So, I’ll take Bill Gross’ recommendation one step further. Forget now. Dividend-paying stocks ALWAYS deserve a place in your portfolio.

Yet, in this market, it’s increasingly difficult to find reliable dividend stocks.

“This is going to be the worst [dividend-cutting year] in 50 years,” Howard Silverblatt, Senior Index Analyst at Standard & Poor’s, predicted in January. So far he’s right with industry titans like General Electric and Dow Chemical announcing cuts.

Keep in mind, Dow Chemical maintained or increased its dividend every year since 1912. That means conditions this year are worse for the company – at least on a cash flow basis – than during the Great Depression.

Against this backdrop, it’s understandable why many investors consider no dividend safe. But that’s a mistake. Fact is, countless companies will weather this storm with their dividend intact.

To find such companies I focus on the following six criteria and I recommend you do the same:

1. Simple business. The fewer the moving parts the fewer things that can go wrong and sap cash intended for dividend payments. Focus on companies doing one or two things that you can understand, as opposed to massive corporations with dozens of operating segments.
2. Steady demand. Given the Great Recession, the first thing we need to verify is demand for a company’s products. After all, a company needs a steady stream of cash coming in to afford to pay it out to shareholders. Stick to industries or sectors with recession-proof or recession-resistant demand (food, alcohol, tobacco, health care, etc.).
3. High cash balance. Cash IS king, especially when it comes to maintaining a dividend. Consider it insurance against any unexpected slowdowns. At a minimum, insist on enough cash to cover one quarter’s worth of dividends.
4. Minimal need for credit. Securing credit in this market is extremely difficult. Accordingly, I focus on companies that do not need to raise significant amounts of capital. Remember, too, when interest rates rise, so do interest payments for companies that rely on a significant amount of debt. So it’s also important to focus on companies with reasonable or low debt balances. This insures interest payments won’t sap money intended for us.
5. Cash flow positive. If a company’s not generating cash each quarter, the only way to pay a dividend is by borrowing or tapping into cash reserves. Such practices are not sustainable over the long term. Eventually, the dividend will be cut.
6. Earnings buffer. Insist on a dividend payout ratio (annual dividends/annual net income) of 80% or less. A company paying out 100% of earnings has no wiggle room in the event of a slowdown. If business suffers, so will the dividend.

Obviously not every stable dividend-paying stock will meet all these criteria. But the more criteria a stock fits, the more stable you can consider its dividend.

I followed these six criteria to unearth all the dividend stocks I’ve previously mentioned here -TEPPCO Partners (NYSE: TPP), Lorillard (NYSE: LO) and Windstream Corp. (NYSE:WIN).

Lorillard and Windstream remain attractive at current prices.

Next week, I’ll reveal another dividend-paying stock worth your consideration. But please note, in the days ahead my dividend-sleuthing prowess will change venues.

You see, because these columns are garnering so much interest, we’ve just decided to revamp the entire mid-month issue of The Oxford Club Communiqué. Going forward, each mid-month issue will be exclusively dedicated to dividend-paying stocks and other safe ways to generate an income.

So if you want a steady stream of stable dividend-paying stocks, you’ll have to join us. Go here to sign up today.

Source: 6 Steps for High-Yield Dividends

After all, this could easily just be a bear market rally. And bull markets rarely begin with a bear market rally and head straight higher.

Beware The Bear Market Trap

It makes sense to hedge against a renewed decline. Here’s why smart investors are doing so using inverse ETFs. Read on to find out what they are, how they work, and why you should consider adding one or two to your portfolio in order to protect it…

ETFs: A Safer, More Effective Way To Short The Market

Just a few years ago, investors who wanted to profit from a market/stock downturn had to borrow shares from their broker to short the asset in question. But today, betting against banks, small-cap stocks, or even entire market averages, is just one convenient ticker symbol away.

You can short the market by using an inverse exchange-traded fund (ETF).

And while I’m generally an investor who subscribes to the fact that stocks ultimately rise and produce solid, long-term gains, there are certain times when using inverse ETFs can be very appealing – particularly in the current market environment.

