Operating Unhedged

In managing my investments, I never hedge. This may seem odd for someone like me, who spent half a career as a derivatives specialist on Wall Street. However, when it comes to investing and managing my own money, I would rather ride the volatility of the market than pay the cost of hedging, especially when I really do not have a need to hedge.

Typical reasons given for hedging are:

* To reduce risk (limit downside);
* To "lock in" returns (as an investor) or cost of funds (as a borrower);
* To generate more predictable earnings.

All of these arguments for hedging essentially have to do with reducing price swings in one's portfolio.

But, is this volatility reduction really needed? For a short-term trader operating with high leverage (or for a leveraged corporation managing both assets and liabilities), hedging is a prudent way to reduce the likelihood of going belly up. Without buying puts or using stop losses (or swaps and swaptions at the institutional level), a leveraged portfolio manager could very easily be hit hard and even toppled by market volatility.

My investment style is to operate with little to no leverage, having assets but no liabilities (see my 21-Mar-2005 post, "Unleveraged Portfolio Management"). Without leverage, large price swings can never put me out of business. Consequently, for survival purposes, I do not have a need to hedge like a leveraged short-term trader or a leveraged corporation or financial institution does.

An ancillary benefit of not hedging is that I avoid paying fees and bid-ask spreads which can be very significant in the options area. Futures offer a more efficient way to hedge a position, but even here round-trip fees from regularly adjusting delta hedges and rolling positions forward can degrade otherwise healthy portfolio returns.

By not taking short-term profits and losses that inevitably result from applying hedging techniques, I also avoid paying taxes earlier than I need to. In my long-term investment portfolio, I am able to defer taxes indefinitely (i.e., until the time that I decide to sell a profitable position).

Operating unhedged, I accept volatility and would even say that this volatility works in my favor (see my 29-Jan-2005 post, "Merits of Volatility in a Portfolio"). History shows that equity markets rise over the long run. So, if the market is down one month, I see little reason to fret--the market is bound to make up for lost ground and could even rise to new heights a lot sooner than popular opinion would suggest.

Perpetual Allocation to Equity

I invest for the long-run based on two underlying assumptions about equity price behavior:

a) Secular Rise: That the overall long-run secular rise of equity values will continue (due to the nature of capitalism, as I have outlined in my 21-Jan-2005 post on “Capitalism and Long-Term Investing”); and

b) Short-Run Indifference: That my chance of success in "timing" the overall market (i.e., knowing when the market will rise or fall in the short run) is little better than the 50/50 odds I get from tossing a coin. (However, if I ever find a short-term timing system that I consider reliable enough to trade on, I will of course use it!)

These assumptions lead me to run a perpetually fully invested portfolio, selling one asset and buying another asset only when I believe that an asset I do not currently own offers better “relative value” (i.e., a higher upside-downside ratio) than something I already own.

Generally, there are two types of equity that I invest in: stocks and real estate. When I sell a stock, I typically also buy another stock that very same day using the sale proceeds. This way, I remain fully invested in the market.

I have tried to apply the same principle when I sell real estate, buying a new “upleg” property at the same time I am selling the “downleg,” to take advantage of tax-deferred 1031 exchange opportunities as well. However, due to a scarcity of appropriate upleg properties, I have in the past opted to trade into stocks rather than immediately go back into real estate. (I would rather pay capital gains tax on my sale of real estate than buy an upleg property I really do not want to own.)

My behavior when I am moving capital across asset classes reveals just how strong my preference is to stay fully invested--always--in some type of equity: If I sell a property to buy a stock, I will buy the stock as soon as the escrow company working on the real estate transaction wires the equity from sale of the property into my securities account. In the other direction, if I am selling stock to buy property, I will typically wait until the very last week prior to close of escrow before selling the stock to generate the proceeds needed to close escrow on the property.

With there being thousands of different publicly listed stocks that I can easily obtain information about and buy (or sell) any day I like, I typically find it much easier to select attractive stocks than to identify promising real estate that I really want to own. For this reason, I tend to use the stock market to “park” funds that I might someday wish to deploy back into real estate if or when a good opportunity arises.

A Dozen Influences

When I sit down and think about the well-known investors whose investment styles I am attracted to, I come up with the following list:

"Classic" Group:

* Ben Graham: Although I do not subscribe to Graham's strict value investing principles, I pay close attention to fundamentals and "relative value" in my search for stocks and real estate properties. I particularly like Graham's "Mr. Market" analogy, describing how stock prices move based on investors' emotions. I also savor the great irony in Graham's uncharacteristic early-stage investment in a little insurance company (his partners wanted to make the investment and Graham reluctantly went along) that eventually became Geico, "incidentally" making Graham more money than all of his many years of "cigarette butt," bargain basement value stock investing combined!

* Warren Buffett: Buffett was Graham's student, who learned from the master and adopted a more growth-oriented value investing style, focussing on ROE and the intrinsic value of companies. Like Buffett, I invest for the long-term, rarely sell what I own, and prefer businesses with low leverage that have been in operation for many years, making their future performance more predictable. However, unlike Buffett, I am heavily invested in technology stocks, believing that this sector shows the best promise for high sales, earnings and cash flow growth. Also, I am at odds with Buffett's often quoted opinion that today's stock market is overpriced.

* Peter Lynch: As fund manager for Fidelity's Magellan Fund in the 1980s, Lynch became famous for his ability to find "ten-baggers" for his portfolio, often among little known companies that housewives and shoppers tend to find out about before Wall Street does. Always on the prowl for young companies that can become ten-baggers, I like Lynch's way of letting his common sense as a consumer guide him in his investment decisions. However, compared to Lynch who often bought whole sectors for the Magellan Fund, I generally want to do more due diligence on individual companies before deciding to invest, and I run a much more concentrated, single-stock portfolio.

* George Soros: Soros is the epitome of a trader, having the uncanny ability to reverse his thinking on a dime, going from long to short in an instant, largely based on his "intuition" of where the market is headed. My long-term, deliberate investing style is the polar opposite of Soros' short-term positioning and frequent reversals. However, I find similarities with his private, "small shop" orientation as an investor, an approach that he so successfully employed in growing his Quantum Fund in the 1970s and 1980s. I find that Soros' ideas on "reflexivity," describing how participants themselves influence the direction of the market, really add only very minimally to my understanding how markets work and how to invest.

