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My Desert Island, All Time, Top Five

Here's a list of investing books that are not widely known but should be, and titles not considered investing books but could be

William Hester, CFA
December 2003
All rights reserved and actively enforced.

“My desert island, all-time, top five most memorable…” is how Nick Hornby's novel High Fidelity begins. It starts with a list of split-ups, but the theme carries through the entire novel; top five films, top five Elvis Costello songs, and top five episodes of Cheers. The lead character's offbeat friends test each list for its uniqueness and verbally assault any run of the mill pick.

Well, with those demands in mind, here's a list of my desert-island, all-time, top five investing books. It's a mix that falls roughly into two categories: investing books that are not widely known, but should be; and titles not considered investing books, but could be.

From the Top Down

The days of easy stock market profits are over says Tim Hayes in his The Research Driven Investor, How to Use Information, Data and Analysis for Investment Success. The best defense for investors then is to understand when the market will be favorable to them, and when it will not.

Hayes, the global equity strategist for Ned Davis Research (NDR), a firm professional investors turn to for market analysis and insight, follows the leave-no-indicator behind approach. Nearly every measure of valuation, trend analysis, sentiment and economic performance is discussed. Some indicators are well known, others NDR created.

The strength of the book, though, is when Hayes shares the finer points of using each measure. For example, investors should use the ratio of rising stocks to falling ones (known as the advance/decline line) to confirm broad moves, but watch the number of stocks reaching new highs or new lows to measure market extremes.“ Whereas A/D data indicate how many stocks have risen or fallen by any amount, new high and new low indicators are based on the number of stocks that have risen impressively or fallen severely.”

A large number of new lows are not enough to turn a market around, though. It needs to “get pointed in the right direction,” writes Hayes. Look for a large number of new weekly highs following a large number of new lows as a strong signal of a reversal.

You can't always trust conventional wisdom either, says Hayes. For example, strong earnings tend to coincide with poor market performance and weak earnings with strong market performance, showing the markets ability to look ahead.

In the last chapter Hayes discusses a nine-indicator model that has tested well. Importantly, he talks about the challenges of following a model, especially when you try to layer a forecast over it:

“The greatest danger of forecasting is that it can lock you into a mindset that can be difficult to change. The value of a good model is that it tells you about the current risk and reward, which is what affects your investment decisions. The progression of a model's messages over time enables you to scale up and scale down in your market exposure... To buy or sell based entirely on, for example, a forecast Dow Jones Industrial Average level is little different from buying a lottery ticket, except that with a forecast you're less likely to recognize the slim odds of being right.”

From the Bottom Up

If you thought corporate trickery and investor foolishness were isolated to just the bubble years, Kathryn Staley has plenty of stories to share. The Art of Short Selling, published in 1997, is a walk through the who's who list of corporate collapses of the 1980's and early 1990's.

Included are the infamous biographies of Coleco, the maker of cabbage patch dolls, the quick-oil-change franchise Jiffy Lube, and Crazy Eddie, the electronics retailer. The stages of a ‘bubble' company begin to look alike: the share price climbs magnificently based on an easy to tell, easy to sell story; cracks in the foundation begin to appear; investment banks and investors extend the company second and third chances to right the business; finally, the collapse rewards only the steeliest of short sellers (those investors who bet on declining stock prices).

Financial analysis is rarely this fun. Staley peppers the book with incredible examples of corporate malfeasance, such as Harrier, a Utah-based medical products firm, which released a cash flow statement that literally didn't add up (it was overstated by about $2 million, almost the amount of the company's total assets).

As the stories unfold, Staley shares the measures short sellers use to find candidates. Two of the most important: compare the rate of growth in inventories and account receivables to sales. These ratios can show that products are not being bought or are not being paid for, either way not a good sign.

High priced retail stocks are susceptible to even the slightest drop in their expected rate of growth. Therefore, longtime short wisdom says watch for pipeline fill at Wal-Mart, says Staley. When the giant retailer begins to carry a product, store purchases fuel growth. Once the shelves are filled, though, new sales come only from customers. That could be the peak in revenue growth.

Also, be careful betting against a company with a high return on equity (net income divided by equity on the balance sheet). These companies can often fuel growth internally. The steepest collapses in share prices occur when a business is struggling and new cash is needed for survival.

You don't have to short stocks to enjoy Staley's work. Since short sellers have so much to lose (theoretically their losses are limitless) they do some of the most extensive and thorough analysis. There's much to learn from their methods. “How to make money by shorting and how not to lose money by selling are different sides of the same coin,” says Staley.

From the Outside In

In the go-go 90's the investing battlefield shifted slightly. The buyers of stocks and bonds dropped their guard against the sellers of capital. Buyers didn't become the cheerleaders that investment bank analysts became, but they lost their skepticism and adversarial nature. What else can explain companies' ability to attain higher multiples on a progressively lower quality of earnings?

But analysts and investors must keep a skeptical nature when studying the performance of companies, say the authors of Financial Statement Analysis, A Practitioner's Guide. Analysts and executives are natural opponents. A company's top brass works for current shareholders and part of that role is to borrow cheaply. One way to do that is to construct financial statements that put a company in the best light. Of course, the responsibility to shareholders can be violated if that accounting is too aggressive or self-serving (as it can be when executive compensation is tied to the price of the stock). It is an analyst's job, then, to figure out how much the picture has been improved.