Exchange Traded Funds: A Brief Overview

Before we talk about the hedging advantages of inverse ETFs, let’s quickly review what ETFs are, and how they work…

• Exchange-traded funds are securities that closely resemble index funds, but are more flexible because you can buy and sell them during the day, just like common stocks.
• ETFs give investors a convenient way to purchase a broad basket of securities in a single transaction, offering the convenience of a stock along with the diversification of a mutual fund.
• From a humble start in the early 1990s, the ETF industry has exploded, particularly over the past several years. There are now over 700 ETFs, with $450 billion in assets.

And the advantages? ETFs boast several major ones over mutual funds and common stocks…

• Better diversification
• More flexibility
• Lower costs
• More liquidity
• Tax efficiency

Going Short The Smart Way With Inverse ETFs

Inverse ETFs (or short ETFs) are designed to move in the opposite direction of an underlying index. That means you profit when the benchmark tanks. The lower the underlying asset goes, the higher these funds advance.

Perfect for a bear market like this one.

Think of inverse ETFs as a type of insurance policy for your portfolio. Investing a modest amount in one of them can be a useful way to hedge against market declines, or protect your profits in certain asset classes.

And when an index or stock heads south (as we’ve seen many do with a vengeance recently), an inverse fund can help soften the blow – and in some cases, even generate enormous profits.

For example, on September 30, 2008, four days before the Dow went below 10,000, I sent a special newsflash to my ETF Authority readers identifying 14 securities that could skyrocket as the market heads south.

*Source: Bloomberg. Total returns from 9/30/08 – 3/5/09

As you can see, most of the inverse ETF have done exactly what they were designed to do in this rough market. And it doesn’t stop there…

Double Your Money with Inverse ETFs

Some ETFs can even return double the inverse of the underlying security. For example, if you buy shares of the ProShares UltraShort S&P 500 (NYSE: SDS) and the S&P 500 declines by 5%, SDS gains 10%. (Keep in mind that these funds compound daily, so if you invest for longer, the returns won’t line up exactly).

So how are these ultra-short funds able to double the inverse performance of indexes? Simple… by using leverage. The math doesn’t always work out exactly, but you can usually expect it to return double the inverse within a reasonable range.

The trade-off, however, is that these funds can be incredibly volatile – and if you’re wrong, you lose twice as much. So only consider going ultra-short if you have the stomach for it.

Why You Haven’t Missed Out on Short ETFs…

You may think you’ve missed the boat on short ETFs… but think again.

With the market coming off depressing lows, the current rally may simply be a “dead cat bounce” (which have been known to soar), as the market attempts to form a new bottom.

With this in mind, you may want to consider adding an inverse fund or two to help smooth out some of this unprecedented market volatility.

Good Investing!

Nathan Slaughter

Source: Inverse ETFs: How To Profit From The Bear Market Trap

He goes on to say, “But this talk will shift soon to the ‘now what’ questions of what to buy when we do reach that magical point.” Here Scott discusses the Mutual Fund’s cousin, the ETF, and how to take advantage of investing in one.

Many will shun individual stocks for the safety of mutual funds. And with the explosion of index funds, we’ve never had a larger variety of options to help us diversify. These index funds are designed to yield a return equal to that of a particular index. They allow you to purchase a variety of assets as a low-cost, passive-investment strategy. And there are a number of indexes that specify sectors, stock indexes and international markets.

It’s a powerful strategy that allows you to slice and dice the global economy in a risk-managed approach. But we don’t like to stop simply at reducing risk and diversification.

There’s another cousin to the mutual fund and index fund families that many investors have heard of but haven’t taken advantage of. If you own mutual funds, indexed or otherwise, you need to know if using exchange-traded funds (ETFs) makes more sense for you. Here’s what you need to know about ETFs, the close relative to your mutual funds…

Exchange-Traded Funds – Index Mutual Funds on Steroids

Exchange-traded funds (ETFs) were first introduced in 1993, and are based on index mutual funds. They use similar principles, but have fewer management and transaction costs associated with them.

Unlike mutual funds, which can be bought or sold only at the end of the day when NAV is calculated, you can trade ETFs throughout the day, just like a share of stock.

