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Tax Guru-Ker$tetter Letter
Friday, November 08, 2002
Stock Picking Formulas

I understand that some people consider this James Glassman guy to be some kind of financial guru. This article doesn't convince me much on that account. While he does have a decent amount of skepticism towards people who claim to be able to reverse engineer into magic stock picking formulas (the unachievable Holy Grail of finance), he makes one comment that betrays his ignorance of simple accounting.

He claims that comparing a corporation's stock price to its gross sales is a more practical approach to valuation than comparing it to the corporation's net profits because gross sales are harder to manipulate than is net income. What planet is this guy from? Artificially inflating sales figures is the easiest thing to do on this planet (Earth). Gross sales are routinely pumped up by artificial churning of sales in and out between allied companies. It's no more complicated than I sell a bunch of items to you and then you sell them back to me and so on and so on back and forth. The discovery of this kind of thing led to some of the big corporate accounting scandals of this past Summer. It is much more difficult (but definitely not impossible) to use churning to inflate net profits because someone has to eat the difference. Churning sales is a simple break even process.

One of the reasons I have avoided investing in the stock market is the fact that it is too irrational and cannot be defined by any kind of formula. Anyone who claims to be able to do that is nothing more than a con artist. The dot-com boom of the late 1990s proved that. Stocks were selling for huge multiples of their gross sales, while their bottom lines were projected to be negative for all foreseeable future time.

If you are going to objectively look at any stock purchase, you need to step back and look at it for what it is. As the new commercials for AmeriTrade (owner of Motorola in a tour bus, etc.) illustrate, when you buy capital stock, you are buying a percentage of the actual business. Try to extrapolate that concept to buying 100 percent of an actual business, such as a corner convenience store. When you and your financial advisors are deciding on a fair price to pay, which figure is more important: that it has gross sales of two million dollars a year or that after paying all operating expenses, the net profit is $10,000 per year? Would it be a wise move to buy the store for a million dollars? Anyone with even the most basic of accounting training would focus on the net profits. Part of analyzing any investments involves comparing alternative uses of the money. Why would anyone invest a million dollars to earn just $10,000 per year (a one percent yield) and also have to put up with the hassles of actually running the business when you could stick that money in a bank account and earn much more, with far less hassle?

How about paying a million dollars to buy a business that will lose money from now until forever, as dot-com stocks were? The only way that makes any sense is based on the greater fool theory, where you need to be sure a bigger idiot than yourself will come along to pay you more than you did. As with any pyramid or Ponzi scheme, greater fool plans eventually run out of fools and the market collapses.


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