Writing Band Descriptors Task 1

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Above
Average
Investing
for the Average Investor
Table of Contents
1 Introduction: You Don’t Need This Book
5 One: The Experts Say…
9 Two: Am I Gambling?
11 Three: Is the Market for You?
14 Four: A Little History
20 Five: Emotions and the Market
34 Six: General Rules on Buying Stock
72 Seven: What to Buy, What to Avoid and Why
104 Eight: How to Find Stocks
130 Nine : The Hardest Part of Being in the Stock Market
159 Ten : Putting It All Together

I n t ro duc t io n
You Don’t Need This Book

While I thank you and appreciate the fact that you paid
hard-earned cash for this book (if you received it as a gift,
then I am thanking the wrong person), there are other good
sources of the information you’ll find here. I felt compelled
to write this because I wanted to write a book about invest-
ing that laid out the basics in straightforward language, and
in a friendly tone—something I would like to read myself. I
will not unveil any mysteries of the stock market, and I cer-
tainly won’t reveal any secrets. If I had a crystal ball, I would
be using it, not writing about it…at least not until after I set
up my own “Gates Foundation” with my own billions of dol-
lars. I have attempted to offer enough detail and background
to help you understand how the market works, and how it
can help you reach your retirement goals.
What this book will do is explain how an average person
with an interest in the market can turn that interest into the
high probability of making money in stocks. It is not rocket
science. In fact, it is not a science at all. Instead, it is merely
1
Above Average Investing 2
buying a piece of America, or at least a piece of the American

dream, owning something of value with the possibility of
growing that value. I realize that by claiming you are “owning
America,” I am stretching a bit, especially when you can own
stocks of foreign companies, but that is exactly the point. The
world is becoming smaller, and the United States’ system of
free markets, despite its home-grown problems and foreign
imperfections, is spreading worldwide. Who would ever have
thought that a free economic system would be embraced by
and flourish in a communist system like China?
The free economic system’s impact is growing there, and
frankly, I can not see how that type of government is go-
ing to be able to stop freedom from spreading as a result.
Mainland China is becoming more like Taipei, China. A free
market system, almost by definition, will result in more per-
sonal freedoms. Of course, it won’t happen overnight, and
they are going to eventually hit a wall, a recession, at some
point. At that point, China’s commitment to a free economic
system will be tested.
While China’s free economic system is important and in-
teresting, I am straying from the point of this book. The
stock market and the prices of stocks have been analyzed by
much smarter and deeper thinkers than me, but that does
not mean that they have come up with a better way to make
money. In fact, a few years ago, some Pulitzer prize–winning
mathematicians invented a way to invest using very complex
formulas and derivatives of the bond markets and currency
market. These guys were actual geniuses, but despite that
high-powered intellect, they lost huge amounts of money be-
fore they went out of business. Why? Because they focused
on their perfect formulas and their precise calculations and
ignored human reactions to fear and greed—the only two
emotions that mean anything and the ones that control all
short-term thinking in the stock market.
3 Introduction
There are a lot of smart people in the stock market from

stock pickers to analysts, but don’t rely on any of them to
help you. One of the great truths in the market is that the
experts are usually wrong. Since I do not consider myself
an expert, I am hoping this book will help guide you. As a
student of the market, I reserve the right to be wrong and
accept the strong possibility that it may happen.
So, do not look for any great revelations from this book.
If you do, you will be sadly disappointed. It will try to ex-
plain what moves stocks, both emotionally and financially,
and how these two things interact. What makes stocks go
up? What makes them go down? Why does the stock mar-
ket overreact in both directions, and why is it that a stock
always seems to go down just when you buy it and up when
you sell it?
One last great truth before we move on. The stock mar-
ket is a great place to make lots of money—far outper-
forming every other kind of investment over time. History
does not lie.
O n e : T h e E x p ert s S ay…
Investing Rule #1: The experts are wrong.

Markets are moved by complex issues and that is precisely
why experts are often wrong. Information spreads at incred-
ible speeds, and once that information is disseminated, ev-
eryone reacts to it. Government statistics are released daily
and updated constantly, and corporations are constantly
scrutinized as experts pick over every aspect of their busi-
nesses like buzzards on a carcass. These analysts, the ex-
perts, don’t miss one bit of flesh; yet, time and time again,
they come up with the wrong conclusions.
Consider the abundance of buy recommendations on
Internet companies just before the bubble burst in 2000.
Very few experts predicted that many of these stocks would
lose, on average, more than 50% of their value and that
hundreds of others would go out of business entirely. These
experts were, as a group, bullish on the market. The tech-
heavy NASDAQ index rose to over 5,100 in early 2000, and
by 2002, it bottomed at near 1,100 before it recovered in
2006 to about 2,000. When the NASDAQ was at 5,000, all
5
the experts were screaming: “Buy!” They were wrong!

Why were the experts screaming at us to buy stocks
when a reasonable, rational expert should have been warn-
ing us about the possibility of a runaway train poised to
crush us when we looked the wrong way? Why couldn’t
they see that coming and warn us? We were looking the
wrong way because those experts were telling us to. How
could that happen?
It’s simple. Those experts don’t work for you. They work
for a system that makes money by attracting money. The
markets crave cash. To fill that insatiable appetite, they need
you to give them your money. You can give it to them in the
form of your 401Ks, IRAs or a stock account. The money
can flow to them through mutual funds, ETFs—a relatively
new invention by these same experts, annuities or any form
of investment. These experts eat cash and want you to feed
them. They make that a priority, so their primary goal is to
convince you to be in the market.
Since the tech bubble burst in 2000, there have been
some changes made to make these so-called “analysts”
more independent from the market, but don’t count on
those reforms making those experts impartial. They may
indeed become more critical in their work, but they still
feed on cash. As long as you stay in the market in one form
or another, they will be appeased, but they still really want
you to buy, buy, buy.
I say this with all confidence not because these analysts
are bad, but because they can only serve one master—
the market—and that master needs to be fed. If these
analysts work for a commercial banker and/or brokerage
house, which many of them do, that brokerage house is
looking to increase their assets under management and
grow their earnings, just like any other red-blooded
American company. To do that, they attract companies.
7 The Experts Say...
They want to offer corporate America their services as

commercial bankers and/or as brokerage firms, just as
they like to offer their services to you, the individual in-
vestor. When companies want to issue stock to the public
or raise cash by issuing bonds, they do that through one of
these entities. What company, needing to find a commer-
cial banker and/or brokerage firm to raise money for that
new factory or to fund the purchase of another company,
will pick a firm that has publicly recommended that the
public should sell their stock? The experts that work for
these commercial houses do not want to have a sell rec-
ommendation on any stock. That is why they use words
like “neutral” or advise stockholders to “hold” when they
really should be screaming: “Sell!”
For commercial brokers and bankers, the goal is to keep
everyone happy. They need to appease the corporations
that need their help in financing and the public that looks
to them for sound advice about investing. When it comes
to investing, corporations and the public are not necessar-
ily on the same side, and the financial industry courts them
both at the same time.
There are some truly independent analysts, but if you are
reading this book and are an individual investor, you can’t
afford their reports. These firms are not well known, except
by industry insiders, and each stock or sector report they
produce costs thousands of dollars. You will never hear what
they recommend publicized; they hoard their information
for the few exclusive clients who can afford them.
However, even those independent analysts are often
wrong, and to make money in the stock market, you do not
need to hire them. If they are very good, they will become
known in the industry and their reports will be widely read.
Once that happens, they won’t be very good anymore. That
sounds wrong, doesn’t it? But it’s not.
Investing Rule #2:

When everyone knows something,
it is worthless.
In the late 1990s, there was a method of buying and sell-
ing stocks called the “Dogs of the DOW,” which became
very popular. This method of investing required you to buy
the highest yielding and lowest priced stocks in the Dow
Industrial 30 every year. You hold them for one year, then
rebalance the portfolio the next year by dumping last year’s
picks and buying the highest yielding and lowest priced
stocks again. This method worked for many years until it
became well known.
Keep in mind that by the time that you, an individual
investor, find out about a stock or a method, all the experts
and professionals have known about it for a while. This makes
that tip worthless, even if it is new to you.
T wo : A m I Ga m bl i n g ?
I like to play poker. That is gambling. I have a long-stand-

ing argument with my wife about whether the stock market
is gambling. She thinks it is, and I strongly disagree with
her. My wife states her case very simply, and to a degree,
she is correct. She says you buy stocks hoping that they will
go up, and sometimes they do and sometimes they don’t.
Since you are spending money and hoping for the best, she
sees that as gambling.
This is my counterargument. The stock market has some
very unusual idiosyncrasies. From day-to-day, its reactions
are insane. One day the market is depressed because North
Korea shot off a couple missiles or a terrorist bomb killed a
bunch of innocent people. But in the long term, stock prices
go up and down based on earnings. My proof is just as simple
as my wife’s argument. Compare any company that has made
money with those that haven’t. Microsoft and Google are
good examples of companies that have made money. Or look
at Apple Computer’s history in the market. In Apple’s case,
the stock ran up with its first personal computer and then
languished for years until Apple invented the iPod. Then
9
earnings skyrocketed and so did Apple’s stock. If you don’t

believe me, name one stock, just one, that made money, then
went out of business—causing their stock price to plummet
to zero. This fate may have met a few companies because
of poor or criminal management, but generally, there aren’t
any. Now see if you can find a company whose stock price
did not go up when it doubled its earnings year after year. It
is possible there is a company out there, but if that company
keeps that type of performance up, the stock price will even-
tually reward those earnings.
Gambling, by comparison, is more random. You can
hedge a gambling bet with knowledge and the application
of skill, but it all comes down to a random event based on
an uncertain set of possibilities. Investing is buying an asset
that has value. That value changes based on earnings. The
gambling part of investing is caused by imperfections in the
pricing system for stocks. The system is highly susceptible to
short-term whims and external factors other than earnings
and the growth of those earnings. Of course, my wife would
say that those external factors are what turn investing into
gambling. I can’t win with her, so I’ve stopped trying. As a
last resort in this age-old argument between us, I can always
point out that while she has lost money gambling over the
years, I have made money investing. She hates that.
T h r e e : I s t h e M a r k e t f or You ?
The stock market is a risky place. Stocks go up and down

quickly, and your reaction to the down part is what will
tell you if you should be in the market. I have observed that
emotional, “Type A” personalities have a much more diffi-
cult time being successful stock investors. As I will discuss
later, emotion plays a significant part in stock prices. You
need to know if you can ignore your emotions and the short-
term swings in stock prices. When the stock market is in the
midst of these big swings, does it affect your sleep? Highly
emotional people and people who need a lot of control in
their lives often have a hard time ignoring those big swings.
It can be difficult to know if the stock market is right for
you. When most people buy a stock, they can’t explain why
they bought it, so they have no idea when to sell it. The most
successful investor in history never plans to sell his stocks.
Warren Buffett prefers to buy a company and hold on to it at
all costs, ignoring all market gyrations. We mere mortals do
not have that kind of discipline. I don’t expect you to invest
like Warren Buffett, but his methods have made him the best
stock picker and most successful investor in the world.
11
Can you justify buying more of a stock that has lost 50%
of its value? If you are honest with yourself, you will probably
admit that you can’t, but sometimes when a stock loses half its
value, you should buy more of it. Your ability to do just that is
a good test of your comfort level in the stock market.
Don’t mistake a stock’s price with its value. If a stock
collapses and is fundamentally a valuable stock, the reasons
for its fall must have been short term and unjustified. Why
did you buy that stock in the first place? Have any of those
reasons changed? Remember, the market’s pricing mecha-
nism is fickle. In the short term, its rational judgment can
be perfect, but more often than not, it is completely insane.
That is why stock prices and values can be so different. That
is exactly why a stock’s price can be cut in half and still be
a great value. You need to be able to see through your own
emotional loss to still see the value of that stock.
When looking at your own purchases, do you buy stock
when the market goes insane and prices the stock far too gen-
erously? Or do you buy when the market collapses a stock un-
justly? When Krispy Kreme came out as a public company at
around $20 per share and then shot up to $45 within a couple
months, I could not understand why flour and sugar, boiled
in oil and smothered in more sugar, would be worth so much
more than other donut makers who use the same amount of
oil, flour and sugar. The market disagreed with me, and for a
while, I looked very wrong, but eventually earnings became
the common denominator, and as I write this, the stock is
priced at $8.20. Of course, it didn’t help that Krispy Kreme’s
earnings weren’t reported quite right and that its manage-
ment was being a little tricky in pricing some franchises, but
the point is that the market prices stocks at different levels
at different times. How in the world are you to know when
a stock’s price reflects its value or when it is over- or under-
priced? I confess, sometimes you can’t.
13 Is the Market for You?
You know that you are a rational, emotional being who

likes order in your life. You also know that by participating
in the sometimes irrational world of the stock market, you
cannot always know the real value of stocks, cannot predict
the market, cannot trust analysts, and if you find out about a
great stock, it is usually too late. So why should you want to
be in the market at all? Are you sure you want to do this?
If the answer is yes,

welcome to my world.
Fou r : A L i t t l e H i s to ry
Secular Cycles
I have to bore you with a quick look at the past. Try not
to fall asleep. It is always instructive and inspiring to review
the stock market’s past when I feel particularly blue in the
midst of a down market. A quick review of the market helps
convince me that, as my mentor, Jerry Klein, once advised
me: “America is not going away.” Jerry lived and breathed
the market for well over 40 years, and in his late 70s, he’s
still an integral part of our firm.
The following chart, produced by Rydex Investments, is
a look at the market over a 100-year period.
Several things should jump out at you; first is that the
market has very long bull and bear periods. The shortest is
8 years, and that was the Bull market of the Roaring 1920s.
The longest period was the 25 years marked by the Great
Depression. That bear market didn’t end until the early
1950s. Throwing out the longest and shortest periods, you
can reasonably say that these major cycles are about 10 to 20
years in length. We call these the Secular Cycles. The cur-
14
15 A Little History
rent secular bear cycle started in 2000; therefore, we can

expect to be in this cycle for several more years. It is likely to
end sometime between 2010 and 2020, although it could be
a lot shorter or longer. I believe it is likely to be shorter.
This chart also illustrates that the down periods of the
market, if measured from its beginning to its end, go down
only a little bit while the up periods see big increases. This is
the reason why you hear the buy-and-hold crowd talk about
staying with the market. They are correct. If you stay the
course, eventually you will make money—and lots of it.
What they don’t point out is that if you bought stocks
at or near one of those peaks, and a lot of people do buy at
those peaks, you have to wait up to 25 years just to break
even. Most people can’t emotionally commit to a stock for
that long, and others won’t live that long.
Cyclical Cycles
One thing this chart doesn’t show is the many bear and
bull “cyclical cycles.” Those cycles are market moves up and
down inside these very long secular cycles.
Source data used to create chart: Bloomberg
In the 1966 to 1982 secular bear market, there were four

bull cycles and five bear cycles. The up moves representing
a Bull market averaged 44%, and the down moves in the
bear market averaged 27%. These cycles occurred during a
period when the Dow Jones Industrials ran up and down in
a 400-point range from 600 to 1000.
The conclusion here is that you can make money in al-
most any market if you have a good understanding of how
the market works and can use a little common sense when
buying and selling stocks.
The Current Situation

We are in a secular bear market and that’s ok. Between
2000 and 2003 we experienced a very large pullback in the
market. The NASDAQ dropped more than 50% and the
17 A Little History
Dow about 30%. The Dow recovered in 2003, but we are

still in the secular bear market and will remain there until
the NASDAQ, the Dow and the S&P 500 exceed their old
highs. Don’t expect that to happen anytime soon. It could,
but the NASDAQ stock bubble that burst in 2000 was so
extended and the pop did such extensive damage that I think
it is going to take years for the market to recover.
A big technological advancement—similar to the Internet
phenomena—will likely spark the next NASDAQ rally that
will push that market index above 5,000. That doesn’t mean it
won’t happen. In fact, I can think of three possible reasons why
it will. The first one is the convergence of the iPod, PDA, lap-
top, T.V., camera, clock and whatever else they can stuff into
a cell phone-sized package. That convergence is coming. The
second possibility is the advent of widespread voice-activated
computers, and the third possible market spark is the spread of
the Internet, cell phones and computers into the third world
countries and specifically into China and India.
While these possibilities are on the horizon, we are still
currently in a long term bear market and, if history teaches us
anything, we know that we will experience up cycles as much
as 40% or more and down cycles of 25% or deeper. You need
to be careful, but you need to be buying and selling stocks.
Why Buy Now?

Within each of these short-term stock market cycles, there
are times of contraction and expansion in the economy. Do not
confuse stock market cycles with economic cycles. They are
tied together at the hip, but they are not the same. When the
Internet bubble burst in the stock market in 2000, it caused
the last economic recession and marked the beginning of the
latest secular bear cycle. The economy climbed out of that
recession in 2003 and the market rallied strongly that year,

but it remained in the bear secular cycle. As you invest over
the years, you will find that the stock market always looks the
worst at an economic bottom, even though, at that point, you
should be buying stocks. It is hard to buy at that point because
during an economic recession, the stock market often hits the
bottom. That leads us to the next rule.
Investing Rule #3: Always buy stocks

when everyone hates them.
The worst times in a recession are often the best time to
buy stocks. The problem is, of course, where is the bottom
of the recession? No one ever screams, “Buy now! We have
reached the bottom!” In fact, if you think about how you
feel when the economy is in a recession, you will understand
how difficult it is to buy stocks at that point. What does your
401K look like? Do you have the internal fortitude to invest
more of your hard-earned dollars when the value of your
investments are going down month after month? Most of us
cannot justify it. In fact, I believe the average person cannot
buy and hold stock positions at all. The exception is when
the average person forgets he owns them. If you can force
yourself to buy at that point, you are not average, and I bet
that most people reading this book are not average. You can
do it once you understand why. And you have to be able to
put your emotions aside.
Most people are emotional when it comes to money, es-
pecially their own money, and they are particularly emo-
tional when they are losing money. It is too hard to earn
money and when it starts to evaporate with falling stock
and mutual fund prices, the average person can’t handle it.
They panic and sell—usually right at the bottom. The pro-
19 A Little History
fessionals look forward to those panic sells and wade into

the chaos to buy when they see it happening. Individual
investors need to learn to use their emotions and control
their fears to prevent that panic from setting in during a
downswing. But how?
F i v e : E m o t io n s a n d t h e M a r k e t
Fear and Greed

These are the only two emotions that have anything to do
with the market, and on a short-term basis, they are what con-
trol the market. When I say that emotions control the market,
I must stress that it is only true in the short-term. In the long
term, the market is driven by earnings. If you understand how
emotions affect the market in the short-term, then you can
use it to your advantage. However, it will only work if you can
control your own emotions. One of the most difficult tasks
you can set for yourself is mastering that control. And don’t
think professionals are not affected by their emotions; in fact,
sometimes professionals react to their own fear and greed
much more violently than the average investor.
This emotional response is normal. Humans developed
a healthy survival instinct by fleeing in the face of danger.
It wasn’t pleasant being lunch for some bigger, faster crea-
ture with sharper, longer teeth and painful claws. Fear is
what drove us to develop our own sharp teeth—spears and
knives. Fear was instrumental in honing our survival skills
20
21 Emotions and the Market
by teaching us to focus on gathering and preserving food,

building shelters, and developing the wheel. All credit for
these advancements should go to fear. It allowed us to survive
as a family, a tribe, a country and, ultimately, a species.
Fear served us well, and in many ways, it still does.
however, when it comes to the stock market, the path to
success requires you to ignore fear and control greed. The
stock market didn’t develop naturally over centuries; it is a
recent, artificial instrument invented by man. It is an instru-
ment that operates outside of the natural order of things.
Our genes have not developed survival instincts for dealing
with the market, so we have to make a conscious mental
effort to overcome those same impulses that have success-
fully protected us throughout history because those impuls-
es handicap us when it comes to investing. Emotions have
no place in the market, and because of the effort it takes to
control them, most floor traders last only a few years before
they develop ulcers and heart problems. Years ago, when I
worked near Wall Street, it was common to see the floor
brokers in their colorful jackets—that’s how you recognized
them—drinking their lunches in the bars surrounding the
exchanges. Remember the two-martini lunch? Two for these
guys would have been an appetizer soon followed by the full-
course meal of straight hard liquor, on or off the rocks.
How do you recognize that emotion is controlling your de-
cisions or the decisions made by the overall market? There isn’t
an “emotional barometer” out there to help us…or is there?
The Market’s Fear and Greed

Actually there are certain indices and patterns that show
you fear and greed in the market place. One of the best that
I like, and one that will no longer work if it gets too popu-
lar, is the VIX or the VXN. What are they? According to

Investopedia.com:
The VIX shows the market’s expectation of 30-day vola-
tility. It is constructed using the implied volatilities of a wide
range of S&P 500 index options. This volatility is meant to
be forward looking and is calculated from both calls and
puts. The VIX is a widely used measure of market risk. The
index is often referred to as the “investor fear gauge.”
The VXN does the same thing, but uses the NASDAQ
index options.
I guess my job is done. I feel so much better now that I
gave you the definition. Go forth and apply the VIX and/
or the VXN in your trading life. With these definitions in
hand, you will always buy stocks at bottoms and sell them at
tops. This stuff is pretty easy, right?
Yeah, right.
After you have read the definition a few times, trying to
understand what exactly the VIX and VXN do, and given
up, let me explain how to use it. The VIX and VXN are,
like everything else in the market, tricky. It is a contrarian
indicator, meaning that when it is high, when the so-called
smart money is hedging bets with options because they fear
a market collapse, you buy stocks; when it is at a low, mean-
ing the smart guys think the market is going up forever, you
sell. It gauges the fear and greed of supposedly smart money
investors. At least that is what it is supposed to be doing.
Therefore, by using these two indicators, you are betting
against everyone else.
That seems wrong, doesn’t it? You will find that a lot in
the stock market. When something is going one way, the
smart thing to do is go the other way. This is hard to do. As
I said before, it is tricky. It is at the extremes that the VIX

and VXN are most useful. You have to look at a chart to see
these extremes, and if it was that easy, I could just provide
the numbers of the extremes and tell you to buy here and sell
there whenever it hits these numbers. When it comes to the
market, you will learn that nothing is that easy.
The VIX extreme in the depths of the recession of 2002
was about 45, and that was very high. The VIX, being a con-
trarian indictor, told us that the opposite of what the smart
money thought was going to happen was about to happen
and that the market would rally. That smart money was say-
ing the market was going to continue to fall. In 2003, the
market did rally. That doesn’t make those smart money in-
vestors so smart, does it?
The VIX hit a low of just 10 again in 2004, after the
recession was over. That is your range of 10 to 45 from
2002 to 2004. However, everything is relative. From 2004
to 2006, the VIX chattered between 10 and 20, never ap-
proaching 45 again. And in May of 2006, the VIX shot up
to a high of 24, and at that point, on our radio show and in
our weekly newsletter (which you can order for less than
$10 a month at investtalk.com), we were screaming to buy
because 24 was an extreme not seen since the recession.
But the extreme in the recession was 45, so why were we
calling 24 an extreme? The answer was that we were not
in a recession, and we had not seen that high of a number,
24, for two years. We saw massive amounts of fear, and
we bought it. The fact that the impact of the numbers pro-
duced in the VIX and VXN are relative makes them hard
to read and even harder to implement.
There is another reason why using these indicators doesn’t
always work: they do not tell you how far up or down the
stock market is going to go or, more specifically, how your
stocks will move. This means that these two indicators could
Above Avera ge Investing 24
move from one extreme to another while stock prices may

move only slightly. The VIX and VXN do not give you any
clues about the potential depth of the move. When we were
saying to buy at 24 and it actually peaked at 31. The market
eventually did move up.
I realize that I’ve advised you to use the VIX and VXN as
a way to gauge fear and greed in the market and buy and sell
stocks, but also gave you reasons why it won’t work. Just like
an expert, I am covering my bases without making a clear
recommendation. However, if I don’t give you the whole pic-
ture of the problems inherent in trying to understand the
market’s fear and greed, then I am not doing you any favors.
No one can make easy recommendations, because no one
knows the future.
Investing Rule #4:

There is no crystal ball.
Your Fear and Greed
Besides watching the VIX and VXN to gauge the market’s
fear and greed, you have to closely examine your own per-
sonal feelings. The closest thing you can have to a crystal
ball is your own personal fear and greed meter. I believe by
using your mind to control your reaction to fear and greed,
you can make sound decisions when deciding to buy and sell
stocks. My recommendations are very clear: “When you are
at the extreme of fear, buy; when you are at the extreme of
greed, sell.” But how do you know you are at an extreme in
your own feelings? What is your extreme? For me, it’s when
I think I am going to lose every cent I have because the mar-
ket is going straight down—when I see myself on the street,
begging for spare change for my next meal. That’s when my
mind tells me to buy more stocks or mutual funds. Don’t

think about it and don’t torture yourself if the market con-
tinues down from your buy point, just buy more. It will feel
wrong, and you will be cursing and condemning this book
and wishing that there was a worse place than hell for me to
spend eternity. Take a deep breath when that happens, and
then buy even more!
When determining a place to sell, my mentor, Jerry
Klein, likes to say that every time he thought about going
out and buying a new boat, he sold stocks, because he was
making too much money and was far too happy. That was
his personal greed meter. You need to determine your own
levels of fear and greed when dealing with your money in the
market and react to them properly. Learn from your emo-
tions and then learn to control them. This is very difficult.
I don’t feel the fear and greed much anymore because I have
been doing this for so long that I know what the market does
at the extremes. My personal meter is damaged, but I make
up for it in other ways.
Once you have mastered your personal demons, the
next big issue—and it is big when it comes to the market—
is: What stocks do you buy when you are fearful? Don’t
think that all stocks will go up when fear is at an extreme.
Earnings drive the market in the long term, and the growth
of earnings is what makes stocks go up—not fear or greed.
Emotions have no place in evaluating stocks. We study emo-
tions in the market to help you understand how the mar-
ket works and how you react to it. Emotions and earnings
are two very different dynamics. I cannot stress this point
enough. Emotions are not related to which stocks you should
be buying and selling. In the long term, the only thing that
matters is earnings. You should always buy stocks with
strong, growing earnings.
Can You Ignore Your Emotions?

