Then, I get hit with the request for affirmation-the old, XYZ company is pretty beat up. What do you think? Most recently, the request has been about General Motors and Ford. Before that, Bank of America, AIG, and Fannie/Freddie.

Why do I call this a “request for affirmation”? Most of the time, the people asking have been decimated in the markets and are feeling the need or desire to make it back quick. They want to take a gamble on a beat down company, not because the business is sound, but because what was a $20 or $50 or $80 stock is now a $2 or $3 stock.

So…coming back from a long (and long overdue) break, let’s get back to the basics. And to do that, we’ll pick on General Motors again.

SOME STOCKS ARE CHEAP RIGHT NOW; SOME ARE NOT

At any given time, in any given market environment, the enterprising investor can usually find a bargain. Though stocks in the aggregate move with the markets (because they are the markets), individual stocks move independent of the markets.

The markets are a force on all stocks. When the markets are down 30%, 40%, or more, long-term upward movements in a stock price are usually held back, not reaching their full potential in the down market. When the markets are flying high, overpriced, mediocre, and bad companies can fly high with them.

We’ve seen a few examples of this over the past seventeen months. One that is in the news and on peoples’ lips is General Motors-a company we’ve discussed here a few times in the past. Here’s the chart since F Wall Street started on June 25, 2007:

On the next chart, I’ve highlighted in green the times and prices where I felt GM was a bad business and not worth owning:

IS GENERAL MOTORS CHEAP?

General Motors is down; but, down and cheap are two different things. Over the past forty seven years-a sufficient time to judge investment results-General Motors has returned roughly 1.8% a year to investors. Now, you may think that judging performance at today’s prices is unfair; so, assuming GM was $15 a share, it would have returned 4.4% a year to investors over the past forty seven years.

During that time, General Motors had a CROIC of roughly 4% or so; thus, investors purchasing General Motors at fair prices over the past forty seven years should not have expected much more than a 4% or so return during that time.

So, is it cheap? I can’t tell you that-there is too much uncertainty. If they receive and continue to receive gobs of money from the government and ultimately survive this mess, it won’t change the fact that GM-and pretty much any auto maker-is a mediocre or bad business (from a capitalist perspective).

Now, the question…

DO YOU THINK IT’S CHEAP?

Long-time readers know that I shied away from financials for a long-time, even though there is blood in the streets. Why? They are outside my sphere of confidence and competence. Sure, I’ll miss some high fliers when the economy is better three…five…ten years from now; but, I don’t have to be in those high fliers. There will always be blood in the streets somewhere.

General Motors at $4 a share. Cheap? Ugly? Don’t buy it just because it’s down. Don’t buy it just because Wall Street is talking about how “cheap” the price is. (The table below shows how “wise” Wall Street has been on General Motors for the past two years or so.)

Rip open the annual and quarterly reports, and decide for yourself. Looking at the latest quarterly report, I immediately realized that, if GM were to ever make it out of my “No” pile, it would have to go in my “Too Hard” pile.

We know GM is in a liquidity crisis-a major liquidity crisis. Here’s their plan for solving it:

We will continue to identify and develop additional sources of liquidity, including a broad global assessment of our assets for potential sale or monetization. We believe that we can raise significant liquidity from asset sales without negatively affecting our strategic direction. In addition to asset sales, we will also continue to access global capital markets on an opportunistic basis when the global capital markets are available to access on terms which are acceptable.

Be wary of the managers that tell you that they can sell a significant portion of the company’s assets without negatively affecting the business. I don’t know what GM’s “strategic direction” is; but, without assets, I know in what direction it is headed.

If the company has to rely on stock and bond offerings to keep afloat, look out. (That’s the “we will also continue to access global capital markets” line.) Just ask the folks over at Amylin.

What are the odds that GM will get any money other than government money? Slim to none, short of a complete takeover. So, a little more thought has to go into this.

GM’S “OUTS”

In poker, an “out” is a card or series of cards that will give you a winning hand when you are behind. I think GM’s outs are long-shots at best:

1. Operate under bankruptcy protection.
2. Go belly up and liquidate.
3. Be taken over.
4. Get a life-line from the government and/or some big investor(s) and fix its problems.

The problem with bankruptcy protection (among others) is that it shafts its suppliers and all but forces the other auto makers into bankruptcy protection to be able to compete. Then again, the odds are stacked against GM to compete under bankruptcy protection because it still faces fierce oversees competition in a lowest-price-wins product war for business from customers that, in the aggregate, have little to no brand loyalty.

We’ll assume that “belly up and liquidate” is not an option. It may be the only course; but, this would automatically disqualify GM as an investment at today’s prices.

General Motors can be taken over by a competitor. But who? US auto makers don’t have the means to do so, and foreign auto makers are snatching market share and building and selling vehicles for cheaper. Thus, a GM acquisition would be entirely lopsided in favor of GM, and no intelligent company would make that deal. (I liken it to Bank of America’s acquisition of Countrywide. It was entirely lopsided in favor of Countrywide. What the hell was BoA thinking?! A complete waste of shareholder money!)

GM NEEDS A PLAN

So, GM needs a plan to cut expenses and increase liquidity. By now, you probably heard about the private plan debacle at the Washington hearings. Management seems to be more concerned with squeezing the last nickel out of GM than with making the painful sacrifices necessary to turn the company around.

What should be in the GM plan? Once management is dumped, the next step is to take care of excessive expenses. Then, the company needs to shed some inventory. Inventories have been on the rise which means that the company has been burning through cash to build inventories that nobody is buying.

How do you shed inventory? First, GM needs to slow production. Then, they need to firesale the rest before it is firesold in bankruptcy proceedings. How do you firesale inventory? 50% off.

GM has $11.9 billion of “Finished product, including service parts.” Sell it. Sell it all, at 50% off. “Oh, but we don’t want to take a loss!” Wrong-you have already taken the loss and you continue to take the loss. An inventory firesale serves a number of purposes:

1. It raises up to $6 billion in cash;
2. It reduces expenses associated with storage, transportation, etc.; and,
3. It is brilliant marketing.

