"Ladies & Gentlemen, Start Your Bandwidth Engines!"

For years we have been discussing the significance of the explosion of bandwidth capabilities and what it will mean to businesses and the economic growth of the world. We have argued that as bandwidth proliferates there will be a commensurate benefit to productivity and that its promise had been sidetracked by a series of policy mistakes (volatile Fed policy) and malinvestment (dot.com, housing/mortgage and commodities) over the last several years.

But while the advantage to economics has been less pronounced, the fact is we have seen an explosion of bandwidth since 2000 and it has already started to work its way into economic behavior most notably with the rise of social networking applications and mobile devices that are linked to the Internet.

Bret Swanson of Entropy Economics (see previous posts referencing Bret, here) describes the progression of this phenomenon in his recent piece "Bandwidth Boom: Measuring U.S. Communications Capacity from 2000 to 2008". Swanson points out that while there is a school of thought that believes a "digital Dark Age" has "starved us of communications power", the facts don't show that to be the case and the best is yet to come in terms of what advantages this "Exaflood" will give us.

Of particular importance, Swanson points out how it was onerous regulation that almost killed this expansion and brought about much of the "technology crash" of the early 2000s. He points out that "a series of technology breakthroughs, new business models, and a very helpful relaxation of harmful regulations complemented one another and produced a bandwidth boom."

We certainly hope that the current regulatory environment which seems to be leaning towards ever more government involvement in the affairs of business does not find its way to hinder the march of technological progress! This is important to growth investors because this "exaflood" is producing significant investment opportunities for those that are adept at identifying not only businesses that are driving the technology behind the bandwidth boom, but those that are developing business models geared towards exploiting it.

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Investor Behavior or Advisor Behavior -- 2009

Eighteen months ago, we published a post entitled "Investor behavior . . . or advisor behavior?" in which we pointed out that long-running research by the Dalbar, Inc. consistently demonstrates year after year that investors earn significantly less than the investment vehicles available to them.

We also pointed out that, although retail "financial advisors" tend to point to the Dalbar study as evidence that investors need professional help in order to avoid the kind of self-destructive behavior documented in those Dalbar studies, in actual fact the source of the data that Dalbar uses indicates that around 80% of the investors covered in the study seek some sort of professional advice when purchasing mutual funds outside of retirement plans at work.

In other words, the results depicted in the study and in the graph above indicate that the advisors may be as much or more of the problem than the investors themselves! We have written at some length about why this might be so, and how "intermediaries" can damage long-term wealth creation, even when their intentions are good.

The most recent Dalbar Quantitative Analysis of Investor Behavior 2009, released this past March, again confirms what previous studies have discovered. Covering a twenty-year stretch of time from the beginning of 1989 through the end of 2008, it found that the average equity investor dramatically underperformed not just "the market" (as represented by the S&P 500) but also inflation.

In the graph above, we see the results of the study: while the S&P 500 returned 8.35% annualized over those twenty years, the average equity investor earned a paltry 1.87% annualized over the same twenty years, while inflation averaged 2.89% per year.

As with previous Dalbar studies, the results are the worst for the twenty-year period -- which is especially troubling, since (as we have often pointed out) the results that matter the most to a family building wealth are the results over periods of decades, not over short periods of months or a couple of years.

We believe that the situation is even worse than the atrocious situation revealed in the Dalbar study. During 2008, many advisors recommended their clients invest in international funds, as well as investment vehicles tied to commodities indexes and foreign exchange plays, which did much worse than the US market represented by the S&P 500 in the data above. We pointed out a Wall Street Journal article which backs up that observation in a post last November. If the Dalbar study included data from bets on commodities, or bets on foreign exchange and currencies, or other exotic instruments that were recommended to investors in the name of "diversification" and "non-correlation," the results would probably be far worse.

This is a problem we have been talking about long before the most recent market panic, and which independent research has been identifying for many years. The events of 2008 should be the final wake-up call for investors that there is something seriously deficient in the existing "intermediary" model that has developed over the past twenty or thirty years in the financial services industry.

Unfortunately, just as the results of the Dalbar are often misinterpreted, it is quite possible that the damage of 2008 will be similarly misinterpreted. However, we would advise investors to return to the model which existed prior to the rise of the intermediary system, which we discuss in various places in this blog, and to tell others about it as well.

