What is a Selection
Universe? Nope, not a buy
list, it is the result of
applying a time tested set of selection rules, concepts, and
experiences, to a pre-selected group of securities that are of a known
level of quality i. e., Investment Grade only. It's
just one of the things you need to know...
fairly comprehensive Question and Answer [more accurately, a Question
& Discussion] list that should help you to use the investment
process defined and explained in "The
Brainwashing of the American Investor". ( Yes, the new
Edition is bigger, better, bolder, and includes more information that
you need.) The more times you read
it, the better your performance will be. Here
are my responses to some questions I've received lately from people who
are using my methods... If you have additional questions, please
send them to: steves at sancoservices dot com.
the Investment Grade Value Stock (IGVS) Quality Rating, Additional Factors & Numbers:
The Specimen Stock Worksheet included
in the Brainwashing Book lists only two non-price items: S & P
Rating and Current Yield. Why aren't such fundamental standards as P/E
Ratio included there?
- The IGVSI
(Investment Grade Value Stock Index), and related Market
Stats were recently developed for users of the Working
- The Selection Methodology
presented in Brainwashing is a management technique
employed to simplify, organize, and control the decision making
process so that a consistent approach to stock selection, and
trading, evolves... the KISS Principle. A basic assumption, and the
rationale for using the S & P letter rating system in the first
place, is that their thousands of analysts consider the important
fundamentals in determining the Quality rating.
- A key problem that most users of
investment letters, newspapers, chart selection techniques, and
computer models have in common is the inability to make decisions...
simply because they have much too much information and opinion in
front of them. The Selection Universe removes the analysis
paralysis and provides an efficient tool for identifying
- As you become more experienced
as a user of the methodology, you will find that the vast majority
of the stocks you purchase will fall within the Lower
P/E category. Generally speaking, stocks that are ready to buy
will have reasonable P/E ratios, but there can be exceptions.
- When making the final selection
from the candidates for purchase (and before you have the experience
referred to in the Brainwashing Book) it may be wise to use P/E
and/or other Stock Guide data (profitability, current ratio,
institutional holdings) to select your daily Best Buys.
When you refer to profitability, are you
referring to more than the fact that the company is paying a dividend?
- Yes, absolutely. I focus on the
right hand columns of the Stock Guide ( Earnings per Share) to make certain that there are no recent negative numbers (a
recent operating deficit). It's not uncommon for companies to pay a
dividend for a while after they begin leaking oil. A dividend
cut or omission won't be far behind. We want both, profits and
- Always keep in mind that a bad quarter, in a generally profitable long term
picture, sets the stage for those good quarter to quarter comparisons
that Wall Street gets all excited about down the road. Such earnings surprises always make the news, and often cause a
severe decline in market price.
I stay away from companies with a current
ratio [Current Assets vs. Current Liabilities] less than 1. Does
that seem like a reasonable threshold to you?
- For the most part, but there are
certain industries where the current ratio can't be calculated
[financial companies]. Also, if there is a lot of inventory
[retailers], I like a higher ratio. If everything else looks good, see
if there is a simple explanation for a negative number. If not, find
Could you refresh my memory about the significance of
the Guide's Institutional Holdings columns?
- The more institutional interest
there is in a stock, the more likely it is that there will be the kind
of volatility we need for successful trading, and the amount of
trading volume we need for instant liquidity. Also, analysts follow
the larger holdings, creating more news and more volatility. These are
the guys who buy on good news and sell on bad.
- Although I've never tried to come
up with a level of institutional popularity that is the
best, I'd tend to avoid issues where there seems to be very little
There are Investment Grade Securities that generate very
little trading volume. Are they included in the Selection Universe?