The third point is the key. Auto commercials are ineffective and expensive. Thus…pointless, but necessary. A better way to market your product is to put every Tom, Dick, and Jane into a Chevy, Buick, Cadillac, HUMMER, whatever. Everyone is driving them; so, everyone sees them all the time.

And, it forces a greater need for your products. GM makes parts. When you have the lion’s share of the market because you gave your cars away, you create massive demand for your parts and service.

BUT…IT’S TOO HARD

I could go on for hours; but, it all adds up to one thing: GM has very severe problems. I think that they are fixable; but, you need the right management. And GM does not have the right management for the job.

GM is down. It may even be cheap. But, the best I could hope for (note the key word-hope) is to pick up a mediocre business. Hardly a smart move when, in this sort of market, there are so many highly predictable businesses at or near attractive prices.

So, I’ll move on.

But not today – it’s Thanksgiving here in the US. Happy Thanksgiving all!

American Eagle Outfitters’ financials are getting hit on a number of fronts. The consumer has slowed down. Commodity prices are up, leading to higher inventory costs and lower profit margins. Transportation costs are up which is putting additional pressure on the business. Compared to the previous year’s Q1, net income is down 44%. The only real ray of hope in all of this is that AEO was able to get most of its $500 million in ARS securities liquid again.

Beware of Slim Margin/Poor Turnover Businesses

If you recall from Phil Fisher on Profit Margins, businesses with slim profit margins will generally fare worse than fat margin businesses during periods of business slowdowns:

If your company doesn’t have a “worthwhile” profit margin, it has a problem: When tough times surface (as they always do from time to time), weak margin companies will probably start burning cash rather than generating it.

And as Pakorn Wong pointed out, turnover is just as important as profit margins. An annual profit margin of 10% with 100% inventory turnover is the same as an annual profit margin of 2.5% with 400% inventory turnover.

In the first fiscal quarter of last year, AEO boasted a GAAP profit margin of 13%. This year, the profit margin slipped to 7%. So, slower sales and higher costs are hurting AEO’s margins.

Is There Anything Good About American Eagle?

I have to say that, in my opinion, management is handling this downturn well…if not brilliantly. During the first quarter this year, AEO had an inventory turnover of 143%, compared to 114% during the same period last year and an average of 135% during the first quarter of the previous two years.

What does that mean? It means that, while foot traffic in the stores is down, American Eagle Outfitters is selling stuff faster than it did at this time last year or in the two years prior.

Let’s look at the cash burn. Being a clothing retailer, American Eagle Outfitters generates the lion’s share of its revenues – and thus, excess cash – during the holiday seasons. In the first quarter of last year, AEO burned through $90 million of cash (excluding capital expenditures). This year, on lowered sales and higher costs, operations ate up just $65 million of cash in the first quarter. For all intents and purposes, AEO had a better quarter, in terms of its ability to generate cash, this past quarter than it did at the beginning of last fiscal year.

With 208.1 million shares outstanding, American Eagle Outfitters has 8% fewer shares outstanding than it did this time a year ago which means our stake in the company – our share of future cash flows – grew by 8% over this past year.

At the mercy of “The Consumer.” Is that bad?

Some people believe that the consumer is dead in the water. So overwhelmed with credit card debt, inflated mortgages, high food and fuel costs, and more, consumers have allegedly stopped spending money on everything discretionary.

Why, then, did McDonalds report increased sales in the three- and six-months leading up to June 30, 2008, when compared to the previous year? I’m not talking about international sales or currency adjustments: US-based revenues for McDonalds grew 2% this past quarter versus the same quarter last year when cash was allegedly falling from the skies.

If McDonalds isn’t the mother of all discretionary spending, I don’t know what is.

I’m not saying that the consumer isn’t strapped. What I am saying is that we, as Americans, have proven one thing over the past twenty or so years: No matter how bad things seem, we won’t take care of our finances and we’ll blow money on stupid stuff. We’ll buy second-rate cheeseburgers even though we can make them better at home. We’ll go to Starbucks, opting to spend $3.50 on coffee each morning instead of stopping in to Walmart to buy a $16.88 Mr. Coffee for the office.

I’m not criticizing. In fact, I’m just as guilty. This past weekend, I bought the entire bar a round of DiSaronno on the rocks because my friends and I were laughing about the commercial. A total waste of money, even if it got a few laughs.

My point is this: For as bad as the news and media make it sound, the consumer – feeling the effects of the credit crunch – is not clamping down to the bare essentials, clothing, coffee, and cheeseburgers be damned. Some people – moreso than in the past – are clamping down. Some had spent their stimulus check before it ever arrived.

Making a Decision on American Eagle

AEO is going through a rough patch right now, but it is not entirely consumer-driven. The company is facing higher costs as it works on launching its new baby stores. Higher transportation and commodities (thus inventory) costs are eating away at profit margins. But the company still reported a 5% increase in sales this past quarter over last year’s first quarter.

The business has taken a turn for the worse, but not because of mismanagement or a faltering brand. It is taking an economic beating internally – a beating that may continue for some time.

So, we institute Phil Fisher’s three year rule and wait it out. Because it is a cyclical business, we can’t possibly judge the value of American Eagle until we get through another full cycle this year. Remember: Regardless of what the stock price does, businesses generally don’t change all that fast.

When Uncertainty Turns to Panic

Do I think American Eagle is underpriced relative to its value? Yes. I’m just not sure how much of that pricing is because it is “down” and how much is because it is “cheap.” That is, I don’t know what my margin of safety is. At some point, a stock becomes cheap enough that your heart races and you can barely sleep because you can’t wait to place your order when the markets to open the next day.

American Eagle is not there (for me) at this point, but it is getting awfully close. At some price level, you can look at it and say, “Yep. There’s a fat guy.”

When will I start worrying that consumers – as a group – are going to clamp down to the bare necessities? They may bail on their mortgages. They may ignore calls from creditors. But until they “just say no” to iPhones, Happy Meals, or Coach purses, I’ll keep buying rounds of DiSaronno and looking for blood in the streets – even in the retailers.