The buying and selling of stocks would be so much easier if
we could turn off our reactions to emotions. Think of all the
sleepless nights you wouldn’t miss by worrying. In the stock
market, all you would have to do is look at earnings because
the market would price stocks perfectly based on the facts
and those facts are all about how much money the company is
making and is going to make in the future. In this ideal stock
market world, looking at both earnings and growth of earn-
ings would be the only measure needed. (Even this perfect
market world would be flawed because it can be difficult to
decipher true earnings and growth potential. Just look at
Enron, a company that had great earnings right up until they
went out of business. In case you missed it, they lied.)
This ideal world is impossible for us to attain because we
are emotional beings and that is reflected in everything we
do, especially when it comes to romance, money and, in my
case, food. (I get teary-eyed every time I look at my wife’s
pineapple upside-down cake. That dessert is emotionally im-
portant to me.)
Since you cannot be emotionless when buying and selling
stocks, even if you try and think you are ignoring your emo-
tions—you aren’t, so how do you recognize individual deci-
sions that might be based on emotion? This is another dif-
ficult task; the stock market is full of hard choices. As I have
said before, trickiness is the hallmark of the stock market.
Emotions are one of those tricky things. Fear and greed have
a way of working undercover to influence your rational side.
They worm their way in, forcing you to revisit your personal
decisions again and again, gnawing at your reasons for stay-
ing with a stock, trying to convince you that your cold hard
analysis is wrong. On the sell side, you often feel that you
made a sound, rational decision when, in fact, all you did
was justify your fear and actions with some readily available
facts. If emotions control the market in the short term and
we are emotional creatures, how can we ever hope to over-
come them? Let’s see if I can help you fight the twin demons
of fear and greed in your personal trading decisions.
Let’s say you own a stock and that you bought it for the
right reasons—earnings. Let’s also suppose that the stock
price is neither going up nor down in price. How long do
you hold on to it? If it moves up, where do you sell; if it
moves down, how far do you let it fall before you give it up?
You should have made an unemotional decision about when
to sell that stock prior to your purchase. At that point, you
would have been thinking without an emotional attachment
because you did not yet have your money at risk. That deci-
sion should include how much of a loss you were willing to
take or, for that matter, how much of a profit would be rea-
sonable. On the profit side, you should have determined the
stock’s value based on future or projected earnings. What I
am saying is that when you decide to buy a stock you should,
without fail, decide when you are going to sell it. It’s a deci-
sion of how much you are willing to risk to achieve your up-
side objective. Always make your decision about when to sell
a stock before you buy it. Once you own that stock, you will
be subject to your emotions. You might be good at control-
ling them, but you will still be a slave to your feelings; it’s
only a matter of degree.
That realization doesn’t help you determine how to rec-
ognize emotional decisions. Ok, here’s a clue. When a stock
goes up and you are not concerned about when it is going
to stop going up, greed has taken over. If you look at it only
in passing and feel happy, greed has you in its clutches and
you are going to lose money. You might not lose money on
this particular stock, but rest assured that if greed is in con-
trol—you are not.
If your stock goes down and you are nervous about not
selling, review why you bought the stock. If those reasons
are still valid, then you are making an emotional decision if
you sell it. If those reasons aren’t valid anymore, don’t search
for reasons to justify holding on to a loser; that would be a
strong indication that you are refusing to accept that you
made a wrong decision in buying the stock in the first place.
You may be afriad that if you get out now, the stock will go
up, or greed may be telling you that if the stock is low it is
a good value and you should buy more. If a stock goes down
from the point of your purchase, you are wrong about that
stock. It’s a matter of how wrong do you want to be. Step up
and face the facts. You are wrong! If you had decided where
to get out before you bought the stock, you would not be in
turmoil about what to do. Make decisions beforehand and
save yourself some grief.
A very good way to control fear and greed is to look at a
chart of the stock. I like a daily one-year chart. Chart read-
ing is an art, not a science, and it takes time and effort to
learn this art—and it still can be wrong. However, it is a
way for you to make nonemotional decisions. Many chart
technicians use the 50-day and 200-day moving average. If
the stock price drops below these averages, they sell. There
are other averages used as well. The 20-day moving average
is commonly used, but it is a short-term buy-and-sell signal.
Moving averages are very instructive and using them helps
smooth out the day-to-day volatility of stock movement.
Remember, we are trying to avoid emotions and the market
is driven by fear and greed in the short term, so anything
you can do to reduce your reaction to your emotions is a
step in the right direction. Look into charting and see if that
helps you. Our firm uses charts on a routine basis. There are
a number of very good books on chart reading. My personal
favorite is Technical Analysis of Stock Trends by Robert McGee.
Another way to avoid emotion is using “stops” based on

a percentage move of the stock price. A stop is a sell order.
There are investors that use an 8% or 10% rule. If the stock
falls by a certain percentage from its high or from where
they bought it, they sell. I am not opposed to using percent-
age stops sell systems and, in one way or another, often use
them, but the problem with them is that you can be taken
out of a stock position due only to the volatility of an indi-
vidual stock. In other words, if you have a stock that moves
up and down 3% in one day routinely, it is very dangerous to
place an 8% stop loss because in two or three days of trad-
ing, it will trigger a sell. You have to look at the individual
stock movement when placing a stop. There is no overall
rule you can apply. Some stocks move in pennies a day, and
others are much more violent. Also, the price of the stock
tends to change the volatility. Low-priced stocks are more
volatile than higher-priced equities. It is simple to explain.
If a $10 stock moves up or down $1, it is a 10% move. If it
is a $50 stock that moves up or down $1, it is a 2% move.
Therefore, placing an 8% stop on a low-priced stock may
not be a very good decision. You have to look at each stock’s
personal trading pattern.
There is yet another method for being emotionless when
it comes to your stocks—never look at them. Buy them and
forget about them for 10 years or more and then one day, open
your statement for the first time and see how you did. In fact,
this could be a very good way to own stocks. If you stick to
large blue chip stocks and have a good spread of them, this will
work. I am talking about stocks like Johnson and Johnson,
GE, IBM, and Proctor&Gamble. Do not buy small and mid-
size tech stocks. Most of them will not be around in 10 years.
Something new will come along and destroy the old.
To recap: people are emotional and cannot control them-
selves without effort. Therefore, the stock market is con-
trolled by emotions on a short-term basis. Your job is to

control and recognize these emotions, both in yourself and
in the market. There are only two emotions that mean any-
thing in the market: fear and greed. In an attempt to control
these two demons, you must use methods that avoid or re-
duce their influence. One of the best ways to accomplish this
very difficult task in your personal trading of equities is to
decide when to sell before you make your purchase. Placing
a stop on your stocks can be another effective way of taking
emotions out of the equation, but you must be careful to
closely evaluate each stock before choosing a stop. The last
method for taking emotions out of the process is to buy large
blue chip stocks and to just ignore them for ten years.
Sell When You’re Happy

Selling a stock when it goes up is just as hard or harder
than keeping a stock that is losing. Why? Because greed is
just as powerful as fear. When you have picked a winner,
you feel vindicated—you were right, you knew you were
going to be right, and it was true! Congratulations! Now
what? How long do you think it will go up and to what level?
Stocks move in both directions. If you use my third sugges-
tion and ignore your portfolio for 10 years, there is no is-
sue. You won’t know what is happening. I am talking to the
traders, the rest of us who have to look at our statements. In
other words, us mortals who can’t ignore our money.
One way to sell when stocks are running up is simple: Sell
when everyone else is buying. This is a difficult trigger when
you are in a winning trade. At what point do you determine
that everyone else is buying? Where is that point? Go back
to those two charts of the cycles of the market we discussed
earlier. You can use cycles to help determine when the buyers
are running the market up. If the current chart tells you that
the market is at previous highs, it is time to sell. In the 1966 to
1982 bear market chart, this was consistently true.
Source data used to create chart: Bloomberg
Study the many times the chart comes to a peak and then
a bottom. These tops and bottoms traded in a range in one-
to two-year increments. In a perfect world, we could use this
pattern and be assured that we would have winning trades
when we buy at or near old bottoms of the indexes for the
Dow, S&P500 or the NASDAQ. Even the VIX correspond-
ed well in that period. This works well in a trading range,
but at times, markets break out of ranges. The 2000 to 2003
bear market was a good example: All it did was go down.
You can’t just rely on charts because patterns change.
So what else can you do? When it comes to selling a win-
ning position, I suggest you not only watch the overall mar-
ket but go back to why you bought the stock. You should
have written down why and what target price you thought it
should reach to be at fair value. Do the reasons you bought
the stock still exist? Is growth of sales and earnings still ac-
celerating or has it stopped? Is the current stock price at or
near your target price? These are good solid reasons to sell a
winning position.
Investing Rule #5:

Sell when everyone else loves the stock.
I wish it could be made easier, but it’s not. These rules
sound simple, but they are very difficult to consistently im-
plement. The market tends to not repeat itself exactly the
same way; it is perverse and takes great pleasure in embar-
rassing the maximum amount of people possible. You can
only do your best to apply the rules consistently and adjust
them if they are no longer working. If you want to be success-
ful in the market, you should be able to recognize change.
I like to sell stocks at double and triple tops; this is a
chart pattern in which a stock price goes up to a previous
high point. I may only sell half my position if my value is
still much higher, and there are times when I will hold on,
regardless of the topping action. The hope is that the stock
price will continue to go higher, but stocks will often stop
at previously reached highs. The reason goes back to human
nature. Anyone who held on to the stock the first time it
peaked and did not sell it, only to watch the stock fall back
down, will decide not to make that mistake again. Because
of this tendency, double tops are called resistance levels, and
the stock generally stalls near these points once they reach
them for the second time. Previous owners who refuse to
see their profits go down again may force the stock back
down by selling.
Selling pressure increases at double and triple tops.
When the stock breaks through old tops, then these same
tops become support if the stock falls back down. We will
discuss charting in more detail later, but using these patterns
to sell is a sound technique. If you like the stock and it hasn’t
reached your target price, and it breaks through previous
tops in a chart, then you should buy it back if you sold it, be-
cause no one knows where it is going once it breaks through.

These are very hard decisions to make because if you are
selling winners, you will certainly second guess yourself.
The first time you sell one and it continues up, you are going
to be upset and question your trade. You will remember this
book and think that I am as dumb as a rock. Just remember
that if it were easy, everyone would be doing it.
We’ll be discussing buy and sell signals in more detail,
but remember that charting is not a science; it’s a study of
human nature and of what people tend to do—and that
tendency generally repeats itself. Selling winners is as gut-
wrenching as selling losers, and using charts to help with
the process will give you some guidance. Always remember
that the market is constantly changing and that old patterns
morph into new patterns, old methods need to be updated,
and the process of buying, selling and evaluating stocks is
organic not static. Nothing in the stock market happens the
same way every time; the patterns are in constant flux. In
time, you will learn that being stubborn will lose you as
much money as being stupid. Don’t be either.
Si x : G e n er a l Ru l e s o n Bu y i n g Sto ck
What to Buy and What to Avoid

I’ve already given you a few investing rules and there will
be more rules to come. If you are going to be successful in
the stock market, you will need discipline. For some, that
discipline may come naturally, but the rest of us have to work
at it. Having rules helps instill discipline. Remember, our
goal is to not be controlled by fear and greed. We are fight-
ing our inherent nature, so rules work. However, even when
diligently following these rules, you will always be subject
to your emotions. They are part of your human nature. So
let me warn you about these rules. The rules themselves are
very sound, but what tends to happen is that you will use
these rules and twist them to fit your emotional response.
Fear and greed are all-powerful. Just when you think you
have mastered them, these emotions resurrect and cause
havoc on your wealth. Guard against using these rules to
justify your actions.
34
35 General Rules on Buying Stock
Investing Rule #6: Always buy stocks that

are making money.
It seems like such a simple rule and it overrides all the
other rules, but there are many investors who constantly
violate this rule and when you talk to them, they explain
their reasons and sound so plausible that you almost want to
believe them. It’s a bunch of nonsense. Buying stocks that
make money does not mean buying stocks that will make
money, but stocks that are making money now.
I have stated that stocks only move up when they make
money and that you should measure a stock and its potential
to rise in price by its growth of earnings. It is a simple prem-
ise. In reviewing history, there has not been a single stock
that has increased in value that did not make money. Sure,
you will be able to find some examples of stocks that have
moved up for a year or two on a story that they were about to
make it big but then didn’t. But making it big means making
money. If you were starting your own business how would
you measure success in that business? It’s about earnings—
cash. It’s all about the money. You, as an investor, live in
Missouri—the “show me” state—and you need someone
to show you the money. Nothing else matters. Preserving
assets is important, but only so you can hold on to the asset
long enough to make money later.
Corporations report earnings every quarter. We call
this an “earnings season.” It starts in earnest a week or two
after each calendar year quarter end: January, April, July
and October. This is the report card time. During this time,
companies come out with their Earnings Per Share (EPS)
number and an accompanying statement of some kind hint-
ing about the future or explaining what happened in the past.
A stock will often go down even when the earnings report
is good. There is a saying, “buy on the rumor and sell on the

news,” which describes this phenomenon. It is not always
true, but it does manage to be true enough that it confuses
most amateur stock watchers.
When EPS numbers come out, make sure that you are not
hearing other earnings news except the actual EPS. Watch
out for the term “Pro-Forma Earnings.” What that means is
earnings if you take out one-time or unusual expenses. In
other words, “Pro-Forma” means: “I am going to try and
do a sleight-of-hand trick with the numbers.” A corporation
will say, “We made $1 per share in ‘Pro-Forma’ earnings
this quarter. Aren’t we good?” If you look a little deeper,
you will discover that what they are actually talking about
is that with that lawsuit they had to settle and the disaster
in one of the factories that they had to rebuild, their actual
earnings were zero per share. They will try to convince
you not to look at that lawsuit or the disaster because they
are expenses that are behind them. They were one-time
expenses. They will want you to look forward. It is all lies!
Do not listen! There is always another disaster around the
corner and another attorney ready to sue anyone and every-
one again. Unforeseen and unexpected expenses should be
planned for, so don’t let a company convince you that their
earnings were better than they were with the words Pro-
Forma. Concentrate on real earnings.
Before the actual earnings season comes the “earnings
warnings season.” This is the month before the end of the
quarter. During this period, companies warn that next
month they are not going to meet their expected earnings
projections. It is an attempt to lessen the pain when the
actual numbers come out. If you pay attention, you will see
companies trying to manipulate the public. They will use
the truth to manipulate; public corporations have to report
facts (unless they are practicing fraud and that does happen).
Generally, the vast majority of corporations tell the truth,

but they tell it in a way that makes them look the best. They
will give you Pro-Forma earnings and the real earnings and
they will warn you of problems, unforeseen expenses, or
unusual circumstances. All this is good, but I want you to
realize it is all a way to manipulate you, your desire to trade
the stock, and your perceptions of the company. It a game,
and you need to learn the rules.
Watching this dance of earnings every quarter is inter-
esting and can be profitable, but it still is a lesson on earn-
ings. Stocks go up when earnings go up. Just buy stocks with
increasing earnings. How hard can that be?
The problem is that the market is not sane. It is made up
of very emotional beings, all of whom are trying to beat the
other guy, trying to get ahead. They are looking forward to
next quarter, next year or the next big, new thing, and they
all want to own the stock that will rocket higher because of
the next new thing. Examples of this are everywhere. The
iPod is one of the biggest new things today, or China—yes,
the entire country—with its spectacular growth in the past
few years. Everyone is trying to beat everyone else, and this
causes stock prices to move in perplexing ways. Recently,
UPS reported its quarterly earnings and they beat all expec-
tations, but their stock fell about 15%. Why? Because of what
the investors saw in a certain sector of their global income.
Investors felt that UPS’ growth was slowing in a particular
area in the world. True or not, the stock fell sharply.
Traders are trying to predict the future, and we all know
how reliable that is. Obviously, as investors and speculators
guess at the future, they push stock prices around and, in some
cases, push them to heights or depths that make no sense. That
is why, in the short term, the stock market is not sane. In the
long run and looking back over time, stock prices reflect their
earnings. Thus, Rule #6: Buy stocks that make money.
It is in the inaccurate process of looking forward that

stocks become mispriced. Who knew that the iPod would
be so popular? Or that cell phones one day would replace
land-line phones? Or, for that matter, that the horse would
be replaced by the car? There is a great book called Creative
Destruction by Richard Foster, Pierre Ven Beneden and Sarah
Kaplan that describes how our economic system destroys all
old systems and products and replaces them with new. You
can read that book after you are done with this one.
So how do you find these stocks that have consistent
growth and/or a new way of doing things? How can you see
shapes in the crystal ball’s murky gray clouds? The first step
to successfully choosing stocks is understanding what influ-
ences current and future earnings. That means you need to
be a little clairvoyant. Even though you should not expect to
be able to see the future, be aware that the future is always
seeded in the present. Success lies in your ability to analyze
the current conditions in both the economy and in politics.
It takes patience, a lot of reading, a fair amount of common
sense and a bit of careful prediction.
Investing Rule #7: Do not buy story stocks.

A story stock is one that has a great story and is “cer-
tain” to make money in the future. The story is always very
compelling. Biotech stocks have been selling this “future”
earnings story for years. There has been just enough suc-
cess in the story to keep people buying and selling biotech
stocks. Some of these biotech stocks are spending obscene
amounts of money by issuing the public more and more
stocks while failing to create a concrete business plan. The
story is great, the next big cure for cancer or AIDS, but
usually that is all it is—a story.
Because investors have to be forward thinking and they

want to beat everyone else, they are very susceptible to the
next new thing. They are eager to believe any sound and
convincing story. I hear it all the time. I call these inves-
tors the get-rich-quick group. They purposely seek out story
stocks, and guess what, they find them. Why? Because there
are always people on Wall Street ready to take your money
by selling you a story. What makes you think that anyone on
Wall Street is not willing to spin any number of stories to
part you from your money? That is what they do for a living.
The story will always sound very good. They are masters,
and they have a ready, waiting, willing and wanting audi-
ence. Despite how good they sound, do not buy story stocks!
Buy stocks that make money.
If you find a stock that makes money and has a great story,
feel free to buy it. Those are the best kind of stocks to buy.
Buy Stocks with Growth and Value

One of the biggest problems people have when they finally
find a stock that interests them is that they think that they
have to buy it now. Their reasons are usually the same: They
just discovered it and it’s going to the moon tomorrow. They
don’t want to miss this great opportunity by not jumping on
it. That is pure emotion talking. Never ever feel that you have
to buy anything today. In fact, never buy anything on the first
day you find it. The idea needs to be refined. Pretend it’s a fine
wine. You need to swish it around first, smell it, and roll it
around in your mouth before you swallow it. Those that just
guzzle their wine are usually alcoholics who have no control.
In drinking wine and buying stocks, maintain control.
Don’t even look at this stock unless it is making money.
Dismiss any stocks that are not making money. You can
watch them, you can research their products, and you can
even become an expert on what they do, but do not buy the
stock until that company makes money. In addition to mak-
ing money, you want to buy a stock that is cheap. Cheap
does not mean the stock is selling for $1 or $2 per share.
A stock’s price has nothing to do with whether or not it is
cheap. A stock is cheap or “dear” only in comparison with
its current and projected earnings. It is in that relationship,
between stock price and earnings, that you can determine
the relative value of a stock.
The stock market always looks forward, so you must too.
It does you no good if you only look at past earnings. Yes,
you should analyze the pattern of earnings, and it is nice
to know how consistent the company’s earnings have been,
but when it comes to buying stocks, look forward. Looking
forward means you should look at earnings estimates and
at the relationships of those future earnings to the various
stock-specific elements. What do I mean? To explain, let’s
look at some relationships.
P/Es and EYs

Measuring the relative merits of a cheap or expensive
stock is usually expressed by its price-to-earnings (P/E)
ratio. The stock market’s overall P/E (the S&P 500) ranges
from about 7 to 30 but is considered normal at about 17.
Normal is a loose term, because it refers to historical norms.
However, in studying the P/E ratios, do not assume that a
low P/E is where you buy and a high P/E is where you should
sell. During recessions, the “E,” earnings, are very low or do
not exist at all, and at the same time, stock prices are very
depressed. Despite that situation, the bottom of a recession
is the best time to buy.
Buying Rule #1: Buy relatively low P/E stocks.

So looking exclusively at the P/E ratio is not a good strat-
egy. However, in looking for stocks, the P/E ratio is a good
relative number to compare. Also, you should compare a
stock’s P/E with that stock’s peer group and not just the
overall market. A high-growth industry such as tech gener-
ally has higher P/E ratios, whereas low-growth industries
such as steel or autos generally have low P/E ratios. So don’t
get excited or obsess over a low P/E and don’t be frightened
of a high one. The relationship between earnings, price and
growth is what’s important.
I prefer to look at the earnings yield (EY), rather than
the P/E ratio. The two are related and, in fact, the EY is the
inverse of the P/E. If a stock makes $1 per share and the stock
price is selling at $20, you have a P/E of 20 (20/1 = 20). The
EY, using these same numbers, is 5% or .05 (1/20 = .05 or
5%). Therefore, if you know the P/E, you also know the EY.
Why do I prefer the earnings yield? Because you can
compare the earnings yield of a risky stock to the yield of
a riskless investment such as a treasury bond. Buying stocks
is risky; in fact, buying any investment is risky, but almost
all would agree that buying United States bonds are nearly
without risks. So if a 10-year government bond is paying 5%
in yield, you need only hold it to maturity, and you get your
money back plus 5% and if a stock EY is 5%, and stocks are
more risky than these government bonds, why in the world
would you ever invest in stocks? It makes no sense. What
that means for you is that the higher the yield on a govern-
ment bond, the higher you should demand from a stock’s EY.
In fact, I suggest that you buy stocks that are producing an
EY of 150% or more of the current 10-year treasury bond
yield. I want to be rewarded for investing in a risky stock, so
a 150% premium over a riskless investment is a good place
to start. Many investors use the current 10-year corporate

bond rate, and that is a good measure as well, but it is a
riskier investment than a government bond.
Buying Rule #2: Buy stocks with an EY of

150% or more of the yield earned on a 10-year
government bond.
Remember, a low P/E ratio is a relative number to the mar-
ket, its peer group, its industry and to itself. Do not assume
that a stock with a low P/E is a good value. Sometimes when
a stock’s P/E is at its highest, it is the best time to buy it.
It is very straightforward to examine a P/E ratio in rela-
tionship to its peer group. All stocks types are classified by
sector and industry, so finding the P/Es for the overall group
is easy. Those ratios are all over the Web. However, looking
at a historical P/E ratio may be a little more difficult. In
other words, look at a stock’s history and determine what
your target stock has sold at in the past. I like using the high
and low P/E ratios over a five-year period. This provides a
good benchmark as to where a particular stock has traded.
You then can look at its current P/E and determine its rela-
tive stock price based on its history. History doesn’t always
repeat itself, but it’s a starting point to determine a proper
value for the stock. There are several simple methods to
determine the potential future values of stocks and using a
historical P/E ratio is one.
Again, since we are always trying to determine the future
value of a stock and its relationship to its current price, we
use next year’s estimated earnings to forecast. Obviously,
that means looking at the projected earnings estimates and
that does require some guesswork. We try to determine
what the stock’s P/E ratio will be using next year’s earnings
estimate per share and the current trading price of the stock.
It is a very straightforward method, but when estimating,
there is a lot of room for error. Despite the room for error,
this is the best system available. While calculating these val-
ues, remember that it is all voodoo math and that no matter
how carefully you calculate them, our nice, neat formulas
and values can still be very wrong. In Investing Rule #1, you
learned that “Experts are always wrong,” and that is because
they are the ones projecting future earnings.
Using next year’s projected earnings and the histori-
cal data regarding P/E, you can calculate a stock’s value.
Multiply next year’s earning per share (EPS) by the high and
low P/E of the stock over the past five years. So, if the low
P/E ratio is 10, the high is 30, and the EPS is $1.50 per share
next year, this is the formula:
Low P/E times next year’s EPS = Low target price

(10 x $1.50 = $15.00)
and
High P/E times next year’s EPS = High target price

(30 x $1.50 = $45)
The price range for this stock is $15.00 to $45.00. Now

look at the current price and decide if the stock is cheap or
expensive based on historical norms. Easy, isn’t it? Trust me,
it is never easy. It might sound that way, but it is not. This is
just one of many ways to determine stock value.
I mentioned in the beginning of this chapter that deter-
mining relative value means looking at the relationships
between earnings, growth of earnings and stock price. That
gives you two relationships to examine: the relative P/E
ratio when compared to stock price, and the earnings yield,

when compared to the yield of a 10-year treasury bill. There
is yet another relationship you should investigate: growth
and its role in stock prices.
EPS Growth
While it is important to study the relationship of earn-
ings to the stock price, you cannot look at that relationship
in a vacuum. All professional investors look at the growth
of sales and earnings for the stocks they follow. That focus
means you have to understand those investors’ process if you
want to compete with them. In that competition, you are
trying to gain an edge over them, and to do that, you need
to dissect their thought process. You need to clearly under-
stand the prospects of growth for their stocks’ sales.
If growth of earnings and sales is the primary focus of
most analysts, then you can understand why they are pas-
sionate about watching the earnings that are reported every
quarter by corporate America. There is usually an immediate
reaction in the stock price when earnings are reported. The
impact of earnings reports is a fact of life for every investor,
and you must learn to recognize and embrace it. The stock
price will fall or rise on the reporting of quarterly earnings,
and most of that move is not based on the actual earnings
reported, but on the anticipation of future potential growth
or shrinkage in sales and profits. Therefore, the current
“expectations” of earnings and growth for a particular stock
are paramount, and, in fact, you should have a good idea
about prospects for growth in your stock’s sector as well.
It’s not getting any easier is it? I will try to simplify it, but it
is still a lot of information to comprehend. Earnings, growth
of earnings, projected earnings and sector prospects are just
the beginning of what you must understand. Do you have to

know and understand these things to be competitive in the
stock market? If you want to compete, you do. Being a passive
investor is much easier, and it is the right path for the majority
of people. If this is all too technical for you and you want to
become a passive investor, find either a few good mutual fund
managers and give them your money or find a trustworthy
money manager and let him worry about your portfolio. If you
are still determined to do it yourself, keep reading.
The nice thing about the Internet is that the informa-
tion you need concerning almost anything in the world and,
more particularly, about stocks can be found quickly. When
researching growth rates, you will seldom find the actual
percentage rate of growth, but what you will find is last
year’s earnings per share for a company and this year and
next year’s projections. These are three of the numbers that
you need to make your calculations and compare the relative
value of stock prices.
Stay with me. I know it is getting a little complex.

