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A Successful Investor

Today’s story is about Joe, a successful investor who has his own investing system. His system is unusual in a couple of ways.

A Successful Investor

Musings on Investing Styles

Some Thoughts on Apple (AAPL)

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The world is full of successful investors. Some are famous; most are not. Today’s story is about one of the latter, a guy named Joe.

Joe and my father became friends roughly 55 years ago while they were working at General Electric in the aircraft engine division. My father was a mechanical engineer, while Joe’s talent was operations research; it was a hot new field back then, a bit like Cloud computing today.

Joe’s main hobby was golf, while my father’s main hobbies were music and investing.

Well, Joe never could get my father to take up golf; tennis was more his speed. But my father succeeded in getting Joe hooked on investing, and over the years they spent many hours sharing tips and discussing investing strategies.

After a few years, both moved on from GE. But they stayed in touch.

My parents had five kids while Joe and his wife had three. Our families vacationed together in the summer. Some of us skied together in the winter; I remember piling into the back of Joe’s big station wagon for the ride to New Hampshire many times.

Today Joe is 87 years old. He turns 88 in June. He still plays a lot of golf, in part because it provides increasingly important social connections.

But above all he invests—seriously. He’s successful at it.

And here’s why he is a successful investor.

When Joe retired at age 77, he found himself with a lot of time on his hands. Plus, he found that he wanted a mental stimulant, to ward off any type of mental decline.

So he decided to focus his attention on small-cap investing!

Now, small-cap investing is risky for anyone, and a lot of people who try it don’t last long; they lose their shirt and they go back to mutual funds, or dividend-paying blue chips.

But Joe wasn’t foolish. As a long-time reader of numerous Cabot advisories, he knew enough to avoid the usual beginners’ mistakes.

So he kept the bulk of his investable funds in sensible long-term securities, the way any competent money manager would: dividend-paying blue chip stocks, municipal bonds, etc. It doesn’t take a lot of work, and the resulting average annual return is enough to live on.

But with his “discretionary” money, the money he spends much more time thinking about, Joe began to invest in underfollowed small-cap stocks. More important, he began to research them, in depth.

Just a few decades ago, researching these stocks was difficult. If you wanted to learn anything, you had to subscribe to investment newsletters or go to the library. Barron’s was useful, but it was limited.

Today, by contrast, the Internet has made information abundant. And anyone who takes the time, and has a decent system—and follows that system—can learn enough to do pretty well and become a successful investor.

Joe has the time. He spends about four hours a day on his discretionary portfolio, more than most of my readers.

And he has more than the Internet; he’s a long-time reader of numerous Cabot advisories, and particularly fond of Cabot Market Letter, Cabot Top Ten Trader, Cabot Stock of the Month, Dick Davis Investment Digest and Dick Davis Dividend Digest.

But he’s not loyal to any particular system or editor. He loves them for the ideas they provide, but he has his own investing system, which he usually follows.

Joe’s system is unusual in a couple of ways that are worth mentioning.

First, he diversifies heavily; his discretionary portfolio has roughly 60 stocks! To me, that’s an unnecessarily large number. As a growth investor, I like to focus much more narrowly; I like every stock in my portfolio to be working for me today.

But Joe argues that his broad diversification provides safety. He says any stock that crashes—and small-caps do sometimes crash—won’t have too heavy an impact on the whole. This is a true, but it’s an argument usually used by value investors.

And Joe is, in a way, a value investor!

He has a method of determining the fair value for a stock that prevents him from buying stocks that are “too high” and gives him confidence to hold onto a stock that’s temporarily underperforming.

This valuation model, like many, is based on a stock’s P/E ratio. But Joe adds a twist. Using data found online, he takes the earnings estimate that’s farthest in the future for that company, and then applies a multiplier, based on the company’s expected earnings growth rate; a higher growth rate justifies a greater multiple, which justifies paying a higher price.

Joe’s system doesn’t always work; no system does. And Joe can’t use it on companies that are not yet profitable, including many biotech companies. But he thinks it’s saved him a lot of grief.

Furthermore, as Joe has put more and more weight on this valuation system, he’s evolved away from small-cap stocks. Today, nearly 10% of his stocks are trading for more than $100 a share, while roughly 25% are trading for less than $10 a share.

And not all those low-priced stocks have great prospects!

