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How Stocks Are Meant to Be Traded
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Now that you know the process that companies go through to become public, it's time to figure out how we—you and I—should value them. Determining a company's value tells you what's worth buying. Decid­ing what's right to buy and what's right to sell, and the best ways to do so, are the fundamentals of investing. Doing it correctly and intelligently can make you very rich. Doing it in an uninformed way, the way the vast majority of people do, can make you poor unless you get lucky. This book is about taking as much luck and hope out of the equation as possible.

People ask me every day what a stock they own is worth. They almost always say, "I bought TheStreet.com at ten dollars and it is now at four dollars. What should I do with it?" I tell them immediately, I don't care where a stock traded, I don't care about the past, I don't care where you bought the stock, the only thing I care about with a stock is what's going to happen next. I must say those words a dozen times a week on my radio show because most people don't grasp this simple concept that determines just about everything you need in order to know whether a stock is going to go up or down: the future.

People are constantly trying to bring up the irrelevant when they talk stocks. Maybe you bought the stock well, maybe you bought it badly. It shouldn't influence your decision. They want to mention what went through their minds when they bought it and why they bought. I don't care about that either, because it obviously didn't turn out right or you wouldn't be referring to where you bought it and mentioning how you are down on it.

I'm driven so crazy by this web of meaningless alibis that the only time I take individual questions about individual stocks on my radio show is on Fridays when we play "The Lightning Round." I forbid callers to say anything but the name of the stock and I take it from there, telling them up or down, buy or sell, based strictly on what I think is going to happen in the future. That's because owning stock is a bet on the future, not the past. You must buy into that notion or you mustn't buy stocks yourself.

I didn't always feel this way. At one point, no doubt like you now, I was completely caught up in the notion of my "basis," the technical term, both on Wall Street and with the IRS, for the price I paid for a stock. If my basis for Maytag, say, was $34, and the stock was $28,I would let that unrealized loss get in the way of the decision-making process, because, I, like you, hate to take a loss. Of course, the situation is already in "loss mode" as I like to call it, a loss to anyone but you because you hold out hope that should play no role in the process.

In fact, I would let this basis factor so mar my judgment about the future of Maytag that I wouldn't be able to think clearly about whether I should give up on the position or buy more. I would say, "Maytag, I'm down six, maybe I have to buy more. Maybe I should be bigger, 'cause I'm down." Or, obviously, "Maybe if I buy more I can make it right even if I'm wrong now!" Lots of that kind of logic swarmed in my head when I was starting out.

This pigheadedness about my basis—in the face of obvious facts about how bright or poor the future of Maytag would be—made my wife go ballistic. The Trading Goddess knew that the future was all that mattered, and she knew I was being blinded to it because I was down six bucks when I reviewed the piece of merchandise on which I was "long," or owned. In those grand old days of trading together at 56 Beaver Street in downtown Manhattan, a floor above the steak joint, Delmonico's, a downtown fixture, she would insist we get off the desk multiple times a day and go to a bare office located right above the kitchen of the restaurant. There, with steak fumes wafting in and threatening to embed themselves in our clothes and our nostrils, she would go over each position slowly and methodically, reciting each name from our position sheets. After each stock she would ask me what I thought and how I would rank it on a scale of one to five, a one being a stock I wanted to buy more of right now and a five being one I needed to sell pronto.

These sessions were extremely painful because there would be a dripping tone of sarcasm when a stock had obviously gone awry. She was always exacting in her methods; these weren't lovey-dovey klatches between husband and wife, believe me. They were discipline camps. I would try to think clearly about each position she would enunciate, but invariably I would be blinded by my basis. I just couldn't get past the decline from where I bought the darned thing. My judgment was stymied by the stigma of unrealized loss that each negative position carried.

Then one day, we got off the desk and went to the steak room, as I called it, and she handed out the sheets as always but the basis, the price I had paid, was whited out. That's right, she had grabbed a bottle of Wite-Out and painted over every price that I had originally paid for the stocks. "There," she said, "now you can think clearly."

Of course, when we got down to the Maytag position, I was able, at last, to measure Maytag for what mattered, the future, not what I was letting matter, the past, the 6 points I was down on the position. When not faced with the tether of history, I immediately admitted that Whirlpool and GE were kicking Maytag's butt and that we ought to just face the darned music and dump the stock.

From then on, she routinely whited out all the bases of every stock from our position sheets. And our performance increased dramatically. Lesson number one: When it comes to buying or selling a stock, don't tell me where you bought it, tell me where it's going. That's all that matters when it comes to buying or selling a stock.

Besides the past, people are way too hung up on price, the dollar amount you have to pay per share. Most beginners, but also many people who got in during the heyday, the bubble, when everything was working, don't even realize what "price" is, so let's explain that first before we explore whether we are paying too much or too little for a stock.