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Intellectual Affluence

Recently, George Leef of the John William Pope Center for Higher Education Policy published an essay entitled "Groupthink: Marching to a Single Drumbeat."

In it, he discusses a serious problem facing both parents and children in the United States and Europe: strong evidence that academia is characterized by very little diversity of thought regarding economic and political theory, but rather that there is almost universal "rejection of classical liberal ideas favoring highly limited government and reliance on voluntary socio-economic processes" among members of university faculty within the humanities and social sciences (including economics).

Dr. Leef cites a research article published earlier this year entitled "Groupthink in Academia: Majoritarian Departmental Politics and the Professional Pyramid," in which authors Daniel B. Klein and Charlotta Stern found a striking degree of "ideological conformity" not just within departments at a single university but across widely distant universities, and which explores the reasons why this situation has developed. They found specifically that professors in the humanities and social sciences largely "combine social-democratic leanings and support for (or acquiescence to) most domestic government interventions."

The same authors previously published a study in the Independent Review in which they found that an overwhelming percentage of professors they surveyed strongly supported concepts such as "redistribution," "tuning the economy by monetary policy," "tuning the economy by fiscal policy," and "minimum wage laws."

The rejection of the ideas of classical liberalism among educators has ramifications far beyond the universities themselves. For starters, the doctrines taught at universities tend to make their way into classrooms of children in high school, middle school, and elementary school and to color the teachings that children receive throughout their entire progression up the ranks.

More important, however, is the fact that future potential entrepreneurs and innovators are being exposed to economic ideas that emphasize the role of the government and diminish the role of the individual. This is a serious problem because -- contrary to what is apparently being taught in a majority of classrooms -- it is decidedly not the government that makes economic growth happen.

As we have explained many times before, economies grow through innovation -- and innovation is the product of individuals.

Innovation is in fact the polar opposite of "groupthink." Instead of "marching to a single drumbeat," in the words of Dr. Leef's article above describing academia, the innovators and entrepreneurs who actually propel the economy forward are those who are marching to the beat of their own drum!

This, by the way, is why no one has ever successfully written an algorithm or computer model that will tell you just which stocks to buy in order to "get rich in the stock market" (although many have tried, and many advertisements continue to claim that their product has done it). No one can ever write such an algorithm successfully, because no algorithm can tell you where the next unexpected innovation is about to burst forth.

In light of this fact, and the unpleasant truth that children's heads are generally (with some exceptions) being filled by educators who neither understand this truth nor subscribe to it, we coined the term "intellectual affluence." By it, we simply mean the lifelong benefits that come from a deep understanding of the power of the individual and the power of individual choice in the course of business enterprise and economic progress.

The idea that government is the best way to "tune the economy" or "stimulate growth" is a form of intellectual bankruptcy. Therefore, parents should impart to their children the mental riches of the importance of the individual and his or her freedom to innovate: the concept that the enterprising and innovative individual (as well as the enterprising and innovative businesses that were originally started by enterprising and innovative individuals) is the real engine that drives progress.

A good place to start might be with a free subscription to the Taylor Frigon Advisor! They can sign up to receive updates via email by using the link at the bottom of each post, or they can receive notification of new posts via Twitter by visiting @TaylorFrigon.

Another might be the excellent television series by Milton Friedman entitled Free to Choose, which aired on PBS in 1980 and was revised and re-broadcast in 1990. All ten episodes from the 1980 series and all five episodes from the 1990 series are available for viewing on the internet at Idea Channel TV.

As current California Governor Arnold Schwarzenegger says in his introduction to the 1990 series, the 1980 series changed his life, "and when you have such a powerful experience as that, I think you shouldn't keep it to yourself, so I wanted to share it with you." This is a perfect example of what we mean by "intellectual affluence," and the best part about this kind of wealth is that it does not cost much to get it, and sharing it with others does not diminish it in any way.

We would encourage you not to keep it to yourself either, and to share it with others as well!

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Change -- the Investor's Only Certainty, revisited

Last November, we wrote a blog post entitled, "Change -- the Investor's Only Certainty," which is well worth revisiting based on the developments of 2009 thus far.

In it, we refer to an essay which the late Richard C. Taylor kept through the years, and which had been written by his mentor, Mr. Thomas Rowe Price.

