7 posts tagged “earnings”

When we developed our investment methods, we assumed that using P/Es based on projections rather than lagging P/Es would create a significant difference in results. Over the many years that this basic portfolio modeling has been published and applied in actual market endeavors (covering a wide range of market conditions and thousands of individual stock positions), to our surprise, that the results obtained by using earnings projections in P/E calculations has not (to date) resulted in significantly better results than using lagging P/Es. In other words, although the authors use projections in their analysis, lagging P/Es so far have provided almost identical results. Whether earnings projections or lagging P/Es are utilized, taking the calculations to two decimal points is necessary to maximize the number of buy/sell points.

Since P/E is a function of price, we must consider whether price (a much easier measurement, the week's closing price) can be substituted. The answer is yes, but there will be some (to date quite minor) loss of accuracy. For example, if a stock's earnings suddenly declined dramatically and the stock's market price also declined, the decline in market price might not be directly proportional to the decline in earnings. The price would go down, but the P/E (price now divided by lower earnings) might go up because the earnings drop was proportionately greater than the price drop. Watching for changes in price, without paying attention to earnings changes as well, will prevent your gaining a refined perspective of true supply/demand.

If you choose to substitute price change for P/E change, the accuracy differential can (in most cases) be compensated for by raising the required percentage of issues that must be down or up in price to 80 percent. There will be fewer buy/sell points derived by using price rather than P/E, but (to date) the price method would have identified all major buy/sell points. Consequently, the essential elements for an indication are:

BUY: 75 percent of the P/Es or 80 percent of the prices of the stocks monitored must be down.

SELL: 75 percent of the P/Es or 80 percent of the prices of the stocks monitored must be up.

A question is now raised: Would it not be easier just to see if the market averages had gone lower and take that (or the P/E of the Dow or some other average) as an indication? The answer is no. The averages can be misleading. They can be significantly influenced by dramatic price moves in stocks and stock groups that do not warrant consideration (that is, stocks not on the Master List) as an indicator of investment. An attempt to gauge market conditions by the average of a conglomeration of unrelated stocks brings in extrinsic factors that are unpredictable. Our stock selection is designed to make the most important extrinsic factor (earnings) predictable.

To attempt to incorporate past changes in market averages as forecasting tools for future changes can be done, but it requires extensive calculations, including degree of price change in relation to volume change for each stock involved. It results in lower levels of accuracy than achieved by our technique. In our method, the design is not only to achieve superior results; it is also designed to be as simple as possible. In our method to get a signal from our primary indicator, the degree of decline (what percentage decline in P/E or price occurred) is not a necessary measurement. For example, if 80 percent of the stocks monitored declined in price only 1/8 of a point from their previous price level, the essential criterion for a buy indication would be met. The ancillary criteria are designed to filter for the magnitude of the primary criterion.

Why (for the basic portfolio modeling techniques) do we not consider it essential to wait for some upward price movement to occur to ensure that the effect of selling pressure is gone? Conversely, why not wait for some downward price movement to occur to ensure that buying demand is gone? The reasons are twofold.

First, often when price reversals occur, they are very rapid, and a significant portion (sometimes almost all) of the anticipated price change can occur before positions can be taken.

Second, the authors are in the business of stock trading on a scale that involves many millions of dollars. We are not engaged in theoretical observations that include the naive belief that infinite amounts of stock can be bought or sold at the prices quoted. Stated flatly, for us to acquire stock in large amounts at appropriate prices, it is necessary to have adequate sellers; to sell stock in large amounts at appropriate prices, it is necessary to have adequate buyers. Real people and real money are involved. Stock purchased at acceptable prices is available only when sufficient sellers at the acceptable prices are in place; which is usually as prices are declining, not after the price decline. Selling stock at acceptable prices can be accomplished only when there are adequate willing buyers, which is usually as prices are advancing, not after the advance.

The Master List, whether all the issues are being monitored or only the minimal acceptable number, forms the core of the indication. These stocks, with their relatively high degreeof earnings predictability, we use both to gauge forces within the market and to make specific investments.

