TAKING THE MYSTERY OUT OF JUDGMENT

Session 1 - JUST WHAT IS "JUDGMENT"?
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   To us amateur investors, "Judgment" is commonly
used to describe what we do in the process of analyzing
stocks that goes beyond calculation. It implies subjective
decisions we make about a number of things. When doing a
stock study manually, there are nine opportunities for
judgment. These may be reduced to seven when doing the study
on the computer because the process of estimating what the
historical growth of a company's revenue and earnings has
been in the past is accomplished with mathematical precision
where, previously, it was necessary to use a ruler and
approximate the result. Each opportunity is a "cause to
pause" and think about those things that contribute to your
decision.

   Right off the bat, this discussion must sound intimidating
for those just starting out. So let's go back to the basics
and understand just what "Judgment" really is and, more
important, how simple it really is.

   Don Danko, Better-Investing's longtime editor, described it
aptly when he said that "Judgment" is to "understand what's
happened in the past and use that understanding to project
what will happen in the future." This gets us closer to
ascertaining what it is and why it's important.

   Probably the best way to take the mystery out of it is to do
as most exposes do and break it down into its simple
components. Essentially there are but four and a half kinds
of judgment. The first four are essential; the remaining
"half" is a matter of lore and conventional wisdom that
folks just like you have devised over the years to help them
make their own judgments. Let's get the "lore and wisdom"
out of the way first because this is the thing which
contributes the most to the mystery.

LORE AND CONVENTIONAL WISDOM

   NAIC investors have devised rules of thumb; various
percentages and ratios, and other such guidelines in
the course of their investment journeys, just as you will.
Some of them are suggested by our venerated gurus like
Tom O'Hara, Ken Janke, Ralph Seger and other authorities
respected from NAIC's beginnings. Others come from
experienced folks like some of the participants on this forum
or the I-Club or, perhaps, teachers at national or local events
who are not held in such awe as are the early founders, but
who as willingly share them with others and who are thought
to be authoritative or knowledgeable.

   None of these items is essential. Some of these items are
simply subjective ways to apply common sense to the task
when you come up with your forecasts. They are not mysterious.
They are couched in common sense. And they are things that
you will pick up along the way as by osmosis. You'll just be
mindful of them as you go along.

THE FOUR LEVELS OF JUDGMENT

Making History Relevant

   Eliminating non-recurring events -- Because "judgment" is
   making use of what you learn about history to project the
   future, anything that contributes nothing to projecting the
   future should be considered irrelevant. Events not likely to
   recur in the future should be removed from the calculation
   of historical sales and earnings growth as irrelevant.

   Discounting early growth -- Companies, especially in their
   early stages, grow very rapidly because the starting point
   from which growth is measured is low. Such early data should
   be removed to make the remaining data more relevant for
   forecasting future growth.

   Eliminating inflated PEs -- High historical multiples are
   sometimes caused not by extremely high prices but by poor
   earnings. PE's that are exaggerated should be removed to
   prevent overestimating future price growth and
   underestimating Relative Value (Toolkit) or the HVR (Take
   $tock).

Estimating Future Company Performance

   Estimating future revenue and earnings growth -- Based on
   relevant historical growth, you will estimate future growth
   and, with that, estimate future earnings.

   Estimating future profit margins, taxes, etc. -- Using
   Using the "Preferred Procedure" (Toolkit) or the "Business
   Model" (Take $tock), you can also estimate the detailed
   fundamental items that contribute to formulating the bottom
   line (earnings per share) from the top line (Sales).

Estimating Future Price Performance

   Estimating future Price-Earnings Ratios -- Using your relevant
   historical PE's you will formulate an estimate of PEs over the
   next five years.

   Estimating future high and low prices -- Multiplying your
   estimates of average high and low PEs with your previous
   estimates of future high and low earnings, you will estimate the
   range of high and low prices in the next five years.

Acceptance or Rejection

   Progressive decisions to accept results and continue, or to
   reject the stock. -- One of the better features of our stock
   study process is the progressive nature of that process. Each
   step affords you the opportunity to judge whether the result is
   acceptable or not, and if not, expend no further effort on the
   study.

There are many such opportunities which we'll discuss in the
coming installments..

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Session 2 - QUALITY:JUDGMENT IN THE VISUAL ANALYSIS
================================================
1 - Recent Performance

Accept or reject

Quarterly Growth - The first place one should look following
the header is the area that displays the most recent
performance.