* Donald Trump: During the 1970s, I once listened to a tape recording of Trump, telling real estate investors how vital it is to "protect the downside" by focussing on cash flow and avoiding high leverage. Over the ensuing 20 or 30 years, Trump has apparently not heeded to his own advice, since he has, by choice or not, found himself going in and out of bankruptcy. I find little beyond entertainment value in Trump's flamboyant side, preferring a much more low-key existence for myself. Nevertheless, I have taken Trump's "protect the downside" advice to heart--even though he apparently has not.

* Value Line: Not a person but a stock advisory service, Value Line is the single most useful investment service I read when researching companies to invest in. I like their independent, objective analysis and believe that their lack of affiliation with investment banks (sell side) and fund managers (buy side) adds credibility to their investment opinions.

"Modern" Group:

* Bill Miller: Miller is Legg Mason's star portfolio manager who has managed to beat the S&P 500 for 14 years straight. The other day I took a look at the Miller's Value Trust holdings and was surprised to find a great deal of overlap between his portfolio and my own. Among his top 10 holdings are Amazon and eBay and, despite the fund's gigantic size ($12 billion), Miller owns just 36 different stocks total. Miller is rumored to have picked up positions in the Chinese Internet stocks, Sina and NetEase, recently. Although I do not know much about Miller, I suspect that behind the man is an investment philosophy similar to my own: Think long-term and buy into companies that, almost without question, will be at least ten times as big ten years from now.

* Jim Rogers: Rogers was Soros' right-hand man during the heyday of the Quantum Fund. Rogers performed the analysis and Soros' did the trading, until they had their falling out. I like the Rogers that I read about in his book entitled Investment Biker, which takes him around the world on his motorcycle. He comes off as being a careful macro thinker who is willing to sit patiently on the sidelines until an opportunity too good to refuse (Buffett's "home run" pitch) comes along. Rogers has been bullish on China and commodities for a while. I buy into the long-term story on China. However, unlike Rogers, I favor stocks over commodities right now.

* Victor Niederhoffer: After a brief stint with Soros, Niederhoffer had success as a fund manager but soon lost it all on a leveraged bet on Thai banks during the 1990s. His bankruptcy led him to rethink his life and write a few books on investing. I like Niederhoffer's skepticism and numerical approach to debunking market myths. I take an occasional look at his "Daily Speculations" website but generally find that the topics there wander from the financial markets a little too far for my liking. It will be interesting to see how much of a comeback Niederhoffer can make following his humbling brush with insolvency a few years ago.

* Marc Faber: Faber is a non-numbers guy, preferring the qualitative Austrian school of economic thought for his analysis. He is one of the "outsider" Westerners who has become a well-respected expert on Asia, where he has lived for the extent of his career. He is also a "gold bug," believing that gold is bound to do well in our world replete with governments who mismanage their own currencies and economies. Although I do not agree with Faber on gold, I like his historical and global perspective. Faber is much more pessimistic (see his website: gloomboomdoom.com) than I am, but I feel he has some investment wisdom to share.

* Sam Zell: Zell is the "king" of REITs, being the founder of Equity Office, Equity Residential and Equity Lifestyle. He made his money in his early career by scooping up industrial properties in Texas at steeply discounted prices when nobody else was willing to buy into the market. Like many great investors, Zell appears to have a knack for identifying cheap assets and deploying capital at market bottoms. He is also an empire builder, as his REITs evidence. I favor Zell's style much more than Trump's.

* Motley Fool: The Motley Fool publishes more online columns about stocks and investing than any other news source I run across these days. I agree with the Fool's long-term investing approach, in which they advocate buying stock in companies with solid underlying businesses, largely following the approach of Graham, Buffett and Lynch. I find their commentary generally useful but would prefer that their analysis run consistently deeper than it usually does.

Do Higher Interest Rates Lead to Lower Stock Prices?

A couple of posts ago I looked at the impact of inflation on the stock market and concluded that the correlation really is very weak, i.e., higher inflation does not "normally" lead to lower (nor higher) stock prices. Today I take a look at interest rates, in an effort to find some historical evidence to support the general market sentiment that higher interest rates "cause" lower stock prices.

Common economic "theory" says that, as interest rates rise, stock prices should fall, since investors will demand a higher return on investment (i.e., investors will now pay less for a given future earnings stream) in a higher interest rate environment. Offhand, this logic seems plausible. As interest rates rise, bond prices fall--and so should stock prices, since stocks are a "substitute" investment for bonds.

To see if history supports these common investor beliefs, I took a look at interest rate (10-year Treasury) and stock price (S&P 500) data for the past two centuries:

(Source: www.globalfindata.com)

Period: 1801 to 2004
Average annual % change in 10-yr. Treas. rate: 0.3%
Average annual % change in S&P 500: 4.4%
Correlation between inflation and stocks: -0.14

Quartiles: I, II, III, IV (sorted by change in Treas. rate, from high to low)
Average annual % change in 10-yr. Treas. rate: 13.5%, 1.8%, -1.8%, -12.2%
Average annual % change in S&P 500: 3.9%, -1.6%, 4.8%, 10.6%
Correlation between inflation and stocks: 0.03, -0.10, -0.30, -0.02

Note: "% change" is defined as (R2-R1)/R1, where R1 and R2 are rates or prices in consecutive years.

For this 204-year period, the correlation between interest rates and stock prices has generally been weak, based on annual data. Rising interest rates have been accompanied by falling stock prices just as often as they have by rising stock prices. Quartile data also do not show any pronounced pattern with a strong enough correlation coefficient to lend support to a cause-effect relationship.

Nor is there any obvious pattern among the years with the largest percentage changes in interest rates:

Year: % Change in 10-Yr. Treas. Rate, S&P 500 Return

1999: 38.7%, 19.5%
1994: 34.5%, -1.5%
1919: 30.7%, 14.0%
1969: 27.9%, -11.4%
1967: 22.8%, 20.1%
1987: 22.1%, 2.0%
1931: 22.1%, -47.0%
1959: 21.5%, 8.5%
1956: 21.3%, 2.6%
1814: 21.3%, -16.7%
1950: 21.1%, 21.8%
1980: 20.3%, 25.8%
1958: 20.3%, 38.1%

For example, in 1999, the 10-year Treasury rose in yield from 4.65% to 6.45% (a 38.7% rise, making it the highest percentage change among all 204 years in the study!); yet, instead of falling, the S&P 500 rose sharply by 19.5%.

These data certainly do not indicate any "obvious" relationship between interest rates and stock prices. In other words, the belief that stock prices should fall because interest rates rise is not well supported by historical evidence.

Unleveraged Portfolio Management

There are many ways to "leverage up" when investing. Stock investors can leverage their positions by buying on margin or buying options. Real estate investors can leverage up by financing and refinancing their properties at high loan-to-value ratios. When the market is going your way, leverage is a great way to produce spectacular returns.