When you get a quote, or when you look at a stock's closing price in the morning papers, you are seeing the exact last price at which the merchandise—and this is just merchandise—changed hands. That doesn't mean it's where you can necessarily buy the stock. Stocks trade in bids and offers—you hit the bid, or sell it there, or you take the offer, or buy it there. The uninitiated use the terms "buy" and "sell," but we never do that on Wall Street; we say "take the stock" or "hit the bid." That's because we are intent on getting the job done. "Buy" and "sell" are amorphous terms, too amorphous for most professionals, but good enough for those who are just trying to buy small amounts, typically less than 100 shares. Any more than 100 shares and you are going to have to learn that "buy 200 shares of Nortel" is simply taking your life into your hands. Here's why. "Buy" and "sell" mean "buy at the market" and "sell at the market." Only amateurs and fools enter market orders. Our ridiculous system of buying and selling stocks is predicated upon your being ripped off by whoever gets that market order. And you will be. If you enter a generic market order, the order can be matched with another customer within the system or brokerage you are trading in, at a price perhaps at least surprising and at most entirely disadvantageous to you. Especially when the merchandise you are buying is illiquid or "trades by appointment," meaning that it is difficult to find multiple buyers and sellers. When I was just starting, trading stocks out of phone booths or sneaking out of law school classes to place orders, I always used market orders and rarely did the order ever work to my satisfaction. I always felt I was getting ripped off. It was only much later, after I turned pro, that I realized that I was being systematically ripped off—by myself—because I foolishly believed that the system of buying and selling stocks at the mar­ket was set up to aid the little guy. Just the opposite. A market order is a license to abuse you, at the behest of a larger client or the brokerage itself trying to "find both sides of the trade" internally so it can get the full commission on both the selling and the buying instead of having to share it with another firm.

So what can you do?

Lesson number two in trading stocks: Always use limit orders when you buy or sell any stock, especially when you are buying in un­seasoned situations, with new stocks or just-issued stocks, such as The Street.com on the day it came public. Decide what price you are willing to pay for a piece of merchandise, and then enter it. Never use a market order. You can determine yourself what you think is right, what you think is expensive, or what you think is cheap, and hold out for it. That's vital, that's what you have to do, and don't let yourself be abused by the system. This "limit" order is particularly important in so-called fast markets, when there is news impacting the stock you are trying to buy, making the merchandise a moving target. You determine the parameters. If I want to buy Nortel and the offered, or where I can buy it, is $3.50, but there is news out—a new contract gained from BellSouth, say, that will jack up the price—then I enter the order this way: "Take two thousand shares of Nortel at three fifty-five." That way I've set a limit on the price I will pay for the stock.

Similarly, if I want to sell Nortel and the bid, or where I can sell it, is $3.48, but Nortel has lost some important business to Cisco that I know will send the stock plummeting, then I say, "Sell two thousand shares of Nortel as low as three forty-five ." I make up the price, I give the limit.

That way I buy it at the price I want, and if I buy it at the wrong price at least it's my fault, and not the fault of the system. Nobody tells you not to use market orders because it is in nobody's interest except yours to do so. The broker wants you to do the trade so he gets the commission, but if you "limit" it, the trade might not happen, and then he doesn't get paid. (If the stock never reaches your target price, then the trade isn't executed.) The brokerage wants to cross your order with another order in house to get both of the commissions. A market order lets that happen, but at a price that you might not llke. Never use market orders, ever! If this simple point is your only takeaway from what I have learned the hard way, you are already well ahead of the game.

Now, how about that price, that last sale dollar amount. Do you know what that price means? If you go to Macy's and there are two cable-knit sweaters, one by Polo made of cashmere and one by Macy's house brand made of polyester and cotton, both selling for $100, you know that something's wrong with the price of at least one of these two items. The Polo cashmere should be $400. The poly-cotton Macy's deal should be $49. We can do stuff like that in our heads. We know bargains and we know rip-offs. We are sophisticated shoppers about things like sweaters at department stores. Alas, if only we were better at buying bigger ticket items like stocks at the malls I shop at every day, the NASDAQ or the New York Stock Exchange.

The reason why we can't spot bargains and rip-offs when it comes to stocks is that the prices we pay aren't "real"; they are simply ratios created by the companies through stock splits and share adjustments that often confuse even professionals but always confuse the little guys. When you buy a cashmere sweater for $400, you know it is worth more than the poly-cotton sweater at $49. But in the stock market— and only in the stock market—a $49 stock can be more expensive than a $400 stock!

We have to understand how these ratios are calculated so you can spot bargains and overvalued merchandise as easily as you can at Al- bertsons or Wal-Mart or Macy's. Don't freak out at the mention of the word "ratio." I was doing ratios with my fifth grader last night. They are simple division, something that our schools actually teach successfully to all but the socially promoted. You know I am going to get you through this with flying colors, so drop your objections and let's get to work.