   For the SSG, this would be the quarterly information in the
top, left corner of the growth chart. If the present growth is
inadequate, a wise novice will reject the study and move on.

A confident advanced investor might look at the PERT-A to see
what the trends look like for more than just the last quarter,
do some quality research on the Internet to see if there's
something afoot that others know about but that isn't obvious.
If there's no reason for concern, he or she might continue.

   For the Take $tock user, the recent growth is found both on
Screen 4 (the trailing four quarters), and on the front of
the TSSW form where there's a record of the past four quarters,
the percent changes for each, and for the trailing twelve months
 - a sort of "mini-PERT-A."

   In either case, you can see recent trends and, after
appropriate research, make a decision as to whether or not you
think it wise to continue.

2 - Visual Analysis

First Impressions

   I'm fond of saying, "If you can tell the difference between
a straight and a crooked line, and between a line that slopes
up and one that slopes down, you've already learned nearly all
you need to know about the quality issues." While that's
admittedly something of an oversimplification, it's certainly
true about Section 1 of the SSG.

   Section 1 is called the "Visual Analysis" for good reason.
Looking at the lines plotted on the form, first impressions
are generally the most important. If the lines slope up from
left to right, and if they are reasonably straight, the odds
are that you can benefit from going further. If they are
not, this is an "Accept or Reject" issue and you might as
well discard the stock study.

   Poor candidates are usually easier to spot than good ones.
And marginal ones may be worth further investigation; but,
since we're able to find more good companies out there, why
settle for "iffy" ones. When in doubt, throw it out!

Eliminate Irrelevant Data (Outliers)

Eliminate non-recurring events -- "Spikes," events that are
usually displayed as substantial down-turns in sales and
often breaks in the earnings line at the bottom of the growth
chart, depict events that are serious "potholes in the
road." If there are a number of them, you would probably be
best off to more on to another stock. If there are only one
or two, early in the history of the company -- and, if the
growth from that point on has been reasonably steady and
strong -- you may choose to eliminate it (or them) by clicking
on the line representing that year (Toolkit) or on the year
(Take $tock: Advanced mode). A good rule of thumb is to never
eliminate an outlier if doing so would increase the historical
growth rate of either sales or earnings per share.

Discount early rapid growth -- Companies early in their life
cycles will often emerge from their startup deficits and
display explosive growth -- each year growing spectacularly
from the previous low point. Such growth declines over time,
eventually reaching a point where growth is sustainable year
to year. This decline is clearly visible on the growth chart
as the line depicting sales or earnings growth resembles a
trajectory, each year's slope becoming shallower until it
stabilizes at a sustainable rate.

   The trend line that takes into account all of the available
history, in such cases, will appear as an "string" on a
"bow," crossing the arc between the early and recent data, and
appearing steeply inclined. The rate of growth it describes is
considerably greater than recent growth.Therefore, it's
important to remove the data that contributes to this
overstated growth rate. After all, one would scarcely expect
the rapid growth from the past to occur again in the future,
as the company's success actually causes the rate to decline.
(It's much more difficult for a company with $500 million in
sales to increase those sales 15% than it is for a company
when it has only $5 million in sales.)

   If possible, you should delete the earlier years until the
rate of historical growth no longer declines. This may even
involve deleting all but the last one or two years. In such
a case, you still can't rely upon last year's growth to
continue into the next year. But that's a topic for our next
item.

Estimate Sales and Earnings Growth

   In estimating future growth, let's consider some general
rules:

   First of all, we'll always begin with sales. They're always
the more stable and steady of the statistics, or at least they
should be, since earnings per share are affected by a variety
of expenses and changes in the number of shares outstanding
which makes them less predictable.

   Secondly, never estimate future sales or earnings growth
to be higher than your relevant, historical growth. No matter
what kind of story you read or hear, it will be just too
much of an exception to the rule. So use the historical rate
as your starting point--your maximum.

   Third, don't estimate any growth above a rate that you
believe to be sustainable. Historically, growth above 20%
has not been sustainable over the long haul. For the reasons
discussed before, earnings growth must parallel sales growth
over the long term. Therefore, it's best that you never
estimate the long-term future growth of earnings to exceed the
growth of sales.

   Finally, just remember that your interests are best served
if you forecast it "right." Forecasts don't have to be
accurate; they just need to be "right." Since you'll most
often be "right" if you underestimate rather than when you
overestimate, the more conservative you are, the more likely
you are to be "right." In other words, there'll be fewer
unpleasant surprises and more bonuses.

