the  equation;  a  simple  example  would  be  the  eggmarket. Unfortunately, this market no longer trades, but when it did theprice  of  eggs  rallied,  on  a  religious  basis  (no  pun  intended),  just  beforeEaster each year.
To  the  best  of  my  knowledge  I  was  the  ﬁrst  to  undertake  a  seriousstudy of seasonal inﬂuences on stock prices. Yale Hirsch had done a littlework on this in the 1960s, and I did an exhaustive study in the late 1970scovering  more  than  500  stocks  to  see  if  I  could  ﬁnd  times  when  somestocks have a reliable tendency to advance or decline.
The ﬁrst stock I paid a great deal of attention to was IBM. I wrote, al-most 20 years ago, “IBM is usually a buy around the last week of Octoberwith proﬁts being taken toward the latter part of January. . . . Then look
CCC-Williams 2 (67-144).qxp 4/24/03 6:55 AM Page 141
SEASONALITY AND STOCK PRICES
141
for a buy point in April and exits somewhere in the latter part of Septem-ber.”  As  Figure  9.18  shows,  the  seasonal  tendency  of  IBM  continues  tothis day.
Option writers can use this index as a general timing device of when tobe writing calls at times suggested by seasonal market highs, and writingputs at times when we usually have seasonal low points. To pinpoint theprecise time, whether you’re buying or writing calls or puts, you can alsobring into play the sentiment index so you get both in alignment. This isthe ideal strategy for an investor, whether you do an out-and-out purchaseor are fancy dancing in the option business.
Wal-Mart, the world’s leading retailer, has a strong seasonal pattern ofpresenting  a  buying  opportunity  in  February  with  most,  though  not  all,market highs coming in mid to late July (see Figure 9.19). Sometimes thislate July time marks a signiﬁcant high, or at least a stopping point whenthe stock goes into a signiﬁcant trading range with no upside progress be-ing made for investors.
Figure 9.18 IBM
CCC-Williams 2 (67-144).qxp 4/24/03 6:55 AM Page 142
142
MEASURING INVESTOR SENTIMENT FOR INDIVIDUAL STOCKS
Figure 9.19 Wal-Mart
I have worked with this index long enough to gain a great deal of re-spect for it. It could be of great value to anyone who is accumulating a po-sition in a stock. The road map is precise and clear; there are better timesthan others to purchase most issues. It would greatly behoove a fund man-ager, or you or me for that matter, to hold off purchases until the time iscorrect as evidenced by the seasonal tendency chart.
Coca-Cola has an interesting seasonal tendency that probably reﬂectssummertime sales for this beverage. As you can note from Figure 9.20, thebest buy time comes right around the last week of September or the ﬁrstweek of October. The more signiﬁcant highs have been found to occur atthe end of July, just about the time of maximum summertime sales, at leastnorth of the equator, for this company.
Even stocks where one would not expect to see a seasonal tendency doexhibit  strong  repetitive  patterns.  Figure  9.21  of  the  Boeing  Companyshows the stock usually ﬁnds a low in mid-April with a sell close to the ﬁrstweek of August.
CCC-Williams 2 (67-144).qxp 4/24/03 6:55 AM Page 143
SEASONALITY AND STOCK PRICES
143
Figure 9.20 Coca-Cola
So that you might get a better understanding of the seasonal inﬂuenceson  individual  stocks  I  have  presented  the  seasonal  tendencies  of  some  ofthe most widely followed stocks for your perusal.
There  is  real  value  to  these  charts  when  they’re  used  in  combinationwith other indicators. As an example, the ideal sentiment sell signal wouldcome  at  a  time  when  the  majority  of  investment  advisors,  75  percent  ormore, are bullish while an individual stock at that same time is at the tradi-tional  seasonal  high  point  of  the  stock.  You’re  combining  two  indicatorshere, excess of optimism in conjunction with the seasonal pattern callingfor a decline.
It is equally true for buy signals. Here we will be looking for a stockthat is in the area of the traditional seasonal low, or buying area, and hopeto  ﬁnd  the  investment  advisory  index  excessively  negative  at  this  time.When  we  do  see  75  percent  or  more  of  the  newsletters  writer  saying“Don’t buy this stock,” we want to!
