JAY TAYLOR

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The Value
Investor

Jay is a former banker and value investor whose picks have greatly outperformed the S&P 500 since 2000.
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PROFITS AND RISKS

Strategies to Maximize Profits and Minimize Risks

Two of the Best Kept Secrets on Wall Street.

For reasons we expect relate at least partly to brokerage firm commission income, there are some secrets big money players on Wall Street know, but are keeping to themselves. Two of the best-kept secrets on Wall Street are the following:

  1. You can generate far superior investment returns by buying bonds when they are inexpensive compared to stocks.
  2. Gold investments can save your financial life at a time when confidence is lost in paper money.

Using bonds to Maximize Long Term Returns

We have drawn from Michael O'Higgins book Beating the Dow with Bonds, to help us shape our investment portfolio strategy. Mr. O'Higgins points out that by going through a 30 minute exercise at the beginning of each year, novice investors can expect to beat the Dow Jones Industrial Average on their own, over the longer term. No need for a mutual fund. No need for a financial planner. Just follow several easy to understand steps and position yourself in stocks or bonds, depending on which is the least expensive investment.

Buy Low, Sell High. Rational Behavior Ignored by the Masses.

If you are a rational shopper, you purchase things that provide the highest value relative to the price of goods and services purchased. But when it comes to investments, most investors display a highly irrational behavior. Most investors seem to believe the higher a stock rises, the better deal it becomes. How insane! No doubt this irrational behavior can be explained in part by the need people have to be reassured they are doing the right thing. If everyone else is buying Apple or Amazon.com, they assume they must be doing the right thing. But throughout history, when mass psychology leads to behavior in one extreme direction or another, disaster has followed. We believe the psychology of the U.S. equities markets is extreme and that a disastrous bear market lies in the future.

While nimble, astute wealthy folks on Wall Street are hedging their bets against a market catastrophe, common ordinary folks are either insufficiently wealthy or unaware of the ability to hedge their portfolios against a market downturn. Based on historical market actions, we believe we have identified a method that can protect average investors against market devastation that is bound to take place sooner or later. Our portfolio approach is built on a strategy outlined in Beating the Dow with Bonds, by Michael O'Higgins. This strategy is based on a rational approach to investing that has you, the investor buying stocks when they are less expensive than bonds and by buying bonds when they are less expensive than stocks. The logic behind the very simple O'Higgins strategy is as follows:

  • If stocks earn more in relation to your investment than bonds, Buy Stocks.
  • If bonds are providing a higher yield than the earnings yield of stocks, Buy Bonds!

Simple as this rule is, most investors are chasing after the more expensive asset class, namely stocks. Stocks are currently expensive because they are earning less than 3% for every dollar you invest in them. By contrast, bonds are cheap because they are paying close to 6%. But the craze for stocks continues. When it ends, investors who have latched on to the rational O'Higgins approach should be miles ahead of the masses who continue to buy stocks because they believe there will always be "a bigger fool" to buy them at a higher price.

A Bond Strategy that Blows Stocks Away!

The O'Higgins strategy not only outperformed the Dow Jones Industrial Average, but it blew it away! Taken from the book Beating the Dow with Bonds, we compiled the profit that would have been earned from 1972 through 1998 by an investor who used the O'Higgins strategy. A $1,000 investment in the DJIA alone, exclusive of dividends would have appreciated to $10,324 by 1998. However, as shown below, $1,000 invested using the O'Higgins Model, would have resulted in an appreciation of $374,831 by 1998! This is one secret your broker has most likely not shared with you, perhaps because it does not generate commissions for him or perhaps because he is simply not enlightened to this truth.

Using Gold to Reduce Risk, Enhance Return & Improve on O'Higgins

We believe that the commercial bankers and by default, our government has instituted a policy of low gold prices (visit www.fame.org.) and as a result of that interference in the free market for gold, investing in the yellow metal has not been a good investment during the past four years. However, you will note from the chart above, that the inclusion of gold in the form of a gold share mutual fund (Van Eck International Investors), resulted in an improvement for portfolio returns even over the excellent O'Higgins Model from 1971 to 1995.

We believe we may be nearing the time when gold once again provides an enormously efficient hedge against stock market devastation. There have been two time frames this century when if you had held gold in your portfolio, you would have avoided enormous losses that were suffered by the masses of investors. The first was following 1929 stock market crash and the depression of the 1930's. The second time was during the inflationary 1970's.

