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(Guest Commentary by Rick Konrad– July 19, 2007)

Dear Subscribers and Readers,

Before we dive into Rick Konrad's latest commentary (thanks again, Rick, for writing a guest commentary for us this week), I want to show our readers the following chart.  As many of you may have noticed, the NASDAQ Composite has been exhibiting great relative strength ever since the “subprime rout” during late February to mid-March.  However, this period of relative strength seems to be ending, as the internals of the NASDAQ Composite have been quickly deteriorating versus the internals of the NYSE (Common Stocks Only) Composite and the S&P 500.  The following chart (courtesy of showing the number of NASDAQ new highs vs. new lows illustrates this perfectly:

NASDAQ New Highs and New Lows

Notice that the number of new lows (153) is now at its highest level since early March 2007 – a time when the overall market was literally “at the brink.”  This is ominous especially since the NASDAQ Composite only endured a decline of 12.8 points in yesterday's trading.  For now, this phenomenon is restricted to the NASDAQ and small caps (the S&P 600), but this represents a significant divergence in the U.S. stock market and should be watched going forward. 

Now, let us get on with our guest commentary.  For those who had wanted to learn more about picking stocks, evaluating companies, and other issues related to the stock market, we have again brought in one of our regular guest commentators, Mr. Rick Konrad for a guest commentary.  Rick is one of our two regular guest commentators (besides Bill Rempel) and usually writes for us every third Wednesday of the month. Thanks, Rick, for writing for us again.

In this commentary, Rick will be offering his thoughts on the process that he usually goes through when buying or selling an individual stock – with an emphasis on selling –as well as the psychological difficulties that most people having in maintaining a “value discipline.”  Without further ado, following is a biography of Rick:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator of MarketThoughts (please see “Let's Be Careful Out There” for his last guest commentary).  Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years.  You can view a more complete profile of Rick on his blog and should you have any questions or thoughts for Rick after reading his commentary, you can also email him at the following address.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been responsible for grading CFA papers. 

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.

All of us with an ounce of ecological bent are interested in the notion of recycling but few of us are adept at thinking of recycling in our investment management. Just as we need to take our garbage to the curb on a regular basis, much as we need to collect our recyclables for the blue box, effective investment management requires us to clean and tidy our portfolios in a disciplined fashion. In short, we need to recycle our disappointments into new investments.

Of course, this requires a completely honest assessment of your portfolio, one which is not dependent on hope and one which is not clouded by despair!

One of the best ways of achieving honest answers is to build a fact sheet system for each of your holdings. Whenever you purchase a stock, record its fundamental history i.e. its historical earnings and revenue growth rates, its returns on capital, operating margins, its working capital utilization, etc. Record your projections for each holding whether earnings per share, growth rates, projected profitability and so on.

Live and breathe those price targets. There are really only three reasons to sell:

  1. Fundamental failure. You have made a mistake in your assumptions. When the best thing that you can say about a stock is, “It probably won't go down from here,” this is a prime selling candidate.
  2. Hitting the price target.
  3. Moving to more fertile ground.

1) Fundamental Failure

When Management Has Failed You: Anger with a corporate management especially about a stupid acquisition, is relatively easy to translate into a sell order. Earnings growth may be delayed indefinitely, integration plans are frequently difficult to implement, current estimates are heading down because of the dilution…swallow your pride, blame management, and sell the stock.

When You were Wrong: Parting company with a stock when there is no one to blame but yourself, can be one of the most difficult decisions for investors, amateur and professional alike. A disciplined approach to buying a stock will provide a reasonable cushion for the downside, but as with any assumptions, garbage-in results in garbage-out. Living with companies that you have researched well often provokes over-confidence in your assumptions. Persevering with companies, even when you have not paid a lot is a behavior that unfortunately, most of us exhibit. Monitor honestly your expectations for each investment.  When the company is not measuring up to your assumptions, why justify it in your portfolio? Relief comes from not grinding your wheels and making excuses. If you are buying using value discipline, the financial hurt is usually minimized!

2) Hitting the Price Target

Let's suppose that your assumptions were terrific, conservative, and fulfilled. Fundamentals are developing better than your expectations. You get warm and fuzzy feelings every time that Cramer lauds the stock on his show. This is especially true if you had a contrarian stance that has now been vindicated.

Selling the stock means losing your bragging rights! You persuade yourself that somehow you are short-changing yourself by not capturing the penultimate move.

Whenever you feel like bragging about a stock, it is probably time to sell. Catching market tops should never be your game. Leave some upside for the newly awakened buyers of your stock. If they want to play greater fool, let them…that should not be your game.

Falling in love with your stocks is easy. Human nature causes many of us to postpone that decision to sell. Don't let the absolute numbers achieved in a single holding dazzle you! Think about how that stock has enhanced the return of the overall portfolio and how you should go about improving returns in the rest of the portfolio.

Pay particular attention if the great performer is a result of a step-down in quality versus the rest of your portfolio. Recognize that you have been rewarded for assuming an uncharacteristic amount of risk.

3) Finding More Fertile Ground

Apply what some may view as boring principles of value discipline in a consistent fashion. Thanks to proliferating information, short time horizons, and superficial knowledge, traders continue to provide the aware value buyer with scads of opportunity. Coping with too much information causes many investors to chase stocks with a scant understanding of what the companies do and a far less than necessary knowledge of fundamentals.

Failing to perform even the most rudimentary checks on a stock forces many folk into pure speculation, panning for gold in an overworked stream. Like most prospectors searching for that nugget, the gold rush does not end well.  Be willing to look at the over-looked. Assemble your facts and put them together in a thoughtful and logical fashion.

It sounds trite, but the advice of Ben Franklin of so many years ago is still pertinent:

“Be honest; toil constantly; be patient. Have courage and self-reliance. Be ambitious and industrious. Have perseverance, ability and judgment. Cultivate foresight and imagination.”

Avoid the self-destructive nature that characterizes so many involved in investing. A recent study in behavioral finance underlines this tendency-link Trader Feed

As this blog post points out:

Consider the situation in which people face two situations:

1) A majority of their bets win money, but occasional large losing bets cause them to lose money overall;

2) A majority of their bets lose money, but occasional large gains cause them to make money overall.

Nearly half of participants in such an experiment choose the first option--even when they know the negative expected returns. When they don't know the odds in advance, a larger proportion of subjects select the first condition. That is, they prefer winning in the short run to making money over the long haul.

The overwhelming desire for frequent wins causes traders to capture profits quickly; the aversion to losses leads us to hang on.

Conclusion: Recycle your disappointments into new investments. You and your wealth will be grateful for it.

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