However, as we know from hearing the stories of the likes of Donald Trump, Paul Reichmann, Long-Term Capital Management, Victor Niederhoffer and other prominent investors who have made money quickly on the way up through leverage, paper profits can disappear just as quickly on the way down when the markets reverse course. Some, like George Soros, have miraculously managed to cut losses early enough to avoid total ruin when markets have turned. Others, like Warren Buffett, avoid taking on extreme leverage from the outset, preferring a slower and more steady course to wealth-building.

Leverage is like a "throttle" that allows you to "dial in" the amount of risk you desire. Over the years I have used leverage as an income property real estate owner. However, in my stock investing I tend to operate unleveraged. Certainly, many of the stocks I own are shares of companies and financial institutions that employ moderate leverage on their balance sheets to realize higher return-on-equity. But I avoid buying on margin to leverage my own positions further.

In deciding whether or not to use leverage, I weigh "money management" issues as much as I do risk-return tradeoffs. Currently, I run a "safe," unleveraged portfolio. I find that having no loans makes things much simpler from a portfolio management point of view. I have no loan applications to fill out, no monthly payments to make, no margin calls to worry about, and neither banker nor broker to answer to. Without any debt, my personal balance sheet and tax returns are also simpler and, surely, it is impossible for me to go bankrupt. Psychologically, a tremendous amount of peace of mind comes from operating unleveraged.

While many might surmise that investing without leverage is boring, I contend that the level of excitement really is more dependent on how you play the underlying, unleveraged investing game. With the stock market being as volatile as it is and the companies with listed shares being as diverse as they are, there are plenty of opportunities to invest in high-risk, high-return companies with very substantial leverage in their businesses--even without invoking an additional layer of leverage in your portfolio.

I make one final comment on my attitude towards leverage: With interest rates still near historical lows, mortgages offer homeowners (who are also investors) the opportunity to leverage up their overall investment portfolios at an attractively low borrowing cost. However, here too, my preference is to manage my own portfolio without the complications that come from taking out a mortgage and working with other people's money.

I find that "keeping it simple"--unleveraged--works best for me.

Why Inflation Shouldn't Spook the Market

With oil prices rising, a common headline recently has been "Stocks fall on inflation worries." The basic idea is: As energy prices rise, manufacturing costs increase, thereby depressing corporate profit margins and earnings.

But, pursuing this economic logic a few steps futher, I would say: Manufacturers will raise the price of their finished goods to maintain profitability, and consumers will continue to buy at the higher prices because they will soon be receiving higher wages to compensate for the inflation. Sure, there may be short-term time lags of one sort or another, but the basic long-run effect should be that ALL prices--commodity prices, producer prices, consumer prices, wages, and stock prices--rise with inflation.

To see what the relationship between inflation and stock prices has been historically, I downloaded data from 1821 to 2004 (source: www.globalfindata.com). Here's what I found:

Period: 1821 to 2004
Average annual inflation rate: 2.0%
Average annual change in S&P 500: 5.0%
Correlation between inflation and stocks: 0.03

Quartiles: I, II, III, IV (sorted by inflation, from high to low)
Average annual inflation rate: 9.0%, 2.8%, 0.8%, -4.5%
Average annual change in S&P 500: 4.7%, 5.8%, 5.2%, 4.0%
Correlation between inflation and stocks: -0.12, -0.04, 0.22, 0.28

For this 184-year period (as far back as the data go), stocks on average performed better in mild inflationary environments, with returns tapering off slightly in both severe inflationary and deflationary environments. However, since the correlation between inflation and stock prices is very low, it is difficult to draw any reliable cause-effect relationship.

Considering that the "modern" economy may be intrinsically different from the pre-1925 economy, I also restricted the analysis to just the most recent 80 years are re-ran the numbers:

Period: 1925 to 2004
Average annual inflation rate: 3.1%
Average annual change in S&P 500: 8.0%
Correlation between inflation and stocks: -0.02

Quartiles: I, II, III, IV (sorted by inflation, from high to low)
Average annual inflation rate: 8.4%, 3.4%, 2.1%, -1.4%
Average annual change in S&P 500: 3.0%, 11.0%, 10.8%, 7.4%
Correlation between inflation and stocks: -0.33, -0.03, -0.09, 0.49

Here the tapering-off of returns in high inflationary and deflationary environments is more evident. However, when the high inflation quartile (Quartile I) is divided into halves, we have:

Quartile I: Upper half, lower half
Average annual inflation rate: 11.0%, 5.8%
Average annual change in S&P 500: -3.5%, 9.5%
Correlation between inflation and stocks: 0.0, -0.25

This shows that historically the impact of high inflation has not really kicked in until inflation rises beyond 6% annually, which is more than twice the current inflation rate (CPI rose 2.7% in 2004). However, again, since the correlation is so low, it really is not very meaningful to place much confidence in the notion that inflation causes lower stock returns.

A quick look at the years with the highest inflation bears out the "scatter" in the data:

Year: Inflation Rate, S&P 500 Return
1864: 21.8%, 6.4%
1918: 20.4%, 16.4%
1946: 18.1%, -11.9%
1917: 18.1%, -30.6%
1835: 17.6%, 3.1%
1851: 17.6%, -3.2%
1919: 14.5%, 14.0%
1836: 13.3%, -11.7%
1979: 13.3%, 12.3%
1863: 13.0%, 38.0%
1916: 12.6%, 3.4%
1980: 12.5%, 25.8%
1974: 12.3%, -29.7%

In these high inflationary years, stock returns have been as high as 38% in 1863 and as low as -30.6% in 1917. In more recent history, the two occasions with double-digit inflation, 1974 and 1980, showed strikingly different stock returns, -29.7% and 25.8%, respectively.

Conclusion: Historically, inflation has been a lousy indicator of stock market performance, i.e., inflation does not "cause" the stock market to fall. While inflation fears might "spook" investors, history shows that inflation is less of a monster than investors imagine it to be.