• Exchange-Traded Funds are a portfolio of shares that can be bought of sold as a single unit.
• You own a proportionate amount of the shares held, with some ETFs even allowing transfers-in-kind.
• They can range from portfolios that track broad global market indexes all the way down to very narrow industry indexes.
• Exchange-Traded Funds are becoming a preferred way for investors to get all of a mutual fund’s benefits, with none of the downsides.

Think of ETFs as mutual funds on steroids.

Exchange-Traded Funds Becoming More Popular

While exchange-traded funds are becoming more popular by the day, they weren’t always so highly regarded. In fact, the creator of The Vanguard 500 Index Fund was against them and vigorously attacked the possibility of their success. In the end, John Bogle ended up adding a whole series of ETFs to the Vanguard family.

ETF investments quickly competed against indexed mutual funds. By early 2007, over $400 billion was invested in over 300 ETFs in three general classes:

• Broad U.S. market indexes,
• Narrow industry or “sector” portfolios,
• And international indexes.

The first ETF, like the first indexed mutual fund, matched the S&P 500 index and was given the symbol SPDR for Standard and Poor’s Depository Receipt. Many know it by its nickname, the “spider.”

Spiders spawned many new exchange-traded fund products like “Diamonds” that are based on the Dow Jones Industrial Index DJIA, Qubes based on the Nasdaq 100 index, and WEBS based on the World Equity Benchmark Shares of a portfolio of foreign stock market indexes.

The Advantages of Exchange-Traded Funds Over Indexed Funds

A big advantage of an exchange-traded funds over a conventional index fund is that they trade continuously throughout the day. You can buy and sell ETF shares just like a share of stock, while with an indexed mutual fund – where the net asset value is quoted – you have to place an order to buy or sell but that doesn’t transact until after the market.

This can be frustrating if your technical analysis indicates a buy or sell trigger at some point during a trading session but the market moves too far for you to take advantage of it by the end of the trading day.

And unlike mutual funds, exchange traded funds can be sold short of purchased on margin like a share of stock.

When you analyze these factors in light of the fact that options also trade on exchange-traded funds you can place positions in the general market, global market, or industry sectors, where you can:

• Employ protective hedges with puts or calls on your long or short ETF portfolio.
• Use combined buy-write options strategies where you collect premium from the short sell of an option to compensate for the cost the long options – bull and bear spreads, calendar spreads, diagonal spreads, butterflies, iron condors and so on, are all available to you trading ETFs but NOT with indexed mutual funds.

Exchange-traded funds also have tax advantages over mutual funds:

• When large numbers of mutual fund investors redeeming their shares – but you don’t – the fund has to sell securities to meet the redemptions. This creates a capital gains tax that is passed on to the remaining shareholders.
• Which means you end up paying the other guy’s tax obligation!
• In an exchange-traded fund, when somebody else sells, they have to pay the tax, not you.
• And when very large trades redeem their positions in the ETF, the transactions is settled with shares of stock in the underlying portfolio – not triggering a stock sale by the fund sponsor and no bogus tax bill to you.

Using Exchange-Traded Funds: How to Put Your Index Mutual Fund on Steroids

This from Chris:

With each new trading day, the nation seems to be inching ever closer towards the sequel no one wants to see: Great Depression II. But there’s always a sunny side…

At least that’s the way Phil Carret looked at things. Born in 1896, Carret (rhymes with “hurray”) was one of the more inspiring and successful investors of the 20th century. He played through all the great booms and busts of the 20th century. In fact, in the pit of the Great Depression — 1932 — Carret decided to start his own mutual fund.

Yes, a quarter of the work force was out of work. But that left three-quarters working. And the Dow did lose 52.7% of its value in the prior year, but that meant that 47.3% remained.

Carret’s Pioneer Fund went on to compound shareholder capital at a rate of 13% annually for 50 years, despite slogging through losses in the early going. After he sold it, Carret managed his own money and private accounts. He was the great endurance man of the investing world, its Lou Gehrig or Cal Ripken.

Even at the age of 100, he put in a normal work week. He was a Wall Street marvel. Old Carret was a cool hand to the end, always looking for the bright side. He turned very bearish on stocks in 1997. The Dow was 7,000. Asked if he was selling stocks, Carret said: “I’m not going to do anything about it in my own portfolio. If stocks go down, they go down. I’m 100 years old and due to conk out any minute. If I conk out at the bottom of a bear market, it would save a lot of estate taxes.”