In effect, we are functioning in a market within a market. We want to buy low and sell high. By confining interest to specific stock issues that have demonstrated fundamental superiority, we have chosen stocks that have an upward bias relative to the market as a whole. This bias in itself, however, is far from enough to meet our goals. We are very much interested in the relationships between demand and supply. We want to purchase when there are strong signs that selling supply might be exhausted. In other words, we want to buy soon before or in conjunction with the last period in which the sellers are dominant. Once the selling dominance has been eliminated, buyers can dominate and prices can advance. Conversely, we want to sell soon before or in conjunction with the last period in which buyers are dominant. When the buyers have exhausted their influence^, sellers can dominate and prices can decline.

The best indication of seller dominance is a downward shift in marketprice relative to earnings (the price/earnings ratio). Lower P/Es both provide stock at lower prices relative to earnings and indicate that sellers are using up their influence. Therefore:

• For a buy indication, it is essential that the P/Es of the stocks monitored are falling.
• For a sellindication, the P/E condition must be the reverse of that fora buy: It is essential that P/Es are rising to have a sell indication.

Since by the design of Drach's published Time Overlay portfolio modeling we are looking at the market weekly and comparing it to four weeks before to see the relative change, we are looking for upward or downward moves in P/E relative to the P/Es four weeks ago. The minimal acceptable level is that 75 percent of the stocks monitored have moved down or up in P/E from their level of four weeks before. If the percentage is less than 75 percent, there is no indication. To repeat:

• The essential factor for a buy indication is that 75 percent or more of the stocks monitored have declined in P/E from their level four weeks before.
• The essential factor for a sell indication is that 75 percent or more of the stocks monitored have advanced in P/E from their level four weeks before.

In the calculation of P/E ratios, both price and earnings are variables, that is, both change over time. In most financial publications, the P/Es listed are "lagging P/Es." That is, they are calculated by taking the corporation's earnings over the last four quarters (one year) and dividing the earnings into the current market price. Because earnings change and because one of the criteria for stocks to qualify for our Master List is earnings predictability, it is reasonable to assume that calculating P/Es using earnings projections covering the next four quarters (the next year) would be a more accurate gauge of the P/E shift, indicating that the stock was becoming (or is) under- or overpriced.

In Drach's publication, as well as in actual account management under the author's supervision, P/Es are calculated using earnings projections. Also note that the authors' P/E calculations are to two decimal points since this significantly expands the number of buy/sell points.

Keep in mind that our stock market participation is limited to the very select group of stocks on our Master List. In effect, we are dealing in our market within the overall market.

At any given time, each stock on the Master List will vary as to its relative over- or underpricing when compared to the others. When a buy indication occurs, we do not want to buy the entire list. We want to choose from the list the specific issues that appear to provide the highest probabilities for appreciation.

To accomplish this objective, as well as to demonstrate valid factors that can be utilized in specific stock selection, three separate methods (earnings, yield, price) are incorporated into our portfolio modeling and each method is followed in detail in the published weekly Report.

Earnings

The most fundamental value of most corporations is earnings, which can be measured relative to stock pricing by the price/earnings ratio. The higher the P/E is, the higher the relative pricing. Conversely, the lower the P/E, the lower the relative stock pricing will be.

Lagging P/E ratios (the current stock price divided by the last full year of reported earnings) are provided in the daily stock quotations published in most major newspapers.

The problems associated with using the published P/Es are twofold.

1. The earnings of most corporations are erratic and basically unpredictable. What looks like an attractive low P/E could suddenly skyrocket with lower earnings. To overcome this, one of the conditions for inclusion on the Master List is an established record of earnings predictability. Only by confining interest to stocks with demonstrated earnings predictability can the P/E selection method be viable.

2. The published P/Es are associated with past earnings and earnings change. This is why we use earnings projections that are somewhat time-consuming to generate. To repeat, although we continue to use earnings projections in our P/E selection technique, over the many years of this technique's publication there is not a significant difference in the results obtained using either lagging earnings or projections.

Having made a reasonable attempt to overcome the obstacles associated with P/E valuations, our objective during buy indications is to purchase issues that are trading at the most attractive (lower) P/Es. Each stock on our Master List has a history of P/Es; that is, the past P/Es are available, and you can see the high and low P/Es (the P/E range) that the stock has experienced. We go back seven years in determining the range.

