio, PE2 is 18. Initially, the investor is willing to pay $15.00 for $1.00 of earnings. At the end, the investor is willing to pay $18.00 for $1.00 of earnings. The change in stock price just due to the change in the P/E ratio is $3.00. As a percentage of the initial price, the change is $3.00/$15.00 or 20%. If the time period, T, is 10 years, then the average annual change is 20%/10 yrs or about 2%/year. Adding in the initial dividend yield, Y, and the rate of growth in earnings, R, the total annual return is predicted to be:
AnnualReturn = Y + R + (PE2 - PE1)/ (PE1 * T)

For example, if Y is .07 (7%) and R is .03 (3%), then
AnnualReturn = .07 + .03 + 3 / (15 * 10) = .12 or 12%

The initial dividend yield is known at the beginning of the period. The rate of growth in earnings is fairly predictable over a year or so; however, the change in price-earnings ratio is difficult to predict.

User-defined fields
Valueline not only provides the above stock parameters, it also has projected price earnings ratios for one or more quarters into the future. So, all the above parameters are available. We can define the above formula in a user-defined field. Then, we can use this new computed field to select our stocks.

I have found that this general method works fairly well when the "character" of the stock market is not undergoing a change. For example, in the beginning of 2000, the investing climate shifted from "irrational exuberance" to "general pessimism". Just before this shift, the predictors were generally way too positive and subsequent results were much lower than predicted. Almost any stock screening method should be viewed with some skepticism in this sort of shift in the market climate.

Options

There are may types of options available. A "Put" is an option where you may sell a specific stock at a preset price (called the "strike price" up until a specified expiration date. For example, "XYZJuly 50 put" is an option whereby you may sell 100 shares of stock for $50. The offer expires the next July. A "Call" is the same as a Put except that it is an option to buy rather than sell the stock.

You may use put options as a hedge. Suppose that you purchase 100 shares of the stock XYZ for $52 and also purchase a Put option on this stock at $50 (strike price). If the stock rises in price, you may sell your stock and let the Put option expire. If the stock falls in price below $50 you may sell your stock by exercising the Put option to obtain a minimum of $50 for each share. Note that you lose the cost of the option if the stock rises, but you also reduce your risk in case that the price of the stock falls.

Options may be used in a wide variety of ways as a part of your overall investment strategy. We shall leave options as a topic for future discussion. However, if you wish to explore this topic now, consult the reference below Options as a Strategic Investment.

Summary

None of the above strategies works 100% of the time. Sometimes, almost all of the stocks will rise in value. Sometimes, none of the stocks will increase in value. On the average, a strategy should pick more winners than losers. You may want to fall back to a more conservative strategy for a portion of your investments, such as Method 0, investing in low-cost mutual funds when the market is falling. Then shift more of your investments into a more aggressive strategy as the market conditions improve.

Here is a way to project future market conditions. Apply the formula described in Method 3 to an index fund or to a broad range of stocks. If the formula predicts a comfortable 3-month profit, you may wish to shift some funds from a conservative strategy to a more aggressive strategy and vice versa.

Considerations
Here are some considerations in deciding what to do:

• Time. Compound interest can generate enormous wealth over time. To take advantage of this effect, you must employ a consistent strategy over an extended period.
• Money. Some discretionary funds must be available for investing. Save regularly over time.
• Discipline. "A winner focuses, a loser strays". Select a strategy that you are comfortable with and stick to it.

Concerns
Here are your enemies that you must guard against:

• Debt. Eliminate debt, especially unsecured debt. Why pay others interest? Let others pay you!
• Financial Advisors. Real experts aren't going to seek you out. Advisors have an agenda (to make money for themselves, build fame or increase their ego) that rarely works to your advantage. Following the advice of one advisor after another precludes a consistent winning strategy.
• Inflation. Inflation reduces the buying power of your investment. To get ahead, earnings must exceed inflation.
• Taxes. State and local taxes, estate taxes, sales taxes. The list goes on and on. Taxes is the elephant in the dining room that mutual funds hope you do not notice. The Roth IRA and 401K retirement plans are your best weapon to reduce the tax bite.
• Fees. Transaction fees, front-end loads, back-end loads, annual expenses can take a huge bite out of your earnings. Less noticeable, but more insidious, are markups, kickbacks, and spreads between the bid and asked price. Read the prospectus of any fund. Make sure that the fund offers low annual fees and a low turnover. Use TreasuryDirect.gov to avoid fees when purchasing treasuries.
• FUD. Fear, uncertainty, and doubt. Many just succumb to these emotions and put their money under the mattress (or in a savings account). They panic every time that their investments take a hit. The best antidote is to keep a percentage of your money in cash equivalents (CDs, MMFs) and invest the rest in a few carefully selected stocks. Be sure to dump your losers promptly.

Conclusions
Here is a summary of the investing strategies presented here:

1. Low-cost mutual funds. Invest in a low-cost index fund, such as one or more of the Vanguard index Funds.
2. Peter Lynch Strategy. Pick 10 or more stocks from companies that you do business with. Look for stocks that are offering a valuable new product or service.
3. Motley Fool Strategy. Pick ten or more stocks from companies that dominate an industry. Examples are described in their Rule Breaker Portfolio.
4. Valueline. Pick the stocks shown in their Selection & Opinion newsletter in the Selected Investments: Recent Developments section. Their Portfolio I has had outstanding performance according to the Hulbert Financial Digest.
5. Value Investing. Apply stock screening to select a list of stocks that meet some criteria that you choose. Invest in ten or more stocks from the list of survivors. At the end of each quarter, re-evaluate each stock. If a stock rating has decreased, replace it with a stock that now has a top rating. As a hedge, also sell ten stocks short. Select ten stocks with poor predicted performance.