Simply put, focus on earnings and growth of earnings. To
evaluate the price of a stock and determine if it’s overpriced
or underpriced, you want to try to estimate future earnings.
Even though you cannot accurately determine future earn-
ings, you still need to use those numbers to make your cal-
culations because everyone else is doing the same thing and
that effort, in the short term, drives stocks up and down.
Even though they are certainly wrong, you still have to use
projected earnings.
We not only want to know what those projected earnings
are, but we also need to know current earnings so we can
determine the percentage of growth of earnings. How fast is
the company growing? These are fundamental numbers, and

once you have them, you can work with them and compare
them with other stocks in the same industry or with current
growth rates of a particular stock.
Also, you can use the EPS (Earnings Per Share) estimate
for next year and its growth rate to compute the future value
of a stock. This is another, second quick-and-easy way to
determine a stock’s future value. Using the last five-year
high and low P/E ratios was the first method, and this gives
you a second one that is actually easier to use.
You need three bits of fundamental information to make this

calculation:
1. This year’s actual EPS,

2. Next year’s estimated EPS and
3. The growth that is derived from these two
numbers.
If the current EPS is $1 and next year’s estimate is $1.20,

that is a 20% growth rate. In effect, you only really need
two numbers because use of those two numbers provides the
third. You can get an estimated target price for the stock by
multiplying next year’s EPS by the growth rate.
$1.20 x 20 = $24.00
Note: I did not use 20% but rather the number 20 to do my

calculation.
Now compare the target price of $24.00 with the current

price of the stock. Is the stock cheap or expensive? This is a
very good method to quickly determine a future price target
and current value of a stock. If the stock is selling for $10 per
share, it is a great value; if it is currently trading at $30 per

share, stay away from it.
However, there is a problem. If you use this formula long
enough, and believe me when I say I have, you will discover a
problem. The formula works fine for midsize, growing com-
panies, but for very small companies and very large com-
panies, it tends to fail. The reasons make sense. First, if a
company is not growing its earnings and is stagnating, this
formula won’t work at all. If you are searching for stocks to
buy and you are running into this problem with mid-sized
companies, be aware that you are considering stagnant, non-
growing companies. Why would you do that? Are you buying
a story stock? What have I said about that? If it’s not growing
and you are considering the company as a buy, you are likely
being driven by a story. Many large companies have trouble
growing because of their size. If you are looking for large
companies because you feel they are safer, do not use this
method to determine value.
On the other end of the scale, this formula doesn’t work
for small companies because they generally grow too fast. It
is easy to double your sales and earnings when you are small.
The whole world is your market. If you double your earnings,
that is a 100% growth rate and 100 times next year’s EPS is
your target price. One hundred times anything is not a rea-
sonable expectation and you are bound to get hurt looking for
those types of earnings. I would love to own a company that
grows at a rate of 100% per year, but so would everyone else
and I can assure you that the price of that kind of stock will be
high in relationship to other fundamental factors.
This doesn’t mean you can’t buy large and small compa-
nies, it just means you can’t use this very simple formula when
considering them. You need to use some common sense.
GPE
By now you should have figured out that I like to study
relationships between different fundamental numbers. We
have talked about historical P/Es and EY in relationship to
bond yields, now I am going to give you another relationship
to consider. It is called the GPE and is an examination of
growth (G) in relationship to the company’s P/E ratio. The
GPE helps calculate the purchase of very high growth stocks
which generally have higher than normal P/Es. Everyone
wants to buy stocks low and sell them high, and most people
believe that a low-priced stock means a low P/E. That is not
true. High P/E ratios happen all the time. If a low P/E does
not mean the stock is on sale, what should you use to make
that determination? The GPE is a good answer. Ideally the
growth of earnings should be two times the P/E ratio or
more. I constantly mention the GPE of a stock on our radio
show and in our newsletter because it is a very important
concept. In fact, all the relationships are important and they
all need to be computed and compared with each other, but
the GPE disregards the P/E entirely. As long as the growth
of the stock is two times the P/E or more, you can buy any
high P/E ratio stock you want. Growth supports the high
price. Growth can make up for a lot of problems when look-
ing at stocks. Growth of earnings and sales are so important
that almost all the fundamental numbers in this book do not
work without growth.
Again, determining the growth rate of a stock is easy.
If a stock made $1 per share last year and is going to make
$1.20 this year, that is a 20% growth rate. If it continues to
make 20% next year, then next year’s EPS will be $1.44. It’s
a simple mathematical formula. If this seems complicated to
you (and if it does, I bet you haven’t balanced your check-
book either), then do not consider investing on your own.
Don’t stress over it, my wife hasn’t balanced our checkbook

in years, and she is pretty smart. Some things in life just
appeal to a certain type of person.
I am suggesting, after you have done the math, that you
want to buy stocks that have growth rates of twice the P/E
ratio. Using our example of 20% growth per year and our
GPE factor of two, you want to buy this stock only if the
current P/E is around 10 or less. The higher the growth
rate, the higher a P/E ratio you will accept. The P/E can be
100 as long as the growth rate is 200%.
Keep in mind that whenever we talk about numbers of
any kind and try to determine a good value for a stock, we
are looking forward at next year’s numbers. At the risk of
repeating myself, current and past numbers are nice and
something that you consider when appraising consistency,
but all professionals study the future prospects of a company,
not the past. There is a theory that states that everything
known about a company is already considered and reflected
in the current stock price. That theory suggests that you
cannot glean any new information from research because all
past information is already built into the price, so why try?
Remember Rule #1: The experts are always wrong? If
that is true, it means that if you do your homework, then
you, the individual, have just as much chance of producing
superior results in your portfolio as a professional. In fact,
I think individuals actually have the advantage. You do not
have to worry about the liquidity of the stocks you buy or the
size of your position in any one company, unlike a big mutual
fund or a trading house. You can be far more nimble, and
you can pick smaller, faster-growing stocks. You can beat
them, but you have to have knowledge.
This brings me to the third buying rule.
Buying Rule #3: Buy stocks with GPEs

of 2 or higher.
You will not always find stocks that meet all three of these
rules. In fact, if you are considering large cap stocks, you
will likely not find any that fit rule three. The rules are not
set in stone; they are guidelines. These rules define ways to
examine relationships. If a large capitalization company has
a low GPE, which will be common simply because they are
large and can’t grow very fast, then stress the EY or its rela-
tive P/E ratio or, more importantly, look at its price-to-sales
ratio. Yes, I slipped in another relationship for you to study.
I need to be sneaky about these relationships every now and
then or you might stop reading. Before we get into the new
relationship though, let me further explain the GPE.
Many experts talk about how they want the PEG ratio
(price/earnings growth) to be low. The PEG is the inverse
of the GPE. The PEG is the price of the stock, divided by the
earnings growth (P/EG), whereas the GPE is growth of the
stock, divided by its price earnings ratio (G/PE). Don’t get
confused; you want a high GPE or a low PEG.
The GPE works best with stocks that are not large. What
does that mean? Stocks are categorized by size, as well as
by sector, industry, growth, value and many other terms
you may or may not be familiar with, but when we are talk-
ing about the size of a company, they will be categorized by
“market capitalization.” You can find the market cap almost
everywhere on the web, but it is important to understand
how this is determined. There are three basic sizes of com-
panies: small, mid and large. A company’s size is deter-
mined by the price of the stock multiplied by the number of
shares outstanding (the number shares available to trade).
Generally, any company with a market cap of $1 billion or
less is considered a small cap company. From $1 billion to

roughly $7 billion is considered a mid-cap company, and a
large cap company is over $10 billion. I realize there is a gap
in my numbers. There is no hard and fast rule on market cap.
Some people say a large cap is over $10, and some lower that
number to $7 billion. Both definitions are acceptable.
The reason that a large cap’s GPE is usually low is because
of its growth. Think about how difficult it is for Microsoft to
grow today. It has a growth rate of about 12% and a P/E of 15,
so its GPE is below 1. It is no longer the growth stock it used
to be when its growth was 30% or higher for years. When
growth slows, P/E ratios tend to contract. When growth
accelerates, they tend to expand. Microsoft has a billion shares
outstanding, which is a direct result of that growth. In its
growth phase, the stock would go up and split, continue up
and split again. The shares grew in number as the price of the
stock continued up. Since we measure the earnings growth
using the earnings per share number and there are a billion
shares outstanding, how much in earnings does Microsoft
need to produce to continue to grow to achieve a decent GPE?
That number is in the billions. The law of large numbers takes
over. You can’t keep growing any company at the same per-
centage rate as that company gets larger and larger.
Smaller cap stocks have a much easier time growing.
They have fewer shares outstanding, so their market cap is
small. That means they generally have an easier time grow-
ing their earnings per share numbers. Therefore, they can
achieve a GPE of 2 or higher. The GPE looks for those stocks
that have great growth of earnings but that are still not too
expensive in relation to those earnings. Another benefit to
the GPE number is that it will always keep you in stocks that
have earnings and that are growing. Using the GPE number
to choose stocks means that you avoid all companies that
don’t have earnings or that have negative growth. That is a
nice little side benefit. You cannot have a P/E ratio or a GPE
without earnings. With all the complexity involved, it is nice
to have a little bit of simplicity available.
P/S
There is one more important relationship to consider. It’s
the one I slipped in on you in the middle of the last section.
In all the three previous relationships, earnings ensured that
you considered strong stocks. The P/E, EY and the GPE all
must have earnings to make them work. You want a rela-
tively low P/E, so if the price of the stock is high, you have
a much higher earnings number. The same is true for each
of the other two relationships. Earnings control the number.
However, that is not true for the price-to-sales (P/S) ratio.
I mentioned earlier that the P/S is a good number to
compare when analyzing large cap stocks because it is very
difficult to find GPEs of 2 or higher for large cap stocks. The
price-to-sales relationship is nothing more than comparing
the market cap to the gross annual sales of the company.
That number should be around 2 or less. Some other experts
like to use 4 or less, but I feel that is a little too generous.
Buying Rule #4: Buy stocks with

a P/S ratio of 2 or less.
Again, I want to stress that these are guidelines and that
not many stocks will fit all of these rules. If they do manage
to fit all of them, you might want to consider them too good
to be true and look for their flaws.
You can use Rule #4 in either a flourishing or recession-
ary economy. I mention economics because Rules #1–3 need
earnings to compute the ratio and you will find it difficult to

apply them in a recession. Earnings and growth collapse in
a recession, but a P/S ratio improves. Corporations still sell
products in a recession; they just may sell fewer products.
They may not show profits because of the shrinking sales
growth. Growth and profits evaporate in recessions. As a
result, stock prices generally deflate faster than sales. That
only makes the P/S ratio look better. In a recession, I recom-
mend you focus more on P/S ratio than on the other three
rules because the best time to buy stocks is in the depths of a
recession. During a recession, P/E ratios are usually at very
high levels or are nonexistent because of flagging earnings.
The GPE stinks if the P/E stinks, and there is no growth in
a recession—that’s why they call it a recession. You will find
some stocks that meet all of the rules, even in a recession,
but they are few and far between.
The fifth and last buying rule focuses on Return on Equity
(ROE) and Return on Assets (ROA). ROE and ROA are
related but not the same.
ROE = net income/shareholder’s equity

That’s simple, or is it? What is equity? Simply put, it is the
money you, the shareholder, have invested in the company. It
is also referred to as shareholder equity. The formula tells us
how profitable the company is. It is a measure of a company’s
profitability in relation to the dollars invested in the com-
pany. Return on Assets (ROA) is a little different because it
includes both debt and equity.
ROA = net income/total assets

ROA reveals the earnings a company generates on its total
capital and how profitable the company is based on its assets.
These simplified definitions of ROE and ROA will suffice
because you only need to use the numbers. You don’t need
to understand the accounting that produces these numbers.

We are investors—we just demand that the numbers are
accurate and then use them in our formulas.
Buying Rule #5: Buy stocks with at least

a 17% ROE and/or ROA.
Even though this is the last buying rule I am giving you,
there are many, many other relationships that exist that
influence the decision to purchase stock. I strongly suggest
reading the bible of value investing, The Intelligent Investor. It
was written by Benjamin Graham in the 1930s and is still
highly relevant. It remains the best book on value investing.
It is still in print, and I guarantee you that every professional
worth his or her weight in gold has read this book. I also
recommend you check out our web site, www.investtalk.
com, and read every book on our book list.
To recap the buying rules:
#1: Buy low P/E stocks.

#2: Buy stocks with EYs of 150% of the yield
on a 10-year government bond or higher.
#3: Buy stocks with GPEs of 2 or higher.
#4: Buy stocks with a P/S of 2 or less.
#5: Buy stocks with a ROE and/or ROA of 17%
or higher.
These are the rules I am going to ask you to apply diligently.

They appear simple, and you would think that their applica-
tion will be easy and lead you merrily on the path to financial
success. You would be wrong. I am going to give you some
examples that may challenge your application of the rules, but
before I do, we have to discuss stock and industry compari-

sons. When we apply these five stock-specific rules, we have
to do it in a way that makes sense. That means we have to make
comparisons with other similar stocks within an industry.
Industry Comparisons
It will help you apply the buying rules I have outlined if
you learn the differences the stock market places on the val-
ues of various industries and sectors. The most obvious and
striking difference, and one you might already know, is how
the market tends to place higher values on the tech industry
than most other industries. That has been changing since the
Internet bubble burst in 2000, but there is still a bias to over-
reward tech stocks with above average P/E ratios, low EYs
and much higher P/S ratios. The reason is fairly straightfor-
ward. It is because that industry is a very high-growth part
of our economy. High-growth stocks deserve high P/Es.
Therefore, it is wise to stress the GPE in tech stocks when
you consider owning them. As explained, this ratio allows
for high P/Es for companies with much higher growth rates.
Again, always look at the relationships between a stock’s
fundamental numbers. Can earnings and more importantly,
the growth of earnings support a higher stock price?
On the other hand, steel is a basic industry group which
is generally thought of as a slow-growth industry; therefore,
stocks in this sector deserve and attain low P/Es, but at the
same time, they usually have low P/S ratios. If you are look-
ing for stocks in these kinds of industries, expect low GPEs
and concentrate on low P/Es, high EYs and low P/S ratios.
Almost all types of commodity stocks are slow-growth
industries. At least historically that has been the case. In the
last few years, oil and commodities have shown constant
higher growth, but the perception is still that they are slow-
growth industries; therefore, their P/Es are low.
These various characteristics of different sectors and
industries mean that you cannot get excited at finding great
values using our rules without first considering the funda-
mental idiosyncrasies of the sectors and industries involved.
Let me make it simpler than that. If you see low P/Es in
a high-growth stock in a high-growth sector with a great
GPE, then you can get excited. The best way to hunt down
value in a particular sector or group is to compare the target
stock with the average fundamental numbers in its group or
sector. Just what you wanted to hear, more work for you.
Although it’s sometimes tedious, you should really do this
type of research if you are serious about investing. I met with
an investment club some time ago and tried to explain the
need to do this kind of work. They showed me their recent
investments, and it was obvious that they totally ignored
industry comparisons. They bought a high P/E stock in a
low-growth industry and didn’t understand why this great
company—and it is still a great company—did not go up in
price. You can’t fight the market. If the market says certain
types of stocks deserve low or high P/Es, then you better pay
attention. Remember who makes prices go up and down. It
is the professionals, not you. They are what matters when
valuing stocks, so you need to know what they think. What
you think doesn’t matter. Too many individual investors fall
in love with the stock they pick and that was exactly what
happened to this investor group. The companies they were
buying were very strong companies with great prospects,
but when these investors bought these companies, their
stocks prices were too high for their industry.
Peter Lynch, a retired mutual fund manager—and the
most successful mutual fund manager in history—wrote sev-
eral very good books. His main advice to individual investors
is for them to buy what they know. I think this a very good
idea, but I have observed that when individual investors do
that, they become infatuated with their picks. Just like the
early stages of any teenage love affair, they become blind to
the problems that will certainly develop later. The in-love
investor fails to see the slowing growth, overvalue, or the
progress of a bigger and better competitor. The investor only
sees the great products they use and like, how busy their
local store might be, or that all their friends own those prod-
ucts and love them too. How can the company not be great?
Maybe the company is great, but the stock price might not
be. Always run the numbers and insist on very good num-
bers. Always do your homework. Teenagers fall out of love
just as fast as they fall in, but when you buy a stock, it’s like
getting married. Make sure it’s a good pick for the long run,
that it has staying power. At least when you marry a stock it
is cheaper to divorce. Even if you fall in love with your stock,
don’t be afraid of a divorce if it’s not working out.
Are You Up to the Challenge?

By now, I’ve given you 7 investing rules and 5 buying rules.
While I want you to obey these rules, I cannot guarantee
that you will become wealthy by applying them. In truth, I
strongly believe that they will help you choose stocks more
wisely and make money, but anyone who tries to guarantee
performance or a huge return when dealing with stocks and
the stock market is a charlatan. These rules work and they
work well, but implementing them successfully is a fantas-
tically difficult job. For example, I gave you two investing
rules that are related: Rule #5: Always buy stocks when
everyone hates them and Rule #6: Sell when everyone else
loves stocks. How in the world are you supposed to know
when love and hate exist in the market? I tried to give you
some guidelines to recognize those times, but implementing
these rules can be incredibly challenging and the timing so
nebulous that most investors will get it wrong. When you
add in the fact that your judgment is clouded because you are
trying to control your own personal fear and greed, it makes
the process even more difficult.
Did I just tell you that you can’t apply my rules? Not at all.
I’m just saying that it is a challenge. If you are still with me,
I think you have a good shot at getting it right. All you have
to do is realize that you are going to be wrong and wrong
often—and just accept it. But if you learn from those mis-
takes and diligently apply these rules, you will make money.
The question of how much depends on how good you are.
Part of your success understanding valuations and ratios is
in your ability to see stocks in a larger context. Numbers
are important and relationships between those numbers are
very important, but looking at numbers without comparing
them with their peer group and the overall economy is an
exercise in futility.
Buy Stocks That Compare Favorably

within Their Industry
According to Vector Vest, a database of about 8,000 stocks,
there are about 40 sectors and 190 industry groups. Every
stock belongs in these groups. You will need to study sectors
and industries because stocks tend to perform as well as their
overall group. For instance, the Steel sector has two industry
groups: Steel (Basic) and Steel (Alloy). If you are looking at a
steel stock in the Basic industry, there are 19 companies. The
average P/E ratio is 8, the EY is 12 and the GPE is .97 with
a P/S ratio of 1. All these numbers are very good, except for
the GPE. If you were looking at a stock in this industry, would

you want to buy the best one in that industry? If all the num-
bers for all the companies in the group are very good, what
does that tell you about the industry?
What this should tell you is that this industry is full of
inexpensive stocks for a reason. That reason, historically
speaking, is that it is a slow-growth area and deserved a low
P/E ratio and a high EY. With an average GPE of under 1,
I would be careful about buying stocks in this industry, and
I would look for GPEs of stocks in the group that are much
higher than that group’s average. Those GPEs may still be
lower than the rule I gave you of 2 or higher, but that doesn’t
mean you should ignore the entire group.
The lesson here is that all industries and sectors trade at
different average P/E ratios, EYs, GPEs and P/S ratios. It is
your job to pick the best in the group. Learn which indus-
tries deserve and, thus, trade at higher or lower multiples.
To start the process of understanding relative funda-
mental numbers, you need to start with the S&P 500. Why
do I suggest the S&P 500 as a starting point? Because it
represents about 80% of the entire market. Its long-term
average P/E ratio is about 17. That number changes, but
it gives you a basic understanding of where stocks gener-
ally trade. In times of low inflation, the average tends to
be higher and in high inflation, it is lower. What about
the long-term EY, P/S ratio and GPE for the S&P 500,
and what about the other indexes? There are many other
indexes. Where do their P/E ratios trade? This exercise
can get very detailed, and there are a lot of analysts out
there producing these numbers. I do not want to bury you
with this minutia. Just remember that when you do your
homework before picking stocks, be sure to compare that
stock with others in its industry and that industry’s average
P/E ratio with the overall market. This knowledge will
bring you an increased understanding of the market and

help eliminate the handicap you would have without it.
When looking for stocks, I strongly suggest you buy
stocks in rising sectors and rising industries. I don’t want to
make it a rule, but I feel it is important enough that you need
to make note of it. Notice: I did not say buy stocks in the
top industry or sector. In a bull market, you can buy the top
stocks in the top industries and probably do well, but I tend
to shy away from them because I don’t want to buy the top
of the market. I would rather buy industries that are mov-
ing up, relative to other industries. This movement is where
you will find the winners. Do not buy industries that are
moving off of the bottom either. Look to the middle of the
pack and buy those movers. They have to show you that they
are for real: off the bottom and moving towards the top—
not on the bottom and not formerly at the top but moving
toward the middle. Do not buy stocks in industries that are
beginning to slow down. They may be near the top, but if a
particular industry is beginning to weaken, you should avoid
stocks in that industry.
This industry and sector stuff is not easy, but by now you
could not have been expecting easy. Still, you cannot ignore
it. The industry and its relative historical valuations is some-
thing you should, at the minimum, understand before buy-
ing a stock.
How to Use These Rules in Real Life

The rules are to be applied to all companies at all times,
but you have to bend the rules depending on market cap,
industries, sectors and economic conditions. The buying
rules are very sound, but if pressed, I would say they work
best for companies that have market caps of from $1 billion
to $10 billion and in growing economies. These are the

middle-sized companies. If you are looking at smaller com-
panies, they tend to have very large growth rates or none at
all. Also, the rules do not work with companies that don’t
make money. You can’t have a P/E ratio, GPE or an EY if
you don’t have any earnings. Without earnings, three of our
ratios cannot be calculated. Always remember Buying Rule
#6: Don’t buy stocks that don’t make money. Your goal in
buying stocks is always to make money.
Earlier I have said the big capitalization companies are
best analyzed by focusing on the P/S ratios; however, that
doesn’t mean you get to ignore the other rules. All that I
am suggesting is that you focus on the P/S ratios—not use
them exclusively when considering the big companies. As I
discussed before, big companies have a hard time growing
very fast, and these ratios tend to undervalue the big guys.
For instance, General Electric, one of the largest U.S. cor-
porations, is currently sitting on a GPE of .71—far below
our target in Buying Rule #3 of 2 or higher, an EY of 6.39,
a P/E ratio of 15.67 and a P/S ratio of 2.35. So I ask you, is
this a good value for GE?
To answer this question, we need more information. What
about its industry? How does GE compare to its peers? GE’s
growth rate is about 10%, and that is in line with the rest of
the industry. The industry’s P/E ratio is 15 and so is GE’s,
and in fact, GE is so large that the entire industry weights
their average to GE’s. However, there is one little thing that
is dragging on my sense of right and wrong and that is the
industry’s P/S ratio of 1.2. GE’s sits at 2.35—almost twice
the industry standard. I don’t like that.
If I was considering buying GE, and if everything else
was equal, the P/S ratio, the very ratio that I am suggest-
ing you use when looking at large cap stocks, would tip me
into not buying the stock at this time. I am saying that even
though GE’s P/S ratio is close to our desired number of 2 or

less, since it is only 2.35, I would not consider GE because
its peer group, the sector that GE belongs to, has an average
P/S ratio of only 1.2. In relationship to its group, this means
that GE is expensive.
This exercise has absolutely nothing to do with whether
or not GE is a great company; in fact, it is a great company.
I like their 3% dividend yield; they are the leader in their
industry, and they have consistently grown their earnings
per share year after year, even in the most recent recession.
What is there not to like? I also approve of their focus on
worldwide growth not just growth in our domestic market.
I want to own GE, but I want to own it at a reasonable price.
How to determine a reasonable price for a stock will be dis-
cussed later, but with a P/S ratio of twice its industry aver-
age, GE is too expensive for me…at least for right now.
Let’s look at another company I want to own, Johnson &
Johnson. This is another large cap leader in its field, with a
market cap of $189 billion. You should have a greater appre-
ciation of Johnson & Johnson’s size when I remind you that
large cap companies are defined as having $10 billion or
more in market capitalization. (For comparison, GE sports
a market cap of $348 billion, Microsoft is $261 and Exxon
Mobil is $415. These are a few of the largest companies in
the world.) Since market capitalization is based on the price
of the stock multiplied by the number of shares outstand-
ing, how could any of these big companies grow by more
than single-digit or low double-digit percentages? They
can’t! There are a finite number of people in the world who
can buy a company’s products, and if the company already
sells its products to them, then you have to discover major
new markets to grow your sales. This lack of strong growth
means you can’t use growth as a main component to evalu-
ate the big stocks. At the risk of repeating myself, I want to
make sure you understand that you have to look at different

company sizes and sectors differently. Did you think it was
going to get easier? Dream on!
Johnson & Johnson (JNJ) is a 100-year-old company. It is
growing about 8% per year. Its GPE is .43, its EY is 6.1, its
P/E ratio is 18 and its P/S ratio is 3.67. I am looking for a
GPE of 2 or higher, an EY of 150% of the 10-year treasury
(which, at this time, would be about 7%) and a P/S ratio of
2 or less. This stock meets none of my criteria. But let’s look
at its industry—Drug (ethical).
When I discovered that JNJ is in the drug industry, the
first thing that popped in my head is that JNJ is not just a
drug company. There is a large drug component of the com-
pany, but they also sell consumer staples: shampoo, soap,
Band-Aids, and anything to do with related consumer and
medical devices. So when looking at its industry, you are
going to have to take it with a grain of salt, it just doesn’t fit
in with any one industry. The Drug (ethical) industry has a
P/S ratio of 1.86 while JNJ has 3.6—again, almost twice
as high. Based on those numbers, I would not consider JNJ.
Here’s the trick, just to make your life more complex—I
believe that JNJ may actually be a good buy.
Why? It goes to what value I place on this stock. What
should this stock price be? What other indicators of fun-
damental value should I consider? Finally, is it fair to put
JNJ in the Drug industry to compare price to sales ratios?
These are questions for experts to answer. You do not have
the time or knowledge to deal with them, so don’t worry
about them. There are just too many other stocks we can
analyze that will match up nicely with my rules, so let’s
move on. The time to consider JNJ is when everyone else
hates it; that’s the best rule to consider for a stock like this.
When everyone else hates JNJ, it will mean that the stock
will have collapsed. At that point, JNJ’s numbers will look
a lot better, or at least the P/S ratio will. That is when you
should consider buying it.
How about stocks that are not large cap but that are
more in line with our target group of $1 billion to $10
billion in market cap size. Let’s look at a few we, at Klein
Pavlis & Peasley Financial Inc., owned when this book was
written in the latter part of 2006. Here is a short list:
AXS – Axis Capital – Market Cap of $4.7 Billion

