Q: Neal, you have often talked about your experience working in the brokerage industry as a major influence on your investment success. How so?
A: In 1966, I became a stockbroker because I wanted to learn how to make a fortune in the stock market. Knowing that people like Bernard Baruch had made millions in the stock market, I wanted to find out how he did it, figuring there had to be a special way to achieve that great wealth in the market. I was poor back then and not wanting to stay that way, I felt the stock market was the way to go. After being a stockbroker for six years, I left the brokerage industry because I didn't want to have to contend with the distractions and conflicts that brokers have to deal with every day such as making phone calls, sales meeting, appointments, etc. I realized that in order to succeed in the stock market, I needed to give it my full time attention and focus on investment decisions rather than on a broker's duties. I then started my own business - not because I wanted a management company, but because I wanted to be a successful investor. My objective has always been the same-to make a fortune in the stock market. And, with my own company, I could also help other investors do the same. An important part of your investment philosophy centers around managing an investment portfolio as you would a business.
Q: How do you do this?
A: Our first and most important objective for our managed accounts, as in any business, is to stay in business. When you open the doors of a new business, that is when you are the most vulnerable. If someone was opening a new business today with $100,000 in total assets, it would not be wise for them to invest all of their working capital into a store, inventory, computers, etc. and hope for the best. New business owners need to plug in factors such as the economy, their location, how much demand they will have for their products, etc., and adjust the commitments to their business accordingly . We take a similar approach with our new managed accounts. Because potentials are so great, safety of principal is an important objective. Therefore, our investment philosophy with new accounts is to move as slowly as necessary to ensure protection of our valuable investment capital. We try to calculate all the variables as we invest the money. If we are in the early stages of a bull market, we would want to become fully invested rather quickly. Apart from those most advantageous times, the approach we believe in is to take it a step at a time, try to build a profit cushion into the new account, and then seek to maximize profits. We want to be operating from a position of strength. The objective of the investment business, as in any business, is maximum profitability, but it is a step-at-a-time process.
Q: What do you look for in a company before you buy?
A: What we look for, the ideal stock to find, is a relatively small company that you can look at and have a lot of conviction about its future. A company where you can say with certitude that three years from now, this company is going to be a lot bigger, a lot more profitable, and a much higher quality kind of company than it is today. The most important factor that will allow for a company's value to increase is the rate at which the earnings and expectations are growing. Wall Street's perception of the company should be tremendously altered between here and there as institutional interests develop, and this will create a dramatic change in the price movement of the stock. All stock market investing relates to a rather arbitrary something known as "value". "Corporate values" are what it is all about. The marketplace is where one person's opinion as to value matches up to someone else's'. Understanding value is one of the important keys to stock market success. At the extremes, bull market tops and bear market bottoms, most perceptions of value are distorted. "Nearsightedness" must be avoided. Theoretically, ultimate value relates to some vague formula as to earnings potentials and dividend payments to shareholders. But possibly the most important fact to understand about corporate values is that the long term capability of corporations to earn money for their shareholders and pay dividends to them, sometimes translates into a substantial stock price valuation that goes far beyond anything that is visible.
Q: What creates a decision to sell one of your positions?
A: Mainly, our sell decisions are based on fundamental changes in a company's perceived value. There are several key factors for selling a company: 1.) A stock becoming overvalued or its price fully reflects its future earnings potential. 2.) A company's earnings decelerate as a result of its growth rate declining or its industry leadership deteriorating. 3.) A change in the stock market's trend from positive to negative. 4.) A negative corporate discovery that invalidates the original reason for the purchase or detracts from the original growth estimates. 5.) To replace the stock with a stronger holding. 6.) The desire to move into a larger cash position.
Q: You have said that bear markets are predictable. Please tell us how you go about anticipating them.
A: Well, quite simply, bear markets will always follow major bull markets. Trees don't grow to the sky. Every bull market that has gone too far has been followed by a period of price adjustments to lower levels. What is extremely important for a successful investment program is not to buy into the euphoria at major market tops nor to emotionally sell into the face of major market bottoms. Think back to the major market tops and bottoms of the past. A great example of a stock market extreme was in 1973. The Vietnam war was ending, the soldiers were coming home, corporate profits were at record levels, interest rates were low, alternative investments were relatively unattractive, there was a recognized boom in the economy, and there had been two previous years of rising prices. We went 100% into cash in the face of all this great news prior to the devastating 1973-74 bear market. We then sat with 100% cash for all but six weeks of the entire two bear market years. Then from January 1975, in the face of a terrible news background, to mid 1977 we became fully invested and compounded 85% per year. That compounded 85% per year result over two and a half years translated into the 38% compounded return for the entire 1972-1977 period. We had by far the best results of anyone in the country during that trauma time and, as you can see, it took the extremes to create that fantastic buying opportunity. These emotional extremes are exactly what creates the changes in the stock market, and with these change fortunes can be made if investors can properly "manage" their money.