Revenue Growth -- Now let's look specifically at estimating
sales growth.

   * First, start with your relevant historical sales growth.

   * Reduce it slightly, just for normal decay as companies
        grow. Perhaps down to the next half or a whole percentage
        point.

   * Next, look to see how stable historical sales have been.
        If they've been like a railroad track, there's little need
        to back off, but if they zigzag a little, then, the more
        unstable they've been, the more you need to reduce the
        rate for that uncertainty.

   * Then, temper your estimate using your common sense
        assessment of the sources of growth, likelihood of
        competition and any other subjective issues that cross your
        mind.

   * And finally, if your estimate is still above it, reduce it
        to no more than 20%.

Earnings Growth -- Estimating the growth of earnings per
share is very similar to what will have just completed with
your sales estimates. There are, however, a couple of
differences.

   * First, of course, as you did with sales, you'll start with
        your relevant, historical rate.

   * Reduce the growth if it's above sales, to the rate of
        sales.

   * Next, again as you did with sales, reduce it to reflect
        your diminished confidence if it has historically been
        unstable. The more unstable it has been, the lower your
        estimate.

   * Again, apply your common sense to the subjective
        consideration. How sustainable are the profit margins, for
        example? We'll talk later about the so-called preferred
        procedure. This is simply another way to arrive at the
        earnings per share by considering all of the intervening
        items that affect the company's income, as it makes the trip
        from the top to the bottom line. If the result of this
        process comes out to be lower than your estimate so far,
        then you'll probably want to use that result.

   * And finally, again, if it's above 20%, reduce it.

Accept or reject

Historical growth -- Ideally, you're looking for historical
growth that has been able to double the value of revenues or
earnings over a five year period. If the historical growth
is inadequate for your needs, or is too unstable to offer
much confidence in your forecast, you will probably want to
reject the stock as a candidate and try another company.

Future growth - If the forecast growth doesn't come up to
your requirements, you should probably quit and try another
company.

Visual Analysis - Lore and Conventional Wisdom

   Here are some words of wisdom from a couple of NAIC gurus
that fall under the heading of "lore and wisdom."

Tom O'Hara - "When I start looking at a company and its
sales report, I usually first think of the kind of business
the company is in because that tends to have an effect on
what I may look for or expect from its sales.

    "For very high growth rate companies I expect to see some
reduction in the rate of growth for the past couple of
years. If it hasn't occurred, I build in an expectation for
a slow up in my projection."

Ken Janke - "Many times we see that earnings are growing
more rapidly than sales . . . . Faster growth in E/S is
usually because the profit margin has been increasing. It
may come to a point where margins cannot increase
significantly.

    "Another reason for E/S to grow faster is that the company
is buying back shares on the market, thus reducing the
number of shares outstanding. When the smaller number of
shares is divided into the net profit, the results will be
higher earnings per share."

I'm leaving for Sacramento today and will be out of pocket
until Monday. If I can manage to do so, I'll continue
from there. Otherwise, I'll resume on Monday.

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Session 3 - JUDGMENT IN EVALUATING MANAGEMENT
=============================================
Evaluate Management

   Although it occupies less space and is less intuitive
and "spectacular" than the Visual Analysis, the "Management
Report Card" is hardly less important. Section 2 of the SSG,
and the "technamental" graphs that display profit margins
and ROE in Take $tock, are the other half of the quality
evaluation.

   This task is often overlooked by novices because there
is nothing, physically, to do. No estimates are required.
However, there is an opportunity to eliminate irrelevant
data and an extremely important opportunity to make an
"accept" or "reject" decision.

Eliminate non-recurring events

   Both of the management evaluation parameters can be affected by margins
and/or ROE values that have been skewed
out of the norm as a result of non-recurring events that
have occurred in the past. Again, to consider only relevant
data is important here; and you should eliminate such
extreme data so as not to affect the five-year averages
that they have impacted and against which the most current
data is compared to indicate a trend.

Accept or Reject

Profit Margins - By far, the most important consideration,
for me, are the profit margins. Let me explain:

   Expenses are paid out of revenues, as a rule. In fact,
any company that has to dip into its equity to do so is
likely in trouble. Pre-tax profit margins, the number of
cents the company gets to keep out of every dollar of
revenue, represents a measure of management's efficiency
--its ability to control expenses.

   While there are some exceptions, a decline in profit
margins is an indication of management's failure to control
their costs effectively. We'll talk about those exceptions
in a moment.