Not all stocks or stock groups trade in the same range. Stocks that are viewed as having superior growth will trade in a higher range than those viewed as stodgy.

During a buy indication, we want to purchase issues that are trading in the lower portion of their P/E range, thereby providing higher probabilities for appreciation than those that are trading in the upper portion of their range.

In the published portfolio model concentrating on the P/E method, generally, during buy indications, a wide variety of stocks with different P/E ranges are selling at a similar low level. Since only a very limited number of stocks are selected, a mechanical technique to determine which issues are selected from among those in similar P/E ranges is employed. You simply select those with the lowest P/E, irrespective of the range. Consequently, this selection method tends to concentrate in low-P/E stocks. In addition to the selected stocks being in the lower portion of their P/E range, they must also be selling below their price four months ago.

In our method of stock selection, we first determine which specific stocks warrant investment consideration. Qualification for consideration does not necessarily translate into actual investment. Consideration is only the first step. The actual implementation of purchase and sell decisions depends on a number of other factors which will be described after we have determined the general group of stocks we want to utilize. The qualification process is a filtering technique, through which thousands of different stocks are condensed down to a manageable number. This is not a hypothetical process. It is the actual method we use, and it is the basis from which our extraordinary high degree of accurate price forecasting was developed.

While very logical, the stock selection procedure is possibly too lengthy for the average investor. Do not be alarmed. After explaining the long method, we will describe a greatly simplified approach that is easy and quick, and that approximates the results of the longer method. The following lengthy explanation, however, is necessary for an understanding of the logic of the selection process.

The Criteria

The following qualifications are considered mandatory for the stock of any corporation to be of sufficient quality to warrant possible inclusion in our market strategy.

1. Earnings Predictability.

If you are involved in a serious hunt for a dangerous prey, your primary concern is the reliability and working condition of your weapon. Our weapon is common stock, and its specific selection is a serious (core) concern. The probability of error must be minimized to help assure survival.

Earnings are generally the most important factor in the value of a corporation. It was also mentioned that earnings generally are not easily predicted. Some corporations, however have demonstrated a consistent record of earnings predictability. Because of the existence of such corporations there is no need to rely on corporations whose earnings are less predictable.

As a rule, we consider the earnings predictability factor acceptable if the corporation has managed to meet earnings projections ±15 percent during each of the previous seven years. Disqualifying corporations that have not demonstrated a satisfactory past predictability as to earnings helps to eliminate fundamental surprises, as well as about 80 percent of all common stocks.

2. Earnings Growth.

Predictable earnings does not mean acceptable earnings. Because of the availability of corporations with demonstrated patterns of earnings growth, it is only logical to direct investment toward these issues.

The reason for this criterion is deeper than psychological reassurance. Corporations with demonstrated earnings growth get wider publicitywithin the investment community, and consequently they are considered for investment by a larger number of investors, both individual and institutional. It is from other investors that profits are taken. The greaterthe number and different types of investors involved, the easier the task of prey identification.

Keep in mind, however, that past earnings growth in itself is not enough. Future earnings projections must also indicate a pattern of growth. Themarket is most influenced by anticipation of the future. Limiting investment to corporations with both earnings predictability and earningsgrowth concentrates attention on quality, which can (but won't necessarily) help in supporting market price.

This earnings growth criterion generally halves the number of issues that were able to survive the test for earnings predictability.

The Right to Earnings

This right is the most important single characteristic of common stock, for it (at least in most theories) is the dominant factor in determining stock price. The corporate earnings (theoretically) belong to the owners (stockholders), who therefore have the potential to realize tremendous profit if the corporation is successful.

One must not blindly assume, however, that if corporate profits rise the stock will also appreciate. The fact is that there is no automatic correlation between corporate profitability and common stock pricing. It often takes more than earnings gains to create an advance in the market price of a stock.