CCC-Williams 2 (67-144).qxp 4/24/03 6:55 AM Page 144
144
MEASURING INVESTOR SENTIMENT FOR INDIVIDUAL STOCKS
Figure 9.21 Boeing
The sentiment index is something I have created in conjunction withGenesis  Financial  Data  Service.  It  is  available  from  Genesis  through  itsdaily update service, or you may purchase the index on individual issuesfor your own personal databases or software conﬁgurations. Genesis canbe reached at 1-800-808-3282 or at www.gfds.com. You can also obtainthe sentiment index from Commodity Quote Graphics at www.CQG.com.
CCC-Williams 3 (145-216).qxp 4/24/03 6:56 AM Page 145
10
THE INVESTMENTCHALLENGE YOU FACE
To ridicule philosophy is to philosophize.—Blaise Pascal
Most investors simply don’t have a clue as to what the parameters of thegame  really  are.  The  reason  they  come  into  the  stock  market  is  more  tomake  a  killing  than  it  is  to  develop  a  consistent  moneymaking  machine.Not knowing what to expect means you don’t have boundaries or the per-spective of what is good and what is bad.
Let me tell you how good and bad stocks have been over the long pull.From  1926  forward,  stocks  have  averaged  12.3  percent  per  year(1926–1993), while Treasury bills returned 3.74 percent per year on aver-age.  Long-term  government  bonds  yielded  5.3  percent,  and  corporatebonds netted an investor 5.9 percent.
This needs to be placed in perspective, because while all showed gains,the  clock  was  running.  As  inﬂation  has  averaged  3.2  percent  per  year,which knocks down the true rate of return. That’s how much money youlost  simply  by  holding  onto  cash.  Inﬂation  certainly  takes  its  toll.  In  thecase of the Treasury bill, investors’ net gain was 0.54 percent over that 67-year time.
The  bondholder  did  better  but  still  not  spectacularly  well,  while  thetrue rate of return for the stockholder was 9.09 percent after inﬂation. Thistells us what we should expect, on average, our investments to return. If
145
CCC-Williams 3 (145-216).qxp 4/24/03 6:56 AM Page 146
146
THE INVESTMENT CHALLENGE YOU FACE
you can do more than 9 percent per year, after inﬂation, you have beatenthe markets.
The ancillary of this is why in the world people would incur debt withinterest rates of 12 to 18 percent, a heavy tariff to pay, usually for the costof holding onto a quickly depreciating luxury. These are two-time losers,losing not only the 9 percent a year they could get from stocks, but also in-terest rate payments of 12 to 18 percent. That means the alligator is bitingthem at a 21 to 27 percent rate! Now you see why no debt or very low debtis so incredibly important to an investor.
WHAT WE NEED TO DO
An investor has yet one more way to measure his or her investment suc-cess. The common yardstick is outperforming the broad-based market av-erages over the time period, which is usually the prior 12 months.
You  would  think  this  should  not  be  so  difﬁcult,  yet  approximately80 percent of the mutual funds do not beat the averages. This is highlysigniﬁcant because if you want to outperform normal performance, theodds of success are only 2 out of 10 if you turn your money over to asupposed  expert  in  the  business.  Plus,  the  20  percent  who  outperformthe averages are not the same group every year! Only 20 percent of that20 percent show consistency in beating the Dow Jones Industrial Aver-age performance.
As I develop our master long-term strategy we will refer to this basis as
a reference point in measuring our success, or lack thereof.
IT’S ALL ABOUT VALUE
By  the  time  you  are  through  reading  this  book  you’ll  probably  be  sickand tired of hearing the word “value.” But it is the most important con-cept  an  investor  can  use  to  gain  an  advantage  in  the  game.  Understandvalue and you will outperform not only the market but the vast majorityof fund managers.