   Companies that are in equilibrium, operating at peak
efficiency, display a steady and reasonably constant trend,
and are usually found to be leaders in their industry.

   Companies that have recognized that they can improve
their margins and have taken steps to do so, will display an
up-trend in their margins. Either of these conditions is
acceptable.

   A down-trend is usually unacceptable and cause to reject
a stock without going any further.

   There are some exceptions--cases where management has
made conscious but reasonable decisions that have resulted
in a decline. These include taking on new product lines that
have smaller margins and sell in higher volume; acquiring a
company whose product line has a lower margin; reducing
prices to "buy" market share or fight competition, to name a
few. Common sense should tell you what to look for when
doing your research. If, however, you can't find a good
excuse, throw it out!

Return on Equity - While ROE is given "equal time," it's by
no means as clear an indicator of management's performance
as are the profit margins.

   In the first place, equity--as we indicated before--is
traditionally used to implement management's long-term
decisions and not those of immediate consequence. Buying a
company jet, buying property to build a new headquarters
building, replacing obsolete machinery, acquiring another
company--all are typical uses of a company's equity.

   The consequence of those kinds of decisions are not known
until much after the expenditure of the capital; and the
wisdom of those decisions can't be ascertained until then.
The results, rather than showing up with any significance in
the ROE, will LAATER show up in the profit margins.

   Therefore, if there is a downtrend in the profit margins
because the decision was unwise, the trend in the margins
will already be evident, and it is that trend that affects
the trend in the ROE.

   Secondly, calculated using ending equity (EPS divided by
Book Value per Share) distorts and artificially reduces ROE
values, in the SSG. (Take $tock uses beginning equity so as
not to suffer that distortion.) Even a transaction like
buying back shares or paying dividends will reduce the Book
Value, elevate or retain the EPS, and cause an increase in
ROE that is deceptive.

   Our suggestion is to pay little attention to ROE for
these reasons. If you're going to calculate Implied Growth
(Sustainable Growth), using ROE, as an indication of the
potential growth of a company, be sure to use ROE calculated using beginning
equity to do so. The formula is ROE x RR
(Retention Ratio - the complement of Dividend Payout), and
is not really valid unless you do. The higher the earnings
growth, the greater the distortion caused by using ending
equity.

The proverbial "Barbed Wire Fence"

   The Visual Analysis and "Management Report Card" comprise
the quality assessment of a company. Nothing else is
required!

   There are many metrics and ratios that the pros use. And
there are some within our ranks that swear by evaluating
financial and operational vulnerability using many of those
tools. They are interesting, perhaps fun, incrementally
enlightening, and absolutely unnecessary!

What separates the "technamental"--NAIC--investor from the
rest of the folks that insist on complicating fundamental
analysis is that we have learned what's essential and what's
not.

   No CEO worth his salt micromanages his subordinates. Neither is there any
reason for you to believe you must. In
fact, you have more companies to monitor than the typical
CEO. The many metrics are merely tools that management uses
to achieve the results we judge. And, we need only to look
at those results to draw our conclusions.

   We can't hire, train, or fire the managements that use
those tools; nor do we have access to the data to which they
are privy to--neither, I might add, do the professionals.

   Management is highly motivated, better equipped, and has
far more time than you do to begin to second-guess their
decisions. So--as the serenity prayer so cogently suggests--
"grant me the courage to accept the things I cannot
change...and the wisdom to know the difference."

   At this point, you are ready to make a critical judgment.
Is the quality of this company, based on the results you've
analyzed, good enough to go further? Is the growth
sufficiently strong and steady? Is management exhibiting an
ability to sustain that quality of growth?

   At this point in your study, you have before you a
figurative barbed wire fence looming between the Management
Evaluation and the next sections in which you will assess
the Value--the reasonableness of the price. You must not
attempt to scale that fence if there's any doubt about the
quality issues. Why is that?

   The worse a company performs (fundamentals, not price),
the better a value it will appear to be. Because people sell
rather than buy the stock of a company that's perceived to
be performing poorly, the price will be low, the PE will be
low. For those reasons, the risk will appear much less than
the reward, the return will label the stock a "bargain"
at the price, and you can be seduced into thinking it's a
bargain when it's far from it.

   Only when you're absolutely satisfied that the company's
quality indicators are solidly positive should you move to
the other side of the "fence." If you do otherwise, it's
like cheating at solitaire.

