Microsoft's Purchase of Yahoo!

 
One of our perennial messages is that you should commit your money to an investment only when the odds are in your favor. To illustrate, consider the Super Bowl.

If the Patriots win the Super Bowl tomorrow they'll complete an undefeated season and lay claim to the title of "Best Football Team Of All Time."

We have a few rabid fans (not me) in the office who are really pumped up about this, so yesterday we had an office rally, complete with a pool on the game; everyone threw in a dollar and guessed the final score. Closest guess to the final score takes the pot.

Everyone in the office - with the exception of one person - bet on the Patriots.

I bet on the Giants!

Not because I hope they win, and not even because I expect them to win, but because it's my best chance to win the money! And I like to win.

If you understand this, good. You have the makings of a successful cold-hearted investor.

And if you don't, let me explain. If the Patriots win, one of those other people will win the pot. Assuming there are 20 of them (to make the math easy), each has a 5% chance of winning (assuming their guesses were reasonable). If the Giants win, I win the pot.

Of course, the Patriots are favored to win the game, and I appreciate that. But what are the odds? Let's say their chance of victory is 75%. Taking 5% of that means everyone in the office who bet on the Patriots has a 3.75% chance of winning the pot.

Assuming the Giants have a 25% chance of winning the game, my chance of winning the pot is 25%, or over six times better than if I had bet on the Patriots.

To get the odds down to nearly even, you'd have to think that the odds of the Patriots winning were approximately 95.2%! At that point, my chance of winning the pot would be down to 4.8% while each of the Patriots-backers would see odds of 4.76%.

Of course, some people in the office (the rabid ones) might claim that the Patriots' chance of winning actually is 95%. But most of us would recognize that because they're fans, they're not entirely rational about the game.

Which brings me to investing.

Love Versus Logic

The worst thing you can do in investing is fall in love with a stock ... or hate a stock. Love makes you hold onto stocks even when they're telling you to let go. And hate (or fear) keeps you from investing where and when you should, when the odds are truly in your favor.

The fact that I'm not a big football fan makes it easy for me to talk rationally about the Patriots, and to bet my dollar against them.

But the fact that I love investing means I'm just like most investors; I sometimes get into trouble when my love for a company overrules my logic.

Still, recognizing the problem means I'm halfway to the solution. I generally take care not to invest in the stocks of companies I love. Or if I can't resist, I take a very small position, just putting a toe in the water. When you recognize that your emotions are conflicting with logic, I suggest you do the same.

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Letters From the Mailbag

And now, dipping into the old mailbag (email that is) I have two letters to share.

The first, from JK in Texas, reads:

"Since I have been receiving the news letter I have yet to buy any stock. Picks selection to me are too many to choose from. I would like for you to list only seven of your best selections that you like now. I would appreciate this very much because I am ready to buy."

What troubles me about this letter is the phrase, "I am ready to buy." It suggests the writer recently came into some money and is now ready to make it grow through smart investing. What he ignores is the fact that we're just come through a very damaging January and the market is still dangerous!

Investing according to his own situation and ignoring the market's situation is a great way to lose money!

So I told JK to take it slow here, and to wait until the broad market regains its health before putting the pedal to the metal. It's good advice for everyone.

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My second email of interest, from GC in Mexico, came in response to Monday's column in which I mused "the world has grown so complex that no one person can understand it all, " and concluded "the role of the wise village elder has been assumed by the Internet (the electronic cosmos), which knows nearly everything about the past and the present, if not the future."

Her response? "Have you seen Zeitgist and End game Yet? Maybe those DVDs will shed some light."

Well, I hadn't even heard of either one, so I investigated. And here's what I found.

Zeitgeist: The Movie is a documentary (in the loose sense) that provides evidence in support of the theory that the Pentagon was hit by a missile and not a plane on September 11; that supports the theory that a small group of bankers, namely the Federal Reserve Bank, are to blame for most of the world's ills since the mid-1910s; and that claims that a conspiracy of the elite plans to form one world government that will dominate the masses.

Endgame: Blueprint for Global Enslavement, mines similar ground, detailing the imminent collapse of the United States and the formation of the North American Transportation Control Grid. But it goes one step further by claiming that once the global elite have firmly established the "New World Order," they'll hold onto their power by exterminating 80% of the population and enslaving the rest!