The idea of value has been around a surprisingly long time. This ap-proach to investing most likely began with an article by Robert Weiss in1930 (“Investing for True Value,” Barron’s, September 8, 1930) that cul-minated with this commentary: “The proper price of any security, whether
CCC-Williams 3 (145-216).qxp 4/24/03 6:56 AM Page 147
IT’S ALL ABOUT VALUE
147
a stock or a bond, is the sum of all the future income payments discountedat the current rate of interest in order to arrive at present value.”
Samuel Elliott Gould added to the subject matter in 1931 with his arti-cle,  “Stock  Growth  and  Discount  Tables”  (Boston  Financial  Publishing).This author deﬁned value as the average rate at which a company’s earn-ings  grow  over  time,  the  dividend  that  would  have  been  paid  over  thatsame time, the price-earnings ratio, and ﬁnally the internal rate of returnthe investor needed to achieve.
If  the  pundits  and  advisers  of  the  late  1990s  had  simply  read  andtaken to heart these writings from the 1930s they would never have put apenny  into  the  stocks  that  decimated  their  customers’  long-term  invest-ments. So to that extent there are lessons from the past that do apply toour future.
The avowed father of fundamental analysis, Benjamin Graham, madean interesting comment in 1946: “In the years to come we analysts must goto  school  to  learn  the  older  established  disciplines.”  Half  a  century  latermarket soothsayers are still trying to develop new lessons and new rules onthe  assumption  there  is  a  new  economy.  There  isn’t.  Obviously  thingschange,  and  today’s  economy  is  not  yesterday’s  economy.  But  value,  likegravity,  is  always  there  regardless  of  what  object  we  toss  up  in  the  air.Gravity doesn’t care if it is new or old; it always exerts the same force.
And so it is with value, which is why so many nonvalue investors werehurt so much, and are always hurt when markets decline. Value is the coreof all investment success, while trend is the basis of all proﬁts. Trend is adirect result of fundamental considerations—that is, value.
While  investors  are  lured  by  the  possibility  of  gargantuan  returns, it goes without saying that the greater the potential reward, the greaterthe risk.
Speculating is about maximizing your return in the shortest time. Thatis not what investing is about; investing is about consistently making morethan the guy next to you.
In my case I am more than willing to let the guy next to me make akilling every now and then because I know in the long run, since he is as-suming undue risk, those rewards will have their setbacks along the way.This  means  on  average  I  will  outperform  someone  who  does  not  have  astrategy or program to approach the markets.
One needs to ﬁnd the balance between risk and ample rewards. If yourmain  goal  in  life  is  to  escape  worry,  you  will  stay  poor.  Tranquility  has advantages,  but  it  doesn’t  bring  about  monetary  wealth.  Given  a  choice 
CCC-Williams 3 (145-216).qxp 4/24/03 6:56 AM Page 148
148
THE INVESTMENT CHALLENGE YOU FACE
between being worried and being poor, I’ll take worry every time. As Sig-mund Freud replied, when asked about how to achieve a state of balance,“And for what? Balance can only achieve the happiness of quietness.”
Risk is a funny thing in that you have absolutely no hope of becomingwealthy in the stock market without taking on risk. But this is a two-edgedsword, because that same risk can cause you to lose your wealth. Thus riskcontrol becomes our key ingredient in long-term investment success. Riskcreates and destroys wealth.
THE ONLY THREE WAYS TO CONTROL RISK
I have done a great deal of research and have concluded there are onlythree  ways  one  can  control  risk  while  still  retaining  the  potential  forgain. The three considerations, or factors, that inﬂuence our exposure torisk are:
1. The quality of the investment one makes.
2. When you decide to purchase the investment.
3. How much of your bankroll goes into that investment.
Obviously,  the  lower  quality  the  investment  is,  the  greater  your  riskwill become. Invest with low-quality people and expect low-quality results.Invest in junk and you’re going to get junk back. This chapter will be fo-cused on determining what is and what is not “junk” in the stock market.The time when you decide to make a purchase is just as important asthe  quality.  If  you  bought  Microsoft  at  the  right  time  you  would  havemade a fortune. So timing makes a difference. Never let anyone tell youotherwise.