To help us understand the real or underlying worth of merchan­dise versus the arbitrary price per share that we pay, let's stick with Maytag, the washer and dryer company everyone knows, and compare it to Whirlpool, its biggest competitor. Recently Maytag traded at $27 a share and Whirlpool traded at $67 a share. Are they roughly the same price? The beginner, of course, says no, one is $40 more than the other and is therefore much more expensive. Only on Wall Street, where so much is done to confuse the millions of people who shop at our store, is the answer "yes" to the question whether Maytag at $27 and Whirlpool at $67 are the same price. In fact, they are almost ex­actly the same price, as befits two competitors that duke it out pretty evenly. But you have to understand their price-to-earnings ratios to see through the $27 to $67 disparity. You have to understand the ratio to know that $67 isn't more expensive than $27.

You see, we don't care about the actual price that we pay per share. If Whirlpool, for example, were to announce a two-for-one stock split tomorrow, you would be paying $33 a share, and instead of saying that Whirlpool is selling for $40 more than Maytag, you would say it is selling for $6 more. Or, if Maytag were to do a two-for-one reverse split, so that it was selling at $54, you would think they are selling at similar prices. But share prices are just guideposts that a company can change at will. They don't help you figure out relative worth at all. (Never forget that while splits are exciting, they produce no more "pencil." That's my shorthand for taking a pencil and breaking it in half. You have two pencils, but you haven't created more lead. That's all a stock split is!)

What really matters isn't the price that you pay or that you see at the end of the long column of numbers next to a stock symbol or name in the newspaper stock tables each day. What matters is the price-to-earnings ratio of each stock. You have to take that last price on that line in the paper next to the stock's name, and you have to divide it—come on, take it and just put a line under it—by the amount per share the company earned in the previous year. Maytag earned $2.18 last year. That's a number that can be found by simply inputting MYG, Maytag's symbol, into Quote.Yahoo.com. This will instantly tell you how much money, on a per share basis, Maytag made. (You can arrive at that number yourself, as you used to do be­fore the Web's incredible explosion of free information, by dividing the amount the company earned for the year—that's back to the process of share issuance as we talked about with TheStreet.com—by the number of common stock shares there are.)

Now, you divide $27—the last price paid—by $2.18, and you get 12 (rounded to the nearest whole number). That's the magic number that you need to know, Maytag trades at 12 times earnings. You are paying 12 times Maytag's previous earnings per share for each share that you buy. That's the real price. The (M)ultiple, 12, times $2.18, the (E)arnings per share, equals the (P)rice per share. We express the price as an equation: M X E = P.

You should always remember this equation as a way to understand how we arrive at prices. We take the earnings and we figure out what we are willing to pay for the earnings—the multiple—then we times them and we arrive at the price. This formula can also help us figure out future prices. If we know what the earnings estimates are going to be (E) and we can figure out what we might be willing to pay for those earnings (M) we can arrive at a future price or we can figure how much above or below a stock might be from where it might trade in the future. The multiple allms us to make apples-to-apples comparisons with the stocks of other companies in the cohort.

To put it another way, if we have the price, and we have the future earnings estimates, we can measure whether we are paying too much M or too little M for the stock right now versus its peers. Any change in the earnings estimates (faster growth, for example) or any change in the economic landscape (such as lower interest rates, as we shall see) can affect what M we will pay.

Congratulations, you have just mastered the art of figuring out what a stock is worth and what it might be worth in the future.

Professionals never say, "Maytag's a bargain because it trades at twenty-seven dollars." They say "Maytag's a bargain because it trades at twelve times earnings and yet it is a consistent grower that deserves to sell for a higher multiple." Or professionals might say, "Maytag's expensive at twelve times earnings given its spotty history." The subjectivity is in the comparisons to other equities of similar nature.

Whirlpool, on the other hand, earned about $6 last year and it trades for $67. What does it trade at times earnings? What's its magic number? Divide the $67 by the $6 and you get roughly 11 (again, we are rounding because the precise multiple isn't as important as the ap­proximation). So Whirlpool trades at a multiple of 11 times earnings. Now we have something that allows us to compare the two companies; we have something that explains the relative worth of each company's shares. Maytag trades at 12 times earnings while Whirlpool trades at 11 times earnings.

Here's where it gets really interesting. While the Whirlpool at $67 seems almost $40 more expensive than Maytag at $27, when we make the comparison apples to apples, when we break it down by PIE (price-to-earnings) ratio, we see that Whirlpool trades at 11 times earnings and Maytag at 12 times earnings. That's right, Maytag at $27 is actually more expensive than Whirlpool at $67. Almost 10 percent more expensive, despite the prices quoted.