You see, like many investors, Joe has trouble selling stocks that go down. In fact, of his 60-odd stocks, roughly 10 show losses of greater than 50%, and some are over 90%. I would sell all of those big losers today and work to put the money in stocks going the right direction. But Joe says, somewhat wistfully, “They’re not worth selling anymore.” And as is common among all investors who hold their big losers, he has some lingering hope that they might come back!

Nevertheless, his numbers are very good. He is a successful investor.

Through last Friday, Joe’s discretionary portfolio was up 20.1% year-to-date. By comparison, the Dow was up 12.3%, the S&P 500 was up 10.9% and the Nasdaq Composite was up 8.6%.

And Joe isn’t even trying to maximize his return! If he did, he’d work more hours, and do more trading. But he doesn’t want to work harder. He just wants to make his account grow, and to keep his mind engaged enough to keep from turning into a couch potato.

I think Joe has done a marvelous job of developing an investing system that works for him, in more ways than one, and I recommend that you do the same and find a system that works for you, if you have time.

If you don’t have the time, by all means consider a no-risk trial subscription to one of Cabot’s investment advisories. A great place to start—as well as the most affordable—is the one that I edit, Cabot Stock of the Month.

I’ll be providing my subscribers with a new recommendation tomorrow, and if you sign up today, I guarantee you’ll have that recommendation in your in-box soon after the market closes tomorrow.

Learn more about Cabot Stock of the Month.

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MUSINGS ON INVESTING STYLES

I like to say that one of Cabot’s missions is to help you find the investment system that’s right for you. So here’s a quick, subjective appraisal of some growth investing styles.

Joe’s investing style might be called “Growth at a Reasonable Price,” or GARP. It works for him, as similar GARP systems work for many investors. He doesn’t rely much on charts, and as mentioned, he could do better at selling.

My father, who founded Cabot, didn’t give a hoot about valuation. He liked strong charts. If a stock was going up, and the story was good, he’d happily jump on board, knowing the potential was there for it to climb even higher. In fact, Joe remembers my father saying many times, “Always buy more of your best performers.” For my father, that sometimes meant 40% of his portfolio ended up in one stock—and he was fine with that! My father was also big on the idea that it was changes in perception that moved a stock, so the best time to buy a stock was just ahead of a big wave of improvement in investor perception. He seldom sold too soon, while he sometimes sold too late.

Mike Cintolo, by contrast, is a great fan of high-potential chart set-ups. He won’t buy a stock that’s over-extended; he doesn’t want the risk. But with a long watch list of well-researched great growth stories, when a set-up does materialize, Mike is often ready. Mike spends a little more time than my father thinking about valuation, but not a lot; he likes to say that for growth stocks, “Valuation is the result of good performance, rather than vice versa.” Finally, Mike has proven himself better than both my father and Joe at selling; he’ll often take partial profits near a stock’s peak and he’ll sell quickly when a stock breaks down.

Finally, there’s me. I don’t care much about valuation; I think future numbers are too difficult to predict for great growth stocks. I do respect charts a lot, so I prefer stocks that are under accumulation. And I like great, often revolutionary growth stories. But I’ve come to realize that what makes me different is my focus on investor psychology. I like recommending stocks where investor perception is very likely to improve, like Tesla (TSLA), which I recommended more than a year ago, or First Solar (FSLR), which I recommended just three months ago. And I’m leery of stocks that are too popular, like Apple (AAPL) last year, where a shift toward lower perceptions has the potential to set off a selling stampede.

There are different ways to be a successful investor.

For a taste of my Cabot Stock of the Month recommendations, see here.

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Lastly, some thoughts on Apple (AAPL).

Most—perhaps all—investing systems that measured value called Apple a decent value last year. Joe’s system did, and so did our own Cabot Benjamin Graham Value Investor.

But that value didn’t stop the stock from falling 31% in little over six months!

In recent weeks, more and more advisors have been popping up calling Apple a buy “at these depressed levels.”

Well, I respectfully disagree, and here’s why.

First, I wasn’t surprised when Apple topped last year. As I wrote both before and after the top, when a stock is owned by everyone who has the potential to own it, the only way it can go when perceptions begin to worsen—even infinitesimally—is down, regardless of valuation.