Always looking for the bright side, indeed…

Carret died in 1998 at the age of 101. Most of the above material comes from a chapter in John Rothchild’s The Bear Book: Survive and Profit in Ferocious Markets. If you’re interested in reading a little more, there is also a nice tribute to Carret here.

American Home Products was another Depression-era success story – not by looking on the bright side, but by prudently capitalizing on the gloomy side of things. Started in 1926 by a group of businessman long since forgotten, AHP was a maker of household products. It started small and grew quickly through acquisitions. Nothing so unusual about the tale so far. After all, the second great merger boom in American business took place in the 1920s.

But AHP was unusual in two respects. First, it continued its acquisition spree through the Great Depression when everyone else was battening down the hatches. It could do this because its finances were top-notch and its earnings power robust. Ben Graham, that great old investment writer from long ago, gave AHP a mention in his 1940 edition of Security Analysis. He gives us an appendix with the stock prices, earnings and dividends of AHP from 1929-1939.

AHP was not immune to the Great Depression, but the stock never came close to reporting a loss. Peak earnings of $5.49 per share in 1929 fell to $3.93 in the depths of 1932. It recovered by ‘39, turning in $5.23 per share.

Investors who held it through the Great Depression did all right. The stock price bounced all over the place, as you would expect. It hit a high of $86 in 1929 and a low of $25 in 1932. But by the late 1930s, it was still humming along in the $50s and would hit $60 per share in 1939.

All the while, it paid its investors nice dividends — a total of $34.35 over the decade. Considering what happened to the rest of market, and keeping in mind the dollar held its value better then, you would’ve been happy to park some money in AHP that decade.

There is a second trait that marks AHP as an anomaly: It bought businesses in unrelated industries. It owned firms in floor wax, coffee, oil, cheese products, insecticides and much more. It was the early model of a conglomerate. In this, AHP defied the wisdom of the times, which consolidated related business. The company’s diverse platform helped it weather the Depression better than if it had only a floor wax business.

So here we have a model of survival in the worst of times. AHP was a well-financed business that did more than one thing. It was an opportunistic business in the best sense of the term. It bought firms when and where they were cheap, without regard to the lines that divide industries.

Well, maybe the conglomerates of today will also fare better in today’s harsh climate. Over the last few months, I’ve recommended a number of financially strong conglomerates to the subscribers of Capital & Crisis. Seaboard (SEB: Amex) and PICO Holdings (PICO: Nasdaq) are two that come to mind.

Seaboard (SEB:amex) is a diversified international agribusiness and transportation company that processes pork products and ships cargo. The company also merchandises commodities, mills flour and feed, farms produce and sugar, and generate electric power. For example, Seaboard operates floating power generators off the coast of the Dominican Republic. And importantly, the company’s finances are strong.

PICO Holdings (PICO: nasdaq) is another compelling conglomerate. PICO’s stock is trading for only $25 a share, but the company owns water rights, land and a portfolio of cash and investments that are worth about $60 a share. As recently as last September, the stock was trading above $47. So the current quote represents a VERY steep discount to the company’s net asset value.

Both Seaboard and PICO seem like strong candidates to continue the legacy of American Home Products – asset-rich conglomerates that can excel in the midst of economic adversity.

Source: Carret, Rhymes with Hurray!

At this point, the temptation to work as long as possible, and then blow what remains of your savings on a round-the-world cruise and a suicide pill is considerable.

However, such despair is unwarranted.

Unless you have already given up all paid employment, or absolutely have to retire in the next year or two, the current bear market may have made your eventual retirement prospects more secure, not less.

You see, the most damaging factor for your retirement happiness was not the current downturn, but the preceding decade-long bubble.

Let me explain.

Savers who devote an equal amount each month to their long-term plans benefit from an important mathematical principle: Dollar cost averaging. Under dollar cost averaging, you put in the same amount of money each month, so that amount buys more shares if prices are low than it does if prices are high.

Thus, if a mutual fund trades at $1 in month one, $2 in month two and $1.50 in month three, then a dollar-cost-averaging investor investing $300 per month will buy 300 shares in month one, 150 in month two and 200 in month three. After his month three investment, he will own 650 shares at a cost of $900, for an average cost of $1.3846. Since the average price of the shares over the three months was month three’s $1.50, he has made an extra $0.1154 per share compared with the average share price.