We say, using the vernacular of Wall Street, that Maytag is "one multiple point more expensive than Whirlpool." We are simply sub­tracting Whirlpool's 11 multiple from Maytag's 12 multiple to arrive at that one-point disparity. Do you know why a $27 stock can be more expensive than a $67 stock? There are many reasons. One is that a Maytag appliance might be slightly better than Whirlpool's. A second may be that Maytag's brand has a better reputation than Whirlpool. A third could be that Maytag's management might be better than Whirlpool's. All of those reasons do matter. But the real reason why one trades more expensively than the other is that one grows faster than the other. All reasons for changes in multiples pall compared to Wall Street's intense growth fixation. The main reason Maytag trades at one-multiple-point premium to Whirlpool is that it grows faster than Whirlpool. On Wall Street we care about growth, growth, and then more growth of the future earnings stream of an enterprise. That's the major determinant of what we pay. The other reasons are quite secondary, despite what you have read or heard otherwise. Growth is the focus, the be-all, the end-all of investing, the mother's milk. Nothing trumps growth. If you understand that seeking growth, or more important, seeking changes in the growth rate that may be unexpected by others, is the most important factor to focus on as an investor, you will catch all the major spurts in stocks that can be had. That's because stocks move in relation to changes in growth of earnings at the underlying company. If you can predict or forecast changes in growth in the underlying company—either through management changes, or product development cycles, or changes in the competitive landscape, or through macroeconomic concerns like lower taxes or lower interest rates—you can predict big moves in a stock before they happen. That's what I have spent my whole life searching for, and I am living proof that these changes can be forecasted, found, and acted upon ahead of the crowd.

How is growth measured on Wall Street? To chart future growth, you have to start by looking at the pattern of earnings, particularly earnings per share, or EPS. If you pick up the annual reports, or download them online, you will discover that Maytag has been growing its earnings much fastea than Whirlpool. In fact, if you do the arithmetic, or if you go to Yahoo! or ~he~treet.com or any other Web site and ask for the "quote," you will also get the long-term growth of the enterprise. You will see, for example, that Maytag has been growing its earnings at 9 percent a year, while Whirlpool has been growing its earnings at 5 percent a year. Maytag has been growing its business much faster than Whirlpool. Again, Maytag trades at a higher multiple than Whirlpool, 12 to 11, because it grows its business faster. Wall Street pays a premium for high growth and awards a discount for slow growth. The multiple I have measured reflects past growth, but people on Wall Street presume that past growth can help indicate future growth, and they judge companies accordingly unless the companies make acquisitions, change management, or discover something new and different that can make them grow faster. While not always an accurate predictor of future growth, past growth is a terrific starting point for projecting a company's future growth.

For many this growth fixation seems somewhat alien, if not counterintuitive. We tend not to rate any of the other goods we buy according to how fast they grow. It isn't an ordering principle in other walks of life. We don't buy cars, for example, for how fast they go, unless we are race car drivers. Houses don't go for growth, they go for looks and convenience. We don't choose mates or friends by growth. That's another reason why everything on Wall Street is so counterintuitive: Other than college basketball coaches trying to figure out which high school athletes to recruit, growth is a metric that matters only in the stock market.

We do, however, have a concept that all of us understand in the bet­ting world that is analogous to the multiple we pay for growth. Despite its alien terminology, the multiple is actually nothing more than "the line" as expressed in Wall Street-speak. We take the line as second na­ture for every bet we have ever made. Anyone who has made even the friendliest of wagers, say, on the Super Bowl, knows that you can't bet on the favorite team without having to spot the other guys something. Teams are not traded even up. Their records matter and they get factored into the price of the bet. There's a favored team and a team that's the underdog. You often have to give or take points. The multiple is our own expression on Wall Street of the spread between the winners and the losers. You have to pay a higher price for growth on Wall Street just as you expect to have to give points to the lesser team in betting on a football game. In sports, the favorite could be favored because it is better coached, has better players, is bigger, or has a history of winning. In business, a company is favored because it has more consistent growth over time. That company is favored, and the cheaper company is the underdog. Just as in wagering, you have to pay up to place a bet on a superior company on Wall Street. The cheaper company, the underdog, tends to stay cheap, just as the underdog tends to lose. Think of the lower multiple as the handicap, the discount factored into a lesser equity that makes it possibly compelling as something to wager on. But only when it gets so cheap as to make it seem that the line between the good team and the bad team is wrong does it pay to invest in the underdog.

Now, let's notch things up a bit and decide how to figure out if the line is right in stocks or whether the market's oddsmakers, all of those buyers and sellers, have created an opportunity because they might be wrong about a company's future. We know that all too often there are imperfections in the line when it comes to sports wagering. Are stocks any different? Let's figure out whether the cheaper of Maytag or Whirlpool is too cheap and might be worth buying. Remember, all we have done so far is figure out which one is trading for a higher multi­ple than the other. We have figured out which one is more expensive and determined that Maytag is one multiple point more expensive than Whirlpool because of its higher growth.

