Exceptions to the Rule

This month we made an exception to our rule of always selling the stock that has risen to the top of the 2 for 1 ladder of 30 stocks. The HFS sale is partially explained on page 1, but there is more to it. If you notice on the back page, our positions in NWL and MFCB are not strong ones and, by the first week in June, we would have been deciding what trimming or “portfolio balancing” would be required in order to have the cash on hand needed for the June purchase. This has and will happen from time to time and, for this month, we were fortunate to have the additional consideration of the merger of PHH and HFS. As stated elsewhere, HFS is not really our kind of company and we would have probably sold it before it got to the top of the list anyway, but fortuitously, it provided a good return and by selling now, our cash position is strong enough to get us through June without having to bother with any other partial sales of companies we would just as soon hold onto.

The 2 for 1 portfolio management procedure is designed to be extremely simple to administer. However, there will be the odd situation from time to time. If the sale of HFS (PHH) caught any subscriber off guard, we apologize. As a result of this situation, we have developed a procedure to notify, prior to publication of the regular monthly issue, anyone requesting advanced warning of any changes in the portfolio that would be considered deviations from the norm. In other words, if any position is to be sold, other than the stock at the top of the list, we will call or e-mail the advanced notice of same to any subscriber free of charge. Let us know if you are interested in this service.

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A Balancing Act

Simple but effective portfolio management procedure can be based on a few easily understood principles. In the case of 2 for 1, these principles can be summed up as follows: 1) Pick stocks from a universe that provides a built-in advantage, i.e. stocks that have recently split. 2) Use “laddering” to constantly add new stocks just beginning to benefit from the effect of splitting and divest the portfolio of those stocks that have outgrown the advantage imparted by splitting, and 3) Use the fact that owning 30 stocks allows great flexibility in keeping your portfolio balanced and diversified among industry sectors and between small and large cap companies.

The concept of a “balanced” portfolio must also include the notion that no one position can be allowed to dominate or overwhelm the portfolio as a whole. This can be a catch-22 when a stock does very well. Even though, in our case, each stock was 1/30th of the whole, or 3.3%, when it was purchased, the position can grow to 5 or 6% of the portfolio in the case of the most successful stocks. In other words, if all stocks rose or fell together, they would stay in the same ratio to each other even though their dollar value is constantly changing. Instead, some stocks will inevitably do better than others and the portfolio gets “out of balance”.

The 2 for 1 procedure forces us to address this condition because we need cash every month for our next purchase. If there is not enough in the cash account from the regular monthly sale, a portion of the most successful position can be sold to “take some profits”, thereby providing the needed cash and bringing that stock back into balance with the rest of the portfolio.

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8000 on the Dow

The market hit 8000 this week. We can’t honestly say that a bear market or even a slow-down would be welcome, but looking back over the historical data, the 2 for 1 procedure appears to hold up very well in the down cycles of the market. We have not been able to quite keep up with the market on this upswing, but we expect to do better than the market on the next down turn. The test of the 2 for 1 procedure in a down market may well come in the next 12 months. We’re not making a prediction, but it’s good to remind oneself that stocks actually do go down sometimes. However, trying to time the market is like predicting earthquakes – we know we’re going to have them, we try to be prepared for them, but in the end, they always catch us by surprise. In the stock market, you can get prepared for the downturns by looking at the big picture over the long term. Unless you need your equity in the near future, it has been shown that leaving your portfolio in common stocks will provide the best overall return.

If you do need to tap your portfolio, or you are convinced that you are able to predict the highs and lows of the market, here are a few ideas regarding procedures for selling. 1) If you have some big winners, balance your portfolio by selling portions of the more successful stocks. 2) If you wish to cut back on stocks and increase your cash, or get into, say, gold or real estate, we suggest you maintain your 30 stock 2 for 1 portfolio by simply selling a percentage of each position. 3) Liquidate over time by selling the stocks “at the top of the ladder” without replacing them at the bottom. Remember, 2 for 1 splits have an advantage over the market for up to three years.