Well.

Much as I dislike the growing power of government, I have no fears of a global conspiracy. Our leaders are having enough trouble running one country; to even consider running more, given our vast differences, is simply unthinkable.

Yet I'm a big fan of freedom of speech, freedom of choice and open access to information, so if anyone chooses to use his or her free time and money to investigate any such possibility, that's fine with me. Just don't expect a government grant to fund your efforts. And don't expect wild conspiracy theories to help you make money in the stock market; we say believe what you see, not what you think.

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Now on to the investing idea of the day.

Microsoft wants to pay $44 billion--perhaps the largest technology purchase ever--to buy Yahoo!

Why? To compete with Google!

But does it make sense? Well, from a big-picture point of view, anything that can thwart Google's dominance of Internet search and advertising probably makes sense for Microsoft, and if they've got the cash, there are worse places to spend it.

But does this make for an attractive investment opportunity? Do you want to own a piece of Microsoft/Yahoo!, recognizing that the Microsoft part is eight times the size of the Yahoo! part?

To find the answer, I put on two hats, one after the other.

Growth Hat

With my growth hat on, I look at the pair and assume Microsoft will be the dominant partner. So I ignore the one-day chart strength of Yahoo! and note that Microsoft's chart is no stronger (or weaker) than the market. Since the end of 2000 it's been a market performer. And we want our investments to beat the market.

Fundamentally, I see annual revenue growth that has been under 20% in every one of the past eight years; the company is just too big to grow at the rates typical of growth stocks.

Finally, I see that while the number of mutual funds on board has shrunk from 1,722 back in 2004 to 1,248 at the end of the third quarter, that's still far too many holders; there are more potential sellers of this stock than buyers! It's undiscovered by nobody.

Conclusion: As Yoda might have said, "A growth stock Microsoft cannot be."

Value Hat

So then I put on my value hat and open up the latest issue of Cabot Benjamin Graham Value Letter. And there I find Microsoft, listed as one of the 250 highest-ranked stocks! This ranking is based on a complex combination of valuation, growth, consistency, technical strength and more. As of the end of January, Microsoft ranked high on quality, slightly above average on value and growth and very high on technicals. Added up, it achieved a rank of 8.99 on a scale of 10. And that's pretty good!

But it doesn't end there.

One of the greatest benefits of the Cabot Benjamin Graham Value Letter system is that it prevents you from overpaying for stocks. It sets Maximum Buy Prices for every stock and tells you never to pay more than that price for the stock. Thus it provides a Margin of Safety.

For Microsoft the Maximum Buy Price at the end of December was 31.06. The actual price of the stock back then was 35.52. But now the stock has fallen below 31, and patient investors who are in for the long term are welcome to buy it with my blessing.

But what's long term? How long do you hold? As long as it takes for the stock to hit its Minimum Sell Price, which in Microsoft's case is 46.76. Above that price, risk is excessive; when that price is hit, editor Roy Ward says you should sell and buy another stock that's undervalued.

If all goes well, Microsoft and Yahoo! will join together and make beautiful music and that Minimum Sell Price climbs as earnings grow.

But what if the deal goes through and the two companies have trouble working together? Well, by buying low, your downside risk is minimized (that Margin of Safety), so you can't lose much. And as a writer, I'll at least be glad that I no longer have to type that silly name with an exclamation mark at the end!

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Editor's Note

Microsoft/Yahoo! may never be mentioned here again, but you can keep up to date on Microsoft's rating in every issue of Cabot Benjamin Graham Value Letter. Using the tried-and-true discipline that's been used by successful value investors for decades, the newsletter's two portfolios have accumulated an excellent track record. Since inception in 1995, the Wise Owl Model has a compound annual return of 17.2% compared with the S&P 500's 7.6%. Since inception in 2002, the Classic Model has a compound annual return of 22% compared with the Dow's 8.3%.

To get started, simply click the link below. 

http://www.cabotinvestors.com/ebgvicwa12.html

Yours in pursuit of wisdom and wealth,

Timothy Lutts
Publisher
Cabot Wealth Advisory



Timothy Lutts can be found on Google Plus.

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