AAUK – Anglo American PLC – Market Cap $65 Billion
AINV – Apollo Investment Corp – Market Cap $1.57 Billion
PCU – Southern Copper Corp. – Market Cap $13.1 Billion
TTM – Tata Motors Ltd – Market Cap $6.9 Billion
IO – Input Output Inc – Market Cap $738 Million
Let’s start with Axis Capital (AXS). It is an insurance

company. The industry is Insurance, but there are several
sectors in Insurance such as Life and Health and Property
and Casualty. It is important to understand that you need
to make comparisons in the same sector and not just in the
same industry. The numbers are:
AXS Industry-Insurance (PC)

P/E 7 10
EY 13 9.5
GPE 4.03 1.05
P/S 1.6 1.3
ROE 3% 10%
It started out looking very good with a lower P/E and

higher EY than the industry and the entire industry aver-
age exceeds our rules for both of them, and AXS is even
better than average in its industry. The GPE is almost

400% better than its industry. The P/S ratio both for AXS
and the industry is well below our target of 2 or less, but
the industry average is better than AXS and the ROE is
bad for the industry and worse for our stock. This is a mid
cap stock with a $4.7 billion market cap, so my focus is on
growth. Therefore, the number that really impresses me
about AXS is the GPE. The growth rate of this company
is about 30%. Can it keep up that kind of growth? This is
a very important question because the P/E is very low, so
if growth slows and the stock price goes up, my GPE will
turn sharply downward. I do not put much weight in the
P/S issue because it is below my target of 2 or less, even
though the industry is lower. I think for this stock it is a
nonissue. However, I am concerned about the ROE for
both AXS and the industry, and those numbers make me
feel hesitant.
The lesson here is that you can’t have everything. As you will
see in the next few examples, it is a common situation. Not all
your numbers will line up perfectly most of the time, so don’t
even expect it, but most numbers should. Keep your eye on
the market cap since that will affect the numbers. Remember
your target market cap? Let’s try another example.
Anglo American PLC – adr (AAUK). This is a com-
pany out of the United Kingdom. You can tell it’s a foreign
company trading on our exchange by the “adr” designa-
tion. That means American Depository Receipt. The easi-
est explanation is that in these situations, a block of foreign
shares of this company has been deposited in the U.S. and
those shares are packaged to sell on our market. To do
that, the foreign company has to meet U.S. standards in
corporate disclosure of statistics about the company. That
is all you need to know about it.
AAUK Industry-Mining (Other)

P/E 11 11
EY 8.8 9.2
GPE 2 .75
P/S 2.3 1.8
ROE 12% 16%
So what is so impressive about this one? It is the Mining

(other) industry. It’s “other” because it is very diverse. It has
mines all over the world looking for industrial minerals, gold,
platinum, base metals, and coal and also has large interests
in forest products. Still, why do we own it? Did you note the
market cap? It is large, and yet this company has a GPE of 2,
which means this huge company is growing at twice the P/E
ratio. That is not easy. The industry average is only .75. All
the other numbers are in line, except for the low ROE, but
again, for a large company, it’s not bad. In looking at these
numbers for a large cap stock, you should be very impressed
with its GPE of 2. It is rare to have such a large company
growing that fast—especially in a slow-growth industry like
mining. We were impressed.
You can see already that you need to use judgment. I
have mentioned the merits of the different industries and
discussed how you should decide to be in a particular indus-
try at all. Generally, you want to be in industries that are
relatively strong in relation to other industries, but to deter-
mine that, I would need to analyze each industry and sector,
and that is not the focus of this book. For our purposes, let
me say that you need to stay away from weak industries and
concentrate on stronger ones. Is that vague enough? Need a
little more help? Ok. Recently, the commodities industry
has been strong.
The next investment to analyze is Apollo Investment

Corp (AINV). This is a company that develops businesses
by investing its money in middle-sized companies by selling
them senior-secured loans.
AINV Industry
P/E 11 18
EY 8.8 5.5
GPE 2.3 .71
P/S 9.3 2.7
ROE 11% 17%
Great P/E, EY and a fantastic GPE, but the P/S is a disas-

ter and the ROE doesn’t look so good either. We, at Klein,
Pavlis & Peasley, focus on GPEs for these middle-sized com-
panies. While it is generally the first number we look at, it
is not the only one. However, you should insist, as we do,
on strong GPEs in these types of middle-sized companies.
There is one other number we like about this company. It
pays over a 9% dividend. That is a balm to a nervous heart.
You need to make sure the company has enough free cash
flow to maintain that dividend—and this one does.
If I have not already mentioned the significance of divi-
dends, remember that they are very important to your stock
portfolio’s overall return. All things being equal, you pick
dividend-paying stocks over all others. Of the six stocks I
listed at random that we currently own, all but one of them
pay dividends. I didn’t pick these stocks from the 40 or so
we own entirely because they pay dividends, but most of
our positions do. I picked these six stocks because, while
sitting at my desk writing, they were the first six that came
to mind. I am a simple man.
The next stock is Southern Copper Corporation. This

company is out of Phoenix, AZ, but their mining interests
are in Southern Peru and Mexico. This mining company is a
copper producer.
PCU Industry-Mining
P/E 6.5 11
EY 15 9.2
GPE 2.59 .74
P/S 2.93 1.79
ROE 46% 15%
Even if you ignored this stock’s 9% dividend—which

you shouldn’t do, this stock is undervalued compared to its
peers. The only number that is suspect again is the P/S when
compared to its industry, but that slight negative is far out-
weighed by not only the dividend but also by the outsized
ROE number. The only question you need to ask yourself
is: Do you think commodity-type stocks are a good place to
be? My answer is that we have had a multi-year bear mar-
ket in commodities until 2005, when most commodities
started to make a run. I think we can expect a multi-year
bull market in these issues. Yes, there will be fits and starts
in commodity prices, but it has a lot of market potential for
strong growth in China and India, home to well over 2 bil-
lion people who are just beginning to warily discover the
benefits of consumerism. Demand for everything from toilet
paper to gasoline to food is going to rise sharply. Think of all
the miles of copper wiring needed to build homes and busi-
nesses or anything electronic in those two countries.
Next is Tata Motors Ltd. (TTM). It is an Indian manufac-
turer of heavy/ medium/ light commercial vehicles, private
passenger cars and utility trucks and accessories. It is the

largest manufacturer of vehicles in India. I hope you are
not getting the idea that we invest mostly in foreign stocks,
because we don’t, but at the same time, you should properly
assume we are currently leaning on them as a significant part
of our overall portfolio. The last chapter of this book deals
with portfolio management, a subject that addresses the
risks and talks about controlling those risks. If you only have
mining stocks or foreign stocks in your portfolio, you are
dramatically increasing your risk. Look at the tech stocks
the NASDAQ index peaked at 5,000 in 2000. Today, seven
years later, they are priced at less than half that amount.
Do you still have a 1990s portfolio? Did you not diversify
properly?
Let’s check out TTM.

TTM Industry
P/E 14 14
EY 7 7
GPE 1 .51
P/S 1.48 .27
ROE 26% 10%
There is nothing really striking about the numbers. They

are good except the GPE, which is well below our desired
number of 2 for a company that is only $7 billion in mar-
ket cap size. That is not impressive, but it is twice as high
as its industry group. The ROE is two and half times the
industry’s average, and that is impressive. But if you corner
me in a back room somewhere, I would have to admit the
reason we like this company is because it is India’s leading
motor company and we think India, the largest democracy
in the world, has great prospects. Just because we feel that

way does not mean we ignore the numbers. They are in line
with their industry and meet most of our strict criteria. It
doesn’t hurt that there are fewer than 10 vehicles per 1,000
people in India, so they have no where to go but up. At least
in my opinion. However, these numbers also mean we may
not stay with this stock for very long. Remember, we live in
the show-me state. The stock price has to show me its ability
to go up. If not, I am gone.
Finally, Input Output Inc. (IO). They provide seismic
products and services to the oil and natural gas industries.
They produce some unique technologies in the business of
looking for energy, so you can understand the basic reasons
we like this industry when oil prices are $50 to $70 dollars
per barrel.
IO Industry
P/E 23 14
EY 4 7
GPE 2 1.56
P/S 1.7 1.7
ROE 6% 11%
This one is a speculative play. It is acceptable to take a risk

sometimes, and we are doing so on this one. Even though
we view this as a speculation stock, we still insist on earn-
ings; otherwise, we would not have a P/E, EY or a GPE.
Why did we buy it? The growth of sales and earnings are at
near 50% and have been accelerating. If that stops, we are
in trouble because it already has a high P/E. Earlier when I
was examining P/Es, I wrote that you can have a high P/E
as long as the growth is twice the P/E number. IO has that
relationship. This is a small company with high growth, so

it could be a very big winner or it could fall flat on its face.
Therefore, we will have our finger on the trigger if it falls.
Did you note there is no mention of the stock price at all in
looking at these securities? The price of a stock has nothing
to do with fundamental analysis. You should not care what
the current price is. Stay focused on what’s important—
earnings and growth of earnings. Stock price plays a part
and so does the trading volume of a stock, but that part is a
minor part of the picture for you as an individual investor.
It makes me crazy to hear that someone doesn’t want to buy
a stock because the price of the shares is too high. If a stock
goes from $100 a share to $120 a share, that is a 20% return.
It is the same as a stock going from $10 a share to $12. It’s
the return you want, so who cares about the stock price?
Applying my stock rules is not as simple as just looking
at the numbers. As you can see from the stocks we own and
my comments about them, there are other considerations.
Should you be in foreign stocks or commodity stocks, and
when might tech stocks come back into favor? How does an
individual investor anticipate what might work well in the
future? In the following chapters, I will address that issue.
Picking stocks is more than finding the right numbers. There
is a vast sea of stocks, complete with currents, eddies and
both turbulent and stagnant water. Still other stocks are full
of growing life. The sea is always changing, and if you expect
to survive and thrive, you need to ride the various waves as
best you can. That is even a little too poetic for me. Suffice
to say that you can look forward to a couple more sugges-
tions that will help you determine where, when, and at what
price to buy or sell stock.
Seven: What to Buy, What to Avoid and Why
Economics
There is no getting away from talking about economics
when discussing the stock market and potential stocks to buy.
Buying is a positive action, a fun exercise. It only turns ugly
when the stock you buy goes down and keeps going down.
This chapter is about the fun part of investing—buying stocks.
Unfortunately for you, we have to go over economics and its
effect on stock prices first. I know you are tempted to skip this
section, but don’t. If you don’t like economics or choose to
ignore it, then you are doomed in the stock market. You might
as well buy the indexes and hold them forever because you will
not understand why stocks go up or down or the economic
cycles that dictate broad stock market moves.
At the beginning of this book, I showed you a couple of
charts that tracked past cycles in the market. There is a large
but imperfect correlation between economic expansion and
contraction and broad-based movements in the stock mar-
ket. It is vital that you understand the how and why behind
those economic patterns.
72
73 What to Buy. What to Avoid and Why
Fundamentally, stocks move up and down with earnings

and earnings increase or decrease depending on economic
growth or shrinkage. It is an imperfect relationship. The
stock market looks forward and tends to move up before eco-
nomic turmoil ends and tends to move down at a peak in the
economy. That leads me to the first subject on economics.
There are basically four phases of any economy: expan-
sion, peak, contraction and trough. Since the end of World
War II in 1945, there have been ten economic business
cycles. The average number of months from peak to trough
in those cycles has been 10 and from trough to peak—57
(Source: Public Information Office, National Bureau of
Economic Research, Inc.). Expansions last much longer than
contractions. In 2006, when writing this book, the most
recent expansion currently being enjoyed is about 40 months
long and still going. However, when finally finding time to
rewrite the initial draft it looked like we were heading into
a contraction phase. That was confirmed in 2008 and we
are still in a contraction phase. Though rare, we have expe-
rienced expansions from trough to peak extending over 100
months. There is no telling how long any one cycle move
will take. Analysts look at history, but I fear too many people
put too much emphasis on trying to deduce what is going to
happen based on past experience. The average length of the
expansion/contraction cycle is a good guide, but each has its
own characteristics and each is different.
Once you understand these cycles, you may conclude that
by recognizing the peaks and troughs in the economy, you can
match the returns of the stock market. You would be wrong.
Have you noticed that it is never as easy at it seems? It is true.
In this case, every trader out there is trying to get ahead of
everyone else. In doing that, they are guessing about when the
economy will turn and their guessing alone is enough to move
markets. The professional traders have the massive amount of
money needed to move markets and they do so. The consumer

also has considerable power. If he feels good about himself and
the future, he will keep spending, and that spending keeps
the economy going. It’s a self-fulfilling prophesy. Traders do
the same thing. If they think the economy is going to recover
from a recession six to twelve months from today, they start
buying stocks—pushing stocks higher. You can see this pat-
tern in stock charts discussed in a later chapter. This action
results in an imperfect relationship between the stock market
and economic cycles.
Therefore, you cannot ignore human nature. We all are
trying to beat the other guy when determining the turning
points of an economy. There are hundreds of statistics and
economists who analyze those statistics, but that will only
help us better understand the past, not predict the future.
Then, in addition to the mountain of data, some unknown
and unforeseeable event could happen to throw us into an
economic slump. I am not trying to be negative or mini-
mize the importance of understanding the economy, but the
very reasons experts are often wrong is because there is a lot
of guesswork and crystal-ball gazing. As uncertain as that
seems, it means that you, as an individual investor, have just
as good a chance of succeeding as anyone else.
Have you ever driven in the fog? There is always a fog
surrounding economics. That fog makes large potholes hard
to see. September 11th was one of those potholes. The eco-
nomic impact of that event didn’t last long, but it rippled
throughout our economy. Understanding how economics
affect earnings helps you look through the fog. It doesn’t
offer any answers, just guidance.
When studying the economy, we look at economic reports
from various government offices and private economists.
These reports are divided into two broad groups. They are
called the “leading” and “lagging” economic indicators.
Lagging indicators:
1. Labor cost per unit of output in manufacturing
2. Prime Interest Rate
3. Outstanding commercial industrial debt
4. The Consumer Price Index
5. Credit level as a fraction to personal debt
6. Unemployment rate
7. Ratio of inventories to sales
Leading indicators:
8. Average length of the work week
9. Initial jobless claims
10. Factory new orders for consumer and material
(Factory Orders Report)
11. Vendor performance (Purchasing Managers Index)
12. Manufacturers’ new orders for non defense capital goods
13. Building permits (from Housing Starts Report)
14. The level of the S&P 500
15. Measure of M2 (Money Supply Report)
16. The interest rate spread between the 10-year trea-
sury and the fed funds rate
17. The expectations report (Consumer Sentiment Index)
Obviously, we are going to focus our attention on leading

economic indicators because we are trying to pick up hints
on the future economy, not the past. This chapter is about
buying stocks, so we keep our eyes firmly fixed on the future
so we can ferret out the winners from the losers. To do that,
we must have a firm understanding of future earnings for
not only the companies we are buying but for the entire
economy. Leading economic indicators can help us.
If this chapter were on selling stocks, I would be saying the
same thing—keep your eye on the future, not the past. These
leading indicators are the place to focus, but remember that
everything is in flux. Speculating about what the economy

might do in the future is difficult, so all you can do is make
your best educated guess. All the experts, traders, economists
and pundits are reacting to what they see in the future. You
have to do the same thing. The truly best investors see things
differently than the norm, but you have to know what the
norm is so that you can be one of those different investors.
Keeping up with the statistics by examining the list of
leading indicators probably seems like a monumental task,
and I have to admit it is time consuming and can be confus-
ing. However, just think how hard it would be to compile
this information yourself. Thankfully, we have both private
and public agencies that do it for us. Both daily and weekly,
we are bombarded by reports on the economy.
Once a week, we get unemployment claims. That is
the number of people filing for unemployment benefits for
the last week. A one-week report is virtually meaningless;
therefore, all the experts look at the four-week average to
ferret out a trend. You will have to do the same. How do
you know that? You don’t, unless you study this stuff, and
that is something most people do not have the time or the
desire to do. I am going to try to make it a little easier. I will
list the indicators again, and this time, I will describe what
you should look for in each report and how to relate it to the
economy.
T h e A v e r a g e W o r k W e e k . This number is expressed

in hours per week and is reported monthly in the employment
report. The average work week is usually below 40 hours. Just
as when you are examining economic or company-specific
numbers, you want to seek a trend and, more specifically, a
change in the trend. So, if the average work week is shrink-
ing, that generally means companies are laying off employees.
It is an indication of a weak employment picture, a possible
slowing of the economy. Shorter work weeks mean less money

for employees to spend, and since the consumer is 66% of our
economy, he/she is the engine that drives the train. If they
spend less, corporations make less. Increasing earnings drive
stocks up and decreasing earnings drive them down.
Wouldn’t it be nice and easy if just a glance at the average
work week provided enough information to make our buy
and sell decisions? That’s just not how it works.
I n itia l J o b l e s s C l ai m s . This one is a weekly report,

but you only need to consider the four-week average. It is
generally considered good if the four-week average on unem-
ployment claims is under 350,000. If it is above that number,
the job market is in decline and there is a possible recession
in our future. Again, look for trends. Is the number rising or
falling? Is it flat? Below 350,000 and shrinking is good, and
above that number and growing is bad.
N e w F act o r y O r d e r s . This is a monthly report that

gauges the health of factory production. There are a lot of
components to this report. These numbers often exclude
transportation because the buying and selling of airplanes
and automobiles can be very erratic from month to month.
Since we want to understand the underlying strength or
weakness of factory production, it makes sense to exclude
those things that blur the picture. That does not mean you
ignore transportation, but just that it doesn’t weigh heavily
in the equation. Obviously, increasing factory orders indi-
cate economic strength.
P u r c h a si n g M a n a g e r I n d e x . This gives you a view

of the health of the vendors and an idea of if they are going to
be buying or cutting back on purchases of goods and services.
F act o r y O r d e r s R e p o r t . This analysis is a monthly

report on the manufacturing sector and its increasing,
decreasing or steady order flow of capital goods. Look at it
with and without defense orders. They can be very volatile
from month to month.
B u i l d i n g P e r m it s . This report comes out weekly, but

you should use it to look for monthly trends. It gives you a
look at the future health of the building industry. Distinguish
between home building and commercial building. Sometimes
they are very different.
T h e L e v e l o f t h e S& P 500. The stock market is a

very good barometer of the health of the economy. Investors
are focused on prospects of future earnings, so when the
market goes down, it usually does so before the economy
begins to weaken, and it goes up in advance of an economic
rebound. That is why it is considered a leading indicator.
M o n e y S u pp l y . This is an inflation gauge. When money

supply goes up, expressed in M1 or M2 by the government,
it suggests that the economy is either growing strongly or
that the Fed is easing money to try to grow the economy. If
it shrinks, the Fed is generally trying to slow the economy.
I n t e r e s t R at e S p r e a d . This is a measure between

short- and long-term interest rates. Short-term is the 1- or
2-year treasury bill, and long-term is the 10-year treasury
bond. It is the direction of the interest rate spread and
degree of spread that is important. It is normally referred to
as the yield curve. A normal curve would be one in which
the long-bond yield rate is higher than the short-term rate.
An inverted yield curve is one in which the short-term rate
is higher than the long-term bond rate. An inverted curve is
considered a sign of a future slowing of the economy or of a

looming recession. Therefore, you look for the expansion or
contraction of the spread between the two rates.
C o n su m e r S e n ti m e n t I n d e x . This index is produced

by the University of Michigan, and the expectations part
allegedly tells you what the consumer may do in the future.
I think this monthly report is not very accurate because the
consumer is constantly changing his or her mind, and this
index vaguely measures their expectations of the future.
These indicators are made up of many individual reports
released by many agencies, primarily agencies of the Federal
government. There are a few other important reports you
might want to study.
B e i g e B o o k . This is released by the Federal Reserve board

eight times a year and is a report on the current economic
conditions.
C o n su m e r C o n fi d e n c e I n d e x . This is released by the

Conference Board and is a sampling of 5,000 U.S. house-
holds on a monthly basis. It tries to gauge the consumer’s
attitude towards their present and future economic pic-
ture. Another report that does almost the same thing is the
Michigan Sentiment Index.
T h e C PI a n d PPI . This index is released by the Bureau

of Labor Statistics and is a measure of inflation at two dif-
ferent levels. The CPI (Consumer Price Index) is a measure
at the consumer level, and the PPI (Producer Price Index)
measures it at the wholesale level. It’s a monthly report.
There are more reports on housing, retail sales, employ-
er’s indexes and much more. The onslaught of ongoing revi-
sions and the release of new ones is bewildering. It is your job
to understand what they mean and what weight you should

place on each. Simple, right?
However, put most of your effort in understanding
and following the leading economic indicators. Their
function is to attempt to predict the future, and in that
attempt, they can be wrong, but when the numbers are
released—right or wrong, they tend to move markets. All
the reports that make up these indicators are important,
but you and I are not economists, we are investors. Our
job is to understand the implications these statistics may
have on the economy and the market. And if you look at
them carefully and boil it all down to what they are really
saying, you are just asking every one of these reports the
same question: What is this going to do to earnings for
public corporations?
If the economy slows, earnings go down. What part of
the economy is slowing? Which stocks will be affected and
how fast? Is there going to be a steep reduction in earnings?
Are we going into a recession? Even though we can’t look
into the future with any degree of accuracy, we still try, and
that effort moves the market.
Understanding economic cycles and the components
that make up the economy is important. You can buy the
best stocks in the world, but if the entire market is going
down because the economy is tanking, your great stocks
will lose value. They still will be the best stocks out there,
but that will mean little when your overall portfolio value
goes down.
Now that I have depressed you with all the information you
need to have at your fingertips (and just so you know, I only
lightly touched on the subject), let’s move away from the dry
subject of the economy and on to a more interesting topic.
Buy Stocks That Make Money

I can’t say it any simpler than that. It sounds easy,
doesn’t it? However, a large part of the investing public is
willing and, in fact, begging to buy stocks that don’t make
money. Before you scoff, I would hazard to guess that you
have as well. Everyone is looking for the next Microsoft,
though they will likely never find it. The average investor
wants to buy something that will make them rich for just
a few pennies or a few dollars per share, and they want
to do it before anyone else finds out about it. If you in-
sist on these characteristics, you will buy stocks that don’t
make money. These stocks tend to be low-priced stocks but
aren’t always. They are usually priced low because no one
else wants them. You buy them because you think you will
beat other traders to the punch.
The smart money, however, wants to sell these types of
stocks to you. There is a reason why no one else wants them.
If it was a great stock, the price would be much higher. I
suggest you not try and compete in this highly speculative
area of trying to find the next big winner, but just leave it to
the professionals who have the expertise, time and money.
Remember who it is that you are competing with. Low-
priced stocks are priced low for a reason.
Note: I did not say anything about cheap stocks. Some
stocks can be cheap at $100 a share. Cheap denotes a rela-
tionship. It is a relationship between earnings and the price
of the stock. A low P/E or high GPE with a high EY can be
considered cheap, but low P/Es don’t always mean a cheap
stock. If I lost you, refer back to the rules. So a high-priced
stock can be cheap as long as its earnings are much higher
and it fits the relationship I have suggested. Let me repeat
that one more time: Buying a cheap stock has nothing to do with
the actual price of the stock.
A few years ago, a client called and stated he wanted to

buy Lucent Technology. He said that it was on sale at $6.00
a share and that it used to be $50 per share, so it had to be a
bargain. He said it was “cheap.” I begged to differ. I looked at
Lucent’s earnings and saw that it was losing money and going
to be losing money again next year. I told him the stock was
expensive, not cheap. I talked him out of buying it, and it
eventually ended up selling for less than $1 per share before
rebounding to $5 and then falling back down to $2. It never
recovered to $6 before it was bought by a competitor.
Do not focus on the price of the stock.

It means nothing.
I realize there are examples of stocks that, while not pro-
ducing stellar earnings, experienced great moves in price ap-
preciation. Anyone can look back and pick winners. I can show
you biotech stocks that haven’t made money in years or, for
that matter—ever, and yet move up and down dramatically.
I realize that. But you and I are not gifted with second sight.
We have to live and work in the real world and that world, in
the stock market at least, is a lot more predictable when you
use companies making money than when you take a chance on
those that don’t. I am not suggesting that, even when you use
companies that produce earnings, you can predict the market,
but I am saying your odds of being successful increase signifi-
cantly if you buy stocks that make money.
Let’s take it a step further. Not only should you only buy
stocks that make money, but you should also buy only those
with prospects to make more money next year. The stock
market looks forward, not backward. Traders are trying to
estimate next year’s earnings and, in fact, the current stock
price is trading based on those traders’ guesses about future
earnings. That guess is often a bit wrong and sometimes

quite wrong. Earnings estimates are just that—estimates.
They are imperfect and constantly changing, but they are all
we have to work with.
In an ideal world, you want stocks to increase their earn-
ings every year, and there are stocks that do just that. Wal
Mart is a good example. Year after year, Wal Mart has grown
its earnings. You would think that because it has been able
to do that, the stock price would go up every year, but you
would be wrong. Wal Mart’s stock price hasn’t gone up since
2003. Earnings and sales have gone up, but the stock price
has not. It is trading in a range, like many other stocks from
the same period of 2003–2006. So just because earnings are
going up every year, doesn’t mean the stock price will appre-
ciate too. There is always a lag or anticipation in price. You
have to look at more than just earnings. Earnings and the
growth of earnings are all important and looking at them is
a great place to start, but that is all that it is—a start.
Stock Valuations
Once you have developed a list of stocks that all fall within
a range of all my guidelines (and I will list them again be-
low), you should set a target price for your stocks.
Buying Rule #1: Buy low P/E stocks.