But the Reality Is: Patterns Last Until They Don't (II)

Using data available at www.globalfindata.com, I went further back in time to see if the years ending in a "5" continue to show stellar returns. Here's what I found for the 124-year period from 1801 through 1924 (to complement Dr. Yardeni's study for the 80-year period from 1925 through 2004):

Period: 1801 to 1924
Years Ending in: Average Return (Number of Yrs. with Neg. Returns)

0: 3.0% (4 out of 12)
1: 3.3% (4 out of 13)
2: 7.7% (3 out of 13)
3: -1.1% (9 out of 13)
4: 0.5% (6 out of 13)
5: 4.8% (4 out of 12)
6: -1.9% (5 out of 12)
7: -7.8% (7 out of 12)
8: 8.0% (3 out of 12)
9: 4.4% (4 out of 12)


Year: % Change in S&P 500

1805: -4.4%
1815: 2.7%
1825: -5.8%
1835: 3.1%
1845: 8.1%
1855: 1.5%
1865: -8.5%
1875: -4.1%
1885: 19.8%
1895: 0.5%
1905: 15.6%
1915: 29.0%

For the 1801-1924 period, the years ending in a "2" or an "8" did better than the years ending in a "5." The magical performance of years ending in a "5" has, well, become a lot less spectacular.

However, for anyone wishing to continue to believe in miracles, please note that we must go all the way back to 1875 before finding a year ending in a "5" that actually shows a negative return. You might say that you've got close to 130 years of history on your side if you're counting on this year (2005) showing a positive return as well.

Yet, something tells me that this "fives" pattern is little other than a fluke, a coincidence, and maybe even a little data mining.

Moral: In the financial markets, patterns tend to last until they don't . . . and superstititious investors only believe until they lose.

A Good Omen for 2005, If You're Superstitious (I)

As summarized by Dr. Yardeni at:
http://www.yardeni.com/pub/yearsendingin5.pdf ,
this year the stock market should see a healthy rise, if you believe that historical patterns are likely to repeat themselves.

A look at S&P 500 performance since 1925 reveals:

Years Ending in: Average Return (Number of Yrs. with Neg. Returns)

0: -2.0% (5)
1: -1.4% (4)
2: 1.1% (3)
3: 14.0% (2)
4: 5.6% (3)
5: 27.4% (0)
6: 8.2% (2)
7: 2.5% (3)
8: 18.5% (1)
9: 6.1% (3)


Year: % Change in S&P 500

1925: 19.8%
1935: 41.4%
1945: 30.7%
1955: 26.4%
1965: 9.1%
1975: 31.5%
1985: 26.3%
1995: 34.1%
2005: ?

The years ending in a "5" have shown the best performance since 1925. For these years ending in a "5" in the middle of each decade:

1. None have ever shown a negative return;
2. The average return is 27.4%;
3. The lowest return is 9.1%.

This forbodes well for 2005, assuming the pattern continues to hold true.

So far this year, the S&P 500 has been trading in a very narrow range:

Close on 31-Dec-2004: 1212
Low: 1164 (-4%) on Jan. 24
High: 1225 (+1%) on Mar. 7
Today: 1188 (-2%) on Mar. 16

Interestingly, as shown in the graph in Dr. Yardeni's report, March has typically been a weak month, following by a steep rise in stock prices in April.

Assuming history repeats itself, the sagging performance we are seeing this month could all be reversed in April, and by the end of the year the S&P 500 could show a solid double-digit gain.

Realistically, I doubt that the historical data actually shed any light on this year's performance. However, being long a portfolio of stocks, I do hope that the historical pattern continues to bear fruit.

Small-Cap Growth on the Cheap: China Finance Online (JRJC)

Looking for a company that can grow earnings at 30% annually for the next few years and trades at a current P/E of less than 15? Consider a small-cap stock called China Finance Online (ticker for ADS shares: JRJC, derived from "jin rong jie," meaning "financial industry" in Chinese), which provides financial market information and data to investors in China through an online subscription-based service. The company is a leader (possibly THE leader?) in this financial services niche, with aspirations of becoming the "Bloomberg of China."

To summarize the financial profile of the company:

Market Capitalization: $134 mil.
Price Per Share: $6.70 (close 14-Mar-2005)
Debt: None

Cash: $71 mil.
Cash Per Share: $3.55

Enterprise Value: $63 mil.
EV/Shave: $3.15

Year: 2001, 2002, 2003, 2004, [2005 (est.)], [2006 (est.)]
(Figures in $ millions)
Revenue: $0.1, $1.1, $2.4, $6.1, [$14.3], [$27.5]
Net Income: -$0.6, $0.2, $0.8, $4.6, [$9.2], [$18.0]

EPS: -$0.18, $0.01, $0.06, $0.26, [$0.46], [$0.90]

(Analysts' consensus estimates in square brackets)

5-Year Consensus Annual Earnings Growth Estimate: 28.8%

P/E: 25.8 (trailing 12 mos.), 14.6 (current 2005), 7.4 (forward 2006)
PEG: 0.51 (current 2005), 0.26 (forward 2006)
EV/Earnings: 12.1 (trailing 12 mos.), 6.8 (current 2005), 3.5 (forward 2006)

These valuation ratios are incredible! Where else is such phenomenal growth available for so low a price?

Here's the story on the stock: Since its IPO in October 2004 at $13 per (ADS) share, China Finance Online has traded as high as $15.99 and as low as $6.11, and is now hovering at the low end of this trading range. After reporting stellar revenue and earnings growth for 2004Q3 and 2004Q4, management warned in early February that reduced trading volume (January's figure was only 28% of trading volume a year ago in Jan-2004) in the weak Chinese stock market will have a negative impact on the company's business in 2005. Despite (or maybe because of) the seemingly frivolous nature of the warning (i.e., nothing really so new--the Chinese stock market has been weak for years!), investors reacted to the "news" negatively. Will analysts need to lower their revenue and earnings estimates for 2005 and 2006? Wall St. hates uncertainty, and the company's policy of not providing guidance has not helped either.

One worry investors have concerns growth in subscriber numbers. A look at subscriber data provided in the two earnings releases following the IPO shows:

Period: 2003Q3, 2003Q4; 2004Q3, 2004Q4

New Subscribers (thous.): 4.2, 3.3; 4.1, 4.0
Repeat Subscribers (thous.): 2.4, 2.0; 2.4, 3.1

(ASF = Average Subscriber Fee in $ for 3 months of service)
ASF Per New Sub.: $98, $139; $219, $285
ASF Per Repeat Sub.: $99, $127; $268, $297

Over the past two years, the number of subscribers has not risen very rapidly. Instead, revenue growth has been driven by doubling or tripling of subscriber fees, as the company has migrated repeat users to more expensive service packages.