- No, they are purposely excluded if
they average less than 5,000 shares per day, because the trading
methodology really does require liquidity in Common Stocks. Some
newspapers include only the x,xxx most active issues in their
listings, and this may be an inconvenience for travelers without
- On the other hand, many investors
will have CEFs (Closed
End Funds) in the Fixed Income portion of their portfolios, and
these trade in much smaller volumes. When selling, this needs to be
taken into consideration because, believe it or not, even small
traders can affect market prices. It's not unusual for me to trade
positions a few hundred shares at a time, based on the supply and
Dealing with S & P Downgrades:
When a stock is downgraded S & P,
how long thereafter do you stay away from it?
- That's really a function of how
low it goes. I'll get out ASAP if it goes below B+, taking
even a minor profit or loss as soon as I'm aware of the change. Then,
if it's a larger loss, I'll consider it a candidate for ATH loss taking, but some judgment is certainly required.
For example, when IBM went to B status years ago and
Dupont did the same more recently, I held out for those small profits.
With a less well known or widely held issue, say good bye as quickly
- Downgrades between the A gradations are not as significant to me, dependent again
on my familiarity and experience with the company as a trading
vehicle. I don't give up too easily on issues that I've had good
experience with, and even though the overall trading objective can be
somewhere between four and seven months, you will always have
situations that you wind up holding on to for much longer periods.
There won't be many, and it's perfectly acceptable to take a smaller
profit or even a small loss on a seriously long holding.
- A downgrade to B+ should raise a
cautionary flag, but it's nothing to be too afraid of, unless your
overall portfolio seems to lean in the B+ direction. I've made a lot
of money over the years at this end of the Quality spectrum and such a
downgrade may just turn out to be an excellent buying opportunity.
Keep in mind that we are looking at the bigger and stronger companies
in the first place and that many of these become more attractive as
takeover candidates at lower prices.
How often have you found that the S
& P rating was totally wrong?
- Within the Brainwashing book methodology, there are management
controls (checks and balances) that warn of problems at the companies
we invest in. Specifically, a cut in or elimination of the dividend,
and an S & P downgrade of the stock below investment grade. Rarely
is there a situation where serious trouble won't come to our attention
in time through one of these mechanisms.
- I can think of only three glaring
instances over the years where an Investment Grade Rating held up to
the very end: Ames, Enron, and Friedman's. But, and key to the overall
methodology, major individual portfolio disasters were avoided because
of individual security % of portfolio diversification rules that must
never be violated and which must always [absolutely always] be
calculated using The Working Capital
- Also, in each instance, profits
had been made on the security more than once prior to the disaster.
The "Buy More" Decision
Should the opportunity to add to an existing holding
(stick with 30% below original cost) be considered before adding a new opportunity to the portfolio?
- Generally, I won't buy more of an
existing holding if I have an adequate supply of new opportunities to
choose from. Stocks that go down this much on news or because they are
in a weak sector (the drug companies, for example) don't seem to
bounce back as quickly as the newbies.
- I also won't consider buying more
of a stock that has been downgraded to "B" or lower.
These become candidates for the ATH decision.
- Absolutely do not buy more of a stock
that falls below $10.00 per share, even if a high S & P Rating is
Assuming that the fundamentals haven't deteriorated, and that the current
list isn't wonderful, is the 30% down from cost basis a hard
number or a guideline?
I stick to the 30%
faithfully. Although I do consider it a guideline rather than a strict
rule, pushing it higher is probably a safer strategy than moving it
lower. As your experience grows you'll be able to judge better, but
there is nothing wrong with doing nothing.
Buying should always be
done slowly... no matter how impatient you are becoming. When
"Smart Cash" rises month after month, the correction is
coming! The correction is coming!
What is the ATH decision, and what is it used for?
Most of the
investment world worships the bottom line market value of
portfolios, and such a focus (without an understanding of too many
things to mention here) causes a book full of problems. Within the Working Capital Model method of
market value is compared with net deposits to determine if and when
a portfolio is at an All Time High Profit Level.
When it is clear
that an ATH has been achieved, the portfolio should be looked at
carefully to cull the worst performer, at whatever the realized
capital loss happens to be. Issues that have fallen below investment grade must be
eliminated eventually, and this is the least painful time to do so.