Buying Rule #2: Buy stocks with EYs of 150% of
the 10-year government bond or higher.
Buying Rule #3: Buy stocks with GPEs of 2 or higher.
Buying Rule #4: Buy stocks with a P/S of 2 or less.
Buying Rule #5: Buy stocks with a ROE and/or
ROA of 17% or higher.
Yes, I am talking about doing some more math. Setting a

target price will help you determine your risk level with each
stock. Everything in life is risky. Our rules try to reduce
the risk inherent in buying stock, and if you know what the
stock price should be or at least what it should be based on
some basic valuation calculations, then you will know if you
are buying a stock below, at or above value. The higher the
current stock price is, over and above the stock’s intrinsic
value, the higher the risk you are taking.
I have several very simple, time-tested ways that you can
use to calculate the value of a stock. Jerry Klein, my mentor,
has used them for four decades. They are also not perfect. I
know we have discussed these methods in a previous chapter
but let’s go into more detail.
Quick-and-Dirty Method
The first and easiest calculation is the “quick-and-dirty”
method. To use it, take next year’s earnings per share and
multiply it by next year’s growth rate. So if a stock is es-
timated to earn $1.20 per share next year, and it earned
$1.00 per share this year, you have an earnings growth rate
of 20%. Multiply 20 times (not 20%) $1.20 and that will
give you a target price of $24.00 for the stock. Pretty sim-
ple, right? This method of determining the future value of a
stock usually works best for assessing risk in mid cap stocks
(companies between $1 billion and $10 billion in size).
Why? The reason is fairly straightforward. For very small
companies, the growth rates can be outsized at 100% or
more. If I buy $1 per share in current earnings and it is going
to grow to $2 because it is a very small company and can eas-
ily double its earnings, then applying the formula produces a
stock value of $200. Do you think it deserves a 100% P/E?
No. That number is just not reasonable. Also, very large com-
panies have a much more difficult time growing their EPS. If
they achieve a single digit growth rate, which is normal for a
very large company, then this formula will undervalue those
kinds of stocks. So, at the ends of the spectrum of stock com-
pany sizes, the numbers get distorted when you use this quick-
and-dirty formula. In those cases, you may want to use one of
the two other methods to smooth out a target price.
Past-and-Future Method
The second method looks back first before it looks for-
ward. Take the last five-year high and low P/E of the stock,
and multiply both by next year’s earnings per share (EPS).
So if your target company’s low P/E was 10 and high was
17 in the past five years, and next year’s earnings estimate is
$2 per share, then you have a target range of $20 to $34. If
today the stock price is $20, you are near the low end of the
range and, therefore, theoretically, this is a low-risk price.
If the stock price is $10, the stock may be a bargain. This
method makes some reasonable assumptions such as if the
stock has traded in a certain range of P/E in the past, why
would it not continue to do so? Also, because we are using
next year’s EPS, we are projecting the future target price
based on the past P/Es.
Therefore, there are problems with this method, and
in fact, both of these methods are imperfect because we
are using future earnings estimates. The future earning
estimate changes constantly; so to keep your estimates
current, you need to update your calculations constantly.
Also, this P/E range method doesn’t really give you a tar-
get price, it gives you a range and that range can get very
wide, depending on the stock’s previous trading pattern.
That range can become too wide to be useful. When that

range is too wide, you need to use common sense and con-
sider applying another method.
Recession Method
The third method of trying to place a price target on a
stock has it own unique problems, the least of which is that
it doesn’t really give you a target price. This third method
measures the relationship between sales to the market cap-
italization of the target stock. This method is good to use
at all times, but is most useful when the economy is in a
recession or when assessing risk for very large companies.
The stock market’s best performance occurs when the
economy is exiting a recession. The most recent example
was in 2003. After two solid years of dismal performance
after the Internet bubble burst—taking all segments of the
market with it, the economy finally bottomed. Mind you,
the economy did not suffer nearly as much as the market.
The U.S. economy fell into a mild, short recession, and
it was the lowering of interest rates by the Fed that re-
liquefied the economy.
In a recession, earnings for corporate America collapse, in
some sectors more painfully than others. It is during these
periods when earnings are going down—with sales leading
the charge—that the Quick-and-Dirty Method of stock valu-
ation won’t work at all and the Past-and-Future Method tends
to work. But in recessions, this third method works best. On
average, we like to see the market capitalization of no more
than two times the annual sales of a corporation. Recessions
often bring slowing sales and shrinking or absent earnings.
However, there are always sales, especially for the very large
companies, and this Recession Method examines the price of
the stock in relationship to sales. Some companies’ sales, those

that are generally termed defensive, slow much less than their
stock prices collapse. Because the market cap is derived by
multiplying the stock price times the number of shares out-
standing, it is reliant on the price of the stock. In recessions or
just before recessions start, stock prices generally collapse.
Therefore, at the bottom of a market correction or the
bottom of the recession, the P/S ratio looks the best. But
what does that mean? During these times, there will be
many companies with a P/S of less than 2. On which of
these stocks or sectors should you concentrate? There is
no exact science. You will often see ratios much lower
than 1—some of them at a fraction of 1. Even in strong
bull markets, there will be those sectors or stocks that are
below 1, though there won’t be many. The solution is to
look for an overall market that is underpriced by the P/S
method. If the S&P 500 is below 4, it is a good sign of
value. If it falls below 2, you are at an extreme for the
market. In those cases, the stock is apt to strongly rally.
When it is at 2 or less, everyone will be panicked, and if
you can be sensible, you can be the lone reasonable person
buying everything you can. You should mortgage the farm
and buy stocks when that happens. If history is any guide,
most people will be running from the stock market instead
of running to it.
A side note: I don’t mean you should literally mortgage
the farm. I am a big proponent of paying off your personal
mortgage and of eliminating your debt. But when everyone
is running from the stock market, you should put all the
money that you have earmarked for long-term investments
in the stock market.
Remember this final point about the P/S ratio: My num-
ber of 2 or less is very conservative. Other experts believe
that 4 or less is fine. Ken Fisher has written extensively
on this ratio, and he is very firm about buying stocks with

low price-to-sales ratios. That isn’t the only way he deter-
mines value, but I have spoken with him several times and
he favors this ratio. Since his company, Fisher Investments,
is one of the most successful independent investment firms
and he is a very smart man, I tend to listen when he speaks.
Trust me, there are many successful mutual funds and
investment companies that do not have a good track record
of investing, but they have a great track record in market-
ing. Mutual funds and brokers are very good at blurring
the definition of performance. I listen to people like Ken
Fisher who actually manage money and who can point to
consistent performance. They are the ones to trust.
I’ve provided the three easiest ways for the average
investor to establish a target stock price. There are many
more methods and each one is fraught with problems and
has numerous shortcomings. No one method should be a
conclusive factor in buying stocks, but before you consider
buying any company, you must have an idea of the com-
pany’s value. If you are not going to use the methods I have
just described, then come up with your own. If you don’t,
you are ignoring the professionals, because professionals
will determine a company’s value before buying stock and
they react to those changing values. They will buy a stock
when it’s undervalued and sell it when it’s overvalued. The
stock market is the only market place where an average per-
son will buy something and not care or know if he is buying
something that is worth the price. We need to change that.
You need to change that if you choose to compete with me
in the stock market.
Once you have established a value, then you must focus
your attention on growth.
Buy Stocks with Value and Growth

What is the difference between value and growth stocks,
and why do I want you to buy a combination of both? Value
stocks only consider the current stock price and its underly-
ing value. Investors use today’s price of that stock and its
future value to establish a stock’s relative value and that rela-
tive value compares the current price of the stock with its
future value. This is very simple and straightforward.
I have received far too many calls on the radio show that
equate the value of a stock exclusively with its price (you can
hear calls live on my web site, www.investtalk.com or on one
of our broadcast radio stations). Many amateur investors con-
sider $1 per share to be a cheap stock price, but it’s not neces-
sarily! A stock’s price tells you nothing about its value.
The value of a stock shifts constantly; it becomes overvalued
and undervalued as investors favor one or another sector or the
stock of the moment. Google is a good example of the current
stock of the moment. It is being pushed to new highs on the
strength of its growth and profitability. Why do I recommend
against buying it whenever someone asks me? Because of its
relative value. Yes, I have been wrong about Google since it
went IPO a couple of years ago, but it was overvalued then
and it’s overvalued now. Someday—just like Cisco in the late
1990s, when it was also overvalued—it will fall to a reason-
able number or maybe it will just stop going up as the earnings
catch up with the price. Either method will bring the stock
into a proper relative value relationship. This means that, if we
follow the advice in this book, you and I will both miss some of
the best performing stocks. We are trying to think rationally
and to buy stock using a common sense method of investing.
We will miss out sometimes because sometimes the stock mar-
ket does crazy things and unexpected stocks jump up. Just try
to ignore it and be confident in your method.
Once you discover a stock that is cheap or undervalued,

you have completed the first step. Growth is equally impor-
tant. Let me go back to Google and Cisco. It was their growth
that caught the attention of the traders. Both these compa-
nies had spectacular growth prospects in their day. They far
outgrew their contemporaries, and because of that growth,
they became the stars of the market. Microsoft experienced
a similar growth pattern as it grew from a startup in the
1980s. Many stocks throughout history have, for a time,
been the market’s “favored son.” Even the U.S. car compa-
nies had their day in the sun many, many years ago. There is
a lesson to be learned from these most favored stocks. And
that lesson comes from growth. Use it like a mantra: buy
growth, buy growth, buy growth, buy growth.
That doesn’t mean that you can never buy other types of
stocks. Sometimes large companies go on sale, and you should
buy them when they do, but remember that growth and the
rate of growth are what attract traders, mutual funds and indi-
vidual investors to a stock. These investors buy growth and their
actions bid up stock prices. Your stock can be the best, cheap-
est, most undervalued company in the world, but it will not
appreciate in value until it attracts attention. Usually, the stocks
that get the most attention are the stocks that have great growth
prospects. A stock will get attention when mutual funds and
other institutions begin buying it, and you want and need those
individuals and institutions to move the stock price.
There are some stocks out there that are growing but are
dramatically overpriced. You want growth at a reasonable price.
It can be challenging to find those stocks, and when you do,
your patience could be tested because even when you find
one of them, you should still pause and consider it carefully.
If it’s a great growth stock and it’s not overpriced, you need
to know why other investors aren’t buying it. They could be
right! They could also be wrong—and they often are!
When you disagree with the crowd, you are taking a

lonely path. Many investors aren’t comfortable on that path,
and still others do not want to do the work involved in strik-
ing out on their own path. They’d rather follow the crowd.
I never was much for following the herd. I have found that
those who strike out on their own are more likely to strike
it rich than those who keep their place in the herd. Do not
mistake taking a different path with being lazy. It takes a lot
more work to be different, to think ahead, to say that every-
one else has mispriced this stock, but that you know better.
Who are you? I will tell you that it is possible and desirable
but very difficult to ignore the crowd. They are loud and
they are all going in one direction, so if you strain directly
against their path, you may well be wrong. If the market
is moving up, it is moving up, and you have to be with the
crowd to some degree, but at some point, you must be able
to think for yourself. The crowd, after all, ran the market up
for almost all of the 1990s, and then that same crowd caused
the collapse. We left the crowd in 2000, but we were with
them in the 1990s. Jerry Klein in our firm flowed with the
tech boom—though we didn’t have any dot com stocks, and
it was due to his insight that we were able to avoid much of
the market bloodbath of 2001 and 2002.
Truly successful investors are insightful. Those investors can
fully embrace that concept of Creative Destruction. I have dis-
cussed this method of investing in previous parts of this book.
It is a method of thinking intelligently about your investments
and not just following the herd; it advises investors to think
ahead and to let go of the past. Don’t invest in a company that
makes buggy whips when the new fangled motorized vehicle
comes along. Don’t invest in companies that are tied to land
telephone lines when you could embrace cellular technologly.
Perhaps consider dumping any stock in stereo or CD music
systems when Apple Computers developed the iPod.
You need to find a balance between thinking for yourself

and not ignoring the power of the crowd to move the mar-
kets. In other words, be flexible when necessary and stub-
born when required. I realize the challenge in that piece of
advice and can only admit that the stock market is never the
same, never predictable and will always be perverse. You
have to be crazy to invest in it. However, it is also the best
way to make money over any length of time.
Buy the Next Generation of Companies

It is easy to look back and pick out the truly innovative
companies or periods in our economic history. The train,
the car, the telephone or the cotton mill—these were the
next generation companies in their day. The assembly line,
mass marketing, and consumer loans were the next genera-
tion of business methods. If you could have recognized them
for what they were at the time, you would be ultra-rich,
passing down your wealth to future generations.
Today’s generation of companies focuses on the cell
phone, alternative fuels, emerging global consumerism,
medical technology and the continued evolution of a conflu-
ence of Internet, entertainment and wireless technologies.
How do you stay ahead or even identify the future winners
from the losers? Creative Destruction discusses this issue. It
provides answers, and that advice is just what it sounds like.
New companies are constantly being created, and as a result,
others are constantly being destroyed. Pick the wrong side,
and you will lose money in the stock market.
Therefore, look for those next generation companies.
That sometimes means taking a chance on new companies,
but more often than not, it also means finding those com-
panies that are embracing the new at the expense of the
old. AT&T comes to mind. We own this company. It was

an old generation company—one that we would normally
never consider. It has a great brand name and 100 years of
solid history, but their main business was landline telephony.
Landline! Making phone calls over a wire in the ground is a
dead business; it will be extinct someday soon. We decided
to buy this company when they announced their purchase
of one of the largest Bell systems, which owned one of the
largest cell phone networks. Wireless is the future. In addi-
tion, AT&T also has a cable company and has partnered with
another firm to produce the convergence of VOIP (voice
over Internet protocol) business. This old wire line company
is remaking itself into a powerhouse wireless, Internet, and
entertainment company. We saw these steps as leading to
the next generation of companies. The creative side of wire-
less technology was destroying wired telephone calls.
You can play this game in almost every industry. Even
the old steel mills use either very expensive methods of pro-
ducing steel or the new high-output, low-cost methods. Any
old, necessary industrial process can be viewed through the
lens of creative destruction. New technologies in industry
output mean either cheaper labor or cheaper methods or a
combination of both. Using this philosophy to choose stocks
will sometimes lead you to choose stocks outside the United
States because the U.S. cannot offer cheap labor. Why would
you buy a company in the United States, in an old industrial
sector, if they are not on the cutting edge of processing their
product? They need to have an edge: new factories with
robotics, a distinction in product line. Some kind of cata-
lyst must spark growth to increase earnings and increase the
price of the stock. There are many U.S. companies doing
just that, but they better have newer, faster and cheaper fac-
tories outside the U.S. Even if they’ve been around forever,
your focus should not be on old-line industrial companies.
You need to keep an eye out for the newest, latest, next
great thing. What is that? What could it be? My company
found a small publicly traded company that came up with
a new seismic method of finding oil deep in the ground or
under the ocean. It uses old technology, seismic waves, in
a new way—to find oil. That looked like next generation
thinking to us. We also found several companies in a huge
emerging market in India. In India, the middle class is going
to double in a few years and is already larger than the United
States’ middle class. This is the next generation of markets.
China also fits this category. Apple came up with the iPod,
Nokia with the flip phone, and I am not sure who invented
the flat panel, high-definition television, but it certainly will
either force all companies producing the old TV tubes to go
out of business or change. That new thing does not always
have to be a new invention or a new company. It just has to
be on the leading edge of something. Find those companies
that have the new thing that is growing its sales and whose
stock is not overpriced. Then make sure it fits most of our
rules. That’s it. You are rich. It is simple. Now go and make
millions with my blessing. Then why am I still writing? If
nothing else, you will learn from this book that nothing is
easy in the stock market. Let me give you another way to
find stocks with good value.
Buy Companies That Have Been Unfairly Punished

I really like buying companies that look forward, those
on the new horizon of products or services, but that does not
mean I ignore the old companies when they are on sale. The
difficulty lies in determining when a company is on sale and
when it will never recover because its products or services
are obsolete.
Microsoft was the leader and still is when it comes to

the computer operating system, but as a growth company,
it is old. They have already conquered the world market for
their main product. Since Microsoft packaged their soft-
ware system into all the computers, no one could compete.
So Microsoft grew and became old, and its growth slowed
to the high single- or very low double-digit percentages.
However, we bought Microsoft and kept buying it in the low
$20 range in 2006. It was stuck in a trading range of the low
to the high $20 range for several years. Remember our dis-
cussion on value? Here was a company that was still making
huge profits with huge profit margins. It was trying to find
the next big thing and had billions of dollars in the bank to
develop the next big thing. And, this big company was still
growing 10% per year, but the price of the stock was stuck.
We thought that at some point, everyone else was going to
wake up and see that Microsoft was not a dinosaur. Investors
would someday take a look at Microsoft’s cash horde and its
ability to keep growing. When the light bulb came on, the
stock price was going to break out of the range. Until then,
we bought the stock in the low $20s with a plan to sell back
two-thirds of our position when it rose to its old highs. It
finally broke out in November in 2006. This was a classic
stock; you had to buy it when it was on sale.
In Microsoft’s case, it was being punished unfairly because
of its size. It was changing from a growth company to a value
company, but traders didn’t seem to want to reward it for its
value. It is the lonely cow that strays from the herd, but I like
fresh grass every so often, so straying from the herd for the
right reason is good—and green grass tastes mighty sweet
to an old cow.
How do you know if a stock is being unfairly punished?
What are the characteristics? First, I suggest you stay with the
big stocks—ones with a market cap of $10 billion or more.
When looking for stocks that have been beaten down, you
must ensure staying power. Big companies have resources
that little companies just do not have, and that usually means
money or access to money. A candidate that is being unfairly
punished must have a low P/S ratio, a high EY and a low P/E
ratio. It does not have to have growth, although that would
be a plus because as it grows it becomes a cheaper stock in
relationship to that growth if the stock price remains the
same. Growth will make up for a lot of ills.
When looking for the unfairly punished stock, you must
be careful. Stocks get beaten up for a reason, so there will be
a very sound, solid cause behind why the traders do not like
the company. The best kind of cause in my mind is because
the company is no longer growing as fast as it was and is
moving from a growth company to a value company, like
Microsoft. Another one is Wal-Mart. Both these companies
slowed in their growth, but that was not the only reason they
were punished. Both ran into political trouble: Microsoft for
its monopolistic characteristics and Wal-Mart because of its
political incorrectness.
It remains a mystery to me why we, in the United States,
attack our most successful companies. We are the only nation
in the world that does that. So both companies were and to
some extent still are in the news for their supposed faults.
Another company we should discuss is Altria, the old Phillip
Morris, the tobacco maker. It too was big, making lots of
money and was unfairly punished. However, I would not
buy Altria, but would and did buy Wal-Mart and Microsoft.
Why, you might ask? Since you asked, here’s the reason and
why you should carefully consider the reasons behind why a
company has been unfairly punished.
The difference is a shrinking industry versus a stable or
growing industry. Smoking cigarettes is a shrinking busi-
ness. Altria’s litigation fees have never been specifically
defined, though I think those lawsuits are absurd at this

point. At this point, everyone surely knows that smoking
is bad for your health. So when you look at Wal-Mart, you
see a company that is expanding, though not by much in the
U.S. since it has already penetrated almost everywhere, but
it is still expanding. In other parts of the world, it is growing
fast. Microsoft has come out with its new operating system
and several new gadgets that may or may not spark better
growth. These two companies have solid prospects for the
future, whereas smoking is a shrinking industry. How do
you spark more smokers? The government won’t allow com-
panies to advertise, they can’t target kids anymore (although
they denied ever doing that) and they constantly and will
forever be sued until every last smoker has either won all the
money or died. People are quitting in droves. Why would
anyone want to be in that business? Besides, I hate smoking,
and to be honest, that also factored into my decision.
Look for big companies that make money and have some
growth prospects. Separate their problems into short-term
issues and long-term systemic problems with the business.
Look for problems that companies can put behind them. If
a quarter or two of earnings fall short, make sure its tem-
porary. You do not want a company that is being destroyed
by a new competitor with a newer, faster, cheaper widget.
Your unfairly beaten up prospect has to still have the best
widget. In Wal-Mart’s case, their superior delivery of low-
priced goods will eventually prevail, and for Microsoft, it
is the current and continuing dominance of their computer
operating system. Neither of these situations will change in
the foreseeable future. Some day, yes, but not for years.
Once you have found your target company, you have to
make decisions about its stock price. Remember, you need
a low P/S, a high EY and a low P/E. That seems straight-
forward, but to be unfairly punished, these numbers have
to be exaggerated. The best way to do that is compare the

numbers with their industry. They should be the lowest P/S
numbers, the highest EY and lowest P/E, in comparison to
their peers. Remember, these stocks should be depressed in
price, and the reason needs to be temporary—thus unjusti-
fied. Before you buy, look at a chart. This unfairly priced
stock should have put in a solid bottom on a long-term chart.
The stock should be bouncing off that bottom before you
buy. No one knows how low is low.
Don’t Buy Penny Stocks

I have talked about what to buy throughout most of this
book, but other than story stocks, I haven’t really discussed
what not to buy. You should also never buy a penny stock.
This is a stock that is usually selling for under $5 per share
and often for less than a dollar. Most of these stocks are also
story stocks, but some actually have earnings. The main rea-
son I hate penny stocks is that they usually go out of business.
They are usually pumped to the public as a “can’t miss,” get
in on the ground floor before others discover it, the next
Microsoft or Exxon Mobil or Merck, it will just keep going
up in value by a multiple of 10 or 100 or even 1,000. Anyone
telling you this about these types of stocks is “pumping”
the stock to you. It’s a sales job, and they are selling you. If
you buy these stocks after one of those pitches, you are not
making an independent decision; you are letting these sales-
people have control of your stock portfolio. That is a mistake
because they lie.
The company that is sending you that e-mail or fax or
calling you directly is getting paid in shares of the company
they are pushing or already own large portions of the shares.
This company and/or the backer of the stock, whoever that
might be, need buyers to “pump” up the stock price so that

they can sell or “dump” their shares, usually to you, and
realize their profits. It is not illegal as long as they are tell-
ing the truth, and there is often a grain or even a large part
of the truth in the story they tell. This method of selling is
called “pump and dump.” Don’t believe the “truth,” the “half
truth” or the out-and-out lies they are selling. You cannot
accurately separate fact from fiction, and since there is just
too much fiction floating around, penny stocks are not worth
the risks. Stay away from them.
There are legitimate stocks selling for under $5. We already
talked about Lucent; for several years, it was available for less
than $5 per share, but I bet you never received any e-mails,
faxes or a phone calls asking you to buy Lucent or trying to
convince you that it was going to be the next Microsoft. That
doesn’t happen with legitimate companies. That is the realm
of the “pump and dumpers.” Stay out of that realm!
I know I will receive letters and e-mails telling me about
how this person or that person made a fortune on penny
stocks. I also know that someone has to win the lottery every
now and then, but the odds aren’t good that it will be you
or me. If you are going to put money in a penny stock, you
might as well play the lottery or, if you want better odds, go
to Las Vegas and put it all on black on the roulette wheel. At
least you have a 50/50 chance of doubling your money in that
bet. This book is dedicated to making reasonable choices and
managing the risks that you take in buying stocks, and I am
telling you right now that the risks involved in story stocks
and penny stocks are just too high.
I will tell you one story about a pump and dump deal
offered to me years ago. At that time, I was fat, dumb and
happy. (Now I am just fat and happy.) I was sitting in my office
in New York in the late 1970s, right around the time of the
big up market for gold. One of my colleagues came across
this great investment. I could throw some money in with

him and invest in a gold mine. Of course I was interested!
Gold was going up every day. After I expressed interest, he
brought in a salesperson for the mining company. Actually,
she said she was the wife of the original gold mine owner.
She brought a video tape with her for us to watch and a bag
of dirt. It was an actual big bag of dirt, and it was heavy. It
was one of those banker’s bags, and it had a bank’s name on
the outside, printed in nice stenciling. It made an impression
on me. Don’t think less of me; remember, I was young and
impressionable at the time.
We went into the conference room and we watched a
twenty-minute film about this new mining method to make
huge sums of money in gold. When it was over, I wasn’t
impressed, even at my young age. What this lady was trying
to sell us was a huge pile of dirt from this gold mine. There
were any number of piles of dirt, and they showed you the
dirt piles in the film. For only $2,000, I could buy a specific
pile of dirt. Then they would process the dirt and remove
the gold. The pile could have ten times $2,000 dollars in
gold, or it could have very little gold—or it could have no
gold at all, that was the risk you were taking. However, even
if there was only a little gold, it didn’t matter because gold
was rising so fast that all you have to do is hold off in pro-
cessing your pile or buy several piles of dirt and sell them
to another investor (another sucker) for a higher price. Her
final push to sell me a pile of dirt was to show me the bag
of dirt she brought and a much smaller bag with the actual
gold produced from this big bag. Now I know I was from
California working in my first big-city job in New York, but
I didn’t realize I looked that dumb.
While her pitch was not exactly a pump-and-dump
scheme or penny stocks, her process was the same. She was
selling a scam. She was trying to convince us of the fortunes
we were going to make if we bought her dirt. The whole

scam was a crock of—to be polite—manure.
My friend actually bought a pile of dirt. He never saw
even a faction of an ounce of gold and then gold prices col-
lapsed. Why didn’t I buy? Because I was convinced that any
pile of dirt I bought would not have gold in it because, if
it did, they would exchange my pile for another one. How
could I ever be certain of which pile was actually mine? I
want to keep you from being sold this same pile of dirt in the
form of penny and story stocks.
The Seasonality of Stocks

Earlier we touched on the large secular bull and bear mar-
ket cycles and the smaller cyclical moves inside those cycles,
but there are other tendencies in the market that might help
you when buying and selling stocks. In any calendar year from
January to December, there are annual trends in the move-
ment of stock prices. Broadly speaking, the first and last three
months of the year are the best times to be in the market. It is
not a guess or a feeling. It is true; the statistics don’t lie. Since
1970, from October through March, the average return has
been 6.92%. From April to September, the average is 3.45%.
This pattern has held up for many years. The weakest month
has been August, followed closely by September.
You would think that you could use this to time the
market, and to a degree, you would be correct. However,
in the past 15 years, August has been up 8 of those years
and down only 7. It is just that the down years outweigh
the up years, and a couple of those years were way down.
Timing the market has never been a good idea, but learning
the trends will help you decide when to be aggressive and
when to just sit back and relax. Black Mondays will also
occur randomly. On October 19th, 1987, the stock market

fell 508 points. That does not seem like much with the
Dow trading at or near 8,000, but back then the Dow fell
to 1,738– a 22.6% decline in just one day. You don’t get
that kind of collapse very often. How many of you would
look at that and not panic? In the long run, timing the mar-
ket is not a successful strategy. If you would have followed
the annual trend, you would have been in the market fully
in October 1987.
There is a lesson to be learned by Black Monday.
Tuesday, the day after the crash, was the absolute best day
to invest in the market for the next 20-something years.
This is one of our rules: Buy stocks when everyone else
hates them. The headlines on the front page of The Wall
Street Journal read: “Stocks Plummet 508 Amid Panicky
Selling,” “The Market Debacle Rouses Worst Fears of
Little Investors,” and “A Repeat of ’29? Depression in
’87 Is Not Expected.” The Wall Street Journal, a respected
business newspaper, was telling you that there was panic
in the street—on Wall Street. If the Journal’s dire head-
lines were depressing, what do you think the mainstream
television news and other papers were saying? They fed
on the panic and made it seem worse than it was. Yet, the
day these headlines came out was the best time to invest.
Mind you, there were those who said to buy. Leo Fields,
a member of the Zale family, was quoted as saying he was
gathering a list of buys in that same paper, but most oth-
ers were talking doomsday. You have to be able to think
for yourself. Do not listen to others and always remember
that sometimes it is best to ignore the crowd.
In my weekly newsletter, I sometimes warn investors
to be careful and sometimes advise them to invest all the
money they have, but even when I warn of a market slump
that might be coming our way, I rarely tell my readers to
sell all their positions. No one, and I mean no one, knows

which direction the market will take. You can play the
odds and understand the cycles, trying to get an edge on
the next guy, but timing the market is far too difficult.
I have tried it, and maybe I am just stupid, but I could
not make it work. Thank goodness I am not alone in that
opinion. Maybe you are like me and don’t believe it won’t
work. You want to give it a try? If you do, please do it
with just a little of your money, or better yet, use some-
one else’s money. I wish I would have done that. Actually,
you will find it is more stressful losing other people’s
money than it is to lose your own. It is for me.
Eigh t : How to F i n d Sto ck s
A Way of Thinking
This is a much more pleasant topic. Finding stocks to buy is
exciting. It’s what stock pickers live for, and they work hard to
choose stocks to make as much money as possible. It is a contest
really, a contest of skill, of overcoming the other investor who
decided to sell you their stock. Every time you buy a stock,
someone else sold it. If the stock goes up, you were right and
they were wrong. Buying and selling stocks is a deadly serious
competition. You are competing with everyone else.
What a great game!