That’s why prolonged bull markets are so bad for retirement investors (unless they are lucky enough to retire before the bubble bursts). In this case, the Standard and Poor’s 500 Index stood at 459.27 at the end of 1994. Then after February 1995, when U.S. Federal Reserve Chairman Alan Greenspan moved to an ever-easing monetary policy with low interest rates, it took off for the stratosphere.  It passed its current level of 825 in early 1996, and except for a short period in 2002 has traded above that level ever since.

So, even though retirement savers from 1996-2008 thought most of the time that they were doing very well, in reality they were buying shares at an over-inflated price, and just about every one of their monthly contributions is currently showing a loss.

It’s not the current bear market that has caused that loss. Stock prices in 1996-2008 were always at excessive prices, so a major correction was bound to happen sometime. If the correction had happened in December 1996, when Greenspan made his famous “irrational exuberance” speech, the market would have on average been substantially lower over the subsequent 12 years. And a retirement investor who had saved over that period would be substantially richer today because he would have owned significantly more shares of the mutual fund in which he had invested.

The wise retirement savers who have a few years to go should hope the current lower stock prices stick around, maybe even go lower still provided they recover before they has to draw on the savings or convert them into an annuity. By continuing to invest regularly at these lower prices, the return from dividends and capital appreciation will compound more quickly, particularly if they buy stocks that have a substantial dividend yield.

Even if their savings remain adequate, they shouldn’t convert them into an annuity because annuity rates are currently very low. With long-term Treasury bonds yielding less than 3%, actuaries factor that exceptionally low return into their annuity calculations.

Right now, a 65-year-old man who buys an annuity can expect to receive only around $74 per $1,000 of investment, without any protection for inflation or guaranteed minimum return if he dies quickly. Once interest rates rise, as they are almost bound to, that annuity rate will rise in step with them.

Rather than convert into an annuity, the retirement saver should simply invest in stocks that are both solid and yield more than 7.4% – and there are still plenty of them out there. That way, he can achieve the same return as an annuity while preserving, and maybe even increasing, his principal – in addition of course to any further monthly payments he can make while still working.

By building a portfolio of such stocks including a selection from emerging markets, he can take advantages of the higher-dividend payouts frequently found outside the United States.

Finding stocks with dividend yields equal to or greater than an annuity yield was tough when the S&P 500 was at 1400. But at 800, it’s a lot easier, even if you want to avoid the financial sector for obvious prudential reasons.

Such solid companies as General Electric Co. (GE), BP PLC (ADR: BP), Du Pont (DD), Newell Rubbermaid Inc. (NWL) and Limited Brands Inc. (LTD) yield well over 7% currently, and that’s without venturing into emerging markets companies.

If your retirement portfolio has been decimated, don’t despair. At these lower stock prices it will be much easier to build its value up again, and because stock yields are higher you won’t need so much capital to generate the income you want to live well.

Source: Retirement Investing: How Bear Markets Can Help Your Retirement Planning

** The dollar’s down, but it’s certainly not out.

• From mid-July to the end of November, the U.S. Dollar Index rose a whopping 23%. This tracks the value of a dollar against six major currencies.
• Anyone who knows anything about currency trading knows it’s not normal for a currency to move 23% in such a short time. Forex traders consider a one percent daily move to be big news.
• So it would make sense that the U.S. Dollar Index would have to see a rapid price decline after rising 23% so quickly. It has to go back to the mean, after all. And that’s exactly what happened. The dollar fell 11% between mid-November and mid-December.
• But this drop doesn’t necessarily signal the beginning of a new downtrend. As of now, it only signals a correction. We can see this by looking at a chart below

• As long as the dollar stays above its 200-day moving average, the recent uptrend will stick. But that’s not to say we won’t see dollar weakness ahead.
• It’s possible for the dollar index to trade between 78 and 88 for the next two or three years. It could even move past 88. But betting that it will move under 78 is premature. If you really want to capitalize on a drop in the dollar, wait for a confirmation of the downtrend by allowing the U.S. Dollar Index to trade under 78 before shorting.
• At that point, you could make some good money buying up the Rydex Weakening Dollar 2x Strategy H ETF (MUTF:RYWBX) . For every one percent the dollar losses, you gain two percent. And with Bernanke dropping money from helicopters, it is only a matter of time before the dollar starts seeing bigger drops.