The  problem  with  ﬁnding  quality  and  selecting  the  right  time  is  thatdoing so does have its subtle nuances. We can codify this to an extent, evendeveloping rules and strategies, yet there is part science and part art to this.In  other  words,  judgment  will  be  involved,  but  isn’t  judgment  involvedevery  day  in  our  lives  and  in  everything  that  we  do?  Of  course  it  is,  butgiven a sound foundation, your judgment will serve you better than a per-son without a good understanding of the subject matter at hand.
Finally,  the  amount  of  money  you  plunk  down  into  your  investmentdetermines your exposure to potential risk. Had you bought one share of
CCC-Williams 3 (145-216).qxp 4/24/03 6:56 AM Page 149
SEVEN TRADITIONAL MEASURES OF VALUE
149
Microsoft,  even  at  the  high,  you  may  well  have  been  able  to  endure  thepain of its decline. But had you put in your entire life savings it would be atotally  different  story.  That’s  why  the  entire  Chapter  12  is  devoted  tomoney management—so you can determine what percentage of your port-folio, or life savings, should go into any particular investment. This makescertain you control risk, that you are the driving force of risk, as opposedto risk being the driving force of your life.
All  this  is  very  good  news:  An  investor  can  control  risk.  Speculatorsand plungers seemingly seek to expand risk in hopes of higher returns, yetthe risk ultimately pulls down even their most spectacular gains.
SEVEN TRADITIONAL MEASURES OF VALUE
Analysts have conventionally used seven ways to measure the fundamentalaspect of a stock and its potential future returns
1. Price-to Earnings Ratio—The most widely known measure of valueis  the  price-to-earnings  ratio,  which  is  arrived  at  by  dividing  thecurrent price of the stock by current earnings. The higher this num-ber is, the more investors are paying for what the company is earn-ing.  A  high  P/E  number  therefore  suggests  difﬁculty  in  furtheradvance of price. Traditionally, analysts have said the lower the P/Eratio is, the more positive future market activity should be.
2. Price-to-Book Ratio—Price-to-book ratio is arrived at by dividingthe current price of your stock by the book value per share. The no-tion is that a low value would indicate an investor is paying close tothe liquidating value of the assets of the company. The lower the ra-tio is, the more bullish should be the future prospects of your stock.
3. Price-to-Cash  Flow  Ratio—The  next  common  way  of  looking  atthe value of an issue would be what is known as the price-to-cashﬂow  ratio.  This  ratio  is  obtained  by  simply  dividing  the  marketvalue of the stock by the cash ﬂow of the company. Analysts whoprefer this approach point out that earnings can be manipulated byaccounting techniques and crafty green-shaded gnomes, while it ismuch more difﬁcult to obscure total cash ﬂow. What one looks forhere is again a low value on the assumption that therefore the stockshould perform better in the future.
CCC-Williams 3 (145-216).qxp 4/24/03 6:56 AM Page 150
150
THE INVESTMENT CHALLENGE YOU FACE
4. Price-to-Sales  Ratio—A  relatively  new  innovation  in  measuringvalue has been the price-to-sales ratio. It is similar to the price-to-earnings ratio but compares the price of a stock to the total annualsales  instead  of  earnings.  High  price-to-sales  ratios  are  typicallybearish, low ones bullish.
5. Yield—Dividend yields are yet one more measure of value. Here thequestion  is  what  return  an  investor  gets  from  directly  holding  thestock.  There  is  always  the  potential  for  market  appreciation,  butwhat  about  the  dividend  the  company  pays?  The  theory  is  thathigh-dividend stocks are good values. The mere fact the companycan pay a dividend tells us it is making money and gives us the bestof both worlds, potential upside appreciation coupled with a returnon our investment.
6. Return  on  Equity—Return  on  equity  is  a  value  marker  that  hasbeen used for many years. It is arrived at by dividing the equity ofthe stock into income (after all expenses excluding dividends). Thisnumber is multiplied by 100 to place it in a percentage basis. Here,the higher the number the better.