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Can’t Resist?

Ok Ok, you can’t stand the idea that 2 for 1 is such a mechanical system that there is absolutely no opportunity to time the market or “play your hunches”. Here are a few ideas that may help satisfy those urges while still staying within the basic framework of our portfolio management system.

On the buying side, there is no urgency in putting in your order for the “monthly buy” at the instant you receive the latest issue of 2 for 1. For maximum credibility, we buy our shares when we say we will, which is two business days after the mailing of the newsletter or one business day after it is posted on the Internet. We simply place a market order on Monday afternoon after the market is closed, and the order is executed on Tuesday morning at the market price. This is to avoid any accusations that we engage in front running, which is the touting of stocks that have already been purchased. However, you are under no such restrictions. Why not look at the two weeks, plus or minus, between our recommendation and the end of the month as a window of opportunity. Within this window, we would urge you to time the market, buy on the dips, use limit orders, and any other methods you might devise to buy the monthly recommendation at the lowest possible price.

Next month we’ll talk about some ideas on the selling side. Whatever strategies you might come up with, we would always urge that you stay within the limits of the laddering concept. One buy and at least one sell per month will keep the portfolio “climbing the ladder” toward your goal of financial independence. Write, call, or e-mail us if you would like a more detailed explanation of the laddering concept.

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Selling Strategies

In last month’s column, we discussed a few ideas to consider when buying the monthly pick for your portfolio. There are opportunities to use a little creativity to insure the best possible price for your stock purchases, even if we’re not trying to time the market.

On the selling side, because it is known well ahead of time which stock is up for sale in any given month, we simply place a “good till canceled” sell order for the “monthly sell” at the beginning of the month. We price the sell “limit” slightly higher than the current price and hope there is a little bump that will gain us a few extra percentage points on that position. If the stock never reaches that price, say for a week, we will lower the limit a bit for a few days and keep doing this until the stock finally sells. Last month, we had to go to a “sell at market day order” to be sure the position was liquidated in time for the “monthly buy”. This month, just the opposite happened and the stock kept climbing after the sale occurred.

Any selling that takes place for reasons other than liquidating the stock at the top of the “ladder” can be done at any time and over time. These could be sales to balance the portfolio, to provide income, or simply to take profits to provide capital for other uses. We would suggest trying to sell at market peaks, if you have a feel for that, using limit orders, and paying attention to capital gains taxes if yours is not a tax deferred portfolio. Unless you are cashing out completely, we would still strongly advocate the strategy of one buy and at least one sell every month to maintain the diversity of your 30 stock portfolio. That will keep the portfolio “climbing the ladder” to achieve maximum growth over time.

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Overhead Costs

The single most important factor putting the small investor at a disadvantage when trying to beat the market, or even keep up with it, is the commission or fee paid to the broker for each trade. The numbers quoted each day for the various indexes do not include trading costs which, for the small investor, can be 2, 3, or even 5% per year of the total invested. And these costs go up the smaller the portfolio and the more one trades. It’s hard to beat the market when you actually have to do better by 5% just to stay even. As has been recommend in this column in the past, using a discount electronic brokerage firm is one way to limit these costs.

We have used E*Trade as the custodian of our 2 for 1 IRA portfolio since its inception and have been very pleased with our choice. There are other on-line trading companies that have entered the market since mid ’96 but E*Trade is the second largest electronic broker after Charles Schwab, and it is significantly cheaper. Trading costs with E*Trade are either $14.95 or $19.95 depending on the exchange. Our total commissions for 1997 were $434.61 for 25 trades (12 buys and 13 sells). This is a little less than 0.6% of the value of the portfolio, which is far less than you would pay any professional money manager. It is important to note that our dollar costs would have been the same for a much smaller or much larger portfolio because E*Trade’s rates are flat rates for any trade up to 5000 shares. Because the percentage rises with smaller portfolios, we don’t advise holding the full 30 stock portfolio if each trade involves less than $1000. To minimize costs, we recommend you switch your accounts to a broker such as E*Trade if you haven’t already done so.

