Chapter 17 - Market Precepts, Practices And Generalities

There are certain general rules and practices in handling investments and building a securities portfolio that deserves consideration even though their application may appear more general than specific.

It has always been considered prudent to keep some cash resources in reserve, regardless of the state of the market, or the urgent attractiveness of certain issues. Usually this reserve should consist of money in a savings account sufficient to live for six months, in the manner in which you and your family are accustomed.

Secondly, while borrowing money to buy securities may maximize your market profits when bullishness is rampant, it can be nerve racking if the market sells off. For most investors ownership of stocks is the preferred policy. In any event don't overextend yourself; and make sure that the securities on which you propose to borrow have a broad, active market.

Leverage

It is a good idea to seek some leverage in your stock investments. Leverage is merely the effect upon per share earnings of a common stock, created by bond interest or preferred stock dividends, which must be paid before the common can share in earnings. To illustrate, suppose a company earns $100,000 in a given year and has 100,000 common shares as its sole capitalization. Obviously the earnings equal $1 a share and there is no leverage. A 50% gain or decline in company net earnings becomes a 50% gain or decline in per share earnings on common stock.

Assume, however, a different (and leveraged capitalization, with $1,000,000 in 5% bonds ahead of the 100,000 shares of common stock. Now the $100,000 in earnings are used thus: $50,000 goes to bond interest leaving $50,000 (50¢ a share) for the common. Suppose business improves and available annual earnings rise to $150,000. Then $50,000 is still needed for bond interest, but the balance, namely $100,000, doubles the per share earnings on common stock from 500 to $1. This is leverage. A 50% rise in earnings results in a 100% rise in share earnings, and the leverage ratio is 2 to 1. It is equally obvious that, if available earnings declined to $50,000, there would be just enough to pay the bond interest, and no earnings at all left for the common.

So you see leverage is important but it's a two-edged sword. It can magnify per share earnings in prosperous times but lower earnings rapidly in times of adversity. In general, however, some leverage is desirable in your investments. Utilities and rails provide it automatically. So do gas pipelines, and many merchandising and industrial companies with large amounts of senior securities. Life insurance companies afford a unique leverage, since their capital stocks share in the earnings from reserve funds above a certain percentage; and these reserve funds are frequently 6 or 7 times the combined capital and surplus funds of a "life" company.

When to Sell Stocks

Although there are hundreds of books and articles on the selection, diversification, analysis, and purchase of securities there is relatively little information and guidance on when to sell them. This is quite difficult to understand since the advantage of owning marketable securities is that they can be readily sold; and for each transaction in the market on any day there must be a seller as well as a buyer.

Therefore after you have acquired a list of securities, no matter how carefully or prudently they may have been selected, there will come a time when logic would indicate sale of some of them. Unfortunately most people do their selling less intelligently than their buying. They sell on a whim, hunch guesswork, just because they have a profit or are jittery about a stock that acts sick.

To shed a little light on this rather neglected investment area we're listing below some of the conditions under which sale of certain stocks should be considered. You should give some consideration to selling when:

1. The whole market appears too high. This condition is most apparent at the top of a long bull market when the Dow-Jones average is within 15% of its historic high.

2. A particular industry (in which you hold stock) displays a flattening out of earnings or long term downward earnings trend. The oil industry, in late 1956, is a good illustration. Though the stock market as a whole advanced for the three following years, the major oils declined.

3. A particular stock shows an adverse earnings trend.

4. An industry, or certain stocks in it get "over glamorized" and sell at a times/earning ratio that discounts the millenium. Uranium shares in 1955,
air line stocks in 1946, and certain electronics in 1959 illustrate this overvaluation.

5. You need money. This can occur regardless of the height of the market, or the trend of earnings. The point to remember here is to sell the weaker issues, and (usually) those that show a loss, first. Most people do it the other way around selling the best issues and one's showing a good profit.

6. The stock you bought has attained the market objective for which you purchased it and you are satisfied to take your profit and pay the tax.

7. For tax reasons. To establish a loss, offset loss with gain, anticipate inheritance taxes, achieve a loss "carry over" or for many other tax reasons, selling may be both appropriate and effective. Get the guidance of a good accountant on such matters, however. In any event don't stubbornly hang onto a stock that should be sold, just because you hate to pay the capital gains tax. Your market profit may melt away.

These are some of the standard reasons for selling stocks. Market averages will indicate to you whether stocks in general, are getting too high. If good bonds yield 1% or more than good stocks, or if banks are "loaned" up to the hilt, you are given further notice that the stock market is at a rather high level.

Resume

1. Borrowing to buy securities is not recommended.

2. Seek some leverage in your securities.

3. Don't be afraid to sell when the time is ripe.

4. Visible decline in the long term trend in earnings is a prime reason for selling a stock.

5. Consider selling when bullish enthusiasm in the market is greatest.

6. When you do sell, sell "at the market" and don't shop for that last eighth!

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