Don’t be an optimist. Don’t be a pessimist. The best returns are made by realists.

[W]hile I realized thoroughly that if I were to make the kinds of profits that are made possible by the process that I have described as zigging when the rest zags, it was vital that I have some sort of quantitative check to be sure that I was right in zigging. With this in mind, I established what I called my three-year rule. – Philip Fisher, Common Stocks and Uncommon Profits

If you haven’t read – that is, memorized – Common Stocks and Uncommon Profits, do it now (it’s just $13). When Buffett says, “I am an eager reader of whatever Phil has to say,” it would behoove us to be avid readers as well. I’m going to spend the next few weeks on Fisher, covering topics from analyzing management to investor psychology; still, I suggest you pick it up and dive in for yourself.

I have repeated again and again to my clients that when I purchase something for them, not to judge the results in a matter of a month or a year, but to allow me a three-year period. pages 244-245

Holding On For Three Long Years

We all know that intelligent investing requires patience and discipline; still, it is easy to forget how long “three years” really is. Let’s put this into perspective:

• I feel like I’ve been writing forever. With its first article appearing on June 25, 2007, F Wall Street is not even a year old.
• Don Imus? Old news. Well, not that old. He was fired on April 12, 2007 – just over a year ago.
• Google and YouTube have been together forever, right? Wrong. October 10, 2006 – Google buys YouTube for $1.65 billion. Twenty months ago.

It feels like these things happened a lifetime ago. In reality, you should be ignoring the performance of the stocks you purchased recently and over the past thirty months. Instead, take a look at the ones you bought when Michael Jackson was acquitted in June of 2005, or when Grand Theft Auto San Andreas was released that same month. Take a look at the performance of the ones you purchased as Lance Armstrong was the first to cross the finish line of the Tour De France, for his seventh time, in July of 2005.

Whether I have been successful in the first year or unsuccessful can be as much a matter of luck as anything else. In my management of individual stocks over all these years I have followed the same rule, only once having made an exception. page 245

Price Follows Value, But How Quickly?

Why would Fisher create a “three-year rule” for holding stocks? Though he doesn’t outright say so, Fisher noted that, on average, it takes up to three years for the markets to turn from pessimistic (or ignorant) on a company to rational or optimistic. This, of course, begs the question, “How many times did he sell prematurely, only to find that the stock prices soared after his sale?”

Actually, there have only been a relatively small number of times when I have made a sale triggered by this three-year rule and nothing else…However, in those relatively few cases where it was the three-year rule and only that which caused me to sell, I cannot recall a single case where subsequent market action caused me to wish I had held on to the shares. page 247

Violating The Three-Year Rule

When should you violate the three-year rule? Buffett has said that his ideal holding period is “forever.” Fisher says three years. Does Buffett violate the three-year rule? I don’t think so.

There are three main components to Buffett’s portfolio: Workouts, Generals, and Controls. His portfolio was constructed that way in the early partnerships, and it remains this way today. His arbitrage strategies fall under the Workouts category; Controls are the businesses that Berkshire owns outright, or that it owns as permanent positions (eg. though Berkshire owns 8.6% of Coca-Cola, it can be said that Buffett is in a controlling position of this company that he has declared a permanent position); Generals are stocks Buffett purchases that he subsequently sells.

For example, in April of 2004 Buffett began buying Comcast. Over the next three years, he added to his position, bringing his total ownership to twelve million shares. During that time, Comcast’s business has continued to grow, though the stock price has gone nowhere. Every quarter and each year, Buffett will look at Comcast and ask himself one simple question: Will this company be worth more in five years than it is today?

Why would Buffett violate the three-year rule? He wouldn’t. Fisher does not advocate selling “no matter what” after three years. Instead, Fisher teaches that we need to give our companies three years to achieve what we believe they should. If, after three years, the company has failed to meet or exceed our expectations, then we should sell, even at a loss.

Otherwise, the intelligent investor would be wise to reevaluate his/her companies each quarter and year, and ask the question: Is this company striving to meet my expectations? If so, can I adjust my expectations higher and reset the three-year clock? If not, perhaps the company needs more time, but not more than three years from my original purchase.

Some Guidelines To Selling

I figured it was best to start Fisher with a “When To Sell” discussion simply because of recent market activity. As the markets drop, it’s easy to lose focus on the long-term (now we know that means “three-year”) picture and fixate on daily price movements.

Building on a post I wrote on April 17, 2008 – The Art of Selling Your Stocks – let’s lay down some further guidelines to selling:

1. Sell when the company is no longer attractive from a business perspective; or,
2. Sell when you are no longer comfortable with your valuation versus the price, either because the price has increased, the value has decreased, or the valuation has become murky; or,
3. Sell when a “no-brainer” turns into a “I’m not sure anymore”; or,
4. Sell after three years, unless you believe the company is still underpriced and has wonderful future prospects, after a thorough analysis.

#1: Business Perspective

When the company is not longer attractive from a business perspective, get out. This could be because new management is padding salaries, or the company isn’t willing to change with the times. In essence, it is a fundamental change in the business, turning a good or great company into a mediocre or bad one, not because the company (and its industry) fell on hard times, but because the nature or direction of the company has changed for the worse.

#2 and #3: Price and Valuation

I talked about two recent positions that I sold where two and three came into play. With Graham Corporation, I sold because I was not entirely comfortable with the valuation (#2), because the company was changing rapidly. I felt it was underpriced, but I wasn’t sure how underpriced it was. With the Nutrisystem bonehead move, I was somewhat comfortable with the valuation of mid- to high-$30s. At $19 a share, I wasn’t excited to buy. At $13 a share, it was a no-brainer. Once it ran up again to that “I’m not excited” price, a sale would have been in order.

#4: The Three-Year Rule

Practice your assiduity. Check in on your companies to see that they are working towards meeting your expectations, even if the price and short-term financial statements suffer somewhat. Give them time. Give them at least three years. If, after three years, management can’t get the company together, sell and move on to another opportunity.