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Session 4 - VALUE: JUDGMENT IN ANALYZING HISTORY
================================================

   Here again is a section often overlooked because there's
nothing physical that you must enter--no estimates to make.
Yet the opportunity to make one of the most critical
judgments of the SSG is in Section 3 and in the Historical
PE section of Take $tock.

Eliminate inflated P/E's

   As in Section 1, history is laid out for us in this
section. Only here, we aren't looking at growth; we're
analyzing historical PEs.

   If you were to analyze the gasoline market, you'd want to
look at history and determine what the average price was for
a gallon of gas. You could then both analyze the current
price of gas in view of that information, and you could come
up with a pretty good idea of what price you might expect a
gallon to bring in the future.

   This is pretty easy to grasp, I'm sure; and it should
therefore make a lot of sense when we say that we're doing
the same thing with a dollar's worth of earnings. The PE is
the price paid for one dollar's worth of earnings. That
price fluctuates up and down like the gas prices do--only
the PEs are more volatile than the gasoline! Because it's
normal for the stock's price to fluctuate as much as 50%
above or below the average within a year, it's common for
the PEs to fluctuate nearly as widely.

   To evaluate a stock's price, we will want to analyze the
current PE as it compares with the historical average; and,
in the next session, we'll discuss applying that analysis to
estimating the price of a dollar of earnings in the future.
Before we can apply these historical values, however, we
need to again make sure they're relevant.

Consider this: Stock prices are captured during the company's
fiscal year--and the prices reflect the highest and the lowest
prices from the first to the last day of that year. PEs are
calculated by dividing the stock price by the earnings per
share.

   However, if we assume that the earnings are what drive the
price, and we assume that investors are paying so much for
that dollar's worth of earnings, doesn't it fly in the face
of common sense that those that paid the price they did, up
to and on the last day of that year, couldn't know what those
earnings for the year were until--typically--more than three
months later? That's right. The company can't report its
earnings until after the last day the prices are recorded,
and usually a company will use up the entire time allowed
(90 days from the close of the annual books) before they
report their financials to the SEC.

   This means, of course, that the actual earnings for the
year couldn't possibly influence the price even though both
the price and the EPS are used in the equation.

   The fact is that it is the expectation of earnings that
drives the price; and sometimes, because of accounting
decisions, the earnings reported don't even resemble the
forecasts on the basis of which investors bought. When this
happens, especially when the EPS are much lower than
expected--and this can happen in more than one year--a PE or
PEs will be exceptionally high.

   If that (or those) remain in the calculation of the
Average High and Average Low PEs, then the resulting values
will be enormously distorted--the high PE being
extraordinarily high.

   We are supposed to use history to help us estimate the
future. Right? If we allow this distortion to remain, and if
we use this extraordinarily high PE to influence our
assessment of our future high price, that critical high
price will be much too high. And, our measurements of
value--our total return and risk assessments will appear
deceptively favorable. This inappropriate assessment can
result just because the company had a bad year!

  You therefore must scan the values of the historical PEs to
see if any of the values displayed are out of line--
especially if they are extra high. If there are anomalous
PEs, you must eliminate them. They are not relevant. They
distort what we need to learn from history. And they can
cause a dangerous overstatement of the potential for the
stock you are studying. Eliminating those outliers will
eliminate the overstated data from the calculation of the
Average High and Average Low PE and give you a more suitable
picture of the potential future PEs.

Lore and Conventional Wisdom

   Here's Ralph Seger's comment about this item:
"Look at the historical record. Are there some values that
common sense says to disregard? Frequently, when EPS drop
below trend levels for one year, the price does not drop in
proportion. That results in a P/E ratio for that year that
is not representative of a normal situation. . . . .

"If the historical high P/E ratios seem to discount not only
the future, but the hereafter, it is prudent to lower them
to a reasonable level. . . . When future expectations are
cooled by some realistic expectation, then P/E ratios become
more rational."

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Session 5 - JUDGMENT IN APPLYING ESTIMATES
==========================================

   This is the area where the "rubber meets the road" in
assessing the price of a stock. There are a number of
opportunities for judgment here; but the basics are simply
the estimates of the future high and low PEs and the
selection of a low price. You may also choose to alter the
assessment of the estimated future earnings (using the
"Preferred Procedure" for the SSG, "Business Model" for Take
$tock), and you may decide to use the sum of the EPS for the
most recent four quarters in lieu of last fiscal year's
earnings.