** The Congressional Budget Office estimates that the 2009 budget deficit will reach $1.2 trillion.

• That was one day after President-elect Obama said, “Potentially we’ve got trillion-dollar deficits for years to come, even with the economic recovery that we are working on at this point.”
• The government has already backstopped the financial markets to the tune of over $8 trillion. Now our politicians are starting to spend obscene amounts of money in a failed effort to “jump start” our economy.
• If the markets continue to suffer, the government will have to cover losses for years in the future. This means they will continue to create funny money to cover those losses. And inflation should become a big concern.

** According to Bloomberg, General Motors said it has enough government loans to cover its worst-case forecast for U.S. auto sales and won’t need more if the economy holds up.

• It’s extremely difficult to believe that a one-time loan to GM would be enough to fix their problems. A former Merrill Lynch auto analyst has said that GM’s plan “all depends on a lot of difficult-to-forecast factors, like the size of the market.” And during congressional testimony, another analyst said Detroit would need up to $125 billion to become whole again. This is very different from the less than $20 billion that GM and Chrysler got from the government in December.
• The truth is that GM is taking a big fat guess on the amount of taxpayers’ money it needs to stay afloat. And to make matters worse, it seems GM’s management is far too detached from reality to make a good business decision.
• Considering GM’s current predicament, why would anyone believe GM to be right about its super-ambitious forecast? Don’t believe a word of it. GM will ask the government for more money this year… more losses will force the government to create more money… and the politicians leading us will be “forced” to spend more to try and “buffer” a recession in vain. Buy gold.

With actively managed mutual funds, a hot record leads to a flood of new money. Smart managers close the doors when they begin to struggle to put this money to work. A larger mutual fund is more difficult to manage because bigger dollar amounts can force the manager to alter his investment style. The plain truth is that there are more opportunities available to smaller amounts of money.

I’m attracted to funds run by the deep-value market masters. Value investors like to know if the fund’s underlying holdings are cheap, but it can be difficult to discern whether funds represent a good “Buy.” Many mutual funds only disclose their portfolios once a quarter, making it difficult to see what stocks it owns at any given point.

Following the 2001 to 2002 recession, we saw many of these funds close their doors after years of outstanding returns. But in market corrections, we can see the doors reopen. In fact, several funds have recently cracked their doors open again. I encourage you to use the opportunity to buy these now, because they could shut again at any time…

Dodge and Cox Stock Fund’s Phenomenal Returns

The returns at the Dodge and Cox Stock Fund have been phenomenal over long periods. This firm has been in positive territory in 33 of the last 42 years.

Recent returns for the Dodge and Cox Stock Fund:

• Year: 2003
  Return: 32.22%

• Year: 2004
  Return: 19.17%

• Year: 2005
  Return: 9.37%

• Year: 2006
  Return: 18.53%

• Year: 2007
  Return: 14.00%

Not a bad run for the last five years. And this mutual fund carries no load – expenses run a slim 0.52%.

Long-Term Perspective Unlocks Long-Term Value

The history of Dodge and Cox Stock Fund is storied. Established in 1930, it survived the Depression, World War II and the raging inflation of the 1970s. Operating out of the San Francisco Bay area, they have kept themselves from being swept up by the investment fads of Wall Street.

Their investments are conservative. John Gunn has been the lead manager since 1977 and he summarizes the Dodge and Cox investment philosophy this way:

“Decades of investing have taught us that the perception of an investment’s worth fluctuates much more widely than its underlying fundamentals.

We are skeptical that short-term market trends can be predicted with consistency, so we look further out in our analysis, focusing on the key fundamental factors that will determine investment value over the long term.

As our view diverges from the consensus, we find investment opportunities. We continually focus on the long term by asking ourselves the hypothetical question: based on what we know now, how would we invest an “all-cash” portfolio today assuming we could not trade for the next three to five years?

