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Posted 1/25/2001
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The Speculator
5 battle-tested rules for a mystifying market
In a market with operatic twists, countless critics and an audience willing to believe almost anything, we offer some time-tested truths to keep you in the front-row seats.
By Victor Niederhoffer and Laurel Kenner
Let's vary piracee with a little burglaree.
-- Gilbert and Sullivan, "The Pirates of Penzance" (1879)
Only lyricist W.S. Gilbert could have written a topsy-turvy plot rivaling the market's magical rise year to date. Gilbert's story lines were a little farfetched even for his partner, composer Arthur Sullivan, who at one point was so fed up with Gilbert's stock of devices that he refused to write the music for his latest libretto.
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"I do not like it," the disgruntled composer wrote, in a scene brought to life in the Mike Leigh film "Topsy-Turvy." "First, because it is going back to the elements of topsy-turvydom and unreality which I had hoped we had now done with. And it bears a strong resemblance to 'The Sorcerer', inasmuch as in both pieces, by means of a charm, people all fall in love with each other."
Fortunately for us, Gilbert came up with a new libretto that pleased Sullivan, not to mention generations of music lovers to come: "The Mikado."
We confess that we, like Sullivan, are tired of magic charms, whether provided by the Federal Reserve or otherwise. The levitation of individual stocks this year defies belief as much as one of those charming early Gilbert plots. We therefore have decided to write this week about some of our tested rules for making money during periods of market fluctuations.
Everywhere you look, the straws are in the wind. The attractive TV commentators are saying tech is back. Fancy restaurants are filling again, and the wait staff is nibbling at stocks after losing much money on high-flying Internet issues last year. We wouldn't be surprised before long to find a feature in the only newspaper that Vic reads, The National Enquirer, about a former welfare recipient now raking in millions by day trading, right next to the morning line on the Bill-Hill marriage, Rosie and late-breaking tests of diet techniques.
Examples of changed fortunes continued to surface after we wrote last week about how last year's beaten-down industry groups and stocks have soared this year.
The TheStreet.com Internet Index, down 74% in 2000, is up 36% this year. The picks of technology guru George Gilder, tracked by our friend Dick Sears on his noncommercial Web site Gtindex.com , lost an ignominious two-thirds of their value from March 6 through Dec. 21 last year; they have since risen 53%.
Even our own portfolios have not gone untouched. Five beaten-down stocks we recommended on Dec. 28 ("Down 78%? We call that stock a buy" ) have returned 40%. (You can view our picks on our Recommendations page.) That dwarfs the returns on the three stocks we recommended last week, which are up an average of 10%. But then again, 10% compounded per week can add up to a nice figure by the end of the year.
In yet another example, we recommended in our Oct. 12 column ("Big stocks under $5: real bargains?") a portfolio of NYSE stocks that had fallen from above $10 to below $5. They proceeded to fall 10% more through the end of the year. As of Monday's close, they were up 35% year to date.
Battle-tested truths
Nobody asked us, but most lists of rules are worthless. They contain numerous seemingly sound precepts. The problem is that when you look at them, they all sound so sensible that you can't tell the valid from the invalid. To try to avoid this problem, we have followed the example of John Caples, who revolutionized the advertising industry in the 1920s. One well-known Caples ad: "They laughed when I sat down at the piano -- but when I started to play ...!"
In his magnum opus, "Tested Advertising Methods," Caples notes that some advertisers have very well-known products yet spent comparatively little on ads. What is their secret? Testing, testing, testing. "Based on proven results, they spend the bulk of their advertising dollars on tested copy in tested media," Caples wrote.
We will attempt to follow in Caples' footsteps and will not present a rule to you, our loyal reader, unless it has been thoroughly tested. When topsy-turvy changes in grounding and reversals of fortune occurred in Vic's career in various racquets games, he would circle the wagons and try to stick with fundamental rules. That winning habit seems to be appropriate now in the market.
Rules for trading
Cycles are ever-changing . Robert Bacon, in his classic chapter "The Principle of Ever-Changing Cycles" in "Secrets of Professional Turf Betting," wrote that when a system is known only to a select few, it makes money for them. But when it becomes common knowledge among even the most ignorant players, the public's bets begin to even the odds. Eventually, the system starts to lose as the percentage of winners declines.