Corporate management has the choice of doing any one (or a combination) of three things with earnings:

1. Retain them within the corporation to finance future growth.
2. Distribute them to stockholders.
3. Steal them.

Most texts on the market ignore theft, considering such nastiness a rare event that it is not important. The general perception of corporate theft is that of a slimy little over-the-counter stock sold to the public at a ridiculous price by management or a seedy embezzler packing misappropriated cash in a suitcase and running to Brazil. Theft at the expense of shareholders can take many forms and can occur in dramatic amounts in the largest corporations. There are two basic types of theft:

1. That in direct violation of law. All you need to do is look at the paper to see the Mr. Boesky types being taken away for stealing millions, or the billions in fraud that contributed in making the insurance protection for the entire savings and loan industry of the United States insolvent. Such behavior cannot be shrugged off or considered a laughing matter because of the light penalties; remember whose pockets—stockholders' and taxpayers'—were fleeced.
2. That not in direct violation of law. This includes management's paying itself exorbitant salaries, perks, options, and other compensation without merit. It also includes such practices as putting friends and relatives on the payroll at inflated costs or making corporate contracts at a price above real market value because of personal interest. In the most abrasive form, management sells corporate assets (or the entire corporation) to itself or "others," where management has an interest at a significant discount. In effect, any managerial "decision" that unethically takes from the rightful owners (stockholders) is stealing. Such activities are common and easily identified, but, since they fall into the classification of "business judgment," they are beyond statutory prosecution.

The point: There are very nice people and very nasty people involved in both the structure of securities trading and in the corporations represented by that trading.

As we will discuss in Chap. 2, there are methods to significantly reduce the chance of becoming victimized by scoundrels, but the reality of the market must include clear, ongoing recognition that the environment involves some unsavory characters. To repeat, it is not a team sport.

Setting thievery aside for the moment, can concentrate on whether corporate earnings should be retained to fund future growth or distributed to stockholders via dividends.

The generally "taught" academic approach is that the corporation (extrapolated to read "stockholders") is most benefited by applying earnings to future growth; consequently, a low dividend policy expands futurepotential.

From the perspective of professional investing, however, an exceptionally low (or inconsistent) dividend policy is a weak point. There is a real correlation between the degree of potential price decline and the dividend when the stock price descends to the point where the dividend payment is offering an exceptionally high yield in relation to the market price of the stock. In other words, people will buy the stock simply because of the dividend. This buying can help support the market price of the stock and minimize risk. It should be noted that, although the dividend yield may help soften the decline of a stock, there is no significant evidence that a high dividend in itself will help the price of a stock to advance.

We have found the three basic stockholder rights to be shallow at best, with only the right to earnings providing a general benefit. Even this right, stolen or not, provides no guarantee that the market price will appreciate.

As an investor, your primary concern is optimal utilization of common stock in your own capital growth. In this context, stockholder rights in themselves do not warrant any emotional attachment. The advantage of the stock market is liquidity. That is, you can easily move in and out of the stock market as well as within the market. By being long (buying) in anticipation of rising prices, or by going short (selling) in anticipation of lower prices you can benefit either way, as long as you correctly anticipate the direction, with very low transaction costs. It is a function of easy maneuverability to whatever area is providing the most opportunity at any given time.

To identify yourself with an individual stock issue is effectively to identify with the "rights." The rights are often illusion and in any form do not guarantee success. Emotional attachment to the rights only encourages relatively poor performance because it does not allow either objective reasoning or full utilization of the liquidity factor.

Face it. As a holder of common stock from a professional trading perspective, you are involved for the price ride. And, like it or not, to maximize profit, the ride has to be for a limited duration. No matter what the stock, the time will come to get out of the market entirely or obtain a position in another stock for another ride. To function as a professional, you must accept in fact that stock is a piece of paper to be utilized as a medium of exchange in acquiring the monies of others.

What really roils me is that so many Americans have their necks overexposed to the risks of common stocks to start with. By that I do not mean that stocks are generically too risky, although I do recommend staving out of the overpriced U.S. stock market and dollar-denominated stocks. Stocks that are selected conservatively and pay high cash dividends are, in fact, my favorite investment alternative, especially where there is the prospect of currency profits, as I'm going to discuss later in detail.

But Wall Street has led the American public to think stocks have the safety of bonds. There's a huge difference, of course. Stocks carry all the risks inherent in business ownership Bonds are contractual loan obligations that must be paid before owners get anything. Because stockholders have all that risk, they should naturally expect a higher rate of return than bondholders. But Wall Street has fostered a myth that because shareholders enjoy unlimited upside (capital gain) potential, they Should settle for a dividend return that, if it exists at all, is often far lower than the interest rate on comparable bonds.