So, if you buy stock today, check the quarterly and annual reports, and be prepared to act quickly. You’ll want to sell in June of 2011 if things aren’t working out. Until then, close your browser and enjoy life a little.

When it comes to business and investing, it doesn’t pay to be an optimist or a pessimist; the big money is made by realists. If you can take all of the emotion – yours and that of others – out of your investing, you can begin to more clearly predict the future with a degree of confidence and competence. Forget tomorrow. There is no tomorrow.

Here’s your crystal ball question.

What Will Happen Five Years From Now?

If you can answer that question with a fair degree of certainty, you will make very satisfactory returns over your lifetime. It is a question that great value investors like Buffett are able to answer with confidence, which is precisely why they can earn high returns and ignore short-term volatility, all while sleeping peacefully at night.

If you know what is going to happen five years from now, you needn’t care less what will happen tomorrow.

The Price of Gas, Gold, and More…Five Years From Now

The truth is that I have no idea where gold, gas prices, or interest rates will be in five years. Because of that, I have absolutely no business investing in gold, buying or shorting oil, or betting on or hedging against interest rates. On one side of the argument are oil bulls screaming that US gas prices are headed to $10 a gallon; on the other side, oil bears are calling a top. They both use statistics and compelling arguments to make their points.

I don’t understand it; so, I have to stay away. I trust Homer Simpson on this one:

Oh, people can come up with statistics to prove anything, Kent. 14% of people know that.

Your Business in Five Years

When you look at a company – any company – you need to first ask yourself, “Where will this company be in five years, regardless of where it has been or where it is now?” Whether or not your business is growing is inconsequential (though admittedly, I prefer growing businesses). It’s pretty easy to say that Coca-Cola will be here in five years. Then again, everyone knows that, which is why you will rarely find opportunities for growth in Coca-Cola’s stock.

Where you do make money is when you buy companies that Wall Street is unsure on for whatever reason. Peter Lynch does a great job explaining why Wall Street doesn’t look at these companies in his book One Up On Wall Street; so, I won’t rehash what he already said. Instead, let’s look at the Wall Street mentality versus that of the intelligent individual investor.

The Small Company

Many investors, and particularly Wall Street and mutual funds, find comfort in “big” companies – companies with a market capitalization over, say, $1 billion or $5 billion (or even $10 billion). And for a seemingly good reason – stock prices of small companies are often much more volatile. Then again, if you know that price is a tool, not a guide, and that price follows value over the long term, why would you ever equate volatility with risk? Is a business “riskier” because speculators are trying to profit on price movements?

In the early 1970s, Wal-Mart was a small company with a small, or even nonexistent, moat. By 1974, it had just 78 stores open, a number that would grow to 276 five years later. A great growth story? Yes. But most people never looked at the stock, which is why early investors that rode the volatile, value investing wave made immense profits.

How small and “scary” was Wal-Mart? It wasn’t until early 1981 that Wal-Mart became a billion dollar company on Wall Street. The graph below shows the daily market capitalization for Wal-Mart from August 1972 to August 1974 – a $60 million to $260 million company. Was it a crazy ride? You bet. Buying Wal-Mart on August 25, 1972 would have seemed like a disaster six months later when your investment was down 30%. By July of 1973, you would have been down more than 50%. Ouch.

The 77% Loss

It’s now December of 1974. You’re down 77% on your Wal-Mart investment, insisting that the company is much more valuable than the current price. Wal-Mart trades as low as $56.9 million of market capitalization. It’s small…real small. Still, you content that Wal-Mart will be more valuable in five years than it is today. It’s a tough pill to swallow; still, that’s the markets for you.

Five Years Later…

August 25, 1977. You’re sweating bullets. You still contend that Wal-Mart will be more valuable in five years than it is today, but you’re finally “even” on your investment. You remember the pain of being down 77% – of almost losing everything. Can you go through it again if the markets don’t reward you soon? Your portfolio is right back where it started; you’ve lost five years.

The company is definitely growing. When the hell will the stock price follow?

Another Five Years Pass…

August 25, 1982. Wow. What was a tiny, growing company just a few years earlier is becoming one of the greatest American growth stories of all time. Wal-Mart is trading at $2 billion, and you have hit pay dirt. A 23% average annual return – your $10,000 investment is now worth $77,500. Had you continued to add to your position in the mid-1970s, when this valuable business was trading for $60 million, you would have had even more astronomical returns.

Still, you think Wal-Mart is even more valuable; so, you hold.

Another Five Years Pass…

Wal-Mart is trading at $20 billion, and your $10,000 investment is now worth $830,000 – the result of earning 34% for fifteen years. Not too shabby.

I’ll Spare You The Rest

We all know the Wal-Mart growth story. Now a $220 billion business, Wal-Mart was once a $60 million company – trading well below the radar of anyone on Wall Street. It had a small, hidden moat in its pricing, but Wall Street was convinced it would easily be crushed by its larger competitors. From its August 25, 1972 open – trading at just $250 million – a $10,000 investment would have growth to $8.7 million, excluding any dividends you would have earned (and assuming you didn’t sell when it became fairly priced in the early part of this decade).

It All Comes Down To The First Question

Where will this company be in five years? It’s very easy to look back in time and say, “Sure. I would have held on and enjoyed my 21% average annual return.” Easier said than done. Can you stare at a 50% or 77% loss in the face and comfortably and confidently say, “I’m right”? Knowing that price is a tool, not a guide, can you answer the question and then wait five or ten years to be proven right?

Peter Lynch talked about “ten baggers” – stocks that would increase tenfold, the holy grail of investing. Don’t expect to find ten baggers in $20 billion stocks. Sure Wal-Mart grew from a $22 billion to $220 billion market cap, but it took eighteen years to do so, providing investors with a 13% average annual return during that time (excluding dividends). In the eighteen years prior to that, from August 1972 to March of 1990, Wal-Mart grew from $255 million to $22 billion – an eighty eight bagger – returning 29% a year to investors, excluding dividends.