References

Books. Here are a few references for those who wish to explore investing further:

• Investing Strategies. "One Up On Wall Street" by Peter Lynch, Penguin Books, 1989.
• Investing in Mutual Funds. "Common Sense on Mutual Funds" by John Bogle, Wiley 1999. Good insights into index funds, asset allocation, transaction costs, and tax considerations by the founder of Vanguard.
• Valuing Companies. "Valuing Wall Street" by Smithers and Wright, McGraw-Hill 2000. Explains why stocks were extremely overvalued starting in 1998. A cautionary tale.
• Professional Investors. "The Predictors" by Bass, Holt 1999. How professional investors operate. Traders must compete with these experts.
• Stock Market Factors. "The Inefficient Stock Market" by Haugen, Prentice-Hal1 1999. Explains some factors that affect the stock market. Why big, liquid, well-known stocks generally perform better.
• Stock Market Factors. "A Random Walk Down Wall Street" by Malkiel, Norton 1996. Why investing based on factors such as those described in the above book are controversial.
• Money Management. "The Consumer Reports Money Book, Third Edition", Consumer Reports, 2000. Banking, money management, insurance, taxes, retirement planning.
• Investing in Mutual Funds. "4 Easy Steps to Successful Investing" by Pond, Avon 1997. Somewhat simplistic investment advice, typical of many, many books on investing.
• Options. "Options as a Strategic Investment, 4th Edition" by L. G. MacMillan, New York Institute of Finance, 2001.
• Attitude. "Millionaire Mind" by T. J. Stanley, Andrews McMeel Publishing 2000. Stanley interviews hundreds of millionaires to uncover what differentiates millionaires from the pack.

Summary of Links

Here are a few web sites (in alphabetical order) that I found of value:

• www.aaii.org - American Association of Individual Investors. An organization that helps individual investors. They have local clubs and lots of useful literature.
• www.bankrate.com - finds the best rates for CDs (Certificates of Deposit) and MMFs (Money Market Funds).
• www.better-investing.org - all about investment clubs.
• www.bondresources.com - lots of info on bonds.
• www.buyandhold.com - a stock broker that facilitates a buy-and-hold strategy.
• www.fool.com - lots of advice on investing.
• www.gomez.com - rates companies including stock brokers.
• www.goodmoney.com - scroll down to select forums, lists of stocks.
• www.hoovers.com - analysis of industry sectors.
• www.house.gov/jct/ - summary of latest taxation changes.
• www.hulbertdigest.com - Rates financial newsletters.
• www.investinginbonds.com - advice from the Bond Market Association.
• www.money.com - lists 50 top financial sites.
• www.moneycentral.msn.com - select investor, quotes, options to get detailed information on options. Powerful stock screening tool.
• www.morningstar.com - rates mutual funds, ETFs (Exchange Traded Funds), and stocks.
• www.netstockdirect.com - lists 1600 plans with information about each.
• www.quote.com - investment tools, message boards, stock and mutual fund information.
• www.quote.yahoo.com - lots of investing info.
• www.ragingbull.com - message boards, financial news, quotes.
• www.realassets.org/social_investing/ - social investing basics, using screens.
• www.rothira.com - a very comprehensive site on the Roth IRA
• www.schwab.com - good info on investing, including information on the Roth IRA
• www.senate.gov/~finance - official info on the Roth IRA.
• www.sharebuilder.com - a lot like a stock broker.
• www.valueline.com - lots of stock information. The Hulbert Digest rates their Portfolio I as one of the few portfolios that outperforms the S&P 500 stock index over an extended period. They offer an introductory 13 week subscription for $55.
• zacks.com - stock analysis and stock ratings.

Here are a few companies (in alphabetical order) that offer investing services:

• www.etrade.com - a low-cost stock broker
• www.scottrade.com - a low-cost stock broker that sells mutual funds, stocks, bonds, etc.
• www.treasurydirect.gov - a very low-cost way to buy treasury bills, treasury notes and treasury bonds. Never buy treasuries from a stock broker.
• www.vanguard.com - offers low-cost mutual funds.
• www.wsj.com - lots of investing advice.

Glossary of Investment Terms

APY - Annual Percent Yield

The total amount of interest paid per year divided by the amount of the loan.

Callable

The issuer of a callable bond or callable CD may pay off the debt prematurely, cheating you out of the higher interest rate that you would otherwise receive.

Cash equivalents

CDs or MMFs.

CD - Certificate of Deposit

A CD may be purchased from banks and other institutions. The bank repays the CD with interest on a specified date in the future.

Equity

Stocks or other ownership in a company.

FDIC - Federal Deposit Insurance Corporation

A federal agency that guarantees all deposits up to $100,000 in any member institution.

Traditional IRA

A tax-sheltered account that you can open with a stock broker or other financial institution. Your contributions to an IRA are tax deductible.

MMF - Money Market Fund

A savings account that pays daily interest. The interest rate varies depending upon the current interest rates. If the institution is a member of the FDIC, deposits are insured up to $100,000.

Portfolio

A collection of stocks or other securities (a portfolio may be owned by an individual, or it may be a list suggested by a financial adviser).

Roth IRA

A tax-sheltered account that you can open with a broker or other financial institution. If you qualify, you can contribute up to $2000/year (or more starting in 2002). Qualified distributions are tax free including all of the earnings and all of your contributions! There is no mandatory withdrawals during your lifetime and a Roth IRA can be passed on to your beneficiaries who can also make tax free withdrawals.

Treasuries

IOUs issued by the US Government. Treasuries are very safe, and the interest paid by treasuries is not subject to state income taxes.

Uptick

A stock trade at a price that is higher than the previous price.

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Last update: July 30, 2001