The best example of how ownership of gold shares can not only save your portfolio but actually result in substantially higher returns over the long run is provided by observing the results of allocating Homestake Mining Co. to a portfolio of Dow Jones Industrial Stocks.

The Dow Jones Industrials + Homestake Mining Co.

Homestake Mining Co. provided daily share price data from 1888 to 1998 to J Taylor's Gold Resource & Environmental Stocks newsletter. Because we did not have Dow Jones data earlier than 1903, we applied Homestake data to our study only from 1903 through 1998 in our study. Based on this information and our analysis, we were able to determine the following:

  1. A portfolio of Dow Jones Industrial stocks could be significantly enhanced with a 15% allocation to Homestake Mining Co. at the beginning of each year.
  2. Following the bear market of the 1930's, the portfolio containing Homestake outperformed the straight DJIA portfolio by 66.9%!
  3. Following the 1968-1980 bear market in stocks, the inclusion of Homestake in a portfolio of DJIA resulted in a 90.1% superior performance to a portfolio comprised solely of the DJIA.
  4. Despite the fact that gold has been in an 18- year bear market, the inclusion of Homestake from 1903 through 1998 still provided an advantage. The portfolio with a 15% allocation to Homestake at the beginning of each year was, at the end of 1998, worth $245,300 compared to the straight DJIA portfolio, which was worth $195,160.

Why Homestake Helped

Modern Portfolio Theory requires diversification of assets. However, not just any asset diversification will do. What allows an investor to maximize his portfolio returns while minimizing risk is the allocation of an optimum mix of assets whose returns do not increase or decrease in value at the same time. In other words, we need to find assets whose returns have negative or low correlation with stocks. There has never been an asset more negatively correlated with stocks and bonds than gold. This is the reason gold has been a financial savior for centuries for investors who cared to look at the facts rather than self serving rhetoric of stockbrokers and politicians.

We are indebted to the World Gold Council (www.gold.org) for the following data and charts illustrating the negative correlation of gold with most other assets in recent years. Chart V illustrates that for the years 1986 through 1996, gold displayed a rather strong negative correlation with U.S. Equities, Real Estate, T-Bills, Bonds, International Stocks and Small Cap Stocks.

BONDS BOOST RETURNS BUT DO NOT REDUCE RISK AS WELL AS GOLD

O'Higgins demonstrated how opting for bonds when they are less expensive than stocks, can help boost long term portfolio returns. However, as noted above, bonds are positively correlated with stocks. Hence bonds are not nearly as efficient in reducing portfolio risk (i.e., volatility of returns) as is gold. This is also demonstrated by Charts VI and VII. In nine out of ten years, gold was negatively correlated with the S&P 500 while the return on bonds were positively correlated in all ten years.

GOLD SHARES ARE AN ESPECIALLY EFFICIENT PORTFOLIO INSURANCE

While the returns of gold bullion are negatively correlated with most other investments, gold shares can provide an even more efficient investment insurance policy. This is true because gold mining companies profits, and thus share valuations, are leveraged to the price of gold. Historically, the leverage factor for major mining firms is somewhere between three and five times. Thus, if the price of gold rises by say 10%, we can expect the share prices of mining firms to rise by a factor of between 30% and 50%. This profit dynamic for the gold mining industry is illustrated by the performance of Homestake during the Great Depression and also during the 1968-1980 bear market for stocks. Annual returns for Homestake and the DJIA are pictured in Chart VIII. This explains why and how a 15% allocation to Homestake Mining Co. during the two major bear markets this century not only sheltered portfolios from huge losses but enabled them to outperform the market as a whole.

STOCKS OVERVALUED & GOLD UNDERVALUED

We noted above that bonds are much less expensive than stocks. With regard to gold, we have merely noted that its returns are negatively correlated with stocks. As such we have suggested that gold is a good asset to include in a diversified portfolio because it can help reduce risk and enhance returns over the long term.

From a historical viewpoint, stocks are very overpriced and gold is very underpriced as we begin the summer of 1999. This fact is illustrated by Charts IX and X which displays current equity valuations and the current price of gold with their historical mean averages. If you believe that these two markets will revert to their mean valuations, then you must allocate at least a small percentage of your portfolio to gold.

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Each month through our sixteen page monthly newsletter and each week via our weekly telephone hotline messages (both provided by e-mail), editor Jay Taylor discusses his portfolio strategies in light of current market events. Also, each monthly newsletter includes research reports on high technology companies or mining and resource companies that are considered undervalued based on actual or potential cash flow vis-À-vis the stock's market price.

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