Had you continued to increase your position during the “bad” years (that is, when Wall Street was offering an even better price), your returns would have been as high as 48% a year for nearly two decades. (From 12/1974 to 3/1990, Wal-Mart was a “398 bagger”)

Don’t Fear The Small Companies. Embrace Them.

Buffett once said he could “guarantee” 50% annual returns if he were working with smaller sums of money – say, $1 million. How would he do it? He told Shai Dardashti in a letter that he’d invest in small companies at extremely deep discounts.

If you can say with confidence where your business will be in five years, who cares if it’s selling for $60 billion or $60 million? So long as you purchase at a discount and its “business as usual”, you can make money in the long-term. Just remember: Until the company hits Wall Street’s radar and gets picked up by analysts and institutions, you’re likely headed for a bumpy ride in very small companies. So long as you predict the future with a degree of accuracy and confidence, you’ll make some very satisfactory returns.

Focus on the five-year picture. Only then can you truly ignore the volatility.

For more on why Wall Street had to ignore Wal-Mart in the 1970s, take a look at Peter Lynch’s One Up On Wall Street.

This is a prime example of why you should use price as a tool, not a guide.

In the eleven trading days since I wrote that story, the price of RTSX has fluctuated wildly – from as high as $30.02 on the 22nd to as low as $26.58 a week later. This 11% drop shook holders and many people began second-guessing their positions. To truly understand this psychology, one need not look much further than the Yahoo! Finance message boards for RTSX. Some visitors were steadfast; some were terrified because the price was moving for no “apparent” reason.

In reading the merger agreements and SEC filings, we found that management controlled more than 40% of the outstanding shares (and had committed to voting in favor of the transaction), that financing was all but guaranteed, and that little stood in the way of this transaction, save the customary class action lawsuits and final shareholder approval.

At today’s special meeting to approve or dismiss the transaction, 99.7% of the outstanding shares voted in favor of the merger, and it is now expected to close on February 21, 2008. Of course, that sort of super-majority wasn’t required; we needed just 10% of the outstanding votes to agree with management’s 40+% affirmative vote.

Today’s Price and Tomorrow’s Expectations

The above announcement was made at 5:55pm EST, nearly two hours after RTSX closed today around $28. It will likely open and trade close to $32.50 until the close on the 21st, and the premium will probably remain gone throughout (though I’ll be watching it to double-dip).

Use Price as a Tool, Not a Guide

What happened when the price kept dropping? I bought more, even buying some shares on margin. Why? Simple – I used price as a tool to profit, not as a guide to influence my decisions. Regardless of whether RTSX was trading at $30 or $25 this morning, the terms of the deal were the same, and were contingent on a small number of shareholders voting for the transaction.

What happened to the price of RTSX over the past two weeks as this shareholder meeting approached? A slew of people (and likely a number of hedge funds) used price as a guide and began panicking when the price dropped. The more RTSX fell, the more they panicked. It happens all the time.

You must use price as a tool, not a guide, in your investment decisions. In this case, there was no insider selling, no hints of a failing deal, and no news or reason to believe that anything was wrong with the transaction. Instead, sellers lost money and/or opportunity because other investors were panicking. They traded on noise and emotion, not news.

On a short-term basis, emotion and noise drive the markets. On a long-term basis, enterprising, non-conventionalist investors stand to profit greatly from this inefficiency.

Efficient Market people: If all information is immediately priced into every security, how do you explain when no information and 100% emotion is priced into a security like RTSX?

It Ain’t Always Money In The Bank

Why do we engage in workouts? Because it beats the pants off of leaving idle cash in a money market and it helps smooth out down markets. Lest you think every old workout deal is money in the bank, let me assure you that they are not always so – and they require some in-depth research and monitoring (though not necessarily a ton; if it doesn’t jump out at you, pass).

Once you’ve analyzed the deal, considered the possible risks, and determined the attractiveness and relative safety of a particular workout, you need to check in on it every day until the deal is done. I’m not talking about sweating over the price; you need to stay on top of the SEC filings to see if anyone close to the deal is selling (or buying). You have to be prepared to react, and even take the occasional (perhaps substantial) loss, if the deal is falling apart; you must be able to hold strong when there is nothing but price movement. Finally, you must remember that thousands of investors full of emotion – both fear and greed – are trying to make more and lose less than you and that you can not let these speculators influence your decisions.

Time Spent vs. Reward of Transaction

In the end, I spent about an hour or so ripping apart the RTSX deal. (Of course, I’ve analyzed thousands of these deals so I knew what to look for and what to avoid.) Once I invested, I’d be shocked if I spent more than 2 minutes a day looking at the EDGAR filings, press releases (or lack thereof), and price. In total, less than an hour and a half were spent on finding, understanding, and staying on top of this workout. The net result should be about a 24% gain in four weeks, keeping in mind a few things:

1. this return depends on whether or not I hold until the end (depending on how quickly the premium dries up over the next few days); and,
2. I used margin to double my position when the premium widened with no news or signs of trouble; and,
3. nothing upsets the applecart while I still hold my position.

You Don’t Need a Ton of Ideas!

Buffett has been known for saying he just needs one or two great ideas a year. You are no different (except that smaller investors can find many more; Buffett couldn’t put any real money to work in RTSX). If you could find one practically-cash-in-the-bank workout every two or three months, and earn just 10% on each (assuming you don’t use margin), you are looking at a 32% annual return after paying 30% in taxes (46% if done in a tax-free account).

Don’t salivate just yet; you will get caught with your hand in the cookie jar from time to time! Still, your results can be quite satisfactory.

And the question naturally follows, “How much of my portfolio should I allocate to workouts?” On Friday, we’ll take a look at asset allocation for conservative, non-conventionalist investors.

The Market and The Looming Recession

To help delay or stop the looming recession, the Fed cut interest rates by 75 basis points. What does this mean for silent partners/business owners? Not a whole lot. Mr. Buffett on this year’s stock market, economy, interest rates, and the upcoming election:

Stop trying to predict the direction of the stock market, the economy, interest rates, or elections.

The hardest part about watching the markets crash is, well, watching the markets crash. We will see the markets up 20% or down 20% (or more) in future years; still, great businesses will grow and their stock prices will follow. The solution? Stop watching the markets!