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But I have no money!

Calls and e-mails come to 2 for 1 on a regular basis expressing interest in the 2 for 1 procedures and asking how to get started with our program. Often, it turns out that the interested party has no investments, has no IRA account, and has a very limited ability to divert money from his or her daily needs to start an investment program. Even though they would not be well served by becoming 2 for 1 subscribers, these folks are still encouraged to embark on a basic savings program. The following advice is the gist of that given to callers in the “just getting started” category.

Obviously, the basics must be addressed first. Open a brokerage account or IRA account with a low or zero annual fee. Establish an automatic deposit via a regular payroll deduction if at all possible – very important! Invest accumulating money in an index fund or Standard & Poors Depository Receipts (SPY) traded on the American Exchange. Instruct the broker or IRA custodian to sweep new cash and any dividends into additional shares of the above position. Forget about this account, as far as daily living needs, and let it grow. When the account reaches $10,000, then subscribe to 2 for 1 and start investing in individual stocks, but not before then.

A quick note on S&P Depository Receipts or SPDR’s. We have been a fan of indexed mutual funds for smaller accounts but recently have switched to recommending SPDR’s instead. Mutual funds are a little more cumbersome and expensive to trade and have taxable capital gains even when no shares are sold. SPDR’s achieve the same purpose of mirroring the market but do not have the above drawbacks. We will discuss SPDR’s in more detail in a coming issue.

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The S&P 500

The Standard & Poor’s 500-stock index is a popular measure of the performance of the large cap segment of the market. The companies on this list are theoretically the 500 largest companies traded on the three major exchanges. The S&P 500 is usually the measure by which mutual fund performance is judged and, in fact, there are about 120 mutual funds managed to “mirror” the S&P 500. The Vanguard S&P 500 fund is the biggest, with $51 billion invested. The attraction of the index funds is that their management fees are very low (0.2% for Vanguard) because there is really no “management” to do, other than the book keeping functions. If you want a mutual fund that follows the market, this is the one we would recommend.

But the Standard & Poor’s Depository Receipts, or SPDRs, mentioned last month, are another way to invest “in the market”. SPDRs, traded on the AMEX with the ticker symbol SPY, are actually shares in a trust held at the State Street Bank in Boston. This trust is invested in a “basket” of stocks exactly matching the S&P 500 index. The management fee for this trust (0.185%) is even lower than Vanguard’s, but the main advantage of the SPDRs is that you can buy and sell them just like stocks with your regular discount broker.

We recommend SPDRs for any money in your account that should not be spent all at once on the 2 for 1 “buy” recommendation. For example, with a roll-over from a 401k plan or an inheritance, or if you have less than $10,000 total in your account, SPDRs will give you the peace of mind of good diversification while allowing your account to benefit from the growth of the market over the long term.

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Handling Added $$

The 2 for 1 model portfolio works to illustrate the principles of our stock picking and portfolio management procedures, but it does not reflect the real world for most of our subscribers. The 2 for 1 portfolio was started with $50,000 on 7/31/96, and since that time no money has gone into it or been taken out of it. This is great for providing a stable month-to-month picture of how we’re doing but, unlike 2 for 1, most of our readers are, hopefully, adding money to their portfolio on a regular basis.

If a person is adding $166 per month ($2000 per year) to his or her IRA through an automatic payroll deduction program, how does this affect the calculation for how much to spend on each month’s new stock? Theoretically, the extra cash will “bulk up” the cash account over time if it is not added to the amount allocated for the monthly “buy”. But if it is added, the newer stocks at the bottom of the ladder may be out of proportion to those at the top of the ladder. In real life, this apparent paradox doesn’t seem to present a significant problem.