On a more positive note:

1. Number of Subscribers: Despite the decline in price and trading volume in the Chinese stock market over the past few years, China Finance Online has managed to launch and grow its business. In my opinion, this indicates that the company has at least succeeded in identifying a pocket of demand--even in a bear market;

2. Average Subscriber Fees (ASF): ASF has risen dramatically, as the company has found customers for its more expensive, high-end services. A recently announced initiative targeting institutional users with a service costing $5,000 per year could support and boost revenues further;

3. Chinese Stock Market: When stock prices and trading volumes rebound (a bottom might have been reached on Feb. 1 when the Shanghai Composite touched its 6-year low of 1189; today it sits at 1284), the company's subscriber numbers could rise dramatically as more investors become active in the market.

In my opinion, China Finance Online looks very attractive at today's price. Absent accounting fraud or some unforeseen competitor entering the market and squashing its high profit margins, the company has excellent growth prospects over the years ahead. If the company does, in fact, eventually succeed in becoming the Bloomberg of China, or alternatively get bought out by a larger online company or financial institution, investors with a long-term mindset who are able to stomach short-term volatility will realize superb returns.

As a general rule, I do not buy stocks until the one-year anniversary (180-day lock-up on insider sales plus additional six months of "seasoning") following their IPOs, since I like to wait for better transparency, which only comes from "exposure" of the company through conference calls and earnings reports, and the "debate" investors go through in their daily trading of the stock. In this particular case, however, with the shares looking like such a bargain, I am considering taking a partial long position if all continues to check out through the first quarter 2005 earnings release in April or May. Over the next month or two, I will be looking for confirmation in three areas:

1. Sustainability of subscriber growth: Are subscriber numbers still growing rapidly?
2. Institutional demand: Will institutions buy the high-end services? (This is essential if the company is to become the Bloomberg of China.)
3. Competitive landscape: Is China Finance Online THE market leader? (How about homeway.com.cn?)

Suburban Condos: A Good Opportunity . . . for Somebody Else

In my town (Bellevue, WA) a new multi-family listing just hit the market: 12 one-bedroom condo units being sold as a package for $1.032 million. These units are sprinkled throughout a 240-unit condominium complex built in 1978 that happens to be located right across the street from the Microsoft campus. The units are 680 sq. ft. each, which is the perfect size for an aspiring, young software engineer who works long hours and must live close to the office. At $86,000 per unit, or $126 per rentable sq. ft., these suburban condos look extremely cheap when compared to $200 per sq. ft. for other condos of similar age and $400 per sq. ft. for new downtown condos.

I have seen suburban condos in this and surrounding complexes near the Microsoft campus come on the market over the past few years. Beyond their cheapness compared to downtown condos, what surprises me is how suburban condos have been lagging the detached house market, with the condos appreciating just 5% per year compared to 10% for detached houses:

Property: Price in 2001 vs. Price Today

Surburban Condo: $71,000 vs. $86,000
Typical Detached House: $300,000 vs. $440,000
Prce Ratio: 1-to-4.2 vs. 1-to-5.1

Because I believe it inevitable that the surburban condo market will "catch up" (and most likely sooner rather than later) with the rest of the residential real estate market, I think the upside over the next few years is very good for an investment in the 12 units now on the market. These particular suburban condos are the least expensive for-sale units in the local housing market and are priced far below replacement cost. The downside is that rising interest rates could lead to a softening of the entire residential market, possibly impacting first-time condo buyers the most (but this could also drive first-time homebuyers back into rentals, pushing rents up and producing better cash flow for condo owners who rent their units out). Balancing limited supply against potentially softening demand, I think that upward price pressure will win out, producing healthy returns for the investor who ends up buying the condo package.

Despite this excellent opportunity to invest in the condos, two factors prevent me from moving ahead to buy the package:

1. Very low cash flow: Priced at a 4% advertised cap rate (or 3% after taking reserves for capital expenditures and running numbers more realistically), the condos will conservatively support only about 50% loan-to-value and provide very little cash flow;

2. Better alternative investment opportunity: On a leveraged basis with 10% price appreciation, a 20% ROI can result from the condo investment. As attractive as this might be, I believe that better returns are available from wise investment choices in the stock market. I provide an example below.

Since an investor would need to operate the condos as rentals while waiting for them to appreciate in value, let's compare the condo investment to one of the large apartment REITs, Apartment Investment and Management Co. (Aimco, ticker: AIV):

Investment: Suburban Condos vs. REIT (Aimco)

Price: $1.032 mil. (list price) vs. $10.4 bil. (enterprise value)
Revenue: $84,000 (rent) vs. $1.47 bil. (total income)
Price-to-Revenue Ratio: 12.3 (GRM) vs. 7.1 (EV/total income)

Net Operating Income: $42,000 (pro forma) vs. $700 mil. (2004)
Cap Rate: 4.1% vs. 6.7%

Loans: $671,000 (assume 65% LTV) vs. $6.8 bil. (loans + pref.)
Interest Expense: $40,000 (6.0%) vs. $385 mil. (5.7%)

Net Income: $2,000 vs. $315 mil.
Equity: $361,000 vs. $3.6 bil. (market capitalization)
Current ROE (before deprec.): 0.5% vs. 8.7%

Est. 5-yr. Income Growth: 3% to 5% (rent inflation) vs. 4.7% (consensus)

As the numbers indicate, the REIT opportunity wins out as an income property investment:

* Better top-line income multiplier (GRM)
* Better bottom-line earnings ratio (cap rate)
* Better cash flow (current return)
* Similar earnings growth prospects

Where the condo investment should excel is in higher asset price appreciation. Let's assume that the condos appreciate at 10% per year over the next 5 years, and that the apartments in Aimco's portfolio see just half of this appreciation. We can then compare pro forma investment performance:

Annual NOI Increase: 4% for both condos and REIT
5-Yr. Asset Price Appreciation: 10% (condos) vs. 5% (REIT)
Round-Trip Expenses: 8% of exit price (condos) vs. nil (REIT)
Leverage: 65% LTV for both condos and REIT

Equity Investment ROI: 20% (condos) vs. 21% (REIT)

The higher asset price appreciation for the condo investment is largely offset by the better underlying cash flow the REIT investment offers. When the expenses (broker's commissions and transfer tax) involved in selling the condos are factored in, the pro forma ROI for the REIT investment ends up slightly ahead, 20% vs. 21%.

When I also consider the better liquidity that the REIT investment offers and the substantial amount of management time that I would have to expend buying, operating and later selling all of the condos (I speak from experience, having owned and managed apartment buildings over the years), I decide against pursuing the condo package. I need to see significantly higher expected returns from direct ownership of real property than are avaliable in the stock market before I become a landlord again.

