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Investments Inc.

spacer January 2002

There is a host of methods of making money by investing. Some are rather singular: a stock is hot, running big volume, and the upward momentum looks like it has a ways to run. Buy into the strength and sell farther into the upward trajectory. The tech phenomenon was the supreme expression of this.

Alternatively, there are strategies like Dogs of the Dow where, at the end of each year, one purchases the stocks with the top 10 yields. Then, a year later, the portfolio is reshuffled to reflect the new top 10.

This is a simple methodology that makes it easy to pick and choose and requires that you make decisions only once per year. Efficiently sweet -- and a strategy that has been reasonably effective over long periods of time.

James O'Shaughnessy demonstrated in his book, What Works on Wall Street, that a multilayered approach comprising numerous dimensions is better than a method relying on one factor. This course makes palpable -- albeit obvious -- sense, as in virtually every endeavour it is best to analyze the situation from many levels, rather than one vantage point.

At Contra, this is exactly what we do, taking a bevy of parameters and methodologies and distilling them into a system of selecting prospective stocks. Naturally, as with any process, our system has its imperfections and, more often than we'd like, losers that hinder results are purchased.

Regrettably, this will always be the case. It is fascinating to note, however, that some of the best stock pickers of the ages achieved their stellar records while being correct in their choices only about 40 percent of the time. This works primarily because they let their profits run, overshadowing the losers.

Elsewhere on this site, you will find the Contra Philosophies, which remind our readers, and ourselves, of the nuts and bolts of the system. In this commentary we will review some other ingredients that make our methodology successful.

Many of our standards are nothing unusual to value investors. Ideally, we like to buy a stock for less than book value. Doing so helps to insure that we pay less than 100 cents on the dollar -- the investors' version of Boxing Week bargains.

The discounts are not always evident: in the recent technology craze, for example, many firms had vastly inflated goodwill as they overpaid drastically for some of their takeovers, thus distending the stock's true value. Accounts receivable might be a best-case fantasy, with many of the invoices unlikely ever to be paid. Analyzing the balance sheet is critical to arriving at a truer sense of book value and what is a worthy investment.

One way to determine if a company's book value is likely to increase or decrease is to get a sense of cash flow -- the money spent versus the money that comes into an organization. If cash flow is negative, especially over a long period, it suggests the organization is weak, and there is a strong likelihood that the book value will go down. Positive cash flow makes a firm far more enticing.

Studying a firm's cash flow can reveal bargains that the majority of investors will overlook. Investors often ignore money-losing firms with positive cash flow -- even as the pack focuses on the red ink, it misses the point that positive cash flow is a strong suggestion that the company's fortunes will, in all likelihood, soon be changing for the better.

Insider trading remains near the forefront of buy or sell signals. After all, who knows a firm better than those who work there? When a number of insiders purchase a stock, it is a classic indicator that the stock is undervalued.

There are a couple of caveats to bear in mind: 1) are these insiders purchasing shares in the open market or exercising options? and 2) are the purchases large enough to make a statement? A purchase of 1,000 shares of a $1.00 stock does not demonstrate the same level of support as purchasing 100,000 shares.

On the sell side, the same logic applies: when many insiders dump, it is a good bet that the stock is overvalued. Notice that, in either case, a single person buying or selling can just be random opinion; but when, say, three or more people are engaged in the same pursuit, the message becomes meaningful.

In days of yore at Contra, we would purchase firms that were in the midst of a major tumble. Too frequently, the outfits' downward spirals would persist, and after a number of failures we reckoned that catching a falling knife was beyond the capabilities of our tender limbs.

Nowadays, a delay is in effect; that is, we try to wait until the stock appears to have found a bottom, or has started to recover. Purchasing a firm that bottomed at $1.60 and currently trades at $3.00 is not so bad when it has traded at over $10 for eight of the previous 10 years, with peaks in the $30 range.

As one of our philosophies states, only stocks that have a minimum 50 percent upside are selected. Those prospects that seem poised to double, triple or quadruple in value rank even higher in our estimation.

Of course, the greater the margin of return targeted, the longer we expect to wait to achieve our goal. There is also a greater risk that the choo choo will climb partway up the mountain, then cascade downward before reaching the objective. While these factors must be considered, the larger gains are advantageous from a tax standpoint, as money is made on the principal invested plus the gain on the gain, without profits being stripped away early in tax payments.

Downside risk is something that is never far from our minds. Bad choices in the past have taught us to take the cynical, pessimistic view, and to keep in mind the importance of cash preservation. A loss of 33 percent on a stock requires a 50 percent climb to break even; a 50 percent loss requires a 100 percent gain!

That's a lot of ground to recover -- and the time lost in the process severely impinges upon results. Hey, we love the image of happy people holding hands and remaining steadfastly loyal to their investments through thick and thin, but some knowledge of ebbs and flows creates happy people holding hands longer.

Understanding a firm's business is another key. Some outfits are fairly straightforward: StrideRite manufactures and sells shoes, while The Bombay Company retails furniture. Nothing to it. But others are downright byzantine in their complexity, which is more often than not a harbinger of disaster.

Such was the case with Semi-Tech, a firm we had the misfortune to get involved with a number of years ago. Annual reports tend to reflect a company's nature, and Semi-Tech's was long and arduous, which made it hard to grasp the firm's fundamentals. Today, if an annual report strikes us as overly multifarious, our tendency is to give the stock a wide berth.

One arena in which our grip remains spotty is the interpretation of demographic trends. While in certain investments it is clear that these play a central role -- witness our purchase of Service Corp. International -- it's entirely possible that greater understanding of this realm would have a positive influence over our investments. The system's evolution continues.

Just as acquainting oneself with a methodology takes time, so does gaining an understanding of the company being pursued. One principle that we follow is to assign higher ratings to companies that we have been observing for a longer duration. On the one hand, we gain more intimacy with the enterprises; on the other, those firms that have slid down the slippery abyss and survived for an extended duration are more likely to regroup.

Other considerations are also important. We avoid stocks that are likely to undergo a share consolidation; in certain sectors, we look for high R&D expenditures; a reasonable level of ownership by management is desirable, as are the possibility of a takeover and such enterprise-specific advantages as a technological edge or an established brand name, like Coke.

We assign a certain number of points to each of these factors, and when the sum crosses a certain threshold, the firm moves to the top of our Stock Watch list. There it will undergo further, intensive scrutiny under the investment microscope, until the time is right to toss dollars in its direction.

However exact a science this appears, it ain't perfect, and those who promise guarantees of stratospheric returns are merely charlatans with a toolbox.

The inexact nature of Possibility casts the net of the game. And frankly, while it is a pursuit at which we would love everyone to profit at the end of the day, it is fun to be at the top of the heap.

The year 2001 was a fabulous one for Contra. For 2002, 2003 and 2004, however, we make no promises. Which is not meant as a cop-out, but to say that we are minding the store as best we can, in our particular way, and that we will continue to do so with our mounting, ever-evolving knowledge base.

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