I also feel Wall Street puts an unhealthy value on potential Capital gains. Just look at the widely used formula for setting up an individual's investment program. You take 100 and subtract the investor's age. That determines the basic asset allocation. If the customer is 20 years old, you recommend 80 percent stocks and 20 percent bonds, and then adjust the proportions as the investor gets older on the reasoning that youth justifies risk and advancing age requires safety and income.

My problem with that kind of thinking is that it assumes stocks rise in value as a function of time, that they are always a good buy regardless of valuation, and that there's always going to be a pool of people that you can sell out to so you can buy bonds and retire on the interest. As we'll see, though, the market has a well-earned reputation for perversity and there have been long periods when prices remained flat or declined.

Call me old-school, but I've seen enough of self-serving corporate management to make me want cash on the barrelhead. I want stocks that pay cash dividends and provide a higher yield than bonds do.

Wall Street has also muddled the distinction between investing and speculating. The argument that growth stocks of companies that plow all their net earnings back into the bussness reward shareholders with future capital gains assumes that the objectives of corporate managers and shareholders are the same that the two interests are in alignment, to use more elegant language. Now I'll grant that there have been many companies over the years where this has been true, and where investors profited handsomely from capital gains that, until recently, were taxed at a more favorable rate than dividends.

But to overpay for stocks that don't produce income and derive their attractiveness from the promise of future capital gains that may or may not materialize to my mind smacks more of speculation than investment Some stocks will gain, of course, but only at the expense of other companies, whose earnings shrink. If the market is trading at a given multiple, there have to be stocks whose earnings go up and stocks whose earnings go down. They can't all be winners.

Conflicts of interest are rampant on Wall Street and in corporate America, and the victim is the little guy. I started out as a broker with one of the big investment banks, and know from firsthand experience how Wall Street's symbiotic relationship with corporate America has operated to the disadvantage of retail investors. Year in and year out, the risks of common stocks are played down by firms that make their real money from advisory or underwriting services performed for client corporations.

Brokers are paid extra commissions to push certain stocks as favors to corporate clients or to move positions held by their firms acting as dealers. "Suitability rules" designed to protect investors from undue risk are treated perfunctorily as brokers pass spoon-fed recommendations off to trusting customers who think they're getting thoughtful advice.

On the research side, although stricter regulation has resulted from recent scandals, analysts are under pressure to favor existing , or potential corporate clients by assigning higher ratings than their shares warrant or failing to assign negative ratings to inferior stocks that retail investors might otherwise avoid.

Lately, the interests of corporate executives and shareholders have diverged to a point bordering on or actually constituting scandal. The most infamous example, of course, was Enron, where shareholders walked away with nothing after criminal _activities by top executives that were so complex and extensive they are being analyzed to this day. Here’s the point, though, and it’s a big one: if Enron had been forced to pay cash dividends, it could never have pulled that paper off!

There were so many other examples of corporate skullduggery at the expense of shareholders-WorldCom, Global Crossing, Adelphia, et al.-in the early 2000s that it really serves no purpose to go into them.

More significant than the laundry list of major scandals are practices we read about every day. Executive stock options that are timed and structured in ways that give managers incentives to make corporate planning decisions designed to maximize their personal profits at the expense of shareholder values are now commonplace. Just the salaries of top corporate executives have become so outsized as to penalize shareholder returns. Stock repurchase plans are often timed to create capital gains to benefit managers.

As this is written, a scandal seems to be breaking that involved the back-dating of executive stock options to capitalize on favorable stock price movements.

Wall Street has conditioned the public to think about stocks simply in terms of their prices. According to Wall Street, prices can only go up if one simply holds them for the long term. Most investors regard low-priced stocks as being cheap and high-priced ones as being expensive. The real fundamental value of the business those shares represent seldom comes up. This general misconception concerning stocks is evident even among my own clients. Whenever I call one to recommend a stock, the first question that I am usually asked is "What's its price?" My typical response is "What difference does price make?"