Today, Apple is combating its stock’s slide by doing the only thing it can; shoveling cash to investors through stock buy-backs and dividends. In the next year, these efforts will cost it $60 billion, and probably stem the stock’s slide.

AAPL’s chart may help, too. The stock is nearing its 200-week moving average—it’s now at 370—and there’s also support in the 350 region dating back to 2011, so the odds are good for AAPL to build a base in that area.

But I don’t think the stock will reward buyers who are jumping on board here, because investing is not that easy!

This is not about valuation. It’s not about charts. And it’s not even about the loss of Steve Jobs; I’m pretty sure this would have happened even if Steve were still around.

What it’s about is investor psychology.

The way I see it, too many people today still hold the memory of AAPL being a great investment. Too many people still hold the memory of having missed the opportunity to buy AAPL low enough the first time around, and thus too many people are attuned to the “opportunity” to now buy APPL some 30% off its high.

But the market doesn’t give you what you wish for. Instead, the market offers opportunities that you’re not looking for, and that are hard to recognize.

Note: Also arguing for a more difficult future is the fact that Apple’s business is deteriorating fast. Thanks to growing competition and falling prices, Apple’s margins appeared doomed to shrink dramatically in the years ahead. But I won’t get into that here.

THE FIVE-YEAR RULE

My rule of thumb about investing in past big winners like Apple is that the stock needs to fall out of the public’s consciousness first. People have to stop expecting the stock to be bargain; they have to give up on it! That takes time, and experience tells me that five years will usually do it.

For example, exactly three months ago today, I recommended buying First Solar (FSLR) at 28. Today the stock is selling at 46, up a very satisfying 64%.

That’s more than I’d expected so quickly, but I’m not totally surprised, because the potential was there.

Here’s what I wrote back in January.

“First Solar came public in December 2006 at 26, and soared all the way to a high of 317 in May of 2008, for a gain of 1,119%! (Cabot Market Letter subscribers bought in March of 2007 at 57, took partial profits on the way up at 115, 167 and 220, and sold the last bit in September 2008 at 228 as the stock started to crash.) Interestingly, the base that was built following that crash—and which centered on 140—didn’t hold, and the stock crashed again in 2011 and 2012. It’s been less than a year since the second crash, so it’s possible the stock needs more time. On the other hand, it’s been five years since the first crash, and that’s the one that took the stock out of the limelight.”

Lesson: If you’re buying what’s popular, you might be buying near a top. If you’re buying what was popular five years ago, and what’s now out of favor, you might be buying near a bottom. For AAPL, I’d wait until 2017.

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I’ll finish this long letter with a stock most investors don’t know about. Those investors represent potential buying power, as they learn about it.

Its name is Splunk (SPLK), which in my mind puts it in the same category as other fun names like Yahoo! and Zappo’s—and they haven’t done badly!

Here’s what editor Mike Cintolo wrote in Cabot Top Ten Trader a month ago.

“Splunk is a software company whose products give businesses control over the mountains of data that they collect and store in the Cloud, often in Hadoop clusters, which are cheap commodity servers connected with open-source software. Splunk’s software eliminates bottlenecks and security breaches in software applications and networks, and analysts say that it’s such a superior product that the company is competing on an equal footing with HP and IBM. With 60 of the Fortune 100 companies on the customer list and a string of 25 seven-figure contracts signed in the fiscal year ending in January, Splunk is clearly getting major traction .… The demand for software to handle Big Data is so strong that Splunk has been able to grow revenue at an impressive rate; the 51% revenue growth in the latest quarter would have many companies doing cartwheels, but it’s the lowest growth rate in over two years for Splunk. The 200% jump in earnings in its latest quarter is also important, as it pushes the company closer to consistent profitability.”

When that was published, SPLK was trading at 40. Since then it’s been up to 42 and back down to test 40 and now it’s advancing again. I think buying in expectation of a breakout above 42 will probably work.

But what I really recommend is that you become a regular subscriber to Cabot Market Letter, so you can read all Mike’s recommendations, and work toward being as well-informed as my friend Joe!

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Yours in pursuit of wisdom and wealth,

Timothy Lutts
Editor of Cabot Stock of the Month

Timothy Lutts is Chairman and Chief Investment Strategist of Cabot Wealth Network, leading a dedicated team of professionals who serve individual investors with high-quality investment advice based on time-tested Cabot systems.