This framework forces us to reevaluate our portfolio holdings within an ever-changing market environment, and to reaffirm our rationale for each investment’s long-term value.”

Dodge and Cox Stock Fund – Modest Subprime Exposure

On top of that, the subprime exposure of Dodge and Cox Stock Fund has been modest.

Buying a fund run by a deep-value manager is the best way to ensure that your funds’ underlying holdings are undervalued. I am thrilled to see this terrific value-leaning fund has recently reopened to new investors.

Sometimes funds reopen simply because redemptions have been high and they have the capacity to take on new assets. However, a reopening is also an excellent indication that a fund manager sees attractive buying opportunities on the horizon.

I have even recommended that my children take a look at the Dodge and Cox Stock Fund. It’s a rare “buy and hold forever” opportunity.

Good investing,

Floyd

Floyd Brown, a regular contributor to Investment U and The Oxford Club, began his highly successful investing career while still in high school… and made his first million before turning 30. Here are three companies Floyd’s recommending right now.

Source: The Dodge and Cox Stock Fund

Investors Behaving Badly

The Financial Research Corporation released a study prior to the [2001-02] bear market which showed that the average mutual fund’s three-year return was 10.92%, while the average investor in those same periods gained only 8.7%. The reason was simple: investors were chasing the hot sectors and funds.

If you study just the last three years, my guess is those numbers will be worse. “The study found that the current average holding period was around 2.9 years for a typical investor, which is significantly shorter than the 5.5-year holding period of just five years ago.

[While the research below is from a few years ago, recent studies show exactly the same, if not worse, results. Investors in general are not getting any better.]

“Many investors are purchasing funds based on past performance, usually when the fund is at or near its peak. For example, $91 billion of new cash flowed into funds just after they experienced their “best performing” quarter. In contrast, only $6.5 billion in new money flowed into funds after their worst performing quarter.” (from a newsletter by Dunham and Associates)

I have seen numerous studies similar to the one above. They all show the same thing: that the average investor does not get average performance. Many studies show statistics which are much worse.

The study also showed something I had observed anecdotally, for which there was no evidence. Past performance was a good predictor of future relative performance in the fixed-income markets and international equity (stock) funds, but there was no statistically significant way to rely on past performance in the domestic (US) stock equity mutual funds. I will comment on why I believe this is so later on.

“The oft-repeated legal disclosure that past performance is no guarantee of future results is true at two levels:

1. Absolute returns cannot be guaranteed with any confidence. There is too much variability for each broad asset class over multiple time periods. Stocks in general may provide 5-10% returns during one decade, 10-20% during the next decade, and then return back to the 5-10% range.

2. Absolute rankings also cannot be predicted with any certainty. This is caused by too much relative variability within specific investment objectives. #1 funds can regress to the average or fall far below the average over subsequent periods, replaced by funds that may have had very low rankings at the start. The higher the ranking and the more narrowly you define that ranking (i.e. #1 vs. top-decile [top 10%] vs. top quartile [top 25%] vs. top half), the more unlikely it is that a fund can repeat at that level. It is extremely unlikely to repeat as #1 in an objective with more than a few funds. It is very difficult to repeat in the top decile, challenging to repeat in the top quartile, and roughly a coin toss to repeat in the top half.” (Financial Research Center)

This is in line with a study from the National Bureau of Economic Research. Only a very small percentage of companies can show merely above-average earnings growth for 10 years in a row. The percentage is not more than you would expect from simply random circumstances.

The chances of you picking a stock today that will be in the top 25% of all companies every year for the next ten years are 1 in 50 or worse. In fact, the longer a company shows positive earnings growth and outstanding performance, the more likely it is to have an off year. Being on top for an extended period of time is an extremely difficult feat.

Yet, what is the basis for most stock analysts’ predictions? Past performance and the optimistic projections of a management that gets compensated with stock options. What CEO will tell you his stock is overpriced? His staff and board will kill him, as their options will be worthless. Analysts make the fatally flawed assumption that because a company has grown 25% a year for five years that it will do so for the next five. The actual results for the last 50 years show the likelihood of that happening is very small.