Finding stocks to buy is not hard; however, there are pit-
falls to avoid and it takes careful, time-consuming work to
do it right. I am going to go over the things my office does to
find stocks or get ideas. However, I would like to first discuss
some of the common traps that seem to snare everyone at
one time or another.
104
105 How to Find Stocks
Number one is to avoid buying stocks based on a tip from

a friend, a knowledgeable stranger, or even your mother. You
must do your own homework. Doing your own homework
requires reading. If you plan on managing your own funds,
you need to enjoy reading financial magazines, newspapers
and company financial statements. You do not have to be
an accountant, but you do need to understand how to read
a balance sheet and an income statement. Don’t panic. It’s
not that hard. If you buy stocks on tips from others without
doing your own homework, you will be subject to failure. I
assure you that you will fail if you buy based on stock tips.
Many times these tips trickle down to you after everyone else
knows about them. So don’t be impressed if the stock price
of these tips has risen sharply, that’s when tips are spread,
but you will often be the last one in line to hear about it.
So the smart money is selling to you since other investors
already rode the stock price up.
The best way to find stocks is to do some independent
thinking. For example, I have been reading a lot about the
economy of India and other emerging markets for several
years, but it wasn’t until I looked closely at India that I got
excited. They had been growing their economy by about
7% to 8% per year for some time, but when I discovered
that most of their population was very young, educated and
English speaking and that their population exceeded 1.2 bil-
lion people when, in the United States, we have only 300
million, I began to seriously consider buying some Indian
stocks. When I looked at their low per capita income and
the very low number of cars per 1,000 people, and the fact
that they are an old, stable democracy dedicated to the rule
of law, I decided to take the plunge and buy. My thought
process was backed by sound reasoning and basic research.
You have to start the process of buying a stock with
independent thought. It is not as hard as it sounds. Look
around you. Is there something going on in your life that

may lead to a stock? If you have children, what is the new
hot thing they just have to have? Or, for that matter, is
there something that you have to have or need that others
also have to have and need? Something in the news may
spark a stock idea. For instance, recently the Democrats
took back the Presidency. What changes might that bring
in spending? My first thought was less on military and more
on domestic. I will stay away from companies supplying our
military. The slowing in spending won’t happen overnight,
but the prospects have changed. If the Democrats are going
to spend more on domestic issues, who will prosper? Will
more money be spent either through the government or
private industry for homeland defense here in the States?
What companies might benefit? Security companies might
benefit, companies that make bomb detection devices like
x-ray machines or tech companies that check fingerprints
or track people and equipment in some way. Or, increased
spending might appear in social programs and the top of
the list might be medical coverage. On the other hand,
will the government try to control costs, and if so, what
effect will that have on earnings for medical corporations?
It is a thought process. What will change with Democrats
in control? It is not easy, but let your mind explore these
types of thoughts.
I like Peter Lynch’s suggestion to buy things you know
about. If you work for a veterinarian, you know what is hap-
pening in that industry. Do they have new products, services
or devices that will change the way vets do business? Or if
you’re a policeman, what new type of protection or detection
devices are being used or invented to either safeguard society
or find criminals? Keep your mind open to all possibilities.
I have 35 nieces and nephews. Every so often, I take a
few of them to the mall and let them shop. I encourage them
to talk about what is new or what it is that they want. True

Religion jeans were a hot new item at one time, and I actu-
ally bought the stock—knowing full well it was a fad. I could
not believe that paying $500 for a pair of jeans would last,
but for a while, the stock price rose sharply. I got out quickly
to the disappointment of my niece. The important thing was
the idea. Where do you come up with ideas?
The most plentiful place for me is in reading. In our office
we get The Economist, my favorite magazine, and Forbes, two
premium business magazines. We also receive The Wall Street
Journal, The Financial Times, Investor’s Business Daily and a half
dozen different newsletters. We also buy databases of all the
stocks traded on any exchanges in the United States. You can-
not compete with professionals when it comes to information.
However, all that information does not lead to success. It does,
however, provide a fruitful playing ground for stock ideas.
Before you go out and buy a bunch of publications, let
me give you another lesson on what not to do. Do not buy
stocks based on any publication’s top 10 or top 100 list of
best stock performers. In fact, you can expand this lesson
to never buy a stock that is on everyone’s lips or at the tip
of their pen. That means stocks that are on television, on
the radio, or in newspapers or magazines. That is coming
from a guy who hosts a call-in radio show that discusses
stocks. Usually, once a stock is in the news or makes a top
10 list, it is too late. It has already made a run, and you are
the last in line to hear about it. Do not chase performance.
It is a loser’s game.
If you want to be successful, you must have original ideas.
You have to develop a method of finding ideas and expand-
ing those ideas. You do not have to get those ideas from a
business publication; they can come from anywhere. Other
than knowing when to sell a stock, this is probably the most
difficult task to learn.
Once you have some ideas, however, do not go out and

plunk your dollars down on those stocks. Later on, we will
discuss managing a portfolio of stocks and diversification,
but for the time being, take your idea and chew on it a bit.
Having an idea and turning it into an actual buy of a stock is
a process. Don’t rush into it.
If your idea is based on a theme rather than on an indi-
vidual stock you discovered, then you need a way to find
the stocks that fit that theme. For instance, when I began
thinking about investing in some Indian companies, I had no
idea what companies I should buy. All I had was an idea and
some basic research on the economics and demographic of
the country. What’s next?
The Web is a massive free tool available to everyone. If
you do not have a computer with high-speed Web access, I
suggest you avoid investing in the stock market. This pursuit
requires too much research for you to accomplish it success-
fully with low-speed or intermittent access.
Staying with the Indian theme, I needed to find all the
stocks available to purchase that were either Indian stocks
or would benefit from Indian growth prospects. I went
to ETFcenter.com. To start my search, I also went to
Marketwatch.com, Yahoofinancial.com, and MSNmoney.
com. You could also type “Indian stocks” into any search
engine and search for them, but it will cost you a significant
amount of time doing research that way. For me, it was sim-
pler to just start with the ETF center. What is an ETF? They
are a hybrid cross between a mutual fund and a stock. They
are baskets of stocks that shave the market into many differ-
ent slices, based on almost anything. I found two ETFs that
were actually closed-in funds dedicated to Indian stocks that
were trading on our exchange. The symbols are IIF and IFN.
These two ETFs had a basket of stocks of companies in India.
They listed the stocks. That was the beginning of my effort
to buy. From there, I went to the web to find out everything

I could about those companies. What industry were they in?
How big were they? Were they making money? Did they have
any new products coming out? Who were their competitors?
Once I had answers to those questions and I had applied all
our earlier lessons on EY, GPE and P/S ratios, I had a good
list of stocks that qualified. It was a process that required me
to take the data available and conduct my own research.
Once you start a process like this, which, by the
way, can take days or weeks to complete, sometimes it
leads to another theme or way of thinking. For instance,
in researching India, there were a lot of comparisons to
China. In that comparison, there were repeated references
to both countries’ need for raw materials to continue their
growth in the future. Raw materials mean commodities:
oil, steel, gold, food, fertilizer, paper, plastics, natural gas
and more. After revisiting the number of people in both
of these countries and the potential for a consumer boom,
my research led me to look into buying large, international
commodity stocks. You never know where your research
will take you. Keep an open mind and think critically
about what you read. It is not like watching television, you
have to exercise your mind. You will be surprised at the
different ideas you will develop. Pursue them!
Before you get too excited, let me give you another bit
of advice: Do not over-analyze. Jerry, my mentor, calls it
paralysis by analysis. At some point, you need to make deci-
sions. The Internet is a great place to do your research, but
at some point, you have to stop reviewing your options and
decide. On the radio show, I get many calls that begin with,
“I have been watching this stock…” and they have usually
been watching a stock that just continues to go up. They have
done all their research, they like the company, it’s growing
its sales and earnings, but there was something that was not
right. The P/E was too high, or they missed their numbers in
the last reporting period, or that sector may have something
going wrong, so they are watching it. They are watching it
and waiting until all the stars are aligned just right, and then
they plan to buy. The stars will never align perfectly. They
are paralyzed by too much analysis!
Nothing will ever be perfect. You can always do more
work, more research, but you will never be a good investor
unless you learn to pull the trigger. The best way to combat
this anxiety is have a get-out strategy in case you are wrong.
You do not have to buy a stock and live with it forever. The
great thing about the market is that it is liquid. You can buy
and sell any stock any day. Once you have completed your
work on the stock and find that it meets most of our rules,
then take the plunge. Let me revise that: Finish this book
first, but then take the plunge.
Making Decisions and Charting Them

Buying a stock is easy. Anyone can buy any stock at any
price. Buying is an act that is positive, full of hope and
promise and way too easy. In fact, it has gotten easier
with the advent of online trading discount brokers, deal-
ers with very low trading costs. The problem is not buy-
ing a stock but buying a stock at the right price. The “right
price” is a nebulous term, one that is hard to define. The
average investor could buy a stock and have it move up in
price, but he often mistakes his luck for skill. That was
the hallmark of traders in the late 1990s. At that time,
anyone could buy almost any stock—underpriced or not,
because all stocks rose until the beginning of 2000. There
is nothing wrong with being lucky on occasion, but you
should not trust luck to help you with the stock market.
You should learn to be skillful in choosing your stocks.

Then, if a little luck comes your way, you will know how
to capitalize on it.
The hardest part about making money in the stock market
is not buying stocks, it is selling them. Selling is not a posi-
tive act. It is a negative act. Either you are selling because
you made lots of money and are taking profits, or you are
selling because the stock has gone down and you are trying
not to lose your shirt. It is always hard to sell a stock. The
physical act of selling is just as easy as buying, but the emo-
tions involved make it a lot harder.
If a stock is moving up and it’s one of your winners, how
do you know when to sell? Are you saying you will never
sell? That’s Warren Buffet’s philosophy, and I have heard
investors tell me that they are never going to sell their win-
ners. It’s going up—why would anyone sell? I have seen
those same investors sell those same stocks at a loss, finally
giving up after they lost all their profits. Everyone has a sell
point, even Warren Buffet.
If a stock you bought immediately goes down, where do
you sell? Did you make that decision before you bought the
stock. You should have. Before you buy a stock, you should
always establish your sell points, both on the upside and
downside. They may change with time, but always have
them in place before you buy.
One solid method is to sell stocks when they become
overvalued. The problem with that strategy is that if you
sell too early, even if it is overvalued, you could lose a lot of
profit. There are ways to hold those overvalued stocks and
sell them at better prices than those stocks that are at value.
Google is a prime example. That stock was overvalued the
day it went public, so where do you sell it? Using our rules,
you would never have bought the stock, but there will be
times that stocks you did buy that were below value, have
gone up and are now overvalued. Do not automatically sell

them. Using charts will help you determine when to buy
and sell stocks.
When to Buy
Once you’ve done all the research and found a stock to buy,
your job is not done. Do not drop everything and go out and
buy the stock. If you’re trying to buy stocks at the very best
price and sell them at the highest price possible, your cause
will be greatly enhanced if you learn to read charts. Before we
go any further, let me state very clearly and emphatically:
Chart reading is not a science; it is an art.

When you study charts and look for patterns, essentially
all you are doing is looking backward at history. That history
is the actions of traders as they push the stock up or down
in price. The chart knows nothing about the fundamentals,
and it knows nothing about the stock itself. A chart is com-
prised of only two elements: the stock price and the number
of shares traded. All the other studies, and there are many,
have to use these two components.
I am not going to explain all the techniques involved in
reading charts. This book is an effort to make you a better
investor, and to do that, you have to have an understand-
ing of both the fundamentals and the technical details;
therefore, I am going to give you the basics of chart read-
ing. There are some very good books on charting. The
best is Technical Analysis of Stock Trends, 8th Edition. This is
the definitive work on technical analysis. If you want to
be a student of chart reading, you need to buy and study
this book.
I will be giving you samples of charts, these will be real

charts from real companies. Advanced Get from E-Signal is
the charting program being used, and it is one we use in our
office. There are other charting programs and free charts
available on the Internet. At this time, I like StockCharts.
com or BigCharts.com. They have good interactive charting
systems, and everything I will discuss about charting can be
done and seen on these charts.
All the charts I will be using will be bar charts. There are
other kinds of chart structures (candlestick, line, and point
and figure), but the bar charts are often the easiest to grasp.
It is often better to keep it simple than to learn all the differ-
ent ways to study charts. Who has that kind of time?
Buying Trends
Charting Rule #1:
Buy stocks that are in up trends.
Like all good rules, it sounds easy but is harder than you
think. You do not want to be in a stock that is down and has
gone down over weeks or months, but to decide when the
trend has changed and the stock is moving up can be difficult
because of the second rule:
Charting Rule #2:

Do not guess at the bottom.
So how long should a stock move up before you decide it
is in an up trend and that it has established a bottom? If you
have ever bought and sold stocks over any length of time, you
understand this dilemma. Let’s look at a couple of charts.
Source: eSignal, Advanced GET
This is a one-year bar chart of daily stock price movement

for Microsoft. To keep it simple, I took out everything
except the actual price movement. Each vertical bar repre-
sents the movement of the stock price over one day. For the
first half of the chart, you see sideways movement, where
the stock stays in a channel before it collapses, “gapping”
down to a low in the middle of the chart. It hit its bot-
tom after that and then moves up, only to come back to
“retest” that bottom price before breaking up to march to
new highs on the extreme right hand part of the chart.
That retest of a bottom will come up again very shortly, so
remember that term.
If you apply the first rule, you would not buy this stock until
it hit the bottom and bounced upward, but tell me, where did
the upward trend start? When would you buy? Remember,
when you buy the stock, you do not get to see the future,
so what do you use to tell you that a new upward trend has
started? At the very bottom and for a few days to a couple
weeks after that, the stock price moved up, only to fall back
down again. You can see how difficult the task is.
Because of this difficulty, analysts have developed tools

to help you decide where and when stocks change direction.
Now look at this same chart with a few of these tools added.
I drew trend lines and placed another chart below the price
chart. This one tracks the “On Balance Volume.” Remember,
we are trying to decide when a stock has changed its trend;
therefore, look at the downward stroke of a single down trend
line from top on the left to the bottom on right starting in
early May—right in the middle of this chart. When the stock
price broke up through that trend line, it signaled a trend
change. The problem is that in the case of Microsoft, as soon as
it broke up through the trend line, indicating a trend change,
the stock almost immediately broke back down. However, if
you were looking to buy Microsoft, you should have bought
this stock as the price broke up beyond the trend line. Then, a
week or two later, it would have broken down again; so what
should you have done then? This is what makes chart reading
so difficult. In this case, you would have done nothing because

this latest move down was only a retest of the bottom and a
successful retest at that.
Support and Resistance

Charting Rule #3: Watch for support and
resistance points and do not react until the
stock breaks them.
Support and resistance in a chart are those places the stock
price has been before and not broken up and down from those
places. In this chart, the support is at the very bottom of the
chart. The price of Microsoft collapsed and made a bottom.
When the stock bounced up from that bottom, that bottom
became a support. All we are doing is observing the movement
of stock prices as traders push them up and down. The trad-
ers pushed Microsoft to a yearly low; once it bounced up from
that low, we had a support on the chart. The price of the stock
moved up and broke the trend. As it did that, we had a buy
signal, so we bought the stock. The up trend was in place. Then
the stock moved right back down to test the original bottom.
The traders reacted by buying before it actually reached the bot-
tom, moving the stock back up. This is considered a “double
bottom.” It’s not a perfect double bottom, because it did not go
to the exact same price of the previous low. They are rarely per-
fect. If a stock successfully retests the bottom three times, that
is a “triple bottom.” The more bottoms that are tested and the
more the stock moves up each time, the stronger the bottom or
support is, and the more confidently you should be buying.
Therefore, since this stock price did not break down
through the old bottom, you would not have sold this stock,
even though it briefly fell out of trend. Simple, isn’t it? If you
think this is complex, hold on. We haven’t even scratched
the surface of charting. There are dozens of chart studies,
and we have only looked at trend lines.
As the stock price moved up from its successful retesting
of the bottoms, you will note I drew in three trend lines
called a “channel.” A trend line is drawn using at least two
or three high or low points in a stock price. Look closely at
the trend lines. The line is drawn at the tops and bottoms of
stock prices. You are connecting two, three or more stock
price tops or bottoms with your drawn line. As long as the
stock is in a trend, you never have to worry about selling
and, as advised by Charting Rule #1, you want to buy stocks
when they are in an upward trend.
Over-Extension
Charting Rule #4:
Do not buy over-extended stocks.
Again we will use Microsoft’s 1-year chart as the example:

This time, I drew a resistance line straight across the

old tops connecting three places on this chart. The first top
was in November, the next in late January and the third in
March. I drew that line all the way across my yearly chart;
note where it intersected the stock price. You should rec-
ognize this line as resistance as the stock price moves up
to meet it. When a stock moves up to previous old highs,
those highs act as resistance for the stock price just as an old
low acts like support. The new line connected a triple top,
meaning it was a strong resistance point since the stock met
it three times and failed to break through. This shows that
the stock price movement hesitated when it hit that area for
a fourth time. It looked like it would break through and, in
fact, did but traded sideways for two weeks before finally
“breaking out.” Break-outs are very important so try to
remember what they look like on a chart.
After this stock has broken out, is this chart depicting an
overextended stock? If it does, then we do not want to buy
it. Generally, we want to sell it, but rule number three is
not easy to apply. Many overextended stocks possess some
characteristics of value. In this case, is Microsoft over-valued
at its current price of $30 per share? To figure that out, we
have to go back to our rules about valuing a stock. You should
already know what its value is before you bought the stock,
so if you owned Microsoft, you would already know your
target price. In this case, at this time, I have a value of about
$40 per share for Microsoft. So from a value standpoint, it
is not overextended, but the art of chart reading may help
you re-evaluate your value judgment. How you answer these
three questions will help you determine the stock’s overex-
tention though its value is fine. Remember overextention is
a chart pattern and has nothing to do with the fundamentals
of the company itself:
1. Has the stock broken all resistance on a one-year chart?

This one has.
2. Is the stock price movement on a 1-year chart steeper
than a 45-degree angle? Microsoft’s is.
3. Has the On Balance Volume started to break down? On
this chart, it has not.
What is On Balance Volume? I will get to that. So

Microsoft has broken above all resistance—that’s very good,
but it has done so with a very steep chart pattern—and that
suggests danger. Many times, if a stock moves up at a greater
than 45% angle, there will be a pullback, and often, up to half
of the move up will be relinquished before it starts up again.
That is not a certainty, but just based on observation of past
events in thousands upon thousands of charts. Based on that
experience, I would conclude that this chart is overextended
with justification because of the value of the stock. I feel that
Microsoft was overextended on the down side, and the yearly
chart of Microsoft below proves my point:

In 2006, you will see a strong down stroke on the chart.

If you use the support and resistance technique, you see that
Microsoft has strong support at about $20, where the chart
traded at its lows in the recession of 2000 to 2002. It fell
sharply in the first part of 2006, and I would say that was
an overextended drop in price, especially at a time when
Microsoft was making billions of dollars and had billions of
dollars in the bank. The drop was more than 45% and unwar-
ranted. All it did was rebound from that drop, continuing its
move upward from the low made in 2003. For a real test, can
you see the resistance on Microsoft in this 5-year chart? It will
be about $33 per share. That is the old high made in 2001.
That will be the next test area as Microsoft moves up.
Let’s talk about On Balance Volume since I mentioned it
as a way to spot stocks that are overextended. It is more than
just a tool for this purpose. We at KPP use it extensively.
We think it is useful for more than just looking at plain old
volume. Volume refers to the number of shares traded over
a specific time frame. When the volume of traded stocks
is high for a day or week in relation to its normal volume,
it usually suggests that the buyers or sellers are in control.
However, On Balance Volume looks at the type of volume. Is
it up volume or down volume? When a stock trade is made,
a stock’s price either rises in price, falls or stays the same.
When it rises in price, that volume of shares is added, and
when it falls, it is subtracted from the total number of shares
traded. This way, if more buyers are accumulating the stock
on up ticks, you know that traders are willing to bid that
stock up at higher and higher prices. They continue to want
to own the company as prices rise. The opposite is true for
sellers. These buying or selling trends result in a line chart
we call On Balance Volume or OBV.
The only time the OBV line is important is when its
movement is divergent from the movement of the stock price
chart. In my Microsoft example, study the OBV line and

compare it to the stock price movement. The OBV line is
moving in conjunction with the stock price chart. It means
nothing when it is going in the same direction. However, it
doesn’t always look that way. Let me show you an example of
divergence where the OBV line is moving up and the stock
price is not. In that case, the stock price eventually caught
up with the OBV.
5
Note the price of this stock in August and the correspond-

ing OBV line below it. The stock price gapped down in one
day, then recovered the next day, but look at the OBV line.
It too spiked down, but look at the strong move upward. The
stock price only recovered to the $45 price level, but the
OBV moved up much higher than the previous OBV line.
The OBV spiked upward, but the stock price did not. That is
divergence and that OBV line was a buy signal. Even on the
next move down of the stock price in September and again

in October, the OBV line never moved down again. More
buyers than sellers were willing to buy the stock at lower
prices. Those were buy signals. This assumes this stock was
worth buying, which you would know if you did your work
on valuation. We do not buy stocks that do not meet the five
stock-specific rules, even if they go up. This is a good time
to review those Buying rules:
1. Buy relatively low P/E stocks.

2. Buy stocks with an EY of 150% or more of the
yield earned on a 10-year government bond.
3. Buy stocks with GPEs of 2 or higher.
4. Buy stocks with a P/S ratio of 2 or less.
5. Buy stocks with at least a 17% ROE and/or ROA.
We might as well review those seven Investing Rules too:
1. Experts are wrong.