We are looking, in other words, for imperfection. Is there something about that pricing that could be wrong, either higher or lower than it should be? Unlike the supermarket, where there are scanning devices and checkers to be sure the store is selling the product for the right price, our store at Broad and Wall often misprices things. Just like in sports gambling, where we are trying to figure out where the line might be wrong, giving us too many or too few points, we have to exploit the mispricings. Again, Maytag's price-to-earnings ratio is 12 but we have calculated that it grows almost twice as fast as Whirlpool, which has an 11 multiple, or price-to-earnings ratio. I would argue that any company growing twice as fast as another in the same industry should sell at twice the price-to-earnings ratio of the other—not 9 percent higher as it is now—because growth is all that matters. So, in reality, Maytag at 12 times earnings is more of a bargain than Whirl­pool at 11 times earnings, even though they are in the same business, because Maytag is doing better and growing faster. Maytag's the steal at a 12 multiple, and Whirlpool's the more perfectly priced. Therefore Whirlpool will be less likely to produce a win. The line seems "wrong" enough to buy Maytag for an investment to bet it will go higher over time, at least as it trades against its competitor. That would be my initial take if people were to call in to my radio show, for example, and ask whether Maytag is a better buy than Whirlpool. Without having any other insight, I would go with Maytag.

The line can be wrong for a million reasons in well-known competitions like MYG versus WHR. But most investors don't look for the "games" where the line is most wrong—in younger, underresearched, and little-known companies. Instead, unaware of Andy Beyer's advice to seek out lesser tracks that don't attract the best handicappers, most investors traffic in only the big races, stocks like Microsoft or Intel or IBM. These are the Kentucky Derby and the Belmont Stakes of my business, the most known and written about, where the line is almost always perfect and very little money can be made. The imperfect line happens only when you stray away from the major players, go to the lesser tracks, in this case the companies worth $2 billion and less, and particularly the $100 million to $400 million companies. These stocks are considered more "speculative" by the cognoscenti, whether it be the talking heads you see on television or the authors of the dry books about finance. Nothing could be further from reality. The most terrible speculations, as' defined by their risk-reward, are the big, well-known companies. You can't possibly get a homework edge on them; almost all the news on them is already "in : ' or discounted. That's why I preach that your homework should focus on the less well known situations, the markets with smaller, young growth companies. Although you must accept the risks that come with less knowledge, the rewards are far greater than with the perfect lines of the established players. Betting on the favorite to win at the Kentucky Derby might ensure a victory, but at a price that doesn't make the reward worth the risk. In other words, the logic behind Andy Beyer's Picking Winner —out-of-the-way tracks generate outsized earnings because the line is often imperfect—is analogous to Wall Street, where the multiple is often set improperly for lesser-known, underfollowed companies.

Of course there are other details at work in evaluating companies' stocks besides the rate of growth of the corporation underneath the equity. For example, some of us might be yield-conscious. Given the fantastically low tax rate on dividends—15 percent goes to the government, you keep 85 percent—we might want to compare stocks on a yield basis. Whirlpool pays out 43 4: per share each quarter and Maytag pays out 184: per quarter. Again, we do our best to confuse the hell out of you on Wall Street because those two dividends are equal! You have to break out that fourth-grade division skill again and add in some multiplication. If you get dividends four times a year, you are getting 724: a share for Maytag (184: per share four times a year) and $1.72 for Whirlpool (4 times 434:). You then divide that 724: by $27— last price—for Maytag and $1.72 by $67, Whirlpool's closing price, and you get 2.5 percent for both. Their dividends are exactly equal even though Whirlpool seems like it pays more. Again, that's because the dollar amount of the dividend isn't relevant; the yield, as expressed by the dividend divided by the price, is the apples-to-apples comparison.

So, on a dividend basis, these two stocks are equal and we can't differentiate them, although I would argue that a company growing its earnings twice as fast as another company might eventually boost its dividend at a faster pace, too.

Before investing in either company, we might examine their balance sheets. Again, when faced with a security laden with debt versus one with a clean balance sheet, I am going to favor the clean balance sheet, because when the economy turns down, too much debt can be a killer—to the equity holders. But if a fast-growing company with a great opportunity has to take down debt to finance a worthwhile investment, then the case can be made that the company's indebtedness should not be held against it in the competitive derby for your dollars. This brings us back to the price-to-earnings multiple versus that growth rate again as a way to figure out whether Maytag is a better buy than Whirlpool. With dividends equal and balance sheets roughly equal, I will still want to buy the "more expensive" stock, Maytag, because it is only fractionally more expensive (1 multiple point: 12 PIE minus 11 PIE of Whirlpool) but it is growing almost twice as fast. That's simply more compelling than the stock of Whirlpool.