Riding the Chain-Store Growth Wave

As our ballooning trade deficit indicates, the U.S. is a consumer-driven society. Feeding the voracious appetite of the American consumer are chain-store operators, both traditional names like McDonald's and Wal-Mart, and more trendy operators like Starbucks and Whole Foods. These familiar brands bring us convenience, efficiency, lower prices and (ironically) even some sense of new cultural belonging.

By the very nature of their bricks-and-mortar, consumer-driven businesses, successful chain-store operators show steady, largely predictable growth over many years. As examples, I summarize historical and look-ahead operating financials of some of the well-known names:

Company (Ticker): Number of Stores; Historical 2000-2004 Annual % Growth in: Number of Stores, Sales, Net Profit

Wal-Mart (WMT): 5,170; 5.5%, 12.0%, 13.1%
Home Depot (HD): 1,890; 13.6%, 12.5%, 17.8%
McDonald's (MCD): 31,130; 2.0%, 7.6%, 3.6%
Starbucks (SBUX): 8,570; 25.1%, 25.0%, 42.5%
Whole Foods (WFMI): 163; 8.6%, 20.4%, 26.3%
Tuesday Morning (TUES): 662; 11.3%, 11.2%, 26.3%

Company (Ticker): Mkt. Cap., Fwd. P/E, Consensus 5-Yr. Earnings Growth Rate, PEG

Wal-Mart (WMT): $220 bil., 16.8, 14%, 1.20
Home Depot (HD): $87 bil., 13.8, 13%, 1.06
McDonald's (MCD): $41 bil., 16.1, 8.5%, 1.89
Starbucks (SBUX): $21 bil., 44.5, 22%, 2.02
Whole Foods (WFMI): $6.6 bil., 40.0, 20%, 2.00
Tuesday Morning (TUES): $1.2 bil., 16.9, 20%, 0.84

Basic growth patterns among these successful chain-store operators are:

1. The number of chain stores increases each year;

2. The increase in sales is at a rate comparable to or faster than the increase in the number of stores, indicating little to no sales cannibalization of older stores by newer stores;

3. Earnings typically rise faster than sales, exhibiting efficiency of scale.

The strong fundamental growth of the chain stores drives their stock prices higher over the long run. With McDonald's celebrating its 50th anniversary this year and still growing, the outlook appears bright for the other chain stores, which are all much younger than McDonald's.

My own quick assessment of the investment opportunity in these particular companies at this point is (in approximate order of lowest to highest business growth potential):

* McDonald's ("king" of fast food): Very mature both in U.S. and abroad. Some revival potential through a revised menu;
* Wal-Mart ("lowest price" model): Mature in U.S. International expansion opportunity;
* Home Depot (home improvement trend): Growth remaining in U.S. through further consolidation of fragmented home maintenance industry. Some growth opportunities abroad. Stock looks cheap (Disclosure: I am long HD);
* Tuesday Morning (quality at bargain prices): Continuing growth in U.S. Would be good bricks-and-mortar partner for Overstock.com. Stock looks cheap;
* Whole Foods (organic foods trend): Growth remaining as high income consumers shift their diet to healthier foods. Opportunity to extend price range downward to attract middle income customers and compete more directly with Trader Joe's (private). Stock looks expensive;
* Starbucks (urban gathering spot): Continuing growth in U.S. and abroad. Can easily add to menu. Ongoing value in catering to social needs of aging of baby-boomers. Stock looks expensive.

Since all of these names are already well-known, the best investment opportunities are likely to be found in younger yet-to-be-discovered chain-store operators who offer products and services as central to the needs, wants and desires of the American consumer as fast food. Out-sized "ten-bagger" rewards (a la Peter Lynch) await those prescient investors who are able to identify chain-store winners in their early years and ride the growth wave upward.

Bearish Outlook, Secular Bull

Looking across the financial markets, bearish indicators are everywhere:

* Higher interest rates: Yield of 10-yr. Treas. up to 4.51% today
* Weaker dollar: 0.744 Euro/$, 103.7 yen/$
* Record U.S. trade deficit
* Rising oil prices: Above $55 per barrel intraday
* Rising gas prices: Above $2.00 per gallon at the pump
* Inflation fears
* Cooling housing market
* Stocks struggling to move higher

The short- to medium-term outlook certainly "feels" bearish. If I were a trading the market, I would be tempted to lighten up on long positions in stocks and real estate.

However, investing for the long-term, I patiently stand by and wait for the equity markets to firm and resume their upward course. In the long-run secular rise of the value of companies and property, the current "volatility" is a possible correction but not a trend reversal. Through thick and thin alike, I remain a long-term bull, "knowing" that the market will rise soon enough. . . .

Public Information Only, Please!

The biggest challenge a "small guy" retail investor faces is relying on his own acumen and very limited resources to outperform "big guy" Wall St. professionals who have a wealth of analytical capability, cutting-edge systems support and hard-working staff at their disposal.

A fund manager generally has a team of in-house analysts who process information using proprietary models, sifting through mountains of market data with the objective of identifying those few gems that will make a portfolio shine. A retail investor, on the other hand, even with Internet communication these days, generally is privy to far less information and in far less a timely fashion.

In my own investing, I sit far from Wall St. and away from the crowd, picking up what relevant market information I can and trying to hone an "edge" that will allow me to realize 20% annual returns--a feat that most people would deem a near impossibility from the outset. Occasionally, I hear about private equity investments from friends and acquaintances who promise very attractive returns, even as high as 100% annually. Rather than pursuing these "inside track," relationship-driven opportunities, however, I generally decide to stick to my guns and proceed down the path of the public market investing. Deep within my own psyche, I view the public markets as being more "fair," despite the corporate tendency towards financial chicanery and connivery that has reared its ugly head in recent years with Worldcom, Enron, Krispy Kreme and the like. I like to play the investing game in what I perceive to be the most level playing field available, without the privileges and obligations inherent in the rarified world of investing with one's cronies by invitation only.

Over the years ahead, I hope to show how it is possible for retail investors relying solely on public information to identify and take advantage of investment opportunities widely available to everyone. By tuning into the market with appropriate focus and concentration and selecting niches where one has an edge over others, I believe it possible for diligent investors to outperform the averages.

Waiting for the Short Squeeze

I base my long-term investment decisions (i.e., WHAT to buy and sell) on fundamentals but also take a look at techincal factors when deciding timing (i.e., WHEN to buy and sell). The short ratio (number of shares short divided by average daily volume) is one of these technicals. A high short ratio can be a precursor to a short squeeze, when unexpected positive news drives the stock price higher and short sellers are forced to cover their shorts to cut losses, thereby further exacerbating the sharp increase in stock price.