Be careful not to
get carried away with this process. Examine weakness in fundamentals, not in market price, and if you have a choice between
more than one loser, pick the one that loses the least capital... it
will give you more to work with than the others.
(although quite rare) need to be dealt with or your Working Capital
Totals will become unrealistic. Again, when the portfolio value is
at an ATH, in spite of that holding, it is the right time to bite
Oh yeah, an ATH
Profit Level may or may not also be an ATH Market Value... you
Speaking of CEFs (Closed End Funds):
Why can't your Selection Criteria be used with
respect to CEFs?
- The stock selection strategy of the Brainwashing book tracks individual,
Investment Grade Value Stocks. Although CEF common shares represent individual
Investment Companies, the investment purpose is significantly different.
The CEF shares are being purchased because they represent the experience
of a diversified portfolio of Income or Equity Securities.
- Yes, you should still look to sell
them and move on to another if the 10% gain objective is reached, but
there is no need to look for a 20% decline in price for a purchase
decision. With an income fund, focus on the yield, avoiding those
that are unusually high or low, and diversify with a maximum of 10% to
15% if possible.
- Yes, I do use Equity CEFs, and not
just in very small managed portfolios, where they are the primary
security. When the Buy List shrinks to 10 or fewer issues,
you can steal some Capital Gains dividends while continuing
to participate in a broad rally with one or two of the better CEFs. With
an Equity Fund, diversify with a maximum of 15% to 20% in portfolios
under six figures, and normally (5%) above that level.
- I absolutely never touch an Index
- For a more complete discussion, and
links to other websites (click
What do you use to rate the quality of CEFs?
- Actually, I don't use a rating guide
at all. Remember that these are portfolios of securities of a
(presumably) less risky nature so an absolute rating of quality might be
a little hard to believe in. I look at the range of price movement over
a minimum of three to five years to assess risk based on the current
price, and try to avoid buying at extremely high historical levels, when
- The next issue is reasonableness of
the yield vs. the amount of leverage used. Avoid excessively high or low
leverage in the same way that you avoid excessively high or low yields.
- The relationship to NAV is certainly
important to consider, but don't let it become the primary issue.
- The S & P Stock Guide is still the one. Most of the information you need is provided,
toward the back of the book.
- A significant issue, and this is
something you need to develop, is confidence and experience with these
securities both generally and specifically. It takes time and patience.
- Remember, the ability to trade is a
secondary benefit of income CEFs.
Do you have some volume number for CEFs below which you
wouldn't purchase one of them?
- No, not really. In Income CEFs, low volume may be symbolic of the satisfaction of existing
shareholders with a steady, dependable cash flow, and not a real
shortage of shares. If the price is right, they'll trade. Think about
the underlying security... built to hold on to.
- Another reason for lower volume, at
this time of year (3rd or 4th Quarter), could be the habit of some CEFs
to pay their Capital Gains and/or special dividends after
January 1st. This is always something to consider, and information that
you can ask your broker to investigate.
- On the flip side, it's generally a
good time to buy CEFs after all of the irregular dividends have been
sent to shareholders,,, theoretically, the prices should be a bit lower.
So check the early year volume to get the big picture.
- Here's a rare tax note. When you own
CEFs, it's likely that some of the dividends you receive in January will
be booked as the prior year's income... check with your
accountant before you rush to get that 1040 on its way.
How does one determine how much leverage a CEF might be
using to boost it's yield?
- Go ETF Connect: http://www.etfconnect.com/education/fundamentals_etf.asp
- Click on Fund Sponsors
and find the drop down menu on the left side of the page. Scroll down
to the appropriate company name and select it. Then locate the symbol
of the fund you are researching.
- Finally, scroll down through the fund details until you locate the information on
Preferred Shares and leverage %.
- Take a look at a dozen or so to
get a feel for the normal amount of leverage. Note that
leverage only sounds like a bad thing. It's an excellent business
practice, and one that is used in all fields... not just by investment
The NASDAQ Exclusion Issue:
In the book, you mention that there is
no reason why this approach wouldn't work with NASDAQ stocks. Do you
ever trade the Investment Grade Issues there?