On Wall Street many of the professionals, the analysts on both the buy and sell side who compare companies with one another, simply stop when they calculate the PIE and the growth rate. They make their buylsell decisions on those ratios. They take the growth rate of Maytag, and they match it against the growth rate of the average company in the Standard & Poor's 500, the ultimate benchmark betting line. They then compare the price-to-earnings multiple of Maytag to the price-to-earnings multiple of the S&P 500. They use the same process we used to calculate Maytag's price-to-earnings ratio. They figure out the "average" multiple that all of the stocks trade at. They average all of the PIES together, and they use that as the benchmark. Recently, the average S&P 500 stock traded at 22 times earnings. So Maytag's price- to-earnings multiple is substantially lower than the S&P average. But Maytag also grows more slowly than the average company because the average company in the S&P 500 grows at about 9 percent a year. So while Maytag is cheaper than the average company in the S&P 500, as expressed by the PIE, or price-to-earnings multiple, it deserves to be cheaper. Most Wall Streeters declare that Maytag is "fairly va1ued" versus the S&P index because it doesn't grow fast enough to be attractive; it is therefore not much of a bargain even if it is a bargain versus its competitor Whirlpool. If it traded at a smaller multiple and grew much faster than the average company in the index, then it would be a huge bargain. If it traded at a large premium to the multiple of the av­erage stock but grew much slower it would be much too expensive to buy. That's the kind of calculation that highly paid, I would say overpaid, people on Wall Street make every day.

You often hear some talking head on TV say, "Maytag's expensive." That calculus is almost solely based on the exercise we just went through. If they didn't use shorthand, what these people would be saying is, "When you calculate the growth rate of Maytag, and the price- to-earnings ratio of Maytag, and you compare it with the average company as represented by the S&P 500's growth rate and multiple on earnings, you don't find Maytag particularly compelling." Or, to analogize back into sports and betting, the "line" on Maytag is accurate. There's no "steal" there, nothing that makes you feel Maytag's a great bet.

All of this makes sense in the world defined by Wall Street. But does it make sense in the real business world? Ahh, that's still another story. In the "real world" Maytag could be worth $40 a share if Electrolux decides it's worth that and adds Maytag to its business collection. In the real world Maytag could be worth $50 a share if General Electric decides it can't let Electrolux have the property. In the real world these aren't pieces of paper, they are companies that throw off cash and profits and can be used to augment the earnings of other companies. Businesses have a value to Wall Streeters and a value to Main Streeters. The Wall Streeters care about growth; the Main Streeters care about enterprise value and how much it would cost to buy the whole company. Wall Street loves to be bound by simple calculations like growth rates and prices of a company. All that gibberish about "overvalued" and "undervalued" or "fully valued" comes from comparing the price- to-earnings ratio and the growth rate of the average company to the price-to-earnings ratio and growth rate of the S&P 500 index.

Go back to the example of the two sweaters at Macy's. Wall Street is addicted to finding the mispriced anomaly, the cashmere sweater that is priced the same as the poly-cotton alternative. Unfortunately, the big cap part of the market, like the mall, doesn't allow for such obvious bargains, so most goods seem "fairly" valued to most participants because that cashmere item gets spotted by the millions of buyers out there and gets bought, even if it is buried in poly-cotton offerings.

Unfortunately, this kind of calculation, while intelligent and rational, won't make you rich. Too many people, smarter and more knowledgeable than you, can look up these kinds of data and make these comparisons. So, while we want to understand how valuations work, we don't want to be trapped by them if we want to get rich. In fact, just the opposite: We must exploit the anomalies that this rigid arithmetical approach to investing creates every day. We don't want to invest to stay even with others; we want to invest to beat others at the contest of making money.

At one stage in my career I wanted to be an artist. I remember studying fine arts at Harvard, taking a course on modern art affectionately known as "Spots and Dots." In that class, the professor described how modern art didn't want to be bound by the four walls of the canvas, that artists like Braque and Picasso hated being bound by the canvas and actually attempted to make their art more like life itself, which is hardly two-dimensional. They placed things on the canvas to make them come alive.

I think that the analogy of modern art holds up well in the process of picking stocks, and it is one of the reasons why I regard myself as almost always able to pick out big winners among those stocks that are considered overvalued by Wall Street. While I accept the simple equation that E X M = P, I refuse to be bounded by it. I want to think outside the walls of the earnings and multiple, outside the confines of simple earnings analysis to ascertain which companies are growing fast enough to own.

I run a public portfolio called ActionAlertsPLUS.com. Unlike every other commentator in the country, I don't mind showing what I am going to do beforehand so you can run ahead of me. And I love putting my money where my mouth is, which again distinguishes me from all of those talking-head reporter types who swear a vow of stock abstinence, which then makes them incapable of figuring out the process but certainly allows them to claim "honesty" in their ignorance. Frankly, I would rather be smarter and wiser and disclose my positions candidly up front than be divorced from the process. You can't be any good if you aren't a practitioner; you just don't get enough practice. You need to be in the hunt to find great stocks or you shouldn't be commenting or telling people how to do it. I know it may look to some that I am corrupt because I praise stocks I own, even though I tell you that I own them. But think about the logic of it: I champion the stocks I own because I like them enough to put my money behind them. I champion stocks I own because I think they can make me money and you money, too. By similar logic I knock stocks I don't own because I think they are too rich and you could lose money if you buy them. I try to explain this all of the time on radio and TV. Nevertheless, people confuse my motives and believe that I am picking on bad guys and pumping stocks I own so I can make more money. If only life were that simple and if only I were that powerful! You spot bargains in the store the way I spot bargains on Wall Street, except that when I buy a bargain on Wall Street I am telling others and hoping they will take advantage of it, too. (I have established rules banning myself from taking advantage of any pop I might create by freezing my actions for five days if I mention a stock on radio or TV, and I won't sell a stock for at least a month after I buy it.) I regard myself as simply an oddsmaker trying to determine when the line is ab­surd and wrong.