7. Relative  Strength—The  last  measure  that  is  widely  used  by  fundsand money managers received its notoriety in the 1960s when manyanalysts said the relative price performance of an issue compared toanother  issue  had  predictive  value.  This  is  called  relative  strengthand  usually  looks  at  the  price  change  of  all  stocks  today  versuswhere  they  were  12  months  ago.  By  and  large  it  is  assumed  thatstocks with high relative strength numbers, the ones that have beengoing up, will continue going up.
Now let’s turn our attention to these values. Each has merit in helpingus select stocks that have the highest probability for upside appreciation.The more you understand these techniques, the better you should be ableto implement them in your own investment decisions.
MORE ON DETERMINING VALUE
In 1969 Paul Miller, while at Drexel & Co., did a fascinating study of theDow  Jones  Industrial  Average  stocks  by  dividing  the  index  into  two
CCC-Williams 3 (145-216).qxp 4/24/03 6:56 AM Page 151
MORE ON DETERMINING VALUE
151
groups. Miller ﬁrst took the 10 stocks in the Dow with the highest P/E ra-tios  and  studied  their  rates  of  return  from  1937  to  1969.  He  comparedthem with the 10 stocks in the Dow with the lowest P/E ratios. Finally, as abalance against all this, he looked at the total return on all 30 Dow JonesIndustrial Average stocks.
The results are actually staggering. While Miller broke the study downinto four-year increments, I’m listing here just the total results of that 32-year period. But let me point out that in each four-year increment the 10lowest P/E stocks did better than the 10 highest P/E issues or the average it-self. Talk about an advantage in the game!
Dow’s 1937–1969 Stock Performance
10 lowest P/E stocks
10 highest P/E stocks
All 30 Dow stocks
11.7%
2.3%
6.6%
If  you  have  ever  wondered  whether  quality  matters,  whether  somestocks  are  just  naturally  better  than  others,  the  preceding  list  makes  itperfectly  clear,  beyond  any  reasonable  doubt:  Stocks  with  low  price-to-earnings ratios do better than high price-to-earnings stocks. In this casethe  low  P/E  stocks  outperformed  the  high  ones  by  500  percent  and  al-most doubled the return on the average Dow stock.
Another  study,  this  one  by  David  Dreman  in  1979,  looked  at  stocksfrom 1968 to 1977 and the returns of high P/E versus low P/E stocks overtime periods of six months, one year, and three years. The basis of compar-ison was the average of all stocks, which gained 4.75 percent in the nine-year study.
His  study  revealed  the  highest  P/E  stocks,  bought  and  held  for  three
years, on average lost 1.4 percent.
The lowest P/E stocks, bought and held for three years, gained 10.89
percent.
Here’s  the  bottom-line  truth  of  investing:  Low  P/E  stocks  outper-form high P/E stocks. This has been proven—and reproven—over a widevariety of time periods, markets, and companies of all sorts of differentmakeups.  This  is  the  underlying  reality  of  the  marketplace.  It  is  how one ﬁnds value, locates quality, and eliminates, or least moderates, riskexposure.
CCC-Williams 3 (145-216).qxp 4/24/03 6:56 AM Page 152
152
THE INVESTMENT CHALLENGE YOU FACE
Additional Research
A  study  presented  by  John  Slatter  in  his  book,  Safe  Investing:  How  toMake  Money  without  Losing  Your  Shirt (Books  Britain,  1991),  assumedbuying the 10 highest-yielding Dow Jones Industrial Average stocks everyJanuary, then the following January replacing the lower-yielding ones withstocks that had higher yields than those in the original portfolio.
The results are quite impressive for this approach. Had one begun do-ing this program 30 years ago, by the time 1990 rolled around a $10,000investment  would  have  been  worth  more  than  $800,000.  Investors  whosimply  purchased  the  Dow  and  held  on  would  have  seen  their  $10,000grow  to  slightly  over  $200,000.  Get  the  message?  High-yield  stocks  out-perform the average stock by a factor of four.