There are bigger textbooks that tackle financial statement analysis, but there may not be a better one. Martin Fridson, the former Chief High Yield Strategist at Merrill Lynch and Fernando Alvarez, a professor in NYU's Stern School of Business, mix an excellent blend of accounting fundamentals, practitioner's experience, and real life examples.

The book, now in its third edition, has an expanded section on improper revenue recognition, a corporate trend that had its own mini-boom in the late 90's. Investors who seek shelter in the ratio of price to revenue because ‘it's difficult to manipulate sales' will be surprised by the number of ways the top line can be temporarily improved.

For the alert investor, though, there are defenses.“ As a rule, distorting one section of the financial statements throws the numbers out of whack in some other section,” write the authors. Fortunately, one of the longest chapters covers the how-to of ratio analysis.

Often it's a simple cross-check or ratio that will tip you off to funny numbers. Compare earnings to cash from operations and accounts receivables to revenues, to name just two.

For companies who do more than shine the truth, and commit outright fraud, it's surprising how many of them show the classic signs right before their final downward spiral. These can include a delayed filing, a dismissal of an auditor, or a chief financial officer who decides to jump ship after only recently coming on board. If your analysis of the financial statements didn't turn anything up before one of these events, look again, just to be sure.

From Little to Big

Netflix, Inc., a web company, rents DVD's to its subscribers online and delivers the movies through the mail. About 600 thousand people were signed up for the service in May 2002, the month the company first sold shares to the public. At the end of the year the number of subscribers climbed 67 percent to 1 million and then to 1.3 million, according to it's most recent filing in September. Not wanting to get left behind, Wal-Mart rushed into the business and now has a competing service. Blockbuster said it plans to do the same.

Renting DVD's online looks like it's on the verge of wide acceptance. There may be no better study of this phenomena - when ideas or products spread wildly from a seemingly small base - then Malcolm Gladwell's, The Tipping Point, How Little Things Can Make a Big Difference.

Products and ideas spread like viruses, says Gladwell, a writer for The New Yorker. Like viruses, a contagious idea or product can spread quickly when the environment changes, even slightly. The drop in DVD player prices and consumers becoming more comfortable with online transactions are transforming the movie rental business.

Gladwell's message carries far past the retail industry. He shows how seemingly small changes in New York City police procedures cut the number of violent crimes in half during the early 1990's. And how demolishing a few old buildings in Baltimore created a tremendous outbreak of syphilis in that city.

But a large part of the book is devoted to the tipping of children's TV shows, mail order records, dress shoes, and sneakers. Gladwell analyzes each product in the light of the three functions of epidemics: the infectious agent, the people who spread them, and the environment the agent is released in.

Take Airwalk, a maker of footwear for skateboarders. In the early 1990's it was a company with a niche brand known only by the coolest kids. But a larger group of young people, who Gladwell calls the early adopters, made the sneakers their own. The environment was ripe, too, from the memorable ads the company created. The early adopters rocketed the company's products into the mass market and sales increased ten-fold. (To see how this process is applied to picking technology stocks, see Geoffrey Moore's The Gorilla Game).

The stock market is quick to find companies with products that are tipping. Netflix shares have risen 350 percent this year through the middle of December. The shares now trade at a price to sales ratio of 5.3, ten times what investor's pay for Blockbuster's revenue. Keep in mind that the market is just as quick to turn on a stock it's misjudged. Gladwell's book might help you find the story early. See Staley's The Art of Short Selling to know if you're too late.

From the Left Field

If Gladwell's book will excite fans of growth stocks, than Michael Lewis' Moneyball, The Art of Winning an Unfair Game should give some confidence to value investors. Moneyball is a look at Major League Baseball's Oakland A's, a team that over the past few years has tallied the second highest number of wins with one of the lowest payrolls.

It's a look at how outsiders – a lawyer, two Wall Street traders, and a security guard at a pork and beans shop - used a passion for baseball and some computing power to show that the traditional yardsticks to value players were flawed. And it's a story of a coach, Oakland's Billy Beane, who took this knowledge, built a team around it, and exploited the inefficiencies in the game.

The main discovery of their work is that ball player skills aren't valued correctly. Foot speed, fielding ability, and raw power tend to be dramatically overpriced. The ability of a batter to control the strike zone, best measured by on-base percentage and pitches seen per plate appearance, are undervalued.

If the efficient markets theory was applied to baseball, it'd be shattered. How often a player gets on base is a statistic that could be easily followed and properly valued. But because it isn't, inefficiencies remain.

Beane exploits these inefficiencies by buying players on the cheap, letting their market value rise with their performance, and then trading them - in an attempt to start the process all over again. With this portfolio of misunderstood players the A's have ended up one of the best teams in baseball.

Beane, who shows a range of emotions throughout the book, was clear about one feeling. “The hardest thing,” he explains “is there is a certain pride, or lack of pride, required to do this right. You take a guy high no one else likes and it makes you uncomfortable.”

Value investors understand.


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