Our recommendation would be to always use the 1/30th figure as a guideline. (Divide the total value of the account by 30.) If you see that the cash account is getting a little large, spend a little more than 1/30th of present value each month. On page 4, one can see that the percentages held by each 2 for 1 position vary from 2.47% to 4.75%, even though they all started out at 3.33%. A partial sale of some of the more successful stocks on the list can always be used to bring the portfolio back into balance. For most investors, looking ahead and planning these strategies is part of the fun and challenge of managing their portfolio, and we’re here to help.

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Balancing our Portfolio

Because of the fantastic growth in our Morgan Stanley Dean Witter The resulting $1000+ was used to increase our position in KBALB. Kimball International was bought in November last year and has lagged ever since. We feel it is even a better bargain now, so we increased our position from 100 to 160 shares on 7/1. These transactions have been undertaken outside of the normal “laddering” schedule.

It has been over a year and a half since such a “balancing act” has been necessary, so this idea may be new to our more recent subscribers. The object here is to keep all thirty stock positions as close to 1/30th maintaining 30 stocks in the portfolio, each between 2% and 5% of the total, 2) having enough cash after each month’s “sell” to enable the purchase of the proper amount of the current “buy”, and 3) keeping these transactions to a minimum so as to not run up excessive commission charges.

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Take Little Bites

Most kids have probably been told by their parents to “take smaller bites! You’ll get indigestion the way you eat!” This is good advice for the stock market investor as well. If you check the back page, you will see that no single stock amounts to more than 4.87% of the 2 for 1 portfolio. The diversification provided by our 30 stock portfolio, being constantly refreshed “one bite at a time”, has served us well during the recent market fluctuations, as seen in the article to the right. But taking little bites also applies to those entering or exiting the market.

For those just getting started, putting small amounts (hopefully as much as can be afforded) regularly into an IRA or other savings plan probably happens by default. But the same advice would hold for a person investing a larger amount, say an inheritance or a rollover IRA or 401(k). If you are fortunate enough to have this problem, our advice would be to park the money in a safe place, like the Vanguard GNMA fund, and then gradually, over two to three years, sell off this fund and buy individual stocks. Taking these small bites is similar to “dollar cost averaging” and will greatly reduce the risk of making a serious “market timing” error.

For those selling off their account, for living expenses after retiring, for instance, the same concept applies. Because it is impossible to know when the market has “peaked”, why bother agonizing over when is the best time to sell. Planning to convert your stock portfolio into fixed income securities over a period of two to three years will prevent the anxiety that is almost inevitable if large positions are sold over a short time. Taking small bites, when it comes to investments, will definitely prevent indigestion.

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Keeping Track

For most readers of 2 for 1, it is assumed that keeping track of your investments is a chore rather than a compulsion. People who check their stocks every day and like to trade in and out of the market are usually not interested in the boring, plodding pace of the 2 for 1 procedure. That’s good because one of the goals of 2 for 1 is to relieve subscribers of much of the burden of managing their stock portfolio. However, there are a few chores that do need to be done to utilize the procedure correctly.

Everyone with a stock portfolio modeled after 2 for 1 should keep their stock positions in a ledger or on a spreadsheet so they can be updated once a month. You will want to add your purchase and strike out your sale, just as we do on the last page of this newsletter. You also want to know the percentage that each stock position occupies in the overall portfolio. This is necessary because you need to know what 1/30th of the portfolio equals for next month’s purchase, and you need to know that no one stock is too far off the mark from the ideal of 3.33%.

If you choose to keep track of you portfolio on an Excell spreadsheet, as we do here at 2 for 1, it is recommended that a new worksheet be created each month. Closing prices from the last day of the month can be entered from your brokerage statement or from one of the on-line quote services. Columns with simple formulas can be created to automatically calculate your capital gains and losses, percentage of the portfolio total for each stock, and other interesting statistics. A separate worksheet with sales can be maintained for an easy reference at tax time. Keeping track means that you will be informed and you will feel more in control of your affairs.