Slatter also showed that during bear markets the high-yield portfoliosubstantially  outperformed  the  averages  themselves.  On  average,  Dowstocks lost 15.5 percent during bear market slides while the 10 high-yield-ing  Dow  stocks  on  average  lost  only  3.3  percent.  Talk  about  controllingrisk.  By  buying  high-yield  stocks  one  would  have  been  able  to  have  re-duced risk by a factor of ﬁve on the downside while increasing the returnby a factor of four on the upside.
Jeremy  Siegel,  writing  in  Stocks  for  the  Long  Run (McGraw-Hill,2002), presents similar data on buying the 10 Dow stocks with the highestyields versus buying the Dow Jones Industrial Average itself from 1928 to1997, and has broken the return down into various time periods.
Any  way  you  slice  it,  high-yield  stocks  outperform  the  average  itselfover a long time. The total results from 1928 to 1997 show a gain of 13.2percent for the high-yield stocks and 11.4 percent for the Dow itself (keepin mind these 10 high-yield stocks are in the total Dow performance, so ifwe took them out the 11.4 percent would be reduced substantially), whilethe S&P 500 gained 10.64 percent.
The only time the high-yield stocks did not outperform the Dow it-self was in the 1930s—the Depression. But both before and after the De-pression  the  high-yield  Dow  stocks  have  always  outperformed  theaverages. Perhaps most noteworthy is the 1973–1974 bear market dur-ing  which  the  Dow  itself  was  off  about  26  percent  and  the  S&P  500down close to 40 percent. These were proving grounds for a system orstrategy, and quality had its reward in spades. The amazing strength andwisdom of selecting quality and value were shown by the 10 high-yieldDow stocks; they posted a gain of about 3 percent. Granted, not much
CCC-Williams 3 (145-216).qxp 4/24/03 6:56 AM Page 153
MORE ON DETERMINING VALUE
153
of a gain, but compared to a loss of 30 percent, I’ll take that measly 3percent any year.
In  James  P.  O’Shaughnessy’s  book,  What  Works  on  Wall  Street(McGraw-Hill,  1998),  each  of  the  ratios  is  dissected  and  its  impact  onstocks  revealed  for  the  ﬁrst  time.  This  monumental  study  is  very  signiﬁ-cant, making for a book that is a must-have and must-read. I will summa-rize  the  results,  but  you  need  to  read  the  entire  book.  O’Shaughnessyshows the impact of these value ratings and calculates the results of thesegauges on different groups of stocks. I have chosen to show them only onlarge issues as I believe those stocks are more stable, hence offer us less riskand downside exposure.
The results reﬂect a $10,000 investment from 1951 to 1996.
Result
Annual Gain
Price-to-earnings ratio
Price-to-book ratio
Price-to-cash ﬂow
Price-to-sales ratio
High dividend yield
Return on equity
Relative strength
$3,787,460
$5,490,121
$5,773,333
$3,853,418
$2,898,099
$1,138,300
$4,429,185
14.10%
15.05%
15.18%
14.15%
13.43%
11.10%
14.50%
The ﬁrst point to make is that while there is a large difference betweenwhich technique you use and the investment results to attain, each valua-tion measure exceeded what stocks did on average during that same time.It is good news that in an absolute fashion we have found some things thathelp us beat the averages.
The  question  now  becomes,  how  can  one  best  use  these  techniques?The  O’Shaughnessy  study  went  just  a  little  bit  further  in  the  analysis  ofearnings per share that I would like to touch on. He did one study lookingat large stocks that had the biggest one-year earnings increases and notedthose stocks actually underperformed the market averages. The hypotheti-cal $10,000 grew to $1,292,138; that makes for an 11.68 percent annual-ized gain. He then looked at the same stocks but checked out the results ofthose that had the largest ﬁve-year increases in earnings per share.
This  is  what  the  long-term  buy-and-hold  crowd  thinks  works—thatthese stocks should outperform the market. O’Shaughnessy’s work suggests
CCC-Williams 3 (145-216).qxp 4/24/03 6:56 AM Page 154
154
THE INVESTMENT CHALLENGE YOU FACE
otherwise. The $10,000 investment in large stocks with the highest ﬁve-yearcompound  earnings  didn’t  do  very  well