I’ll admit – it’s easier said than done. And yet, for decades leading up to the 1990s, that is exactly how regular people had to invest. Quotes were only available the next day, in the newspaper. To invest in the stock market, you had to buy great companies at great prices and then let time do its thing.

Yesterday morning, I work up to an e-mail sitting in my inbox that read:

Tomorrow (or I guess it’s today) is going to be a blood bath for U.S. markets. Right now, U.S. futures are posting steepest decline since 2001. I’m predicting the DJIA to be down 500 tomorrow. People are already calling tomorrow “Black Tuesday.” It’s going to be bad.

Watching CNBC in the morning, you would have thought the world was coming to an end. And what did I think? In fact, what was my exact response to that e-mail? (Word for word):

I know. I have been excited all morning. Businesses are going on sale today!

The Lesson

Buffett tells us:

Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.

If, for even a second, you became “panic-stricken” yesterday and sold – or considered selling – your great, underpriced companies because of market movements, you probably shouldn’t be in the markets. Unless there was a fundamental change in your business from Friday to Tuesday, there was no real change.

The Major Drops In Prices

I don’t know what you experienced, but here is what I noticed: A lot of great, underpriced companies have not dropped nearly as much as the markets. In fact, a combination of workouts, patience, and long-term outlook have provided some very rewarding results over the past six months. (Not a good timeframe, but appropriate for this discussion).

In the past six months, I have only showcased three underpriced companies (JNJ, WMT, AEO) and one complete workout (Tribune). Hey, investing is boring.

Putting 10% of your portfolio into each position at those prices (Note: Do your own research, don’t just buy what I say, and don’t judge your portfolio on six-months results!), your portfolio would be up 4.1% since June 27, 2007 (the JNJ post and first position) versus down 10.6% for the DJIA (and likely more for those fee-heavy mutual funds).

If you can lose less in down markets, gain in sideways markets, and keep up (in whole or in part) in up markets, you’ll end up with some very satisfactory results.

What Does This All Mean?

If nothing else, it should remind you that there are always a ton of overpriced companies that, from time to time, must be corrected by moderate to severe market drops. When the value of those companies cannot support the inflated prices, prices begin to drop. Considering that great, underpriced businesses are hard to find, it is no wonder that, regardless of the markets, you often get more protection in great, underpriced businesses than great, fairly priced businesses, speculation, or any other form of “investing”.

(What are the markets but a collection of businesses? When the majority of businesses are overpriced, that pricing will correct and the markets – the collection – will fall, regardless of any individual company’s price or value.)

What Should We Be Doing Now?

Look for opportunities – workouts, great businesses, etc. I’m not going to tell you to “stay the course” because, well, there is no “course” – just opportunities. If you panic when the markets are down, regardless of the health of your businesses, consider getting out now, buying individual bonds, and never looking back.

And for goodness sake, don’t even think about selling now, just to jump back in when the markets have “rallied” to new highs. If you don’t learn from history, you are doomed to repeat it – at the ultimate expense of your goals and dreams.

The Book

Enough market talk. What’s up with the book? Thanks to my superstar agents at Jonathan Scott, I have signed on with Adams Media to publish F Wall Street. Until the actual release date is firm, I can’t say when it will be out, but we are shooting for in or before mid-2009. Rest assured, you’ll know when I know.

Comment Housekeeping

I am working my tail off to keep up with comments, but please be patient. It may take a day or two for me to respond.

The new comment system has helped kill most of the spam comments, but I fear that some comments aren’t getting through. If you post a comment, you’ll get a “submitting comment” notice while it writes to the database and sends me an e-mail. If you leave during that time, I won’t get your comment.

When submitting a comment, please wait for the confirmation to appear – which may take a few seconds or, in the case of longer comments, up to a minute.

Sorry for cutting in to the Workouts Work Out thread. I’ll finish up on Friday. And thanks for visiting!

Here we go: Great businesses will grow; bad businesses will shrink; stock prices will follow in the long-term. Of course, when I say that, people respond with things like that’s no help or obviously or the likes. We all know that…so why can’t we believe it? And more importantly, why can’t we invest accordingly?

First things first, forget the calendar year. What will make 2008 different from 2007? Or 1997? Or 1967? When it comes to the stock market, the answer is a resounding nothing! The stock market will still be a place to buy and sell businesses – overpriced and underpriced companies, good and bad businesses, large and small operations.

Where is the economy going? The election?

Are we headed for a recession? Depression? What will the election mean to our portfolios? It doesn’t matter! If you are a short-term trader, these questions require a lot of thought and strategy. If you own businesses – businesses with moats that generate a ton of cash – you don’t have to worry. We’ve lived it (some of us, at least) and our businesses have thrived.

The Cold War. The Gulf War. 9/11. The Iraq War. Federal funds rates from 1.79% in 1955 to 16.39% in 1981, back to 4.79% in 2006. 6-month CD rates from 4% to 15% back to 5% over 40 years.

You ain’t seen nothing

In the last 40 years, over a period of six months we’ve seen the Dow drop as much as 32+% (1974) and run up as much as 48+% (1975). Great – but that was 30 years ago. Right – but it was also down 29+% (2002) and up 34+% (1999).

And yet, businesses continued to grow. As Buffett says:

You go to bed feeling very comfortable just thinking about two and a half billion males with hair growing while you sleep. No one at Gillette has trouble sleeping.

Do you own businesses run by management that can’t sleep when interest rates are on the rise? Are your companies largely successful because there is a Republican President? Will the next President’s party make or break their success?

What is 2008?

And that leads to the point of this discussion: Don’t focus on the calendar. Whether it is October of 2007 or January of 2008, the people at your company will be going to work every day to try and make you money. So long as they are banging away at their keyboards, ringing up sales, mixing chemicals, etc., they are working to make you more money. Your businesses aren’t likely to explode – for better or for worse – in just a few months or quarters. It will take years, and if you buy, hold, and sell on that premise, you’ll do very well.