By itself, the share price confers no real information about the underlying value of the stock. Price is meaningful only when related to other factors, such as earnings, sales, book value, and shares outstanding. When such factors are considered, a stock selling for $5 per share can be expensive while another selling for $100 per share can be cheap.

That's why the public is so confused about stock splits, where a stock's perceived value is enhanced simply by reducing its price, with investors ignoring the increased number of shares outstanding. Stock splits originated because under the old system of trading and commissions odd lots (increments under 100 shares) were expensive to trade, so splits made it easier for small investors to trade in round lots.

For similar and equally foolish reasons, investors believe that it is easier for a stock selling at a low share price to double than for one selling at a high price. However, price is meaningless, as a company's earnings would have to double for the real value of its shares to double, which of course has nothing to do with price. If it were really easier for low-priced shares to rise, perpetual stock splits would rule the day.

The only reason low-priced stocks tend to move faster is that most are less liquid and often manipulated. If it were true that low prices meant faster appreciation, all high-priced shares would split, not at $50 or $100, but at $10, $5, or even a dollar. In most Asian markets, share prices below $1 are the norm, even for billion-dollar companies. However, their prices appreciate no faster as a result of prices being lower.

Wall Street's failure of responsibility is glaring even where clear conflict of interest isn't the issue. I strongly believe Wall Street deserves much more opprobrium than it got for its failure to discourage in a proactive way the naive investor behwior that drove the dot-com bubble. Sure, brokers were only giving customers what they wanted, but I strongly feel they had an implicit fiduciary responsibility to make investors aware of the insanity they knew they were witnessing.

At the risk of sounding unctuous, I don't mind saying that I personally sleep at night with a clear conscience. When other brokers were riding the tech-stock wave, 1 spent many hours persuading my clients to avoid the foolish risk of buying stocks without earnings. "But it's a long-term investment," I'd hear. "Sure, in a company that will not even be around in the long term," 1'd tell them, and more often than not I was right. At Euro Pacific Capital, I do no investment banking. I don't make markets or act as a dealer. I am purely a retail broker specializing in stocks that pay cash dividends, and I plan to keep it that way.

But Wall Street, I'll say again, is rigged against the little guy and I see no signs of that changing, either.

Mutual funds are an overrated investment heavily promoted by Wall Street. During the latter 1990s, as I was still cold-calling prospective clients, a typical question I would ask those who professed to be invested in mutual funds was "What is the yield you are earning?" Of course it was a loaded question, as dividend yields at that time were next to nothing, if not zero itself. Even if the stocks that the funds owned paid some minimal dividend, they were not high enough to offset the fees charged by the funds. However, the typical answer to my question was "My funds are yielding about 20 percent per year." What my prospects were doing, of course, was confusing yield with past performance. How much a fund's share price had risen over the years has nothing to do with its dividend yield.

However, shareholders typically confused illusory price appreciation with actual dividend yield.

Another major problem with mutual funds, and one rarely understood or seldom discussed, is the concept of relative versus absolute performance. Investors of course should be concerned with the latter; however, managers are far more concerned about the former. That often overlooked conflict of interest is vitally important and is the principal reason that most mutual funds will underperform the market in the long run.

This conflict arises from the way fund managers are paid and the way funds themselves are marketed. It's all about short-term quarterly performance, relative to either a benchmark or competitive funds with similar objectives. Therefore, no manager wants to underperform and no fund wants its recent performance to compare unfavorably to the performances of its competitors. This reinforces speculative behavior and causes fund managers to chase performance by buying overvalued stocks, the prices of which keep rising as more funds buy.

Then those funds buying such overpriced shares post impressive relative performance numbers, which results in increased inflows from performance-chasing investors. Those funds need to be invested in those same overvalued shares that goosed the performance in the first place, and it is a self-reinforcing cycle. When it ends, of course, the share prices collapse, and long-term investors lose big. However, the managers already earned their bonuses, and since all the funds collapse together, no one cares as no one's relative performance suffers.

Assume a diligent fund manager, with the good sense not to buy the overvalued shares, who instead invests in undervalued companies. The prices of such shares could languish for years before finally rising to reflect the true value of the companies they represent. While such a strategy is fine for investors, it Could be disastrous for fund managers, who would likely lose their jobs long before such investments paid off.