Estimating High and Low PEs

   The most important understanding for Sections 4A and 4B
in the SSG and Future PEs in Take $tock is that you have
viewed historical PEs to learn what's happened in the past,
perhaps eliminating some irrelevant data; and you are now
going to use that relevant history to help you view the
future. This is a separate and distinct decision from
anything you did prior to this judgment opportunity.

   History has given you a maximum as a starting point; you
will now temper that maximum, in the case of both the low
and the high PEs, to come up with a conservative forecast
for the future. The consequence of overestimating these
values can be disappointing at best, dangerous at worst.

   While you may very well elect to use the Average High PE
and/or your Average Low PE as your estimate for the future
high and low PE, this should be a conscious decision, not
just an automatic one. And you should take care to be
sufficiently conservative to satisfy yourself that they are
reasonable and sustainable.

   You may wish to eliminate additional data from the prior
section to help you come up with lower or more conservative
values; but be sure to replace those that you eliminate for
that purpose. Only irrelevant data should be eliminated for
the calculation of Relative Value (covered later).

   The High PE is the most critical, in that it is
multiplied by your estimated future earnings to come up with
the highest price you can reasonably expect the stock to
rise to between today and five years from the end of the
last full fiscal year. This high price is used to estimate
your return.

   Unless you have a very good reason to believe that investors
will consistently pay more than thirty times earnings in the
future--and this is unlikely--don't accept a figure for your
high PE in excess of thirty.

   For the Low PE, the same caveats apply about being
conservative. This value is used, multiplied by the low
earnings figure, to calculate a future low price. And it's
that value that affects your determination of risk. Of
course, you can't set thirty as your cap for the low PE. If
you have had to lower your high PE to thirty, it might be
best to lower your low PE proportionately.

   My own mechanical method of selecting a High and Low PE
is to use the average of the lowest half or majority of the
high and low PEs over the past ten years rather than five.
This will tend to eradicate as irrelevant all of the
extraordinarily high PEs that were prevalent during the
recent "bubble." I will first use those figures (which are
available in the Toolkit using the [Alt+X] option with the
PE Estimate dialog box is open.) It is used automatically in
Take $tock.

High Earnings: the "Preferred Procedure" or "Business Model"

   As a part of the Visual Analysis, you earlier estimated
the future growth rate of sales and earnings and projected
that growth to derive a figure for both sales and earnings
approximately five years out. It is that future earnings per
share figure that is used in conjunction with your estimate
of the future high PE to calculate a forecast high price.
There is yet another way to approach the estimate of future
earnings. This is the "Preferred Procedure" (SSG) or
"Business Model" (Take $tock). Using this method is like
getting a second opinion--another way to estimate future
earnings to corroborate the first result.

   In a nutshell, this method starts with the sales figure
you previously projected. The benefit of this is that,
because sales are inevitably more stable and predictable
(since they are not affected by expenses or the number of
shares outstanding), they're more likely to be "accurate."

   The procedure then proceeds to deduct expenses (based
upon your historical pre-tax profit margins), your taxes
(based on last year's tax), any preferred dividends or other
adjustments, and it finally divides the result by the
estimated shares outstanding to calculate the earnings per
share.

   This is exactly the way a company operates, tracing the
progress of the "top line" down through the income statement
until it becomes EPS, the "bottom line." And, in this
procedure, you have the opportunity to make educated changes
in these values to alter the result.

   When you finish, you will probably see results much the
same as the earlier figures; but they will occasionally be
different. I suggest you accept the lower of the two in
order to be most conservative.

Selecting a Low Price

   Selecting the Low Price is the last judgment you will
have to apply before reviewing the results and making your
decision to accept or reject the stock.

   You have already calculated a low price, having done so
by multiplying the lowest number of times earnings investors
might pay (the forecast Low PE) times the lowest earnings
you might envision the company producing -- your choice of
the last fiscal year's earnings or the sum of the most
recent four quarters' earnings. How much more conservative
can you get with a reasonable growth company than to use the
most recent actual earnings as your projection five years
out?

   The fact is, if earnings per share don't exceed that
figure within a very short time, you're not going to keep
the stock anyway.

   In any event, that estimate of the future low price is a
reasonably pessimistic one. The SSG offers several other
options, only one of which makes much sense to me--and that
only under some conditions. Take $tock offers only two.
The ones that I don't bother with are the average low of the
last five years and the recent severe market low. Both of
those are variations that one might use if analyzing
cyclical stocks, value opportunities, or turnarounds--stocks
in whose past disaster was commonplace and in whose future
it's just as apt to be. I simply don't want to bother
studying those kinds of companies if I can help it. And I
can. <g>

   The SSG's "Price the Dividend Will Support" is an
interesting option. I will use it only under two conditions
that must occur at the same time. If the percent dividend
payout is in the neighborhood of 35% or higher, and
if the value of the Price the Dividend Will Support is
higher than the Forecast Low Price, I might be tempted to
use it.