Forget January. Forget 2008. Forget the stock market. Buy businesses and let time reward you for your good decisions.

My AEO stock is down and the markets are tanking!

But what about American Eagle Outfitters? The stock is at $18 and change! And it may go lower – a lot lower. Is it a good business? I think so. Are people still shopping at AEO’s stores? Yep. Is management still trying to reduce expenses, grow revenues, and generate more cash? You bet. Did you buy it hoping to make a quick profit? I didn’t.

When you buy an underpriced business, it may take years for the markets to correct their mistakes. Fortune smiled on us when JNJ and Wal-Mart ran up just weeks after I showcased them. The Tribune arbitrage play was meant to be a 3-week 10% profit. The fact that Amylin is down 23% since my July 26th cautionary post is a function of mere market fluctuations.

The stock market will do a lot of crazy things. It has always been that way; it will always be that way. Had you bought AEO in September of 1994, you would have seen your position slashed by some 80% over the course of the next year and a half. And had you held? A handsome, 13-year 22% average annual return at today’s price.

The market fluctuations are gut-wrenching. That’s why you have to ignore them. If not, you’ll drive yourself nuts and start making some really terrible moves.

If it works for Warren…

Buffett has been profiting from and holding stocks through the craziest, scariest, and wildest markets for more than 40 years. Think today’s markets are bad? You ain’t seen nothing compared to what he went through.

Price follows value. Maybe not today. Maybe not in 2008. But it does.

Now, let’s make some money the intelligent way and invest like real business owners/silent partners!

As Buffett said:

You go to bed feeling very comfortable just thinking about two and a half billion males with hair growing while you sleep. No one at Gillette has trouble sleeping.

It is easy to get caught up in the stock price. We can buy a company for all the right reasons, and then begin to doubt ourselves when the price starts dropping. Did I make a mistake? What if I overvalued the company or projected too much growth? Does Wall Street know something I don’t?

There’s A Business Under There

When it comes to investing, it is critical to remember that you are buying a piece of a business. Just because you do know the daily stock price doesn’t mean you should know it?nor does it mean that the daily price is relevant.

If you bought a hot dog stand for $100,000, would you freak out every day when brokers were calling you – offering $80,000, and trying to rip you off? Would you freak out if you read an e-mail about how Americans are boycotting hot dogs? Or would you judge the health of your hot dog stand based on the number of customers coming through the door?

The above Buffett quote contains a profound message: The daily business done at your company is independent of the company’s stock price. Think about it: Did you ever pass a McDonalds last year and decide not to eat there because it was a $35 stock? Do their hamburgers taste better today at nearly $60 a share?

The Margin Of Safety Works

Why do we strive to buy $100 bills for $50? Sure, it can lead to huge profits. But there is a flip side to that coin. What if you were wrong about your valuation? What if growth won’t come in at 15% for the long term – but at a mere 7%? Enter the margin of safety.

Let’s say you estimate that your company will grow $1,000 of earnings at 15% for three years, then 12% for three years, then 10% for another four years. Finally, growth slows to 3% for the next ten. You estimate the value around $64 a share once you add in $10,000 of equity and divide by 500 outstanding shares.

Because you don’t want to overpay for this company, you won’t pay $64 a share; you wait until it is trading at $32 – a 50% margin of safety. But the future doesn’t turn out exactly how you planned. Rather than growing at a nice clip, the company grows at just 7% for the next ten years. Year 10 free cash flow comes in at a mere $1,967 vs. the $3,128 you projected. What you thought would be a $170 stock is trading at just $93 – ten years after you bought it!

Did you do the math already? Rather than bringing home an 18.8% average annual return, you eked out an 11.2% average annual return – and you are kicking yourself. Still, the margin of safety saved you. Without the 50% margin of safety, you would have had a mere 4% return after ten years had the company slowed and you bought at $64.

The Moral: Forget Today

Go back and take a look at everything that was said in this story. Notice I never once said anything about the stock price the day after, the month after, or even a year after you bought it. As a business investor, you must allow your businesses time to grow and you must allow the markets to realize their mistakes and correct them.

Let’s Return To The Legend and Coca-Cola

In the summer of 1988, Buffett began buying Coca-Cola. We don’t know the exact date, so let’s pick June 15th as the start of his buying frenzy. Over the next three months, Buffett would have seen his investment in Coca-Cola drop by nearly 8%. It would have gone south right off the bat and he would not see break-even again until early September.

And it wasn’t a smooth ride. Down 4%. Then, it threatened break-even. Back down 5%. Almost even again. Down 7%. Yep – gut wrenching. Bute he was buying a business – not a stock.

Learn To Say, “Nice!”

Every time the markets run up 200 or 300 points, people tend to get happy. The typical reaction I see: The markets are doing well, huh? Up 300 points. Nice! Here’s an exercise for you. Try to maintain that same reaction when the Dow drops 1,000 points in a week. The market’s down big. Companies may be on sale. Nice!

Even if you plan on retiring at the end of the year, you still have 20 or more years of investing in you! Don’t worry about the markets. They’ve made it through the Great Depression, two World Wars, a Cold War, numerous recessions, the Cuban Missile Crisis, and more. We’ll get through the housing bubble. And if we don’t? Then who cares what your stocks are worth? Your money won’t be worth a damn anyways!

Where would he look to do that? Pabrai claims that early, or low-asset, Buffett would look to buy $0.50 dollars and sell them when they reached 90% to 100% of their true value. He wouldn’t be a buy-and-hold investor; rather, he’d look to buy quick-hit (read: 1-3 year) investments.

And with that, let’s take an early Buffett look at Sharper Image (SHRP).

Break-Up Versus Intrinsic Value

Every company has two values-the end-operations-and-break-up value and the ongoing business (intrinsic) value. When you buy at a discount to either of those, you’ll likely come out ahead-assuming things don’t go wildly wrong at your company.

When Wall Street overreacts to bad news, companies can fall out of favor quickly. Prices can drop below intrinsic value, and continue to plummet below break-up value-and business investors can often profit quickly. Case in point: Sharper Image.