Using Yahoo's database, I screened on the following parameters:

Liquidity: Daily trading volume > 50,000 shares
Earnings Positive: Forward PE ratio > 0
Sound financial performance: ROE > 10%

and came up with the following list of companies with the highest short ratios (> 25), also eliminating those companies whose number of shares short as a percentage of float is less than 10%:

Company (Ticker): Short Ratio, Shares Short as % of Float, Current Price

Allied Capital Corp. (ALD): 33, 11%, 27.48
Global Payments (GPN): 31, 18%, 57.82
FPIC Insurance Group (FPIC), 30, 16%, 32.13
Atlas America (ATLS): 30, 52%, 37.80
Affiliated Managers (AMG): 29, 46%, 65.93
Papa John's (PZZA): 29, 23%, 36.56
Mobile Mini (MINI): 28, 13%, 37.73
Irwin Financial (IFC): 26, 17%, 25.15
AMN Healthcare (AHS): 26, 17%, 14.38
Cerner Corp. (CERN): 26, 38%, 52.60
Bank of the Ozarks (OZRK): 25, 28%, 34.68
Duquesne Light (DQE): 25, 12%, 18.98

When the short ratio is high and a significant fraction of the company's float has been sold short, it is possible that improving fundamentals can trigger a short squeeze. The situations with Atlas America and Affiliated Managers, where the number of shares short is equal to about half of the respective floats, look particularly interesting.

I intend to keep an eye on these stocks over the next few months to see whether or not short squeezes result. In many cases, it could be that the short sellers are right and the stock prices will continue to fall with deteriorating fundamentals. On the other hand, if the future is brighter than anticipated by the short sellers and the rest of the market, a few of these stocks could see very sharp price run-ups if a short squeeze materializes.

(Disclosure: I have been long MINI for a few years. This company has a very simple business, basically just owning and leasing storage containers nationwide. MINI's stock price has been rising recently, consistent with its improving fundamentals and accelerating earnings. The conundrum is MINI's persistently high short ratio, which I expect to fall sometime soon when the short sellers decide to cut their losses.)

Speculation vs. Investing

Today, on a rumor that Warren Buffett might be investing in Krispy Kreme Doughnuts (KKD), the struggling doughnut maker's share price skyrocketed 23% to $7.50 per share, making it the largest percentage gainer on the NYSE. With value in its well-known brand name and customer base, Krispy Kreme could quickly recover much of what it lost over the past year (52-week trading range of $5 to $40), if a deep-pocketed investor like Buffett steps in and stabilizes the company. On the other hand, overburdened by loans to its franchisees, the company could also just as easily fade away into history as another one-time high-flyer that bit the dust.

From my humble position as a retail investor, a purchase of Krispy Kreme's shares at this point would be pure speculation, since I have no idea how true the rumor is. For Buffett, however, assuming he is able to get attractive terms in a convertible preferred deal and find synergies with his Dairy Queen holdings, Krispy Kreme could be a very lucrative investment. Playing at the corporate level, Buffett has access to so much more information than I do. In this type of deal looking for a "white knight," he is also in a good position to dictate terms very favorable to himself and Berkshire Hathaway. If Buffett invests in Krispy Kreme, he will probably end up hitting a "home run," just as he has in other white knight plays (e.g., investment in Salomon Brothers in 1991 following a Treasury auction trading scandal that led to the dismissal of CEO John Gutfreund, head trader John Meriwether and others, and almost put the investment bank out of business).

One, albeit very limited, way to participate in upside from a possible investment in Krispy Kreme by Buffett is simply to own Berkshire Hathaway shares. (Disclosure: I have been long Berkshire Hathaway shares for many years.) Since Krispy Kreme is a very small company compared to Berkshire Hathaway, any success Buffett has with the Krispy Kreme deal will have only a tiny impact on Berkshire Hathaway's share price, however.

So, as a retail investor, it is really very hard to profit from a possible Krispy Kreme recovery without walking into a highly speculative situation. Personally, I would rather be sidelined than speculate. Only if the deal one day begins to look more like an attractive investment than like throwing the dice will I seriously consider stepping in.

Value Line's List of Stocks with the Highest Potential Total Returns

Each week Value Line publishes a list of the stocks having the highest potential 3- to 5-year total returns (price movement plus dividends). Value Line's proprietary models are quantitative and based largely, if not entirely, on historical company financials and valuation ratios. Companies with rapidly rising revenue and earnings and a recently depressed stock price are typically the ones that appear on Value Line's list of stocks with the highest potential returns.

As a spot check to see if the high total returns actually materialize five years out, I tracked the stock price performance of the top 10 companies on the lists from February and August of 2000. Below I summarize what I found:

Tables show for each company: Value Line Potential Annual Return, Actual Annual Return, $100 Investment Becomes

Value Line Publication Date: February 18, 2000

Action Performance (ATN): 59%, 12%, $175
Topps (TOPP): 58%, 6%, $135
Tokheim Corp.: 56%, -73%, $0
Federal Mogul: 55%, -52%, $2
Oregon Steel Mills (OS): 55%, 44%, $626
Heilig Meyers: 54%, -81%, $0
Burlington Inds.: 52%, -100%, $0
theglobe.com: 52%, -51%, $3
R.G. Barry (RGBC.OB): 51%, 4%, $125
Oakwood Homes: 50%, -55%, $2

Period: February 18, 2000 to March 2, 2005
Annual Portfolio Return: 1.3% ($1000 grows to $1070)
Annual S&P 500 Return: -2.1% ($1000 shrinks to $900)
Difference: 3.4%

**********

Value Line Publication Date: August 18, 2000

Action Performance (ATN): 81%, 29%, $314
theglobe.com: 81%, -30%, $20
Oakwood Homes: 76%, -53%, $3
Service Corp. International (SCI): 73%, 31%, $346
Navigant Consulting (NCI): 70%, 54%, $715
Burlington Inds.: 68%, -100%, $0
Federal Mogul: 66%, -52%, $3
Gerber Scientific (GRB): 66%, -6%, $76
QAD (QADI): 64%, 23%, $252
Free Markets: 64%, -100%, $0

Period: August 18, 2000 to March 2, 2005
Annual Portfolio Return: 12.8% ($1000 grows to $1730)
Annual S&P 500 Return: -4.5% ($1000 shrinks to $810)
Difference: 17.3%

Ticker symbols are shown in parentheses for companies whose shares are still actively trading today. The companies for which ticker symbols are not shown have been de-listed, presumably following poor financial results that led to large declines in share price. Among the Feb-2000 group, only 4 of the 10 companies are now in sound financial condition. From the Aug-2000 group, 5 of the 10 companies are survivors.