That essay, "The New Era for Investors," was written in June, 1968. It refers to several previous essays by Mr. Price, including one called "Change -- the Investor's Only Certainty," from June, 1966.

One theme of those essays was the impact that Mr. Price predicted that the policies of President Lyndon Johnson, America's 37th President whose years in office stretched from 1963 - 1969, would have on business and investment.

In "Change -- the Investor's Only Certainty," Mr. Price expressed his belief that the "increasing expenditures in fostering the Great Society will accelerate inflation. This will bring further socialization of industry, more government controls, and a probable increase in corporate taxes."

He also stated "The only way the Government of the United States can make good on its endless and countless guarantees of bank deposits, real estate loans, pensions, and all the various obligations of a welfare state, is by issuing more paper money. That is depreciated currency."

As we stated in our November post on those essays of four decades ago, these voices from the past are helpful first and foremost by demonstrating quite dramatically that "massive change is nothing new or unique to the present time." Investors today who are worried about change and uncertainty tend to forget that their parents or grandparents faced just as much change and uncertainty -- and yet looking back with the perspective of history we can see that there were also tremendous opportunities ahead of them, and decades of great prosperity in spite of all the errors that may have been made.

It is also noteworthy to point out the suggested course of action that was made in light of what turned out to be an accurate assessment of the dangers of accelerated inflation and increased business regulation and taxation.

First, among the description of "which stocks seemed best to own during the New Era" was the category "Science and technology." We have explained why this idea is so important, in previous posts such as this one on Clayton Christensen's theory of disruptive technology, or this one in which we explained that major technological paradigm shifts such as the one we believe is already beginning to take place are difficult to derail, even by government mistakes.

Second was a reiteration of the importance of seeking out "Small businesses with high rates of earnings growth." We have provided evidence from the record of the 1970s that this recommendation from these essays of 1960s turned out to be very sound indeed.

We also discussed in that post, among other places, why we have always emphasized the ownership of smaller, more innovative businesses. Other posts, such as the series entitled "Beautiful growth companies" discuss some of the ways of finding those kinds of businesses.

As those writings from the 1960s remind us, change is a fact of life for the investor. Just realizing that fact is beneficial to the investor today, who faces new changes -- and new and exciting opportunities. Perhaps the best way to end this discussion is with a final recommendation from Mr. Price, describing what he calls "the forward-thinking investor":

"He must be constantly alert. He must stick to the basic concepts which have proven sound over a period of centuries, be flexible of mind and be willing to change opinions, change tactics, and not stubbornly stick to old opinions and buck new trends, or try to swim against the tides."

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A wake-up call from Art Laffer

Economist Arthur Laffer has a new piece in the Wall Street Journal entitled "Get Ready for Inflation and Higher Interest Rates" in which he points out the enormous increase in the monetary base since September, 2008 (see monetary base graph, above, from the St. Louis Federal Reserve data).

Mr. Laffer points out that this expansion of the monetary base is "so far outside the realm of our prior experiential base that historical comparisons are rendered difficult if not meaningless." The consequences, he points out, will almost certainly be greatly increased potential for inflation and for higher interest rates.

This is precisely what we argued in our recent post, "Stand still, little lambs, to be shorn!" In that post, we provided a link to a classic Milton Friedman video from 1980 in which he provides vivid historical examples in which expansion of money supply led directly to inflation, time and again.

Art Laffer concludes his piece with what sounds like a note of resignation: "For Fed Chairman Ben Bernanke it's a Hobson's choice. For me the issue is how to protect assets for my grandchildren." However, we believe that all citizens should be asking themselves that same question.

We believe that the terrible long-term corrosive power of inflation on wealth is drastically underappreciated by even sophisticated investors. That is the central message of the original essay, "Stand still, little lambs, to be shorn!" from the AIER.

We have explained that, in terms of financial market assets, the only real way to preserve wealth and to grow wealth fast enough to stay ahead of the ravages of inflation is to be an owner. A post from February 17 of this year, entitled "Return of the 1970s, part 2" dives into this subject in greater detail and examines the period most associated with runaway inflation in this country.

We would also add that, in addition to financial market assets, we believe that investors should understand how to integrate their capital investments between real estate ownership, ownership of shares in private business enterprises, and even ownership of permanent insurance policies (the appropriateness of each area, of course, is subject to the specific resources and needs of different individuals and families).

