by Martin Zweig
Would your indicators work if I invested only in mutual funds?
Sure. You could use the Super Model developed in chapter 6, and invest in mutual funds or closed-end funds (those traded on exchanges) on a buy signal and move to money market funds on a sell signals. Or, you could modify it. You could get fully invested when the model is very good, say 8 points or higher, and you might move to a 50% position when the model is neutral and then get completely into money market funds when the model is, say, 2 points or less. You can also trade the funds with the model presented in chapter 5, the Four Percent Model, which follows the tape, or with the Monetary Model discussed in chapter 4.
What do you consider a reasonable rate of return on a stock market investment?
Studies of stock market activity over the last sixty years or so have found that one would have earned in the vicinity of 9% to 10% a year, assuming reinvestment of dividends. Roughly half of the returns would have come from dividends and the rest from capital appreciation. That’s before inflation. If you factor in inflation of perhaps 3% over that period, it gives you a real return of 6% to 7%. Of course, that includes periods of several years when returns were negative.
If you’re playing the market, you have to realize that you are somewhat at the mercy of what the market as a whole will do. You’re not going to earn 20% to 30% a year if the market is doing nothing or going down.
I prefer to stick with blue chips. Is this a wise investment strategy?
The problem is that a blue chip company is mature and might not have a lot of growth left in it. It might sell at a premium because of the safety, lowering the long-run rate of return. Also, stocks that are regarded as blue chips today may not have that status in a few years. Not so long ago, U.S. Steel was one of the strongest of blue chips, but over the last decade or so it’s been viewed as more of a dog, which, ironically, might make it a better investment since it is out of favor and possibly undervalued.
On rare occasions even blue chip companies cash in their chips, with disastrous consequences. I remember the story of what happened to a New England family in the nineteenth century. When the head of a very wealthy household died, he left an irrevocable trust, putting all his assets into the bluest of blue chips of that day—the New Haven Railroad. It was as blue a chip then as perhaps General Electric is today. Over the years, the railroad’s fortunes sagged and sagged, and the heirs desperately tried to break the trust but couldn’t. Eventually the railroad went bankrupt and they lost all their money.
Generally speaking, blue chips do offer, despite the above example, more safety than the average stock. They also offer less return. Normally, the higher the risk, the greater the expected return.
Should I ever buy a stock because it pays a good dividend?
I wouldn’t buy a stock just because it pays a good dividend. But if other aspects are favorable and the stock has a high yield, that’s a bonus. What you have to be careful about are stocks with exceptionally high dividends. These yields may be excessive for very good reasons, possibly because the company has undisclosed problems. You are probably better off going into the next rung, buying the blue chip stocks with high but not ultrahigh dividends.
If, over the past twenty, thirty, or forty years, you had bought eight or ten stocks from the Dow Jones Average with the highest dividends and adjusted your portfolio each year to stay with the highest dividend payers, you would have done better than the Dow in terms of total return over that period. In other words, appreciation plus dividend return would have been higher for the high-yielding stocks than for the lower-yielding ones. And yet the low-yielding stocks, which pay low dividends or even no dividends, and usually have high price/earnings ratios, are those associated with growth.
In the long run, the plodding types of companies with high dividend yields and low P/E ratios have tended to outperform the growth stocks. So there’s nothing wrong with buying high dividends. In fact, other things equal, it would be the preferred thing to do. I just want to warn you that perhaps 1% or so of the stocks with the highest of all dividends may be somewhat risky.
What about new issues? Should I try to find them?
There are good new issues and bad ones. They tend to run in cycles. When the stock market is speculative, many hot new issues come out. A hot new issue is one that opens at a big premium over the offering price. Suppose the offering price is 20. If you are fortunate enough to buy at that, the stock may open at 25 or even 30. It causes a lot of excitement and a stampede into new issues. Unfortunately, companies of lower quality also rush in to sell their stock. If you get a tremendously speculative period, such as 1961 or 1968 or 1983, a lot of garbage is underwritten and eventually somebody gets left holding the bag.
If you’re buying new issues, buy the better ones. Studies have shown that new issues tend to outperform the market for the three to six months after they appear. But you don’t want to overstay the game. If you had bought new issues at the end of 1968, you would have had a disaster on your hands the following year. The same is true of 1983. If you had bought late in the 1983 new-issues craze, you would have been hurt badly in 1984. So, it’s like everything else. New issues are okay if you know what you’re doing and don’t get left behind when the party’s over.
I would avoid new issues at excessively high price/earnings ratios. I would avoid low quality. I would avoid new issues from the schlock houses of Wall Street. I would stay away from startup companies and concept companies (companies that don’t even have a business going), and I would pass on new issues in which the original owners are big sellers. It’s fine if the company itself is trying to raise money, but it’s not so good in the case of a bailout, where the company’s owners sell huge amounts of stock. If they’re selling modest amounts, it may be okay, but the more they sell, the warier you should be.