In the 30+ years
that I've been fine tuning this methodology, I just haven't had the
need to go there, although the specific stock selection rules would
certainly apply. However, my Statistics That Matter (and the
new IGVSI Market
based on the NYSE alone, and I would avoid getting involved in
securities that trade within a market that is generally known as a
more aggressive and speculative medium.
Brainwashing Book only reasons that the approach should work with
NASDAQ stocks. That possibility has never been tested.
Science or Art:
What's become clear to
me over the three years I've been using this approach is that there are
aspects of both art and science inside. Do you agree?
that is totally a function of the amount of experiences that is
reflected in the overall methodology. The science is a near-equal
partner with the management art that applies it to the day to day
decision making, and all of this takes place within a structured and
well thought out portfolio investment plan.
However, it is not rocket science, and not even one fancy formula is
necessary to do it profitably.
think that there is more Psychology than Mathematics and
involved, on both an individual and on a group basis, but that's all
covered in the book.
In my experience
I've found that engineers and attorneys have the most difficulty
with it while retailers and generalists have the least. The three
people who I personally know have been using the approach since 1979
are a Restaurateur, a Dentist/Orthodontist, and a Manager.
What do you think about taking smaller (say 5% to 7%)
profits if you can do so fairly quickly? I have had several that didn't
make 10% and I've watched them move back to about even.
- This question comes up often.
10% is a target, not a hard and fast rule. Three sevens beats two
tens in this game as well.
- Experience will hone your profit
taking judgment. On an old position, any profit is just fine. Quick
profits take the best advantage of the "McDonald's
Principle", and there is always something else to buy. If not,
the market will correct soon anyway.
- Never hold on above the target
10%, but there is no shame in 5%. Remember, you'll never get poor
- Within extended corrections, you
(should) find yourself taking almost any profit at all once the Smart
Cash has dried up.
In the Brainwashing
the subject of Insider Trading Activity is barely touched upon, if at
- The KISS principle strikes
again! There are a lot of people following this information on a
regular basis... particularly the institutions. This type of
activity finds its way into price fluctuations and adds to
volatility. I feel that it is just another of the thousands of
different pieces of information that you could look at if you wanted
to but really don't need to deal with at all. It's in there.
- There's a statement about the
word know in the Brainwashing book. It doesn't exist in
the Investment World. So if insider trading figures make you feel
like you know something, you are probably wrong.
Is cyclical just one of those buzzwords coined by the Institutions to
make us afraid of these stocks? Their volatility seems to provide more
frequent trading opportunities.
You got it.
Volatility is your dearest friend, and cyclicals are perfect trading
stocks. It's the market value obsession that does
this... as far as I know, the Working
Capital Model is the only cure.
If All Else Fails, Please Read the
Do you have a one page summary of the rules for
operating within your methodology?
- Having the rules on one page, as
you put it, would be a big (but convenient) mistake. There are some
rules and many guidelines, I've found that many people take an engineering approach to the methods I describe. That's
not necessary or recommended. These are decision making thoughts and
approaches to be implemented as things happen during the trading day
and for the overall long term goals of the portfolio.
- It's more important to
understand the concepts and the rationale for the guidelines than to
commit the guidelines to memory.
- If you find one of these somewhere, call
really interested in starting a portfolio based on the ideas outlined in
The Brainwashing of the American Investor and I’d like to
know the risk-side of the equation. What’s the average % draw
down for a typical portfolio?
I don't pay
much attention to market value draw down, I expect it.
The larger it gets, the more opportunities either for buy
more or for new portfolio additions there will be. This is a
basic principle: you must learn to love corrections almost as much
as you love rallies... they're just not as much fun.
A focus on draw
down is similar I think to an obsession with total return... if it
ain't realized, it ain't important.
Financial Website Warning Label: Please Read Me ***