In the final analysis it does mutual fund investors no good to pay managers big-time fees for impressive short-term perfor malice when by the time investors need their money it's all gone. What is important to investors is absolute, long-term performance, which is the furthest thing from the minds of most fund managers.

If you think mutual funds aren't a flagrant enough example of conflict of interest, try hedge funds. Once relatively obscure bastions for the superrich, hedge funds, which are largely unregulated and exempt from disclosure requirements, have become the current rage, now numbering around 9,000 and holding over $1 trillion in assets. Their managers, the latest crop of gazillionaires, conventionally charge a 1 to 2 percent annual management fee plus 20 percent or more of the quarterly profits. You heard right: 20 percent or more of quarterly profits.

Since "hedge" means to protect against risk, it's ironic that the conflict of interest in hedge funds exists because of heightened risk taking, the very thing hedging was supposed to minimize.

Although, to be sure, the hedge fund universe has its share of exceptional managers, too many of the impressive returns boasted by the industry are produced not by outperforming investments, but by investments with ordinary returns that excessive leverage has turned into huge dollar windfalls on which managers base their 20 percent performance fees.

There's actually very little hedging being done. Most hedge funds would be more accurately termed "risk funds" or "ultra leveraged funds." For example, a yield of 8 percent might be achieved by buying junk bonds. But leverage it up 10 times by borrowing

money at 4 percent, and you magnify the return over fivefold.

In other words, simply by assuming additional risk, an 8 percent return is transformed into a 40-plus percent return through the magic of leverage. If a$1_ billion hedge fund specializing in junk bonds merely leverages up 10 times, an 8 percent return becomes a windfall of more than $400 million, That gives the manager a payday of $80 million.

Hedge fund investors, trusting the expertise of hedge fund managers, are accepting risks they would never assume on their own and giving away 20 percent into the bargain. The hedge fund managers are taking a ton of risk, but with other people's money, not their own. When the risks pay off, the manager gets 20 percent. If the risk goes bad, the manager doesn't lose anything; he just doesn't gain anything. The investors take the hit. Heads, the manager wins. Tails, the investor loses.

Sure, when losses occur the fund managers have to get back to the last high-water mark before they can start collecting performance fees again. But the effect of this is a moral hazard even greater than existed before the loss: Now they have an even stronger incentive to push the risk envelope.

So that 20 percent performance fee creates a powerful incentive to use leverage and, since hedge funds tend to pursue similar strategies, they create short-term market momentum in the direction money is flowing. This tends to increase the paper gains for funds already positioned in those strategies, creating a lot of performance fees in the process.

The problems will arise when everyone tries to get out. The big paper profits will quickly evaporate when the momentum reverses, but that's the investor's problem. While the managers were raking in their 20 percent of profits each quarter on the way up, it's not as though they'll have anything to lose on the way down. They will gain as long as there's a profit. Managers can press a trend until it ends. There's no need to get out early, because there's no way they can lose. They can have their cake and eat yours, too.

Take the recent example of Amaranth, the $10 billion hedge fund that blew up in September of 2006. It lost better than 60 percent of its capital in a few short weeks as some highly leveraged natural gas bets went south. As those bets were paying off the managers made millions, but when they finally blew up, it ",as their investors who got creamed.

Did the Amaranth managers really earn their fat incentive fees for strategies that ultimately caused their investors to lose lots of money? Do you think they're going to reach into their personal pockets to help cushion the blow for their shell shocked investors? Don't hold your breath.

Because the risks of common stocks have a way of getting forgotten amid the dazzle of Wall Street's aggressive marketing, I think it's useful to take a minute to revisit the basics. If it sounds like baby talk, forgive me. I meet a lot of intelligent grown-ups who cry like babies when they bring in their stock portfolios.

Common stock is simply corporate ownership broken down into units that can be bought and sold. When companies become publicly traded, which happens by way of a highly lucrative investment banking process called underwriting, the shares, which are traded on organized stock exchanges (like the New York Stock Exchange) or electronic stock exchanges (such as NASDAQ), acquire a market value. That market value is based not just on what the shares are worth as a portion of the company's equity, but on what investors in general think they should be worth, anticipating corporate and economic developments still in the future. The more assured future profits seem to be, the more investors are willing to pay for the shares. In a nutshell, that's what the stock market is basically about, except for one all-important thing, which is the risk that stock investors assume.