Recently, for myActionAlertsPLUS.com account, I had one of my biggest hits ever, AT&T Wireless, which you could have shared with me, and gotten better prices than me, if you had subscribed to that site. (You get better prices because I send out an e-mail about what I am about to buy to give you a head start before I buy it.) In a matter of weeks I had a double in AT&T wireless that was accessible to all who read me. I am not bound by the two-dimensional thinking that hamstrings all of the high-paid analysts on Wall Street. I am not constrained by the growth mantra, as measured by the price-to-earnings multiple, even though Wall Street is. I see the piece of paper that 1 am trading and I remember that there is a business underneath it that the paper can lay claim to as long as the business is solvent. I recognize that stocks trade and, at times, companies trade, too. The stock trades on Wall Street, but the company trades on Main Street . Some companies are so huge that they trade only on Wall Street. Those are the acquiring companies like Exxon or Microsoft or Intel or Pfizer or General Electric. They are too big in terms of their market capitalization to be taken over by anyone else. You can only trade their stock and their stock will be valued traditionally. You will always have to figure out whether the line on Pfizer or the line on GE is too expensive or too cheap to hold on to the stock. That's the best kind of analysis for stock in a company that is too big to be bought by another company. Obvi­ously these better-known companies have more perfect pricing, and it takes a bountiful market to move them up faster than other stocks, given their size and their well-known-ness. How these stocks move up or down is discussed in a later chapter.

But when a company is even the second or third largest in an industry, then the whole shooting match, the control of the company, can trade. A takeover can occur that gives you an instantaneous win.

At the time that I issued an alert to buy AT&T Wireless, it was the third-biggest wireless company in the country. That was right before it was acquired by Cingular, a company put together by BellSouth and SBC Communications, two of the biggest landline companies out there. Before it was acquired the stock of AT&T Wireless had dropped from $32 to $6.I hated the stock in the $30s, when all of the analysts loved it because they thought the company had tremendous growth ahead of it. I thought the other companies in the wireless phone business would eat its lunch.

When the growth at AT&T Wireless faltered, in part because of poor management—something that the analysts who made the faulty estimates didn't take into account—the stock took a header. It went to the twenties, to the teens, and then to the single digits. When it got below $ 10, one analyst after another made the calculations we did ear­lier for Maytag—in other words, looked at the growth of AT&T Wireless's earnings and the price-to-earnings multiple—and decided that it was too expensive relative to the growth and the PIE of its peers and of the S&P 500. All seven of the major analysts were constrained by the growth mantra. They were considering AWE (its stock symbol) as a piece of paper, a stock, not as a company with an ongoing business.

Although I care about the apples-to-apples valuations of AWE versus the S&P 500 index and versus the other stocks of the players in the industry, just as I care about the PIES of Maytag versus Whirlpool, I am not willing to be bound by such two-dimensional thinking when it comes to the actual enterprises the pieces of paper represent. I grew to love AT&T Wireless, the company, even as its stock was marked down by the market, because, unlike the counterintuitive thinkers on Wall Street, I actually believed the company was growing cheaper as it went down in price. No, I am not being cynical or sarcastic. As a stock price goes down, the business becomes cheaper as an enterprise, and we must never forget that ultimately these are enterprises we are trading. Wall Street loathes stocks as they come down because it thinks of them only as ratios versus the growth of earnings. I, on the other hand, love stocks as they come down, because I know the enterprise underneath may not be deteriorating as fast as the stock price. Just as in the mall, I am always trying to spot merchandise that is being marked down below its potential. Or, if we were talking about buying homes, I can see the value of a fixer-upper to someone with deep pockets even as others just think the home looks like an eyesore and has little worth. I am always on the hunt for damaged stocks where the merchandise underneath isn't that badly damaged—not damaged companies, but damaged stock prices. That's where the biggest anom­alies among the established companies can be found. That's where the line is most wrong, among the visible but fallen stars.