Bad News Turns Into Panic

On October 11, 2007, news hit the street that Sharper Image’s sales declined 39%. That same day, a federal judge rejected a proposed class action settlement against the company. Over the next two days, SHRP dropped 52%-from $3.70 to $1.77 a share.

High uncertainty. Big scare. Big profit potential.

Forget Intrinsic Value: Break Up The Company

Admittedly, I can’t figure out the intrinsic value of Sharper Image. I have no idea if they’ll pull out of the mess they’re in and I don’t know if it will ever generate cash again. Fortunately, I don’t have to know that. There are a million opportunities out there. Still, on such panic and selling, I had to take a look early last week.

It initially hit my radar on my stock screener as I looked for companies that were trading at 50% or less of book value. The screener is a lovely place to start looking for ideas-and Sharper Image warranted a closer look.

As I read through the recent reports and worked the numbers, I derived a rough, fire-sale break-up value for Sharper Image between $3.50 and $4.50 a share. In this game, you don’t have to be precisely right-you just need a great margin of safety to protect you when you are wrong.

The Margin Of Safety

Trading at $1.77 a share, Sharper Image was offering a 50%-75% discount from its break-up value. One could essentially buy the company for $1.77 and quickly double their money just by shutting down the doors. Or, we could buy a piece of the company and quickly double our money when Wall Street realized what a mistake it made.

And that is precisely what happened. (Click the image for a larger chart.)

Price Follows Value: Break-Up or Intrinsic

For the most part, the markets are generally efficient. When a company (e.g., Sharper Image) has such a horrendous outlook that it may not survive, Wall Street will generally price the company around its break-up value. Why? For one, Wall Street doesn’t know how else to price it.

But the markets aren’t entirely efficient, and people will buy or sell with absolutely zero information and 100% emotion-be it greed or, in the case of Sharper Image, fear.

Modern Pabrai, Early Buffett Play

In the case of Sharper Image, the goal was to buy a grossly underpriced business, and then sell it when it reached 90% or so of its scared-but-no-better-price break-up value. To make the numbers simple-buy between $1.80 and $2.25, and sell at $3.25.

With no easily calculated intrinsic value, and with a break-up value conservatively around $3.75 a share, there is no reason to hold this company for the long-term. Still, a $0.50 dollar is a $0.50 dollar, and those are always good buys.

Do that once or twice a year, and you can earn 50% or more-just like Buffett.

Side Note: Dabbling In $1.00 Stocks

Last week, I mentioned that the break-up might have been $5.60, but further research showed $3.50-$4.50. Following that post, I got an e-mail from someone saying:

You are an aggressive idiot. There is a reason it is a $2 stock-it is a bad buy!

The fact that a company is priced at $2, or $1, or $0.10 has nothing to do with whether or not it is a good or bad buy. In fact, Berkshire Hathaway can be a $1 stock. All Buffett would have to do would be to split the stock 127,000 to 1 and voila!-a $1 stock.

With 15.2 million shares out there and a break-up value of roughly $60 million, Sharper Image is worth roughly $4 a share (break-up might be slightly higher or lower, hence the price range). Don’t want it to be a $4 or $2 stock? If Sharper Image did a reverse split-say, giving shareholders one share for every ten they owned, Sharper Image would have about 1.5 million shares outstanding. The break-up value would still be $60 million-now roughly $39 a share ($60 million / 1.5 million shares).

The price of a stock is a function of the number of shares outstanding. Don’t sweat stock prices. Instead, find value and buy it when it’s on sale.

Though conventional wisdom and Wall Street say high beta means high risk, well, “F” that. High beta is your friend. Let me explain.

The Setup

Let’s assume that the stock market is going to grow at 10% for the next year. Since the stock market has a beta of 1, let’s further assume that a stock with a beta of 1.5 should grow 15% over the next year. Today that stock is trading at $20 a share; next year, it should be trading at $23.00 (up 15%).

Not a bad return at all. Assuming this was a stellar business with an intrinsic value of $20 today and growing at 15%, there wouldn’t be a whole lot of risk involved in owning the company.

Calculating Beta

What if the company missed analysts expectations by a wide margin and the stock price plummeted to $10 (before you bought)? Assuming the markets did not move much, the beta for your company would shoot through the roof. Remember: Beta is a relative measure. If your stock price goes wildly up and down while the market stays flat, beta will be larger (perhaps much larger) than 1.

Now I ask you: Is a low-risk, $20 company any riskier because it is selling for $10?

Beta In Business

Remember: You are investing as if you owned the entire company. As such, you must realize that beta means nothing. In reality, no small business owner knows the beta of his or her company. It simply doesn’t exist.

Back To The Question

Is a low-risk, $20 company any riskier because it is selling for $10? It is not a question or price volatility, but of the risk of your valuation being off. If your valuation is rational, then the $10 price tag (and higher beta) would actually pose less risk.

If your $20 company had a net tangible book value (i.e., break up value) of $10 per share, and the stock price plummeted to $5, beta would be through the roof. Would your investment be at greater risk because you are buying $10 worth of assets for $5?

You Need High Beta

You can not beat the markets owning stocks that have a beta lower than 1. Why? Well, the markets have a beta of 1. If the markets return 10% and your goal is to earn 20%, you need a high beta. You need your stocks to move faster (or more) than the markets.

Keep in mind that beta says nothing about the price paid for the stock in relation to its future cash flows or its break-up value. It simply measures the past movement of the stock price in relation to other stock prices.

Put The Past Behind You

Finally, keep in mind that beta is a measure of past price movements. A stock’s beta can change in an instant, from well below 1 to well above 1, if the price begins to rapidly move up or down.

Should you screen for high beta stocks? Maybe. If you want to invest like Pabrai-looking for low-risk, high-uncertainty companies-you can see which stocks have plummeted and begin bottom feeding. If you want to invest in low-risk, high-certainty businesses, you want to look for low-beta stocks-companies that have grown considerably but have not seen stock price appreciation.

Both present great opportunities. So, look for stocks with a beta greater than, less than, or equal to one.