Why Common Stockholders Bear the Greatest Corporate Risk

The fact that common stock represents ownership, whether it's ownership of General Motors or ownership of a lemonade stand, means that shareholders assume all the risk of business failure. Except for what they may have received from the business in the form of dividends, which are cash distributions made from profits, the owners (including common stockholders) in the event of liquidation rank last in terms of their claim on assets. Only after every bill is paid, all lenders and bondholders are made whole, and preferred stockholders take their share are common shareholders legally allowed in to rake the rubble.

In a going concern, common stockholders likewise stand at the end of the line when profits are paid out. Lenders, including bondholders, get paid their contractual interest before preferred dividends are paid, and whatever is left is either paid out as dividends on common stock or retained in the business as ownership equity.

How Stocks Are Valued

Stocks, of course, come in all shapes, sizes, and degrees of quality, but their prices tend to be a function of what the underlying companies are expected to earn.

If you were to try to buy a corner cigar store from the retiring owner, for example, you might agree to pay a price of, say, 10 times the store's annual earnings. That would be typical for a business that has an established and reliable Customer base and is mature in the sense that it is not likely to see any marked increase in sales (in which case you might pay a higher multiple). In the case of large, publicly traded companies, a stock's value-whether it's overpriced, under priced, or fully valued is usually measured by its price-earnings ratio, called its P/E or its multiple.

Price-Earnings Ratio

By itself, the dollar share price carries no information with respect to value. The P/E, however, which can be expressed as "trailing" (meaning the current market price is divided by the average earnings per share over the prior 12 months, or as "forward," meaning the current market price is divided by estimated average earnings for the next 12 months), provides an indication of whether a stock is cheap or expensive, particularly when compared to its industry peers.

As we will see when we look at the history of market cycles in the next section, the overall market P/E, based on an index such as the Standard & Poor's 500 index (S&P 500), gives an indication as to whether stocks in general are over- or undervalued by historical standards.

Other Valuation Ratios

The P/E, although the most widely used Valuation tool, is not the only one. Among the others are the price-to-sales ratio, which has the advantage that sales are less subject to short-term variability than earnings, and the price-to-book value ratio, which relates the stock price to value of the company's net assets and is a very rough indication (because assets are depreciated, valued at the lower of cost or market, or otherwise not reflective of liquidation value) of how the stock value relates to the net asset value.

Dividend Yield

The P/E's main limitation, however, is that by relating price to earnings, it ignores dividends. Thus, for our purposes in comparing individual stocks, we would want to look at the stock's dividend yield. The dividend yield, called simply yield, is the current market price divided by the annual dividend (i.e., the latest quarterly dividend multiplied by four). Like the P/E ratio, yield is most meaningful when a company is compared with industry peers. Public utilities, for example, have higher yields as a group than stocks in other industries, where earnings are less predictable.

Like P/E, the overall market yield, as represented by an index like the S&P 500, is a useful tool for determining whether stocks in general are over- or undervalued by historical standards.

A Caveat Regarding Dividend Yield

One caveat regarding yield: American companies place a high value on the consistency with which they pay out dividends. This is in contrast with companies in the United Kingdom, which routinely raise and lower dividends as earnings vary. An American company would lower or eliminate its quarterly dividend only as a last resort to conserve cash. What this means, ironically, is that a higher than average yield can be a sign of financial problems.

Say, for example, XYZ company sells at $100 a share and pays an annual dividend of $3, giving it a yield of 3 percent.

Then something happens that will affect corporate earnings adversely, and in reaction to publicity the stock drops to $50. The company, confident the problem can be solved and wishing to preserve its history of consistent dividend payments, keeps the dividend at $3, which has the effect of raising the yield to 6 percent. An investor attracted to the higher yield would be well advised to investigate the earnings problem and make sure it's not going to result in a lowering of the dividend if the company is forced to conserve cash.

Obviously, the point here is that no investment decision is made on the basis of one ratio. The fundamentals of every investment should be analyzed and the company's financial strength and earnings prospects confirmed.