2. When everyone knows something, it’s worthless.
3. Always buy stocks when everyone hates them.
4. There is no crystal ball.
5. Sell when everyone else loves stocks.
6. Always buy stocks that are making money.
7. Don’t buy story stocks.
If you see the OBV line moving in one direction and the
stock price not moving in that same direction, it is impor-
tant because you have divergence. If the OBV is going up
and the stock price is not or it is moving down, that is a
buy signal. If the OBV is moving down and the stock price
is moving up, get out of that stock. Remember, the OBV
is saying that more buyers are leaving or coming into the
stock on up or down ticks. So if buyers are willing to buy
more and more shares as the stock is moving down, and you
can see this in the OBV line, then eventually the buyers will
exhaust the sellers and the stock will move up. Use the OBV
to observe and react to the divergence between the OBV and
stock price movement.
There is a lot more we can discuss about OBV and there
are many ways to compute it, but this book is not about gen-
erating your own chart; it’s about reading charts.
Double and Triple Bottoms

The next kind of buy signal that I like a lot is when a stock
hits a double or triple bottom. Finding a stock’s bottom as
it comes down is very difficult, and I am not suggesting you
become a “bottom fisher.” That is someone constantly try-
ing to guess at a stock’s bottom before buying. A strong buy
signal occurs after a stock has fallen to a low level, bounced
up from that low level and then has retested that low level
again. If that retest is successful and creates a double bot-
tom, it is a strong buy signal. If it does it again, creating a
triple bottom, and bounces up again, buy more. You have
to be able to see a successful retest of a bottom on a chart
before you can call it a bottom. Bottom fishers do not wait
for that successful retest, they buy when they perceive that
stock has gone down far enough, but they often don’t wait
long enough. I do not like guessing where a bottom is; I want
to verify that bottom on a chart.
Charting Rule #5: Buy stocks that have suc-

cessfully tested double or triple bottoms.
The chart below tracks our company’s recent stock pur-
chase of KBH. This stock is a home builder, and at this time
in history, the home industry is in a lot of trouble. All the

builders have been severely punished. I smell an opportu-
nity. This will not be a long-term hold, but rather, a trade,
and my signals come from this chart:
6
Can you see the strong bottom this stock put in? In June, July
and September, there were three bottoms. One more came
in November, but that bottom was not as low as the others.
We at KPP bought this stock shortly after that fourth bot-
tom. The real trick will be getting out of this stock in time.
It is much harder to sell than to buy. In the next chapter, we
will focus on sell signals. (We sold this stock not long after
the purchase because of the weakening housing market.)
Many stocks put in bottoms, but that doesn’t mean that
you should buy all of them. You still must always check the
stock’s value by researching it, and the bottom has to be clear
and distinct to qualify as a double or triple bottom. In other
words, the bottom has to be at very near the same price each
time it tests the bottom. It can’t be all over the place.
7
There are easily determined bottoms in this chart: one in

October, one in June and July, and the last one to the right
in October again, but there are no double or triple bottoms
anywhere. You can argue that the June and July lows might
qualify because they were close in price on the close of the
day. In charting, there is a strong desire to find the patterns
you seek. You could argue this was a double bottom, but in
my opinion, it was not. You could also argue that the low
in October on the right was a retest of the double bottom
in June and July. You would be trying to squeeze this chart
into a preconceived idea. Be careful! After studying about
10,000 charts, you will get the hang of it.
Moving Averages
In the last few charts, you might have noticed long lines
moving through the year on the price chart. These are mov-
ing averages of the stock price. I am sure you know what an
average is, but you might not know what a moving average
is when discussing stock prices. I like to have four moving
averages on my charts: a 20-day, 50-day, 100-day and 200-
day. These moving averages tend to act as support and resis-
tant points. In calculating an average, take the last number of
days—if we are using a 20-day moving average, you take 20
days of stock prices—add them together, and divide by 20.
This gives you the average price for those 20 days. To make it
a moving average, drop the oldest day price and add the new-
est price on each new day. That maintains the 20-day aver-
age. You plot yesterday’s 20-day moving average and today’s
20-day moving average. Tomorrow, you drop the oldest day
again and add tomorrow’s price. You keep moving forward
by dropping and adding days everyday, and you build a mov-
ing average line that represents the 20-day moving average
of the stock’s price. Using the average helps smooth out the
stock’s daily movement. Once you have the concept, you’ll
see how easy it is to calculate any moving average.
Once you have the moving averages and can plot them,
what do you do with that information? What do those aver-
ages mean to you? How can you use them to buy or sell
stocks? Let’s focus on buying first. A 20-day moving average
is considered a short-term average. It represents about one
month of trading, since the market is not open on weekends.
Even a 50-day moving average is considered short term. The
100- and 200-day moving averages are long term. We use
these moving averages because everyone else uses them. I
know that sounds stupid, but its true. The 200-day moving
average is basically one year’s worth of stock data.
Generally, when the stock price is above all the moving

averages, it is in an up trend and that is a buy signal. In a
market that is in a long-term bull or bear phase, this method
works well. It does not work well when a market is trading
sideways. I won’t make this into a rule because using moving
averages as triggers for buying and selling fall into rule num-
ber one concerning trends. An old investment saying is: The
trend is your friend. Stay with the trends. Moving averages
help you determine when you are in a trend.
Professionals use some of the following signals:
• When the stock breaks up penetrating the 200-day mov-

ing average, it is in a strong upward trend.
• When a stock breaks up through the 20- and 50-day mov-
ing average, a trend reversal is in place.
• When the short-term 20-day moving average breaks up
through the 50-day moving average, the stock is in an up
trend and you should buy it.
• When a stock comes down to one of the moving averages
and bounces up again, it is a buy signal.
These are the basics in using moving averages. Again, just

as in all chart reading techniques, these patterns tend to be
true but are not always true. When you can use the signals
on a chart and your fundamentals together, you have the best
chance of buying a stock at the right price.
Gaps
What is a gap? You can easily see them on a chart, and they
can appear as either a gap up or a gap down. They are neither
a buy nor a sell signal per se. A gap occurs when a stock
price opens at the first trade of the day at a sharp difference

than it closed the night before. For example, if a stock closed
yesterday at $20 per share, and this morning its first trade
was at $25 per share, the stock gapped up $5 per share. To
demonstrate, let’s look at Google’s 1-year chart:
8
There are a number of gaps both up and down on this

chart. The first gap up was in the middle of October to the
extreme left of the chart. It’s very clear on the chart that
it closed one day at one price and opened the next day at a
higher price. There is a gap down in late January, a gap up
in late March and another one in the middle of April. The
last one is in October on the right where it gapped up again.
There are also a number of minor gaps as well.
If there is a gap up, it generally means that the stock is
moving up and will continue to do so. Again, in chart reading,
these things tend to be true but are not always. For example,
look at the gap up in April on Google’s chart, right after that
the stock sold off. That sell off went right to the 200-day mov-
ing average and bounced up, so the 200-day moving average
was a support. It came back down to the 200-day moving
average in August and tested the support line of the 200-day
moving average before it bounced up again. That was a buy
signal. The price of the stock at the end of the chart was about
$500 per share. At that point, is it extended? I feel it might be
because it is so far above the 200-day moving average line and
because the value of the stock is much less. I would not buy
this stock until it comes down and retests the 200-day moving
average where it will likely find strong support.
The OBV line in this chart concerns me. That is the line
below the price chart. Note the OBV high at the extreme
left of the chart is not as high as it was at the beginning of
2006. I do not feel comfortable with that kind of pattern.
If the current stock price is higher now than at the begin-
ning of the year, then the OBV should also be higher. Is that
divergence? I think it is and it is not good in this case. Time
will tell us if the stock will fall.
There is a rule that says: Gaps always get filled. Besides
watching for gaps and understanding that a gap up is bullish
and a gap down is bearish, be aware that gaps leave holes in
the stock chart. Those holes need to be filled, meaning that
the stock price needs go up to the top or down to the bottom
to continue its primary trend up or down. When a stock price
gaps from $20 to $25, that gap gets filled by the stock price
coming back down to $20 and then continuing back up. The
$20 price acts as support when the stock comes back down.
This is a nice rule about filling gaps, but it has one major
flaw. Gaps do indeed tend to be filled, but the time it takes to
fill a gap could be measured in days, week, months or some-
times years. Do not use gaps as a sole indicator of what to do.
Always look at trend lines, moving averages and especially
the OBV when studying gaps on a chart.
Ni n e : T h e H a r de s t Pa rt
of Bei n g i n t h e Sto ck M a r k e t
When to Sell
I have primarily discussed chart patterns that indicate
when to buy. Buy at support, buy when a stock breaks out,
buy when it moves above its moving averages and buy when
you see double and triple bottoms. We can turn those indi-
cators around and sell when stocks break down below sup-
port, sell when they fall under all the moving averages, or
sell when they fail at double and triple tops or break below
double and triple bottoms, but selling is not that easy. You
can use these signals, and you would not be wrong to do so,
but you need to put more thought into the process.
Buying is fun. It is a positive activity full of hope and prom-
ise. It is also the easy part of trading. The far more difficult
task is knowing when to sell. Using charting is one way to sell
stocks, and it is a skill that will help you tremendously when
determining when to sell and when to hold. But there are
other ways to sell stocks, and we are going to explore them.
An honest discussion about selling stocks has to include
the philosophy of never selling. There are those who advocate
130
131 The Hardest Part of Being in the Stock Market
holding stocks forever; Warren Buffet is one of them. If you do

not know who he is, then you are not a serious investor yet. He
is history’s most successful and famous stock picker. He would
say he is a picker of businesses, not stocks. When he buys
a company, his time horizon is forever. Exceptions do occur
when he does sell, but they do not occur very often. Since
he is the greatest investor of all time, you can’t dismiss this
philosophy. His method is valid. The problem with that is that
we are not all Warren Buffet. He has a deep understanding of
what companies to buy that will work for the long run. I found
it interesting that he did not buy one tech company, ever. He
says he doesn’t understand them. I think he does understand
them he just doesn’t like that technology changes so fast that
you could hold the best company today and ten years from
now, it will be out of business. There is a lot to sticking with
companies and businesses you know and understand. In that
situation, being a buy-and-hold investor will work.
In fact, over any ten-year period, the stock market has
always been higher, so if you buy an index of stocks, not indi-
vidual stocks, you can hold the index and eventually make
money. It’s a fact. It also might mean you could be long dead
before you make money. For example, if you have a portfolio
comprised mostly of high tech, NASDAQ stocks that you
bought at the peak of the market in early 2000, by the start
of 2008, you are still 50% below the peak, and it looks like
it is going to take many more years to retrace that collapse. If
you buy individual stocks, the story could be very different;
in six years, the Dow has climbed to new highs. Large stocks
far outperformed the small stocks in that period, but even in
the Dow, which is only 30 stocks, only about half of them
made the move to drive the Dow to new highs. The others
did not do nearly as well.
Odds are that you are not going to be Warren Buffet. You
are going to want to sell at some point. None of this helps
you know when to sell, but it does demonstrate that stock

picking and buying at the right price is important. However,
it is less important than selling. Proper selling techniques are
critical, and if you do not have them, I say again, just buy an
index in the S&P 500 and hold it forever. You will do fine.
For the rest of you, I want to lay down some sell rules.
After all, even Warren Buffet sells stocks sometimes. We
will have two kinds of rules for selling. One will be selling
for basic reasons and one will be for charting reasons. We
have already established one basic reason for selling stocks in
the Investing Rules. It doubles here as a Selling Rule.
Selling Rule #1:

Sell when everyone else loves the stock.
You can even broaden it to include times when everyone
loves the entire stock market. The problem is that we don’t
know when that love is at a point where we should implement
the rule. This is where charting will help you stay with the
market or your winning stocks as long as possible and trend
lines and moving averages on a chart will tell you when the
love has gone out of the stock or the market. Later, I will
show you some more charts that will help you interpret the
signals sent off by that lack of ardor.
First, let’s go over some of the basic reasons for selling
stocks. Some of the signs that the market has turned ugly
and it is time to leave are economic in nature and other
signs are observational. For example, if you observe that the
stocks that make up the stock market are reporting fewer
stocks reaching new highs and more stocks falling to new
lows, then love for the market is on the wane. If up volume
is less than down volume and that trend has been in place
for a few weeks to a few months, it confirms that the love is
gone. At that time, you will notice fewer IPO (initial public
offerings) being made. Merger and acquisition activity will
fall off. Less money will be coming into mutual funds, and
foreigners will be net sellers of our stocks. All these signs
are difficult to quantify, but they are observable. If you pay
attention, you will see the changes. However, to make your
life easier (though still not exactly easy), you should apply
rule number two in combination with rule number one.
Selling Rule #2:

Sell when a recession is on the horizon.
The Fed and Interest Rates
How do you recognize when a recession is coming? We al-

ready discussed government statistics, and I suggest you re-
visit the discussion on leading economic indicators, but those
will not tell you when to sell. They will provide a sense of
economic direction and that is what we are looking for when
determining when to apply rule number two. The problem
with those government statistics is that they are always being
revised, so when the initial report on unemployment data
comes out, you can bet it will be wrong. It is not unusual for
it to be off by 50%. Still, you have to use what you have, and
if everyone else is reacting to these statistics, you need to
understand what they are doing and why.
In general, when looking at an economic cycle, keep an
eye on the direction of interest rates. At the top of a strong,
growing economy, the Federal Reserve begins to increase
interest rates. That is the first round of cannon fire across the
bow of the economic ship. The Fed usually raises rates slowly
and in increments. They usually issue four rate increases in a
row. When the Fed starts the process of raising rates, they are
trying to put the breaks on an overheating economy to fight

inflation. By the time the fourth rate hike hits the economy,
there is usually still no sign of damage. Those cannonballs of
interest rate increases take about 12 months to show any dam-
age in our economy. When the Fed begins shooting those rate
increases, the stock market will start to get very nervous. The
stock market hates rising interest rates, and the Fed almost
always raises interest rates too far, sinking the ship and causing
a recession. Therefore, in general, when the Fed starts rais-
ing rates, an economic slump is on the horizon. When that
happens, the stock market will weaken. It is not a definitive
reason to sell, but it is a good reason to be very careful, and
it should make you feel, as an investor, more open to selling
stocks. After you sell, you might want to sit on the cash for
a while. You do not always have to be fully invested in the
market. Cash is also an investment at times.
Since it takes a very long time from the first interest rate
increase to affect the economy, economic health indicators
will still look very good for a while. Earnings, growth and
employment will be healthy. However, investors always look
ahead, and they react to what they think they see. They too
can be wrong, but that won’t stop them from trying to deci-
pher the future, and it certainly won’t stop them from driv-
ing stock prices downward.
The corollary to the Fed raising rates is the inflation
news. If the Fed is raising rates, you need to watch for signs
of inflation. The Fed uses inflation as the excuse for raising
rates. When the Fed stops raising rates, or pauses, they may
explain their pause by claiming that inflation is moderating.
That may or may not be true.
The Fed has two mandates. They are to keep a steady
economy growing, and they are to control inflation. The
actual law that governs the Fed does not say that, but that is
how the law has been interpreted. The Fed has several blunt
instruments it uses to implement that mandate and the most

obvious and most effective tool on hand is the lowering and
raising of the interest rate on money they lend to banks. If
they say they are raising rates to control inflation, they also
may want to reduce economic growth. If they say they need
to slow the economy, they may really be fighting inflation.
These two things are attached at the hip. You cannot sepa-
rate one from the other.
In normal economic cycles, this is relatively straightfor-
ward, but once in a while we experience economic “stagfla-
tion.” That means that we experience no economic growth
but inflation still rises. Which way does the Fed move in
that situation? We had stagflation in the 1970s, and it was
painful. Another economic malaise that we have not seen in
the United States since the Great Depression is “deflation.”
Japan suffered under this sickness for all the 1990s. That’s
when everything becomes less costly every month. You, as
a consumer, may think that is great, but it isn’t good for the
economy. If you know things are going to be cheaper next
month than this month, what do you do? You avoid spend-
ing, and in doing so, you stop the economy. Jobs are lost and
this goes on and on until the consumer decides that he needs
to spend money or that goods won’t get any cheaper. It is a
spiral that feeds on itself, and for an economy, it is very dif-
ficult to combat. As a consumer, you may like the cheaper
prices, but even cheaper prices won’t help if you lose your
job. I would rather have inflation and a job.
Inflation is the norm, and the Fed telegraphs a pos-
sible recession to investors by increasing interest rates.
The increases take time to filter into the economy, and the
time it takes is why the Fed usually raises the rates too high
and actually pushes us into a recession. The “soft landing”
or “Goldilocks scenario” is where the Fed raises rates just
enough to stop inflation and only slows the economy. The
odds that the Fed can successfully engineer this kind finesse
are remote but possible.
I have one final point on the topic of how the Fed raises
and lowers interest rates. I mentioned that the Fed controls
the interest rates of money loaned to banks. Our banks, the
ones that hold our checking and savings accounts and the
ones that hold our mortgages, are the banks receiving those
higher-rate loans from the Fed. The interest rate that the Fed
charges these banks is the Fed’s fund rate. So when you hear
that the Federal Reserve raised or lowered rates today, they
are talking about the overnight rate of interest they charge
banks. The banks take that money and lend it to you, me
and other commercial entities. They might borrow money at
4%, lend it to you on a mortgage at 7%, and keep the dif-
ference. Being a bank is very profitable. Remember, they get
to borrow someone else’s money and make money on that
money. It’s a nice little system. When the Fed raises rates,
it tends to slow the economy because banks don’t want to
borrow as much money at the higher interest rates. It takes
time for the economy to sense that fiscal reticence. The Fed
can only guess at how high to make the interest rate before
banks are more reluctant.
Selling Rule #3: Sell when the reason you bought

the stock is no longer valid.
Sell when the competition
Selling Rule #4:
changes the game or when your company can
no longer compete.
Selling a stock because the reasons you bought it no lon-
ger exists or when that company can no longer compete are
easy rules to apply. Remembering why you bought the stock
in the first place assumes that you have a great memory for
stocks or you wrote those reasons down before you bought
the stock. I strongly recommend you write down your rea-
sons because memory is not always entirely reliable.
Even though it seems like an easy one, I want to explore
some examples of these rules. The turn of last century was a
great time to buy railroad stocks. They were money-making
machines as they knitted the country together, moving goods
and people much faster than horse and wagon. Therefore,
as an investor, you owned railroad stock. Then came the
automobile. At first, it looked like a great big boondoggle.
It was very noisy and unreliable, but that changed quickly.
Soon the car could go anywhere there was a road and even
some places where there weren’t roads. Still, the railroad
could move large quantities of goods and people over great
distances much cheaper and more reliably than a vehicle. It
was very difficult to see that change in transportation com-
ing. It took years. The bottom line is that the reason those
investors bought the railroad stock changed. Not only were
the reasons you, as an investor, bought and owned that stock
no longer valid, but the railroad could not compete with the
automobile any longer.
Another example is the telephone. AT&T was the only
game in town for many decades until the break up. But let’s
focus on the business model. AT&T was the long distance
carrier for almost all voice transmissions. That began to
change in the 1980s with the advent of wireless cell phones.
At first, everyone felt that the technology was unreliable and
dropped calls and bad reception areas were common. Those
problems have been largely overcome and the land line,
that hard copper wire in the ground, was becoming obso-
lete. AT&T could no longer compete. If you bought AT&T
because they had a monopoly years ago, that reason to own
the stock disappeared when it was broken up into the Bell
regional telephone companies. If you bought AT&T because

they had control of all long distance calling, that reason dis-
appeared a few years ago with the popularity of cell phones
and their flat monthly fee for any call anywhere.
Finally, I will give you a newer example. Where do you
think any business that makes television or computer CRTs
(Cathode Ray Tubes) are going to be in ten years? They will
be all out of business unless they can change to flat panel
screens. This was obvious several years ago. Or, what will
happen to the music CD business with the advent of iPod
devices? Will we still need our big music systems? These are
clear examples of Creative Destruction in the making—new
businesses destroying old ones. These are fairly easy to see
and avoid. However, not all of them are obvious, and in fact,
most changes are hard to see.
In these examples, both selling rule 3 and 4 applied, but
when only rule 4 applies, it is much more difficult to discover
that your company can no longer compete, and decide to
sell. In a current example, a technology company, TIVO, has
changed the game and pioneered a new business. This is pre-
cisely why Warren Buffet stays out of the tech stocks. TIVO
invented a system that records video from the television and
then plays them back whenever the viewer wants. It is a simple
business, although the technology was, at the time, very dif-
ficult to develop. TIVO became so popular that it evolved into
a pop culture verb: “TIVOing it” meant you recorded a televi-
sion show as in, “I’ll watch the game tomorrow; I TIVOed
it.” The same thing happened when “Xerox” became the verb
used to describe making copies because Xerox was the first
company to make copy machines, and Kleenex has come to
describe any facial tissues. But TIVO will also go the way of
Xerox. Cable and satellite companies can now copy the tech-
nology, and they control the signal to the TV. Cable and satel-
lite companies must agree to let TIVO use their system. They
won’t because they see the profits to be made by offering their

own DVR machines that do the same thing. TIVO is toast.
One more before we go to charting. We all saw the suc-
cess of Blockbuster Video. Customers rented movies from
Blockbuster and brought them home to watch. The process
was a long one. You had to get in your car and pick out the
movie, pay to rent it for a day or two, come home and make
sure you watch it within the time frame, and then take it
back in time to avoid the penalty. Then came Netflix, a new
business model where customers paid a monthly fee and
chose several movies at a time. Netflix overnighted the CDs
to their patrons and those customers kept them as long as
they liked. There was no cost to mail them back and no late
fees. As long as the customer paid the monthly subscription
fee, they could get as many as five videos at a time, send
them back and get more. This business model helped destroy
Blockbuster Video’s policy on late fees and significantly dam-
aged the movie company’s business.
Netflix, however, is doomed. Their business model,
though excellent for its time, will eventually be destroyed by
the DVR put out by the cable and satellite companies. These
DVRs have storage capacity. The cable companies can beam
signals into them. If you put them together, as some cable
companies are figuring out with their Movies On Demand
services, you have downloadable movies that you can store
on your DVR and play them anytime you want. The system
is in place now, but the business is not yet booming. All the
cable companies have to do is negotiate fees with the movie
studios and then copy the Netflix model of downloading so
many movies a month for a flat fee. That will be the end of
Netflix. My brother-in-law helped put the company together.
He is going to be looking for a job.
These basic reasons for selling a stock are much more
speculative and subjective than charting reasons. However, I
believe they are better reasons to sell than any you could come
up with by following a chart. Remember, charting is not a
science, it is an art. Never confuse charting with fundamen-
tal, independent thinking, and the basic rules for selling are
all about the fundamentals of a company. Will your company
make money in the future? Can it grow its earnings? That is
what drives stock prices earnings and growth of earnings.
Always buy companies that make money and that will make
more money in the future. From that point of view, it’s easy.
Implementing it can be very difficult. Human nature gets in
the way every time. We are emotional creatures. I am almost
crying right know because I smell my wife’s Christmas cook-
ies baking and I know she will not let me have one. Charting
helps take emotion out of the equation. It is something you can
point to and see; the basic rules are harder to see and prove.
Human nature wants to make things simple and charting does
that. Just don’t fall in love with charting. If you do, you will
eventually see the flaws in charting and fall out of love with
it. Save yourself the trouble and use charts as a tool to help
you make decisions—not the sole answer to the mysteries of
buying and selling stock. Use independent thinking, a funda-
mental understanding of the market and business, and charts
in combination to make sound choices.
Using Charts to Sell
Selling Rule #5: Sell

when a stock price breaks
below its upward-sloping trend line.
I like to apply this rule when a stock has become overval-
ued, meaning that if I value a stock at $20, and it has moved up
to $30, I get nervous. I want to capture as much profit as I can,
and applying the trend line break rule is what we call in the
industry a tight stop out. These “stops” are established sell or-
ders to take us out of stocks. Let’s look at this one-year chart.
9
There are several trend lines drawn. The downward

trend, starting at the beginning of May and pointing down-
ward, shows you a buy signal when the stock price broke
above the trend line. That happened in late June. If this is a
stock that you were watching because all the fundamental
reasons for owning a stock were in place and you were look-
ing for a good buy point, this downward slopping trend line
would have given you the signal to buy. That signal is when
the stock reverses, breaking up through a downward trend
represented by the trend line.
You now own the stock as it continues to rise. Note
the three parallel lines going up following the stock
price. Those are upward-sloping trend lines. If this stock
is overvalued, you could use these trend lines as your get
out point when the stock breaks down. What you are
looking for is a breakdown in price where the price of the

stock falls below the bottom trend line. If it does that,
you would sell this stock. Trend lines are very simple to
follow, and in many ways, too simple to use. They work
best in trending stocks. Stocks that trade sideways or are
very erratic are not suited for trading using this method.
Can you guess what company this price chart represents?
It’s Microsoft again.
Selling when a stock price breaks below its upward slop-
ing trend line is a very tight out point—what we would call
a tight stop. You only use this technique when the stock
becomes overvalued or you think any of the earlier selling
rules or investing rules also apply.
If you see too much love for a stock or if the economy is
headed into a recession, tight stops might be in order. What
is too much love? Study the chart. If the angle of the price
chart is steeper than 45%, that tells me that the price has
gone up too fast because too many people love the stock.
Placing a tight stop out using trend lines is a good course of
action in that case.
If I feel selling rules 3 and 4 are in play, I will also use a
tight stop out. The difference is that if there is too much love
in the stock price, I am willing to buy the stock back when
the profit takers shake out some of the love. As long as the
fundamentals do not change, buying back a stock is not only
acceptable but smart.
On this same Microsoft chart, I have drawn a line straight
across connecting tops in November, January and March. These
tops were resistance levels as the stock price rose, and if you
remember our lesson on resistance points, stocks tend to stop
going up at their resistance points. Now that the stock price
has risen above the resistance point, this line becomes support.
Support is the point where the stock tends to stop going down.
A price break below support levels is a sell signal.
Selling Rule #6:

Sell stocks that break below support levels.
Support and resistance are buy and sell signals and terms
commonly used by professional traders. If you study charts
for any length of time, you will begin to see a pattern of
support and resistance. There are many kinds of support and
resistance. The terms are used constantly to describe what
is happening with the movement of stock prices. Trend lines
can provide support and resistance just as moving averages,
double and triple tops and bottoms and many other chart
signals can. Get used to the terms support and resistance
because if you plan on using charts, you will have to become
a master at discovering support and resistance areas.
You will note on the Microsoft chart that the current
price of the stock is about $30 per share and that the support
level, represented by my straight line drawn across previous
highs, is about $28.25. The percentage loss from its current
price to a break of support is about 10%. That brings me to
the next rule.