   What it is supposed to signify is that the stock price is
low enough to make the dividend yield competitive with other
income investments and people will start buying the stock
for its income in addition to its potential appreciation.

   Ninety nine percent of the time, I'll use the forecast
low price and will never adjust the low price lower to "fix"
the Upside Downside Ratio (which we'll discuss in the next
session).

   In Take $tock, the "Yield-supported Low Price" is
somewhat different than in the SSG. It is based upon a
comparison of the dividend yield with the yield on a 5-year
Treasury Note and will favor that option when the dividend
yield comes within 1 percent of the treasury yield.

Lore and Wisdom

There are a few "crutches" that NAIC gurus suggest which
I'll add here.

Tom O'Hara - :"In an advancing market, the low will be
moving up as fast as the high price. In that kind of market,
I like to test a price 25 to 30% below the recent high just
to see how it compares with other choices. That isn't going
to do you much good whenever we get the big drop because
that will likely be 50%."

Here's another:

Ken Janke: - " One of the approaches I like to use [to
estimate a low price] is to multiply the latest 12 months'
E/S by the lowest P/E of the last five years. If that lowest
P/E happens to be in the most recent year, I may reduce
the price by another 10% just to be on the conservative
side. Remember that the stock market has experienced a 10%
decline 50 times since the turn of the century, so it can
happen any time." [Note: that was last century!] <g>

   This completes the discussion of the decisions you must
make in preparing the stock study for your final judgment.
We'll talk about analyzing the results in the next session,
our last.

--------------------

Session 6 - JUDGMENT IN ANALYZING RESULTS
=========================================

   You've now applied judgment in all of the essential opportunities
that have presented themselves in your stock study. It remains
only to make the final judgment: to buy or not to buy. There
are but three items that you will look at before making that
decision: Return; Risk; and Relative Value (SSG) or
Historical Value Ratio (Take $tock).

Return

   The most important criterion should be the hypothetical
return you might expect to get on your investment. After
all, that's what you're in this for, isn't it.

   You will find several places in Section 5 of the SSG where
you will find return calculated. It's important to understand
each so you won't be confused by them..

Average Annual Return (Section 5C) - SSG only. This is a
calculation of the simple return on your original investment.

   It's based on five years of growth and dividend
contribution combined, measures the total percent increase in
value, and divides by the number of years--five in this case.
It is not compounded growth and can be misleading if the user
is not aware of the fact that it is simple growth. To double
your money in five years, you would of course require 20
percent growth of the initial amount each year.

Total Return - SSG and Take $tock. This is the compounded
rate of return over the period covered. It is calculated by
combining the dividend yield with appreciation which is
calculated from the date of the study to the date the stock
is expected to achieve its high price - that high price
being a function of the forecast high PE, as described
above. It would take just under 15 percent each year to
double your money in five because the compounded return
takes into account the hypothetical growth in value each
year, which the simple calculation doesn't.

Projected Average Return - Toolkit and Take $tock. This is
the same calculation as Total Return; but the high price is
calculated using the forecast Average PE instead of the
forecast High PE. This tells you what kind of total return
you could expect to get if you sold the stock in about five
years at its average rather than high PE. This is,
obviously, a more conservative value.

   Your aim is to find stocks to populate your portfolio that
will contribute to a portfolio return that averages around
15%. This does not at all mean that every stock in your
portfolio must expect that return. It simply means that the
combined return should do it. When deciding whether or not
to buy, you should take into account the other stocks in your
portfolio, the risk entailed in higher return stocks
compared with the more mature, stable, and lower-return
stocks. And you should judge accordingly. A good return that
meets your specific needs is what you are looking for.

Risk

While the return is the most important item, it's possible
to be exposed to too much risk in order to get it. This is
the next item you should evaluate. Risk, for our purposes,
is a comparison of what you have to gain (if the stock goes
all the way up to your forecast high price) with what you
might stand to lose (should it decline to your forecast low
price).