Q: How important is fundamental versus technical analysis to investment success?
A: The fundamental attractiveness of a company and the conviction that those fundamentals are improving are solely responsible for the advance in a stock's value over the long term. The value of any stock is determined by investors' perceptions as to its ability to produce a stream of revenue. Convictions as to the future of that revenue stream - that it will be either greater or less than generally expected - lead investors to either add to or take capital from those revenue producing positions. Therefore, the fundamentals are of greatest importance. In addition, we strongly believe that the merit of a company with strong fundamentals will be confirmed by its technicals - by market action that is typical of stocks who have similar potentials. Some companies have a brighter future than others. It is always the future that counts. And those exception company's stock in the market place will be stronger than others. Therefore, strong market action gives us confidence that our fundamental information is also accurate and can be relied on with a high degree of confidence. Expecting a company's technicals to show strength before investing is essential and acts as a safeguard against misinformation.
Q: What is your investment philosophy as it relates to diversification?
A: You really don't need 50 stocks in a portfolio. You don't need 30. What you do need is some exceptional ones. You could go back to 1955 and look around and identify IBM, Xerox (XRX), Avon (AVP), and Polaroid (PRD). These companies were not invisible. I remember watching our black and white T.V. and every night the doorbell was ringing, "Avon calling." When investors saw the early Xerox machine, I don't think anybody went out and bought carbon paper stocks. Nearly every investor bought a Polaroid camera; very few bought the stock. That's what everybody who's in the stock market should be looking for, to find the next baby Wal-Mart (WMT). And it doesn't have to be a baby, it can be an adolescent. With a baby, you become a billionaire, with a child you become very wealthy. But the earlier you can find them, the better off you are. When I give seminars, I ask the question "How many of you believe that diversification is an essential key to stock market success?" Almost all of the audience will raise their hand to indicate their loyalty to diversification. The proper question is "When is diversification an essential key to stock market success." It's when you're at a bottom and want to be guaranteed the stock market result. At a market peak, a diversified portfolio guarantees you will lose a lot of money. Ideally, at a major bull market peak, with a substantial decline to follow, you would want to have only one holding-cash. The last thing anyone would want from the time of a market peak is a diversified portfolio of declining stocks. Proper diversification is a part of the balancing of both risk and potential based on the trend of the market.
Q: You sound as though you believe that a large part of investing has to do with anticipating the major turns in the market. How does that fit into your philosophy?
A: Our philosophy emphasizes the importance of participating in bull markets, when the long term trend is positive, and also keeping investment capital safe during bear markets, when the trend is declining. Although many believe that stock market trends cannot be anticipated, it would be foolish not to see that there are business and market cycles that create an imbalance of both opportunities and risk. As I previously mentioned, every bull market has been followed by a period of price adjustments to lower levels. Bear markets should be welcomed and not feared, for they are the very reason that, at the bottom, we have the opportunity to make huge fortunes in the stock market. Following the trend of the market is very important. Our twenty-year performance history of investment success proves this point.
Q: What do you look for to indicate that a trend is changing?
A: Market trends can be analyzed because the factors which create market trends can be identified. The only thing that creates and sustains a trend in the market is money either flowing into or out of stocks. During a bull market, money flows in, taking away all of the stock available at current levels. A bear market is simply a prolonged period of time where, because of real or imagined concerns, investors are willing to take money out of the market at progressively lower levels. To identify the direction and strength of the trend, we perform a number of volume analyses which monitor and compare the flows of money into and out of the market over various time periods at various price levels. We also look for extremes in the market where a significant influence has impacted the market for an extended period of time, and try to identify what Bernard Baruch called "the influence that changes the trend of thought". At those junctures, prices tend to start moving in the opposite direction.
Q: You have said you believe in the Presidential Election Cycle or The Four Year Cycle. Can you explain this pattern?