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Seizing an Opportunity

When you receive next month’s issue of 2 for 1, you will see that the position in Lockheed Martin has changed since we bought it on 11/17/98. We bought 25 shares at $105.94/share and an additional 25 shares were delivered on 1/4/99 as a result of the 2 for 1 split. But the 2 for 1 portfolio now owns 65 shares of LMT because, on 1/5/99, a market order for an additional 15 shares was executed at the price of $41.00/share. This departure from our normal procedure of one “buy” and one “sell” per month came about as follows.

Lockheed had dropped over 20% since we bought it in November. The drop resulted from an announcement that earnings would probably not meet analyst’s projections. However, all the numbers that made LMT a buy for us in November were still valid and, after the drop in stock price, many of them looked even better!

The 2 for 1 cash position at the end of December stood at $3136 and we were in line for a nice supplement to that when HFFC was sold. Thus, this higher than normal cash position was not needed for our upcoming “buy” for January. And it will not be needed in the near future because two of the stocks that will be sold in the next three months are well above average in the percentage of the portfolio they occupy. (Anything over 3.33% – see the last page of the newsletter).

The combination of these two factors provided an opportunity too good to pass up. The purchase of a few additional shares of LMT lowered our average cost for that position and brought it back up closer to its proper weight in the portfolio. We also lowered our excessive cash reserve and, if it grows over the coming months, we’ll probably execute a similar “balancing act”.

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2 for 1 and Your Taxes

The 2 for 1 model portfolio, tracked on page four of the 2 for 1 newsletter, is a Roth IRA account and, therefore, is managed without regard to tax issues. It is assumed that all readers of 2 for 1 have maximized their opportunities in regard to their tax advantaged accounts. However, it is understood that some readers will be dealing with the consequences of their investment decisions in other accounts as tax returns are prepared over the next few weeks. Should the investor modify his/her portfolio management procedures depending on whether the account is taxable or tax free? We think not.

Analyzing the 2 for 1 performance for 1997 and 1998 offers some insight. For 1997, the capital gains realized were $4031 and dividends were $1188. Taxes on these amounts, using 20% and 28% rates respectively, would have been $1139. This would be the total federal tax on the portfolio that grew $18454 for the year. For 1998, capital gains were $12687 and dividends were $1828. Federal taxes on these gains would have been $3049 for a year when the portfolio grew by a much more modest $8716. For the two years combined, taxes would add to $4188, or 15.41% of the total portfolio gain of $27170.

We see that the taxes do not necessarily correlate with the performance of the portfolio in any given year, but when averaged out, the taxes are manageable. Because gains are taken on stocks that were purchased 2 1/2 years ago, there is a “tax deferment” for a short time. In the end, if your taxable account makes money, and you don’t give it away, you will have to pay taxes. With 2 for 1, you have the advantage of spreading the load with a “pay as you go” plan, rather than paying all at once when you cash out.

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The 2 for 1 Sell Program

This month’s sale of Avery Dennison serves as a reminder that the 2 for 1 portfolio management system is a very mechanical procedure that must be followed rigorously. Even though one hates to sell when a stock is rocketing up, the monthly sale of the top position on the “ladder” is the key to our success. Let’s review.

The success of any portfolio depends on both the buy and the sell decisions, and the sell decisions are usually the hardest. Most stock pickers will tell you that they sell when the price of a stock hits a “target” or when the fundamentals of the company have changed. In other words, when the reasons they bought the stock no longer apply. In the case of each of the stocks in our 2 for 1 portfolio, the reason the stock was bought in the first place was PRIMARILY that the Board of Directors signaled its optimism for the company for the next two to three years by declaring a 2 for 1 split. Therefore, the reason to sell the stock is that this two to three year period has come to an end. In our case, we have arbitrarily made the cutoff at 2 1/2 years and, using that number of months (30), we have created the “ladder” of stocks now comprising the 2 for 1 portfolio. Taking all these concepts together gives us a logically consistent procedure that takes all the guesswork out of the sell decision. So what if AVY is on a roll lately. We’ll just use the money to buy another great company.

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