As Bacon put it: "Some well-to-do horsemen who sent their horses out to do their best for probable betting prices of 3-to-1 'cooled off' as the prices sank below 5-to-2. Instead of trying their hardest to win, they sent the horses out to win if they could win easily. But the boys were told not to punish the animals, told to pull them back out of the money in the stretch if they saw an easy winning was not possible."
The point to remember is that winning animals and stocks have a new path of least resistance -- and that is a reversal back along the path they have recently tramped down. After a big decline in bonds and rise in stocks, play for the opposite move. Similarly, after an industry gets killed one year, look for it to rise the next year.
Insider buying is predictive. Fifty years of academic studies show that when the last insider trade is a buy, the companies tend to perform better than the averages. And when the last insider trade is a sell, the companies tend to perform worse.
Nejat Seyhun, a professor at the University of Michigan, has done the best work on this. His book "Investor Intelligence from Insider Trading" contains a complete enumeration of all insider trades for all public companies from 1975 to 1996. His conclusion: for the 12-month period after the reporting of insiders' transactions, buys outperform the market index by 2 percentage points, while sells underperform the market index by 3.3 percentage points.
Research pays. The linchpin for starting successful new products is research. Academic studies show that companies make 40%-a-year returns on research spending. Michael Murphy, in his growth-stock newsletter, emphasizes the importance of research to sales. Many companies in the Nasdaq 100 have ratios of research to sales above 10%. That's one reason that price-earnings ratios for Nasdaq companies are not comparable at all with Dow companies, whose research-to-sales ratios are often below 1%. Why should research be deducted from earnings but not the purchase of a plant or land?
Many years ago, we developed a measure that we consider better than research to sales. It's research to price. We recently learned that others have subsequently developed such a ratio independently, tested it and concluded that companies with high R-P ratios have consistently outperformed. In a prospective test in a Nov. 28 column for worldlyinvestor.com, we recommended 11 stocks with the highest research-to-price ratios among the Nasdaq 100. The group proceeded to fall 27% through the end of the year, worse than the Nasdaq 100's 15% decline. Year to date, it's up 50%, compared with up 17% for the Nasdaq 100.
Taking a risk pays. Companies that really look bad are systematically undervalued the same way horses that have lost by more than 20 lengths are undervalued in racing. Apparently, investment managers eschew such stocks for fear that they will be ridiculed or sued.
We performed an update of our study of deficit companies, reported in our MSN MoneyCentral column of Nov. 9, "Why high P/E stocks are good for you." This time, we looked at every company in the S&P 400 over the last three years with deficits over the preceding 12-month period. We found that these companies outperformed the index in price by 6.7 percentage points in the following year. In contrast, companies that made money slightly underperformed the index.
In fact, if the loss was equal to at least 10% of the price at the end of the 12-month period, the performance was a dramatic 30-plus percentage points above the index.
Value Line is a winner. Over 37 years, the weekly Value Line Group 1 timeliness rankings have beaten the market by a wide margin. These rankings are revised every week. At our request, the firm kindly provided figures on returns that would have resulted from investing $100 in the stocks rated Group 1 at the beginning of each quarter, starting in 1983.
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Value Line's wasn't custom-trimmed in any way. In fact, it starts with a decline of 7% in the first quarter and ends with a decline of 16% in the most recent quarter.
Unfortunately, buying 100 stocks a quarter isn't practical for everybody. Fortunately, a random sample of eight to 10 stocks should yield returns quite close to the average.
We have been studying the Value Line performance and came up with the following observation. Over the last six years, the Value Line Group 1 timeliness stocks have lost money in nine of 27 quarters. In the subsequent quarter, the average performance for the new Group 1 is 16%.
Because last quarter was a losing one, as mentioned, we looked for some Group 1 stocks that are our kind of stocks -- ones that have recently registered a big decline and that also have insider buying. We found two: OMI Corp. (OMM, news, msgs) and Sicor (SCRI, news, msgs). We intend to add them to our recommended list as of Jan. 30.
Topsy-turvy market or not, clear crystal ball or no, we will return with more tested rules, hopefully "with joy unbounded, with wealth surrounded."
At the time of publication, neither Victor Niederhoffer nor Laurel Kenner owned or controlled shares in any of the stocks mentioned in this article.
MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.