What is most interesting about the results is that, although only about half of the companies avoided de-listing over the 5 years following publication of the Value Line lists, both the Feb-2000 list and the Aug-2000 list outperformed the S&P 500, beating the market index by 3.4 and 17.3 percentage points, respectively.

Based on such small sample sizes, it is difficult to draw statistically significant conclusions. However, I suspect that the outperformance of the portfolios over the S&P 500 could be a real effect, attributable to the geometric return pattern I discussed in a prior post. See "Merits of Volatility in a Portfolio," January 29, 2005:
http://lloydsinvestment.blogspot.com/2005_01_01_lloydsinvestment_archive.html

The basic idea is that, in a portfolio with many volatile components, the winners more than make up for the losers. The value of a stock with a 40% annual return grows to 5.4 times its original value over 5 years. A stock with a 50% annual return grows 7.6 times in 5 years. In a portfolio holding 10 stocks, one 40% winner, one 11% return, three 0% returns and five completely bankrupt losers is all that is needed to produce a positive portfolio return. Having two 50% winners, two 25% returns, two 12.5% returns, and four bankruptcies will give a very attractive 20% annual portfolio return.

The February 18, 2005 issue of Value Line lists the following stocks with the highest 3- to 5-year potential total returns:

Company (Ticker): Value Line Potential Annual Return

UTStarcom (UTSI): 54%
Conextant Systems (CNXT): 51%
Anadigics (ANAD): 48%
Nuance Communications (NUAN): 44%
Three-Five Systems (TFS): 44%
AMR (AMR): 43%
Adaptec (ADPT): 43%
Delta Air Lines (DAL): 43%
Lattice Semiconductor (LSCC): 43%
webMethods (WEBM): 43%

As was the case with the groups of stocks from the year 2000 that we looked at, it will most likely turn out that only one or two of these 10 companies end up actually providing the indicated potential returns, and half of the companies will probably become de-listed or go bankrupt. However, it could also very well turn out that this portfolio of volatile stocks ends up handily beating the market. I look forward to returning to check up on this group of stocks five years from now in 2010.

(Disclosure: I have a small long position in UTSI, a telecommunications equipment provider active in China that is diversifying its revenue stream globally. When I bought my shares last year, I was aware that Softbank was the largest shareholder of record. Recently, I learned that the Bill and Melinda Gates Foundation bought 1.7 million shares last year.)

Low PEG Helps But High Growth Is Even Better

How useful is low PEG as an indicator of good value and growth potential?

To answer this question, let's take a look at a few examples:

Company (Ticker): Fwd. P/E, 5-yr. Est. Growth, Fwd. PEG Ratio

Exxon Mobil (XOM): 16.8, 6.7%, 2.5
Posco (PKX): 5.3, 13.0%, 0.4
Google (GOOG): 36.4, 30.5%, 1.2
Sina (SINA): 22.2, 36.6%, 0.6

Company (Ticker): Dividend Rate, "Same P/E" Return, Implied P/E 5 Years from Now for 20% Annual Target Return

Exxon Mobil (XOM): 1.7%, 8.4%, 28.1
Posco (PKX): 4.3%, 17.3%, 6.0
Google (GOOG): ---, 30.5%, 23.9
Sina (SINA): ---, 36.6%, 11.6

The price of Exxon has recently soared with the rise in oil prices to the $50 per barrel range. However, analysts' consensus estimates indicate just 6.7% annual earnings growth over the next 5 years. If the current forward P/E of 16.8 remains unchanged, the annual return over 5 years will be 8.4%, including the 1.7% dividend rate. In order to reach a 20% annual target return with the stated growth rate, Exxon's forward P/E would need to rise to 28.1 in 5 years. This type of multiple expansion is very unlikely for a large cap commodities sector company. In this case, the PEG of 2.5 tells us that the stock price is too rich for the earnings growth capacity of the company. Oil prices may continue to rise but probably will not rise at the fast clip needed to boost Exxon's earnings enough for consistent double-digit growth over the next 5 years. Consequently, I do not expect Exxon to deliver 20% annual returns over the next 5 years.

Posco, with a forward P/E of just 5.3 and estimated earnings growth of 13.0%, will produce a 17.3% annual return (including the 4.3% dividend rate), if the forward P/E remains unchanged. With only very modest mutiple expansion to 6.0, this leading Korean steel company can produce attractive 20% returns. The low PEG of 0.4 correctly indicates the good value and growth potential here. Posco shows promise of becoming a solid investment, assuming the analysts are right with their 13% annual 5-year earnings growth projection.

Among investors (and speculators), Google is as well-known for trading at an extravagant trailing 12 months P/E of 129, as it is for being the world's premier search engine. Its forward P/E is a less lofty 36.4 and, if the company is able to deliver analysts' estimated 30.5% earnings growth, the stock will give at least a 20% annual return over the next 5 years if the forward P/E ends up at 23.9 or higher. As Google and the Internet search business matures, growth will eventually slow. However, I would guess that in 5 years' time Google's forward P/E could still be in the high 20s, making it very possible that the stock could produce 20% or higher annual returns over the next 5 years, even though its PEG is currently 1.2.

Sina, with a forward P/E of 22.2 and a very high estimated earnings growth rate of 36.6%, will give at least 20% annual returns if its forward P/E is 11.6 or higher 5 years from now. The ongoing modernization of China, as reflected in the country's GDP that has grown around 9% annually for the past decade or two, is very likely to continue to drive economic (and Internet) growth for many years to come. If Sina's forward P/E remains unchanged at 22.2, annual returns will be a very attractive 36.6%, assuming that estimated earnings growth materializes as anticipated by analysts tracking the company. This potential for high return returns is reflected in the low PEG of 0.6. (Disclosure: I am long SINA.)

To sum up:

1. Low PEG is a good indicator; however,

2. High earnings growth is really the "behind the scenes" driver of high long-term returns.

To achieve our 20% annual target returns over the long run, we really need to focus on companies that can grow earnings at a similar rate for many years to come. With oil and steel prices having shot up more than 50% last year, the higher prices will likely begin to create more supply, since it is suddenly profitable to drill a little deeper for oil and to rejuvenate rusting steel mills. When supply comes on-line to balance new demand from China and elsewhere, the recent commodity price run-up will likely cool back down to normal single-digit growth. On the other hand, with the Internet still a new technology that is drastically changing the way we communicate and live, I see high growth likely for at least the next decade.

Conclusion: Price matters, but growth matters even more.