A: Let's backtrack to the major market bottoms I've experienced. I got out of high school in '57. In 1958, if a person had bought stocks after the bear market of 1957, that would have been a very good time to be buying and holding stocks. The next major bottom following '58 was the Cuban missile crisis the year of 1962. I came into the stock market in 1966, and that was a major bear market year. The 1970 bottom followed an 18-month decline. In '74 we had the Watergate bottom. In '78 we had The Crash of '78. In 1982 you had the Reaganomics recession bear market bottom. In 1986, there was no way the market was going down because you had Reagan and Volcker working their magic and the stock market kept on going. The crash of '87 made up for the fact that it came a year late, but that was the same four year bottom one year later. Then you had the 1990 Gulf crisis bottom that was largely produced by the media. All of these major market bottoms, with the exception of the '87 crash, have been produced two years before each election year. So we had '58, '62, '66, '70, '74, '78, '82, '87, and '90. All major market bottoms, all major buying opportunities. We believe that this Presidential Election Cycle is real, predictable, and should not be ignored.
Q: What is your opinion of the recent surge in mutual fund investing by stock market participants?
A: The most important concept to understand is that mutual funds are the market. Mutual Funds are going to do what the market does. People who think that they are "safe" investments, at some point in their lives, are going to be in for a rude awakening. We have statistics that go back to bear market years, years where authentic declines that were prolonged occurred, and what happened in the mutual fund realm is frightening. When you see things down 40% for two consecutive years, that's not exactly what you would call a "safe haven." If you go back to a real bear market like 1973-74 and look at what happened to mutual funds, to the bank pension trusts, and to broadly diversified pools of money that were supposedly "professionally" managed during that time, it's a scary thing. Mutual fund shareholders were beaten up badly. If you objectively sit back and ask the question, "What do the people that missed out on the bull market of the 80s who are, out of desperation, coming into the market today because they don't like the return on their CD's entitled to ?" The answer is, they're not entitled to profit. The rule of thumb is, whatever is popular is overvalued and isn't a good investment. Mutual fund shareholders today simply don't know any better. Ignorance can sometimes be shrugged off as of little consequence; at other times, it can be disastrous. If an investor has complete confidence in the market's ability to continue to rise, and if the decade of the 90s is to be like the decade of the 80s, then growth mutual funds would again do about 17% per year. Those are gigantic "ifs." We expect the decade of the 90s to be volatile, with major cyclical movements in both directions. Twelve years ago, the world at large hated mutual funds because, in the cyclical market leading up to 1982, they had been such poor investments. Today, the decade of the 80s has changed the perception of mutual funds. We've come full circle. If there is a "free lunch" for desperate investors who don't like having their investment income cut in half; if it's O.K. to "buy the market" twenty years into the bull; if the classic book Extraordinary Popular Delusions and the Madness of Crowds doesn't apply to today's world; and if, in general, a "fully invested regardless of risk" attitude is acceptable, then mutual funds should be every bit as comfortable a holding for today's investor as they were for other investors in 1968. But I hope investors understand what happened to mutual funds on the way to Watergate.
Q: What percentage return do you feel your clients should have as a reasonable objective?
A: Our goal is 20%. We believe 20% is what professional money management should be able to achieve. If an investor is able to compound 20% per year in the market for 10 years, $100,000 grows to over $600,000. After 20 years it is worth 38 times the original amount and after 30 years of 20% growth, it is worth over 230 times your original investment - $100,000 grows to over $23 million. Warren Buffet has become the richest man in America by earning an average of 23% per year. What this implies is that fortunes can be made with two key ingredients: patience and proper management of your money. It is important to understand that the stock market is probably the most competitive environment that exists on earth. Billions of dollars are at stake; an investor can become enormously wealthy over time. The truth is, it's a lot harder than any of us want it to be. I use the following analogies: How many actors make it to Hollywood? Baseball players make it to the major leagues? Business school graduates become CEOs of Fortune 500 companies? Fortunately, the rewards are worth fighting for. However, if Warren Buffet is the most successful long term investor alive and he has become so by earning 23% per year with all of his experience, devotion, and resources, a truly successful investment program is a rarity. In the long run, every investor gets what he deserves. The 1980's have given investors the misperception that the market is easy, that buying mutual funds is the simple answer. In the 60s, everyone loved mutual funds. In the 70s, no one would touch them. In the 80s, mutual fund sizes reached record levels. We believe that mutual fund bubble is ready to burst. So, I think it's essential that investors realize that stock market success does not come quickly or easily.
Q: Neal, is there anything else you would like to add?
A: The stock market is a phenomenal investment medium where mathematical advantages exist that are beyond anything we are supposed to have going for us. Every investor has the potential to become a multimillionaire through the stock market. Geometric growth can occur. So if things are done properly, the stock market, and time, can be great allies of ours. What we don't want is for time to be our enemy because our money vegetates and doesn't grow for us in a meaningful way. While it's tough and requires a full-time effort, and while only a tiny minority will succeed in a major way, those who do can have true life-style changing kinds of benefits that come from this great investment medium called the stock market.