Tails You Lose, Heads I Win

I cannot recommend highly enough a marvelous book by Nassim Nicholas Taleb, called Fooled by Randomness. The sub-title is “The Hidden Role of Chance in the Markets and in Life.” I consider it essential reading for all investors, and would go so far as to say that you should not invest in anything without reading this book. He looks at the role of chance in the marketplace. Taleb is a man who is obsessed with the role of chance, and he gives us a very thorough treatment. He also has a gift for expressing complex statistical problems in a very understandable manner. I intend to read the last half of this book at least once a year to remind me of some of these principles. Let’s look at just a few of his thoughts.

Assume you have 10,000 people who flip a coin once a year. After five years, you will have 313 people who have come up with heads five times in a row. If you put suits on them and sit them in glass offices, call them a mutual or a hedge fund, they will be managing a billion dollars. They will absolutely believe they have figured out the secret to investing that all the other losers haven’t discerned. Their seven-figure salaries prove it.

The next year, 157 of them will blow up. With my power of analysis, I can predict which one will blow up. It will be the one in which you invest!

Ergodicity

In the mutual fund and hedge fund world, one of the continual issues of reporting returns is something called “survivorship bias.” Let’s say you start with a universe of 1,000 funds. After five years, only 800 of those funds are still in business. The other 200 had dismal results, were unable to attract money, and simply folded.

If you look at the annual returns of the 800 funds, you get one average number. But if you add in the returns of the 200 failures, the average return is much lower. The databases most statistics are based upon only look at the survivors. This sets up false expectations for investors, as it raises the average.

Taleb gave me an insight for which I will always be grateful. He points out that because of chance and survivorship bias, investors are only likely to find out about the winners. Indeed, who goes around trying to sell you the losers? The likelihood of being shown an investment or a stock which has flipped heads five times in a row are very high. But chances are, that hot investment you are shown is a result of randomness. You are much more likely to have success hunting on your own. The exception, of course, would be my clients. (Note to regulators: that last sentence is a literary device called a weak attempt at humor. It is not meant to be taken literally.)

That brings us to the principle of Ergodicity, “…namely, that time will eliminate the annoying effects of randomness. Looking forward, in spite of the fact that these managers were profitable in the past five years, we expect them to break even in any future time period. They will fare no better than those of the initial cohort who failed earlier in the exercise. Ah, the long term.” (Taleb)

After taking into account all the reinvested dividends, Benny figures his rate of return worked out to just about 2% per year. “I’d have been better off in a CD,” he said.

And he’s right. Take a look at this nine-year chart of the S&P 500…

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The S&P 500 was at 1,350 nine years ago, and it’s at 1,350 today. Oh sure, stocks have been a bit higher and a bit lower. But for the most part, investors have suffered through nine years of stock market purgatory… and we’re probably in for another nine years of the same thing.

You see, long-term stock market trends often last anywhere from 15 to 20 years. For example, stocks were in a strong bull market from 1946 to 1966. Then the bear took over, and stocks didn’t make any ground from 1966 to 1982.

In 1982, we entered the greatest bull market of all time, and stocks rallied until the year 2000. Since then, however, the market has been trending flat to down. And if history is any sort of a guide, then we’ll likely have six to nine more years of the same action.

The problem is that most investors, like my father-in-law, are still trying to use bull-market investment strategies to make money in a bear market. Back in the 1980s and 1990s, you could follow the rest of Wall Street’s lemmings into an S&P 500 index fund and expect a reasonable rate of return.

That’s not true anymore. If you want to make money in sideways or down-trending markets, then you need to be more involved with your investments. You need to do more research. You need to be willing to move in and out of stocks more often. And you need to incorporate strategies that work well in a sideways market.

One such strategy is selling covered calls, which I’ve written about extensively in previous issues of Growth Stock Wire (read my most recent essay here). Another technique involves setting aside a small amount of money for speculating – ideally no more than 10% of your net investment capital. It’s surprising how much a few reasonable speculative trades can juice up the returns of a conservatively invested portfolio.

I’ll share with you my basic philosophy for speculating in next Tuesday’s Growth Stock Wire.

In the meantime, think about your own investment performance over the past several years. If you’ve been stuck in your own private stock market purgatory, then maybe it’s time to shake things up a bit.

It would be pretty sad to look back nine years from now and say, “The stock market stinks.”

Best regards and good trading,

Jeff Clark