a stock when it breaks
down 8-10% from its most recent high.
This too can be considered a tight stop out of a stock. It
would be easier just to say sell at 10% or 8% from the high,
but some stocks are a lot more volatile than others. If your
stock tends to move up and down 2–4% a day, then you
want to give it more room. Large cap stocks usually move
slower, whereas the small ones can be very volatile. You are
going to have to make a decision as you observe your stocks.
When and if you make that decision to sell at a percentage
fall in price, make sure you write it down and commit to

following it before the actual event happens. I have warned
you about falling in love with your stock, and writing sell
points down will help you remain objective about a stock. I
know it sounds silly because you are sure you will apply the
rules objectively, but I cannot tell you how many people I
have talked to who were convinced they would get out at a
certain point, but just didn’t do it. Why? Because they fell
in love with their stock. If you write it all down and don’t
follow your own rules, then there is no help for you. You
are a hopeless romantic. Remember, our goal is not to fall in
love but to make money. When has falling in love ever made
you money? And that is from me, a hopeless romantic in all
things except money.
These selling rules that use charts are a lot easier to
apply than the investing rules, but keep in mind that charts
are only a tool. They are a good tool, but they do not tell
the future. They are not perfect. Every trader out there
is doing the same thing when it comes to chart reading,
so how are you going to get the edge on those traders?
The simple truth is that you can’t. However, if you use all
my rules consistently, your odds of beating the competi-
tion increase. And you are competing, don’t forget that.
Every time you buy or sell a stock, someone else is on the
other end of the trade. That person has made the opposite
decision. Who will be right? They are betting against you.
That is the sad but complex truth. Do not be naive; when
it comes to making money in the stock market, everyone
is trying to get the edge on you. Sometimes that draws in
criminal activity like the pump and dump artists or people
who try to convince you to buy a worthless penny stock.
Be smart and be careful.
Let’s discuss selling at the break of moving averages.
These are very good triggers for exiting a stock. You can use
long-term or short-term moving averages. If you are going to

use a short-term moving average, I would suggest the 20-day
exponential moving average. This would be considered very
short, and you would use it in the same situations in which
you would use the trend line as an out point.
I need to explain a little about how an exponential mov-
ing average differs from a simple moving average. To com-
pile a moving average, you add the stock prices together
over the number of days of the average you are studying
and divide by those days. That gives you an average. To
make it a moving average, all you have to do is add the
next day drop-off the furthest day back, and re-compute
the number. Each time you do that, plot it, and soon you
are building a line of dots. That is the moving average. This
line is a simple moving average. However, to build an expo-
nential moving average, you have to weigh the importance
of some days over others. The most recent days are given
more weight or importance than older days when comput-
ing the exponential moving average. It is a mathematical
construct, nothing more. Most charting programs, includ-
ing the free ones on the Internet, let you choose between
a SMA (Simple Moving Average) or an EMA (Exponential
Moving Average). In using the 20-day moving average, I
like the EMA. I also like using the EMA for the 50-day
moving average and the SMA for the 100- and 200-day
moving averages. There are a lot of different ways to ana-
lyze the numbers and you will need to play with them to
see what types of information they provide.
Long-term investors use the 200-day moving average. It
is a moving average for a year’s worth of stock trading, so it
shows the average price of stocks for the long haul and many
investors use it for that purpose. Calculating a stop out point
for stocks based on the 200-day moving average would be
considered very loose.

when the long-term
200-day moving average is broken on the
down side.
10
Here is a chart of Goldman Sachs. You will see four

moving average lines and three drawn trend lines. When
looking at this chart, the lower moving average line is the
200-day moving average. These moving average lines are
smooth, running along the daily price chart of the stock.
The smoother they are, generally the longer the moving av-
erage. The line up from the 200-day moving average is the
100-day, the next line up is the 50-day and the top line is
the 20-day moving average. In a long-term, up-sloping chart
where the stock price moves up in a fairly constant manner
for a year, this is how the lines look. It will get confusing on
a chart with a stock price that moves up and down a lot in a
year. On those types of charts, the moving averages weave
in and out of each other as they keep pace. Don’t worry, you
will get used to it. After a while, you will be able to tell at a
glance which trend line is which on any chart.
In May, June and July on the above chart, the stock price
tested the 200-day moving average and bounced up each
time it did so. There was no sell signal, though you would
have been close. We like to refine the 200-day moving aver-
age rule by using 97% of the moving average price on a close
as a sell signal. That means that we wait until the price of
the stock closes at the end of the day at 97% of the 200-day
moving average price. We do this because so many traders
pull the trigger right at the 200-day, and often a day or two
later, the stock recovers after all the “weak hands” sold it off.
It doesn’t get any easier, does it? If you remember our lessons
on how to buy a stock, you could have bought this stock at
several points. When it came down and successfully tested
the bottom for the second time in June (double bottom),
that was a buy signal. It did it two more times: once in July
and again in August. Those moments were buy signals for
this stock.
It would be nice if all stock charts looked like this and the
signals were so clear, but they are not. The Wal-Mart chart
below is a puzzler.
11

It is hard to pick out the moving averages, but with prac-

tice, it will be obvious. The stock price on the extreme right
hand side of the chart just broke the 200-day moving average
as the stock price fell. Normally, that would be a sell signal.
However, if you look back over the year and see how often
Wal-Mart’s stock price has moved up and down through that
average, you might agree that it would be a hard signal to use
to buy and sell this stock. Sometimes the yearly chart doesn’t
tell the whole story. Take a look at a weekly chart going back
to 2001.
12
The story becomes clearer. On the extreme right hand

side of the chart, the top line of the moving averages is the
200-week moving average. Note the change of scale from
days to weeks for the moving averages. It is clear that this
stock is moving sideways from the middle of 2005 to early
2007 within a trading range of $42 to $50 per share after
falling from a range of $45 to $60. These are approximates
using the price scale on the extreme right side of the chart.
As you look at this multi-year chart of Wal-Mart, you

should immediately notice that its stock price does not gen-
erally fall much below $45. On closer inspection, Wal-Mart
double bottomed in late 2005 and mid 2006 at $42 per share.
That is your buy signal. If Wal-Mart retests that bottom and
bounces, buy the stock. That is also your sell signal. If it fails
at that level, get out.
As this example demonstrates, it can sometimes be use-
ful to take a look at weekly charts with weekly averages.
If a stock is moving straight down or up for an entire year,
then go to the longer-term charts to determine support and
resistance. There is no hard and fast rule for using weekly or
monthly charts. If the daily chart is not telling you a story,
then expand your search. Every stock has a story (not to be
confused with “story stocks”…) and if you look at enough
data, you can find it—even if the story is that the stock has
no support or resistance.
There are many other ways to use moving averages as
both buy and sell signals. You could use “crossover,” a situ-
ation where a short-term moving average crosses a longer-
term moving average as a signal. However, I never liked that
method. When charting moving averages, I like to keep it
simple, even though you might not think using the 20-, 50-,
100- and 200-day moving averages is simple. Master these
averages before you move on to more complicated chart-
reading techniques such as parabolics, oscillators, MACD,
stochastics, Bollinger bands and many others. I have been
showing you how to read bar charts, but there are also line
charts and candlesticks and a completely different charting
method called point and figure. I would strongly suggest you
master the basics before moving on. You will make the most
successful decisions using information and methods you can
thoroughly understand and use. I like staying with the basics
and using On Balance Volume as a confirming indicator for
stock direction. I also like the Relative Strength Indicator,

but that may be just me. It took a long time for me to ferret
out the techniques I am most comfortable with. I also have
acquaintances in the business who swear by the point and
figure method of charting. It’s good and I like it, but I can’t
strongly recommend it.
Managing a Group of Stocks
Using fundamental and technical analysis to buy and

sell individual stocks is the foundation to successful invest-
ing, but that is only part of the answer to earning consistent
returns. I know that doesn’t sound like it makes sense, but
let me give you an example of what I mean and one that hap-
pened to a client who gave up trying to manage his portfolio
himself. It wasn’t that he couldn’t pick good stocks that gen-
erally made money. That wasn’t his problem. The problem
wasn’t in his selling technique either. The problem was in his
portfolio management. He tended to buy large amounts of
some stocks and small amounts of others. At one point, his
portfolio was full of Canadian Oil Trusts that were paying
him very substantial dividends, averaging about 10%. Oil
was high and going higher, demand was increasing world-
wide and Canada had huge deposits of the black gold. His
reasoning was very sound, and his stock picks and buy prices
using fundamentals and technical details were excellent.
However, his portfolio management skills were lacking.
When the Canadian government announced that, for the
first time, they would be taxing oil trusts, changing the law,
each one of his picks sank immediately—dropping 20–30%
in a few days. All the fundamental and technical analysis in the
world will not save or protect your portfolio from severe loss
due to an unexpected event. Proper portfolio management
will save you though. It doesn’t just protect you against unex-
pected governmental action, but remember when 9/11 shut
down our market for a week? That was very painful. In 1987,
the market crashed, taking stocks down by 30% in just one
day. Even proper portfolio management can’t save you from
everything, but it does offer you some protection.
When you buy stocks, you are taking risks. The measure
of that risk is something that is very difficult to quantify. The
rules suggested in this book help you reduce your risk and the
use of charts can help you wring out some of the risks involved
in buying and selling stocks. However, stocks are still risky.
Therefore, to mitigate that risk further we need to employ
some techniques that spread the risk over different factors.
I am not talking about buying bonds or real estate,
although those are very good ways to help mitigate your risk.
By investing in those things, you are reducing your wealth’s
overall exposure to disaster. The reward gained from hold-
ing stocks far outweighs the risks, in my opinion, but I want
to assume as little risk as possible while, at the same time,
maximizing my potential for gain. Not only do you have the
best opportunity to make the most money from the stock
market, but the market is also very liquid so you can get to
your money when you need it.
Bonds may be a good risk avoidance tool, but historically,
the returns from bonds pale in comparison to stocks. Real
estate is a very good long-term investment, and if bought
correctly, the return can compete nicely with stocks, but
you have to be willing and able to tie up your wealth for
years at a time. There are a lot of people willing, but they
are not always able to obtain the financial backing to sup-
port an investment in real estate. Do you have the ability to
forego rent for several months or to replace carpeting, walls
or plumbing, if need be? Can you hold onto the property
through recessions where tenants are hard to find and still
not be forced to sell the property at the worst time? Overall,

stocks are much better, and with REITs, you can buy real
estate and still have the advantage of liquidity. I will discuss
REITs later. I want to fully explore how to mitigate risk with
a portfolio of stocks.
The first and easiest way to minimize risk is to avoid
buying too much of any one stock or sector. Generally buy
no more than 3% of any one stock and no more than 10%
of any one sector. Yes, you can buy 5% and 15%, but as you
move up in ownership percentages, you increase your risk.
Can you buy less? Yes, but then you run the risk of being
overly diversified, and in that case, you might as well buy
an index fund. There is a balance. I like to own between
25 and 40 different stocks. Sometimes I will own slightly
more or less, depending on the market and my stock selec-
tion, but if I am fully invested that is my range. I will also
usually have a spread of 10 to 15 sectors. If an industry such
as oil or tech is the flavor of the day and that is the industry
that is moving, I may have two sectors or even three in that
industry. Tech, for instance, could mean telephone, soft-
ware or hardware. I might own three stocks in each, being
fully aware they are related and that I have just increased
my risk. In that case, when I am fully aware of the increased
risks I have assumed, I will have some tight stops in place
to get me out of an overweighted situation. The important
factor here is to be aware of the risk you are taking and to
spread it out. Other factors that make me more cautious
in my weightings would be the economic and stock market
cycles. Are they pointing to a stronger market? Are we
in a bull trend or bear cycle? Is it a secular bull or bear
environment? The backdrop of the market and economy is
very important and should make you more or less cautious.
Your portfolio should reflect that level of caution.
Regardless of market conditions, I strongly advise you to

stay within the 3% and 10% range.
Another way to reduce risk and manage a portfolio of stocks

is to consider foreign equities. Foreign stocks traded on our ex-
changes do not usually move in tandem with our market. This
gives you a good hedge against our market’s swoons. To insure
proper diversification, you can buy an ETF (Exchange Traded
Fund) which can represent a foreign market’s index or a subset
of foreign stocks. If you are not a fan of ETFs, then buy for-
eign stocks traded on our exchanges called ADRs (American
Depositary Receipts). These are stocks that comply with our
general accounting principles, meaning that theoretically they
are more transparent in their accounting methods and easier to
analyze. I say “theoretically” because U.S.–based companies in
recent years have, all following the general accounting rules,
been less than honest in their numbers. But if you buy ADRs to
have foreign exposure, at least they have to lie and steal using
the same bookkeeping methods as our homegrown liars and
cheaters. Doesn’t that comfort you?
There are other ways to not be tied to the foibles of our
market. Commodity-type stocks, though they are still tied
to our market, often react independently from the average
common stock. Gold, for example, has been one of the worst
investments in the past 100 years while, at the same time,
the stock market has constantly moved up. It is not tied to
our market, so as a risk diversification investment, it would
be good, but based on its absolute return, it’s terrible. There
are better options out there.
A good way to reduce risk is to use options, but that opens
up a whole new can of worms and this book will not delve
into that topic. It takes special training and a certain type
of disciplined investor to be good at managing risk using
options, and most investors do not understand it.
Instead, let me describe an easier method that we often

use—shorting! Once you understand what shorting is you
will understand why it can be used to reduce risk. The SEC
feels that shorting is more risky than buying stocks, and
they are not entirely incorrect, but they are also ignoring
how shorting can be employed to reduce risk. In their effort
to try to protect the investor, sometimes the SEC does the
investor a disservice. If you are not smart enough to protect
yourself in the stock market, you shouldn’t be in it. Since
when has government been the best guardian of your wealth
anyway? In fact, the government’s talent lies in the destruc-
tion of your wealth, not in protecting it. Take a look at your
paycheck. Compare the gross pay with what you bring home.
That income tax bill you pay was supposed to be a temporary
tax. I guess it all depends on what “temporary” means. Also,
when they first came up with the income tax, it was sold to
the public as a very small tax to pay for a necessary war. Tax
and war: two of the greatest destroyers of personal wealth!
Don’t get me started.
Back to selling short as a tool to reduce risk. When you
“sell a stock short,” you are expecting the stock to go down,
and if it does, you make money. You are actually borrowing
someone else’s stock and selling it. Note: You are borrow-
ing a stock; so, therefore, at some point, you have to give it
back. This is the central concept to shorting. To exit a short
position, you have to buy the stock back to return it to the
original owner.
It is always easier to understand most things with exam-
ples. Let’s say I want to short Goldman Sachs stock. I intend
to sell this stock I do not own, so I borrow it from someone
who does own it, usually through my broker, who actually
does the borrowing for me. Just by putting an order in to
sell the stock short, my broker ensures that it is borrowable
and that I can perform the trade. If not, they would tell me
that the stock is not shortable or borrowable. If it is bor-

rowable, and I can short the stock, and I do it at $200 per
share—the approximate cost of Goldman Sachs stock. I sell
it for $200. Remember, I never owned the stock in the first
place, so after I sold it, I am short the stock in my portfolio. I
now have a short position in Goldman Sachs. It will show up
in my portfolio as a negative for so many shares at such and
such a price. In this case, the price is $200 per share. Now,
a month later, let’s say the stock fell to $180 per share. If I
want to exit my short position, I put in an order to my bro-
ker dealer or online trading firm to buy the stock at $180.
Remember, I borrowed someone else’s Goldman Sachs stock
and I have to give it back to them at some point. To give it
back, I have to buy it. When that trade goes through, I will
be out of my short position with a $20 per share profit. Most
of this borrowing and giving back activity is taken care of
by the brokerage firm, you just have to make the decision
to short and then to buy to cover the short position. “Buy to
cover” is the term used to exit a short trade.
You can see how this can reduce risk. If you have a group
of stocks that you own “long,” meaning you bought them hop-
ing they will increase in value, you can now offset those long
positions with “short” positions. Put simply, you can short bad
stocks and buy long good stocks. It’s not always that easy.
Also, if you own stocks that you have made profits in, and
for some reason you are uncomfortable with the market or
the economy and you see a danger in owning stocks, you do
not have to sell them to protect yourself. You could “short
against the box.” If you own a 100 shares of Microsoft and
you still want to own Microsoft because you do not want to
pay capital gains tax on your profits, you could sell short 100
shares of Microsoft. If the stock moves up or down, you will
make nothing, and you will lose nothing. Later, when you
perceive the danger is over, you can get out of your short,
never having to exit the long position on Microsoft. Frankly,

I don’t like to short against the box. I am in the stock market
to make money, not to run in place.
A better idea is to hold on to Microsoft and sell short a
related company that has much worse fundamental and tech-
nical characteristics. In that situation, I am hoping that even
if the market turns ugly and I lose money on Microsoft, I will
make more money in shorting a bad stock than I lose on a
good one while, at the same time, I reduced my overall risk
to the market by using shorts.
So if shorting can reduce risk, why does the SEC state
clearly that shorting is very risky? Because in one sense, it is.
If you buy a stock long, hoping it will go up, you are risking
the amount of money you used to buy the stock. The worst
thing that can happen is that you will lose all your money. In
other words, the amount of money you can end up losing is
finite. If that happened to you after you have read this book,
I have wasted my time and you have wasted your money both
in buying this book and buying a stock that you held until it
went to zero.
If you short a stock, how much money are you risking?
You are risking an unlimited amount of loss. This is why the
SEC says shorting is more risky than buying a stock. Let’s say
you shorted Microsoft. How do you lose money on a short?
The only way is for the stock to go up in price. As it goes up,
you are losing more and more money. How far can it go up?
It can go up forever. Your losses are limitless. If you let that
happen, you are dumber than a rock. Still, the SEC tries to
protect those rocks, so they describe selling stocks short as
more risky than buying stocks.
In using shorting as a method of reducing risk, make sure
you have get-out points just in case you are wrong and you
didn’t need to protect your portfolio with some shorting activ-
ity. Still, it is a very good way to reduce risk, just be careful.
Even when the bubble burst in the dot com collapse, my firm
never shorted more than 25% of the portfolio assets. We kept
the rest mostly in cash and held a few long positions. Why?
Because shorting is betting that the market will go down, but
historically, it has a bias to go up on average 10% a year. Some
years it does go down and some years it goes up, but the bias
is to the up side, so when you are shorting, you are bucking
the long-term trend. There are times to do that, but again, if
we are talking about risk, and we are, then the odds of the
market going down are not as good as for the market going up.
Therefore, employ a shorting strategy gently. There are many
other ways of reducing risk in a portfolio of stocks, but they
become increasingly exotic. Stay away from them!
The absolute best way to reduce risk in a stock portfolio is
to invest in cash. Cash is an investment. You earn money when
investing in cash. In a stock portfolio, most investors picked
a money market fund as the holder of any cash. Most people
do not remember that they did this since it was a box that
they marked on an application when they opened the account,
but that money market investment earns interest too. It is an
investment. Sometimes the interest is fairly small, and if it
falls below the inflation rate, you are actually losing money, so
there is risk in holding cash. You have to measure and under-
stand the risks you are taking with each investment.
The methods outlined in reducing risk are easy to
describe, but knowing when to employ them is not. When
a market is overheating, start reducing your risk. When the
economy is faltering, reduce risk; when inflation is heating
up, reduce risk; and finally, when the FED is raising rates,
reduce risk. None of that helps you make day-to-day deci-
sions. Exactly when is the economy overheating or inflation
too high? To make those decisions, you need to become a
student of economics and that brings me back to the begin-
ning of this book when I told you that experts are always
wrong. I do not call myself an expert. I am a student of the

market just like you. If we call ourselves experts, then we
are going to be wrong all the time.
Learn the economic cycles and the causes of inflation.
Track the economic data pouring out of the government
each week that tries to decipher the complex beast of our
economy. Watch and learn the world economic ebb and
flow; the global economy is going to be increasingly impor-
tant to earning money in the stock market. Above all, make
sure you enjoy keeping current on world economics. If you
do not enjoy it, you will not be successful. It will quickly
become a burden, and you will lose interest. When that hap-
pens, you cannot call yourself an investor—you will have
become a gambler.
T e n : P u t t i n g It A l l To ge t h er
Buying, selling, and managing a group of stocks is always

a challenge, but it can be very rewarding both financially and
personally. There is nothing better than picking a stock that
doubles or triples. It gives you a sense of power, a vindication
of your mental prowess, and it is certainly a fun way to make
a lot of money. My life has always been about making money.
I think it started from being hungry and eating pancakes for
dinner because flour, water and colored corn syrup were
cheap ingredients. At twelve, I told my mother that I wanted
to be a millionaire when I grew up, and I remember her
saying that would be nice. I also remember her not believing
me. I made my first million by age 33. I took my family to
Las Vegas for a big dinner party where I announced that I
had made my goal and wanted to share the accomplishment
with everyone. My mother wasn’t very open about it, but I
could tell she was proud by the way she talked about me to
her friends. Making my mother proud was just as important
to me as becoming a millionaire, although I didn’t realize it
when I was twelve.
Making the money was hard work and keeping it is even
harder. My second million was slow in coming. I thought I
159
was smart, but I was actually too smart for my own good. I
went into a series of money-losing ventures, so it took years
for me to get the second million. Along the way, I learned a
lot of traps to avoid, and one of the biggest was not to think or
act irrationally. That means—do not try to get rich quickly;
instead, focus on getting rich slowly but steadily. Not that
there is anything wrong with winning the lottery, it is just
that it is not going to happen to you or me. You can buy a mil-
lion lottery tickets and likely you will end up winning some
money, but you also will become poor. Buying those tickets
because you want to get rich quickly is acting irrationally.
The trick is not to get rich quickly, but to get rich. You
can do it in many ways, but essentially, it will come down
to one thing: Spend less money than you earn. This book is
about getting rich rationally by investing in the stock mar-
ket. If I would have followed the rules I have laid out in this
book—learned from my partner, Jerry Klein, a seasoned
market veteran, that first million would have turned into
two million in a much shorter period of time.
In implementing these rules, do not expect to be an
instant millionaire. The rules are designed to be a common-
sense method of investing, and they will make you wealthy.
The better you apply them, the more money you will make.
You will make mistakes, there will be disasters in your port-
folio, and you will become frustrated when it seems like
nothing is working. You also will be successful. How much
money will you make over what period of time? I tell my
clients that we at KPP will double your money every 7 to 10
years. That may not seem like much, but the power of com-
pounding means that if you are able to do this on the low of
7 years and invest $100,000 at age 21, when you are 65, you
will have made over $7,000,000. You would not have to save
any more money—just let the $100,000 ride. This is a very
doable figure—not some pie in the sky dream, not achieved
161 Putting it all Together
by gambling and certainly not achieved by taking any undue

risks. Sound investing in stocks that make and grow their
earnings and sales and learning to avoid the big draw-downs
in your stock portfolio means you will get rich slowly, but
you will get there.
If you want to get there faster, save and invest more
money. Stop buying the latest and greatest toys or a bigger
house just because you can. Don’t spend every raise you get,
invest it. Always spend less than you earn. Separate needs
from wants. You would be surprised how much you can save
if you just understand that you spend most of your money on
wants and not needs. You need a roof over your head, trans-
portation, clothes and food. Decide how much of the roof is
a want versus a need, the same for your transportation. Ask
yourself: How many times do you truly have to eat out?
Stop whining about not being rich and become rich. I
know many millionaires, and the one thing they all have in
common is that they don’t seem like they are rich. They have
nice homes and nice cars, but they could have much more
if they wanted it. But they don’t. That’s why they are rich.
Contrary to common belief, millionaires are millionaires
because they don’t spend much, not for any other reason.
They don’t have fabulous lives filled with extravagant spend-
ing, trips, jewelry, cars and multiple homes. They lead much
simpler lives than the general public believes. Don’t buy into
the pulp on TV and in the rag magazines; that isn’t real life.
How do you get started? What steps do you take? Begin
by learning. Read some good basic books on investing. Peter
Lynch has some very good books that are well written and
simple. Graduate to the better books, and at some point, you
must read Ben Graham’s book on value investing. There is
none better. Pick up some magazines. Forbes, The Economist,
Business Week, and Barron’s are all good investor magazines.
Don’t get your stock ideas from the television. Always
assume that once you hear about a stock to buy in the popu-
lar press, it is too late. Think for yourself! If you have read
this far into this book, then you can come up with your own
ideas. If you don’t have any right now, don’t worry; the stock
market is not going anywhere. There are always opportuni-
ties; you just have to prepare yourself to take advantage of a
few of them when they come along.
G ood luck !

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KPP Publishing

Copyright © 2008 by Steve Peasley

All rights reserved under the International and Pan-

First Edition, 2009

Publisher publications are available at special discounted

For further information, contact:

1 Introduction: You Don’t Need This Book

5 One: The Experts Say…

11 Three: Is the Market for You?

14 Four: A Little History

20 Five: Emotions and the Market

34 Six: General Rules on Buying Stock

72 Seven: What to Buy, What to Avoid and Why

104 Eight: How to Find Stocks

130 Nine : The Hardest Part of Being in the Stock Market

159 Ten : Putting It All Together

You Don’t Need This Book

buying a piece of America, or at least a piece of the American

There are a lot of smart people in the stock market from

Investing Rule #1: The experts are wrong.

the experts were screaming: “Buy!” They were wrong!

They want to offer corporate America their services as

Investing Rule #2:

I like to play poker. That is gambling. I have a long-stand-

earnings skyrocketed and so did Apple’s stock. If you don’t

The stock market is a risky place. Stocks go up and down

You know that you are a rational, emotional being who

If the answer is yes,

rent secular bear cycle started in 2000; therefore, we can

Source data used to create chart: Bloomberg

In the 1966 to 1982 secular bear market, there were four

The Current Situation

Dow about 30%. The Dow recovered in 2003, but we are

Why Buy Now?

recession in 2003 and the market rallied strongly that year,

Investing Rule #3: Always buy stocks

fessionals look forward to those panic sells and wade into

Fear and Greed

by teaching us to focus on gathering and preserving food,

The Market’s Fear and Greed

lar, is the VIX or the VXN. What are they? According to

I said before, it is tricky. It is at the extremes that the VIX

move from one extreme to another while stock prices may

Investing Rule #4:

mind tells me to buy more stocks or mutual funds. Don’t

Can You Ignore Your Emotions?

Another way to avoid emotion is using “stops” based on

trolled by emotions on a short-term basis. Your job is to

Sell When You’re Happy

Source data used to create chart: Bloomberg

Investing Rule #5:

cause no one knows where it is going once it breaks through.

What to Buy and What to Avoid

Investing Rule #6: Always buy stocks that

is good. There is a saying, “buy on the rumor and sell on the

Generally, the vast majority of corporations tell the truth,

It is in the inaccurate process of looking forward that

Investing Rule #7: Do not buy story stocks.

Because investors have to be forward thinking and they

Buy Stocks with Growth and Value

P/Es and EYs

Buying Rule #1: Buy relatively low P/E stocks.

to start. Many investors use the current 10-year corporate

Buying Rule #2: Buy stocks with an EY of