How do you feel about dollar-cost averaging when buying stocks?
I’m not too thrilled about dollar-cost averaging because it means that you buy more if a stock declines. I don’t like buying weakness. If you buy a stock at $50 and it drops to $40, maybe there’s something wrong. If it’s such a great stock, why did it drop in the first place? I’d rather buy strength and sell weakness. If you are investing income regularly in the market, perhaps in an IRA, where you put in $2000 each January, that might be okay. You’re sort of dollar-cost averaging. If the market is lower, you’ll wind up buying more than if the market is higher. But if market conditions are lousy in a particular January (when it’s time to make the next IRA contribution), I wouldn’t invest my $2000 right then. I’d put it in a money market fund and wait for conditions to improve.
Do stock splits really help you at all?
No. Stock splits are much ado about nothing. They only help the brokers because they create more shares and generate higher commissions. The effect of a stock split is not different from cutting a pie into more pieces. If you cut a twelve-inch pie in half, you still have a twelve-inch pie. No matter how many slices you cut, it’s the identical amount of pie. It’s the same with a stock split. It has absolutely no value, and yet many naive people believe they are getting something for nothing. On the positive side, a split might provide more liquidity for the stock, making trading a little easier. But it doesn’t add any value to the company.
Is there a way to spot special situations like takeovers?
A lot of money has been made in searching out takeover situations, and there’s nothing wrong with that technique. It’s just not my approach. As I see it, takeovers are the domain of professionals who specialize in this most difficult and time-consuming area.
Basically, to uncover takeover candidates, you look for companies with assets substantially in excess of their stocks’ market value. With public information, however, it’s hard to determine actual value of assets. For example, a company might have land in downtown Dallas purchased fifty years ago for $1 million and worth $100 million today. It’s not on the books for that. So you’d have to find some way of determinin
g what the assets are worth.
If you’re interested in combing through annual reports and all sorts of statistical information, you might dig up potential takeover targets. But that doesn’t mean they will be taken over and, if they are, it could take several years. If you favor that approach and can handle it emotionally, then by all means go ahead. It’s not right for me but is right for some people.
Are there any advantages to buying low-priced rather than more expensive stocks?
The public is often tempted by low-priced stocks, say those under $10 a share. People figure that if they buy a $5 stock, they only have to put up $500 for a round lot and that it would be easier for a $5 stock to go to $10 or $20 than for a $50 stock to reach $100 or $200. Actually, that happens to be true in bull markets. However, in a bear market it’s just the reverse. At the bull market top there are a lot of stocks selling for $15 and $20 that have come up from $5. These stocks are going to make a round trip and plummet again. So you’ve got a lot more risk with low-priced stocks, and you’ve got a lot less quality.
Stocks sell for a few dollars a share for a very good reason— they tend to be junk. An exception might be in a year like 1974, after the market had been annihilated for a few years and stocks that had formerly been $30 or $40 were selling at $5. In the long run, I think you’ll make more money by eliminating the junk stocks and concentrating on stocks of reasonable quality that have real earnings or real assets behind them.
While I’m on the subject, there’s a kind of stock even worse than the typical $5 stock. That’s the so-called penny stock, which trades for under a dollar a share. Generally, you’ll find them at some regional markets, such as Salt Lake City or Denver or the Spokane Mining Exchange. Most are mining stocks—very few with earnings or even working mines. In Salt Lake City and Denver they underwrite a lot of high-technology stocks that sell for pennies but frequently don’t even have a product. You’ve got to be very careful, but in periods of speculative frenzy, a 10¢ stock might go to $5. People think they can make a killing in these markets but most wind up getting burned. I would, as a general rule, stay away from penny stocks, particularly if you’re dealing with your IRA or Keogh plan.
Should I consider buying stock on the American Stock Exchange or over-the-counter?
I have no problem with the AMEX or OTC except when it comes to placing orders. Because these markets are generally thinner and dealers have less capital, you usually get better trades on the New York Stock Exchange if you are buying or selling in quantity. As for the stocks themselves, those of the AMEX and OTC tend to be more speculative and represent smaller companies than those listed on the NYSE.
The real question is whether you want to buy secondary-type stocks or the blue chip variety. I would tend to go heavily into the secondary stocks only when conditions are very, very bullish for the market as a whole. This would be a time when our Super Model turns extremely positive and the Fed is loosening credit, especially if we’re in or just coming out of a recession. Then you could probably buy the secondaries with the greatest safety. In a more neutral period, when the models are mixed, I would tend to favor the more conservative companies. And, of course, when the models are unfavorable, you wouldn’t want to be in stocks at all. Most of the references in the book are to stocks. What about bonds? Should I buy them? How do you select them?