   The SSG makes use of the Upside/Downside ratio to provide
you with a measure of the risk. This is calculated by
dividing what you stand to gain (the "distance" between the
current price and your forecast high price) by what you have
to lose (the "distance" between the current price and your
forecast low price). As the current price gets lower, the
top of the equation becomes greater and the denominator
becomes smaller. As you can imagine, when the current price
declines to your forecast low price, there is apparently no
risk. In fact the Upside/Downside ratio becomes infinite.

   You will look for an Upside/Downside ratio of 3 to 1 as the
ideal; i.e., there is three times the reward as there is
risk. You should be reluctant to buy the stock unless the
reward is at least three times the risk.

   Take $tock takes a little different approach to the same
issue. Using a "Risk Index," it measures the distance
between the current price and the low price against the
total distance from the low to the high prices. This percent
of risk, or "Risk Index" is expressed as a percentage and,
when it represents 25 percent of that total distance, is the
equivalent of the 3 to 1 Upside Downside ratio. (Obviously,
if 25 percent is risk, 75 percent would be reward - 3 to 1).
The benefit to this is the fact that, as the current price
rises or falls, the index grows or declines linearly instead
of asymptotically or at a faster and faster ratio. This is
because we hold the denominator in the equation steady.
In any case, if you're happy with the return, all is
probably well if your risk, however it's measured, is
reasonable.

   If, however, the Upside/Downside ratio is too low (or the
Risk Index too high), then the odds are that the stock is
simply too expensive at the moment to give you a good return
with reasonable risk. You should put the stock on your watch
list and wait until the price declines.

   On the other hand, if the Upside/Downside ratio is too high
(the Risk Index too low), it could well be an indication that
there may be something wrong with the quality issues. Its
significance is that the stock is currently selling at a
price well below that at which you've valued it and there
may be some reason that you don't know about but others do.

This is merely a warning signal and should be heeded. But,
it's also--at least to me--a signal that tells me that the
stock may be undervalued and I might be able to get it at a
bargain price. If research reveals nothing that would make
me feel that my valuation is too optimistic, I'll consider
--as is implied--there's little risk at that price.

   There is, however, nnother thing you might consider.

Relative Value (RV)/Historical Value Ratio (HVR)

   To put this device into perspective, it's important to
realize that these metrics are nothing more than a measure
of what other investors think of the stock at the moment. A
corollary to that is that other investors are often wrong!
<g>

  Relative Value is calculated by dividing the current PE by
the relevant, historical five-year average PE. The HVR is
similar; but is calculated by dividing the current PE by the
relevant, historical ten-year average.

   In a nutshell, this value, expressed as a percentage, is a
measure of how the current price (expressed as a multiple of
earnings) compares with the average price (expressed the
same).

   One would expect that a stock, reasonably valued, would
sell at roughly the same PE over its life--perhaps with a
little decline due to the normal decline in earnings growth.

When a stock is overvalued, it will sell at a higher PE--a
higher "rate" per dollar's worth of earnings--than when it's
fairly valued by investors. Of course, when it's "cold" or
undervalued, it will sell at a lower "rate" than usual.

   These metrics tell you some valuable things; but they
should not be used to arbitrarily lead you to a decision to
buy or not to buy.

   If the value is high (we use higher than 110%) it's
obviously valued at a higher price than it has usually been
The first thing you can deduce from this is that other
investors have not found any quality issues that disturb
them. They think it's a good quality stock too!

   It also tells you that they think it's worth more than it
has been historically. Don't simply refuse to buy it because
this value is high! Look at your assessment of return and
risk. If those should indicate that it's a good candidate
for purchase in spite of the RV or HVR, don't worry about
the valuation. It's probably worth the extra price.

   On the other hand, if the RV or HVR is low, don't just
discard it because it's arbitrarily out of range--unless
you're new and lack confidence that you can do adequate
research to prove to yourself that it's a good quality
company and the rest of the world's wrong.

   A low value certainly tells you that investors are selling
and not buying. They may know something you don't know that
has led them to do so; and you must find out what that is,
if anything. However, if you can satisfy yourself that
there's nothing wrong with the quality issues--and the rest
of your study indicates that it's okay--you can now be an
"educated contrarian" and go against the crowd because you
know more than they do!

   I think this about does it. I've blurted out about all I
can think of about basic "Judgment." I hope I've been able to
take away some of the myths and mysteries that have made it
so intimidating and bring it back down to earth for you.

   There is, of course, a world of lore and wisdom out there.
Every instructor has his or her pet rules of thumb and
methods of doing this. Just remember, the basics are all you
need to know. The rest you can find out for yourself.

Ellis Traub