How I came to buy AT&T wireless, this fixer-upper of a stock, is somewhat typical of the kind of commonsense analysis that I do, that you can do, but that isn't done on Wall Street. My ten- and thirteen- year-old girls and I absolutely love the Fox show American Idol. We think it is tremendous that these talented youths duke it out in front of a panel of terrific judges, yet ultimately we decide who wins with our votes. Unfortunately, every time we call to vote on our faves, we get a busy signal. Every morning, I drive "the bus" to the middle school, taking my daughter and picking up kids along the way. It's the time when I find out things I should know but never did during the days when I used to go to work at my hedge fund at 3:45 a.m. so I could trade in Europe . I got tired of hearing how everyone else in the car was voting and getting through and I wasn't, so I asked one of the girls how come she didn't get discouraged by the busy signals that I kept getting. Why, she explained, she text-messaged her vote. I told her that I wanted to text-message, too, and she told me you had to have an AT&T Wireless phone to text-message.

Ah-hah, now that's a gimmick. That day at work I pulled the file on AT&T Wireless and I saw that it had a huge installed base that hap­pened to be growing by leaps and bounds in part because of this Idol promotion. The "file," just so you know, was simply the current quarterly report plus the most recent news clippings I found in Factiva and the most recent Wall Street reports that I found on Firstcall, all publicly available data that once was available in real time only to the richest and largest of mutual funds and hedge funds. I wanted to buy AT&T Wireless, but I could tell that these analysts didn't know why the numbers were so strong. Not one analyst alluded to the Fox promotion that was driving so much traffic to the company, traffic that I figured would certainly stop or diminish once America 's most popular TV show finished for the season. I waited until the show ended and then watched as the numbers slid and the sign-ups, overinflated by the television show that probably none of these analysts watched, dropped precipitously. I noted the decline but still did nothing because I knew that come that ~ovember (2003) the FCC would force the carriers to adopt wireless portability, meaning we could easily switch carriers without losing our phone numbers in the process. Sure enough, when November and December rolled around, the complaints about AT&T Wireless were horrible. The other carriers did much, much better.

It didn't hurt that I went to a bunch of AT&T Wireless and Verizon Wireless stores to hear the complaints about the former and the praise of the latter. That kind of research, while anecdotal, steels your resolve that you are operating in the right direction. I still do it; you can do it, too, if you have the time and inclination. It isn't must-do, but it does help to verify your thinking.

Of course, Wall Street listened too, and then began the sickening process of downgrading the stock from hold to sell, one analyst after another, as the weaker, non-Idol-inflated numbers collided with the poor service of AT&T Wireless sales centers during the portability switch.

But, I recognized that the brand name and the franchise weren't losing their cachet as fast as the stock was losing its valuation. It was only a matter of time before management would get fed up and realize it couldn't compete with the other players. These managements are made up of humans who make the calculation every day whether they should go it alone or cash out, succumb to others for a higher price than where their shares trade. They want to get rich, too, either short- or long-term, and if their stock isn't going up because the business isn't growing fast enough, they can elect to sell and take the money and run. As each analyst, seven in all, downgraded the stock to a sell and it fell from $9 to $6,I issued alerts saying that you should buy more. When the stock got to $6,I said double down, that this franchise wasn't nearly as damaged as the stock itself. Managements don't like looking stupid. They can and do recognize that their job is to make money for shareholders, although it takes an honest management to realize that it can make money for shareholders only by selling out. It does help, though, that management often has incentives to sell out, as was the case with the bountiful options package that was readily available for all to see in the AT&T Wireless proxy, the voting documents for the directors of the company. Remember Andy Beyer's rule num­ber 3: Onlp invest in situations where you have total conviction.

What Wall Street didn't realize was that instead of being bound by the two dimensions of price-to-earnings and price-to-growth rate, there was a living, breathing entity, an actual business, that could be sold to the highest bidder. There has never been a case in history where a company that is not the first or second largest player in a five or six-company competition didn't succumb to a takeover by one of the other players that sought to become the premier largest player in order to take advantage of the tremendous economies of scale—for example, advertising and technology spending—that accrues to number one.

Sure enough, I had to wait only a few weeks before the initial inquiry came. And then another and another and then another again. Next thing you know, while every analyst had a sell on it, there were bidders willing to pay low double digits—all the other players out there.

Boom. Fifteen. That's right, I caught a $15 bid from $6, as the takeover war played out. The analysts caught nothing except scrambled egg on their faces.

It was all ours because we refused to be bound by the two dimensions of the canvas. How clueless was Wall Street? Even the best analyst on the stock, the Morgan Stanley fellow, who downgraded the stock at $7 on fears of wireless portability, upgraded it at $14 after the bid! How silly is that?

If you stay bound by the canvas of the stock, as the Morgan Stanley analyst did, you are always going to miss the bigger picture of the un­derlying entity. Wall Street cares about the growth of earnings, while businesspeople on Main Street care about the business underneath and how much it can add to their own earnings streams. That's why they will boost their pwn stock's worth by buying a fixer-upper.

There is no magic to pricing imperfections and finding bargains. You just have to know which streets to shop on and remember to compare the prices on Wall Street with Main Street before you buy.

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