There is nothing wrong with bonds. When the bond market is strong it generally reflects conditions that are also bullish for stocks. During those periods stocks tend to do even better than bonds. Although stocks probably decline more than bonds during the bad periods, they outperform bonds over the long run. At least, that’s been the record over the past five or six decades. Stocks, however, are more volatile and riskier than bonds. So if you don’t want the risk of stocks, that’s okay; but telling you when to buy bonds is beyond the scope of this book.
Even if I were a long-term investor with an individual IRA or Keogh account and didn’t plan to retire for ten, twenty, or thirty years, I would pick stocks rather than bonds. Many brokers are pushing the so-called Zero Coupon Bonds, which mature in twenty or thirty years with an interest rate that works out to 6.5% to 7%. While this seems tempting for an IRA, I feel that if you have that kind of time working for you, you’re better off with stocks even though there may be a period of a year or two when you don’t do that well. I think that stocks would provide more money in your retirement account at the end of the period.
What about annual reports? Should I get one before I buy into a company?
I don’t use annual reports very much. If you really want to buy companies based on value, you should consult annual reports and also the even more comprehensive 10-K reports filed with the Securities and Exchange Commission. Of course, you’d want to back that up with statistical information from Standard & Poor’s, Moody’s, or Value Line, where you can get a lot of balance sheet information and financial history and tear it apart. If you’re really into it, you can read the footnotes. You can spend an inordinate amount of time analyzing just one stock. By now you know I have a different approach to the market. But there is no one right way to do it. Reading annual reports and related materials can be helpful in specific investment decisions.
Can the stock market foretell business conditions?
Actually, yes. The stock market is one of the twelve leading indicators published by the government—and the one with the best track record for calling the economy. That’s ironic because you hear an awful lot of stock market forecasts based on what the economy will do. The market is a discounting mechanism. It discounts what the economy will do, not the other way around. The market tends to peak well before the economy does and also bottoms first. In general, the market will bottom six months before the economy does. The best time to buy stocks is during a recession. Once the economic downturn has become widely recognized, it’s no great help in the stock market to know what the economy will do. On the other hand, if you want to forecast the economy, look to the stock market.
How representative is the Dow Jones Industrial Average of what’s happening to the overall market?
The Dow isn’t that representative because it comprises only thirty blue chip stocks. There are intervals such as in 1972, when the Dow went up roughly 10% while the average stock fell by a like amount. In other periods, such as in 1977, the average stock rose slightly but the Dow dropped about 15%. So there are times when selected blue chip returns vary greatly from those of secondary or smaller companies’ stocks.
Arbitrary decisions can also substantially affect the Dow performance. For example, IBM was taken out of the Dow back in the 1930s, and not replaced until the late 1970s. The company enjoyed fabulous growth during the forties, fifties, and sixties. Had IBM not been removed, the Dow would have stood at perhaps 1700 or 1800 sometime in the seventies, when the actual figure was 1000. Meanwhile AT&T, primarily a utility rather than an industrial company, stayed in the Dow during that entire time.
While the Dow is not totally representative, the chances are that if it does very well or very poorly over a period of time, the rest of the market will move in line.
Brokers’ advertisements promise returns guaranteed by the U.S. government for Ginnie Maes. Do the ads leave anything out?
Yes they do. Ginnie Maes represent pools of government-backed mortgage securities that may be quite volatile. The maturities in them might run ten, fifteen, or even twenty years. The longer the maturities, the more sensitive these portfolios are to changes in interest rates. For example, on average, for every one percentage point change in interest rates, a portfolio might change by 7%. In other words, if rates went from, say, 6.5% up to 7.5%, the portfolio might drop 7% in price. That’s what they leave out.
How should I go about picking a broker?
First, I would decide what I want from a broker. If you’re a total do-it-yourselfer—that is, if you have your own stock ideas, your own opinions as to where the market is going, and you just want to place orders—go to a disco
unt broker and save half or more of your commission cost. Discount brokers won’t give you much service other than placing your orders and providing the regular transactions information. They won’t call you. You have to call them. That’s okay if that’s all you need.
On the other hand, if you want full service, you should go to a full-service broker. What would full service entail? For one thing, it might entitle you to some handholding. There are people who need that. Brokers can also offer advice.
Brokers at big firms might offer other services. For example, they have products such as mutual funds, municipal bonds, options, and so forth that a discount broker might not have. If you’re a good customer of a big retail firm, it’s possible they might let you in on some hot new issues.
I have a broker I trust. Why do I need this book?
This book may be a good supplement to a broker you trust. First of all, you shouldn’t have a broker you don’t trust. That’s ridiculous. A broker can be trustworthy but still not know which way the stock market is going, or he may not have good sources of investment ideas. Frankly, I think that you are probably better off using a broker to place your orders, to introduce you to other products that might be suitable for you, such as mutual funds, bonds, municipals, and whatever.