Long ago we published a post on that subject in which we noted that this approach is analogous to the construction of a rock-climbing anchor in which three or even more individual anchor points are connected to one another in a way that will be mutually-reinforcing in the event of a fall. Everyone can imagine how dangerous a fall in rock climbing can be without a properly constructed anchor -- investors should realize that inflation is a hazard of equal seriousness.

Art Laffer's article should be a wake-up call to investors.

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A picture is worth a thousand words

There is a "good news" and "bad news" twist to this post. For the good news, our friend Brian Wesbury, Chief Economist at First Trust, has masterfully linked together a series of pictures that coincide beautifully with our belief that the "Panic of 2008" was just that -- a panic -- and that the recovery as things worked their way back to normal would be abrupt.

This gives us a great deal of confidence in the near- to intermediate-term outlook for the economy and markets.

Now for the bad news. We have long said that we weren't worried about government deficits in and of themselves, but worried more about the growth of the deficit and the percentage that the deficit represents of GDP. The picture is not so pretty in that respect:

We would echo the many calls we are hearing for an immediate abandonment of these massive "stimulus" packages and new government entitlement programs that are being sold as "saviors" of the economy. They are not needed and, in our opinion, will simply retard economic growth.

It is going to be very important to be on the right train going forward!

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Socially responsible investing

In 1970, future Nobel laureate Milton Friedman published an essay in the New York Times Magazine entitled "The Social Responsibility of Business is to Increase its Profits."

Professor Friedman's arguments are notable not only because of his masterful exposition of the problems arising from calls for greater "social responsibility" from "the soulless corporation," but also because the 1970s concept of demanding "social responsibility" from corporations has enjoyed a resurgence of late.

Many big corporations mention "social responsibility" prominently on their websites -- ironically, General Motors (which was mentioned in Milt Friedman's original article as being under pressure in this area), is one of them.* In fact, their corporate mission statement, quoted in many places on the web, begins with the declaration that "GM is a multinational corporation, engaged in socially-responsible operations, worldwide."

It should go without saying that their focus appears to have been in the wrong place and that their current condition may be all the evidence needed to support Professor Friedman's argument.

Professor Friedman's essay demonstrates that this idea of pressuring corporations for "social responsibility" beyond their mission of earning profits for their owners is not only detrimental but actually immoral.

He explains that when a corporate executive takes actions mandated by "social responsibility" rather than maximizing profits, he is actually "spending someone else's money for a general social interest." By reducing returns to stockholders, he notes, the corporation is in effect giving their money to some other cause. Instead, the corporation should focus on making money and allowing its shareholders and employees to spend the profits on social causes which they determine themselves. For example, Bill Gates is now able to be one of the most charitable individuals in the world because his Microsoft Corporation* made so much money for him.

Far from being immoral, the goal of making profits is actually profoundly moral. George Gilder explains this idea as only he can in this recent clip from a question-and-answer session. In that clip, he says:

"I believe profit in moral terms represents the index of altruism of an investment. Profit's often seen as a reflection of greed -- I think that's complete nonsense. When you think of what a profit is, it's the difference between the value of a good or service to the people who produced it, and the value to their customers. So it reflects the degree to which a particular enterprise understands the real needs of their customers -- it's an index of the altruism, the index of the orientation toward the needs of others of a particular business venture."

It bears noting that pressuring business to pursue "socially responsible" goals actually turns out to be morally questionable -- in that it asks them to take money from some groups and give it to others, without the same kind of popular representation and checks and balances that the founders of the United States of America declared to be inalienable human rights -- while allowing corporations to pursue profits by maximizing the value that they provide to the needs of their customers actually turns out to be morally altruistic.

To bring this discussion back to an investing perspective, it is noteworthy that there are now dozens of investment firms and fund companies that offer "socially responsible" investing. We would advise all investors to pursue morally responsible investing: by investing their capital in companies that are making above-average profits, and that appear to be in a position to continue doing so.

* The principals of Taylor Frigon Capital Management do not own securities issued by General Motors (GM) or Microsoft Corporation (MSFT).

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Stand still, little lambs, to be shorn!

One of the all-time classic "Economic Education Bulletins" published many years ago by the American Institute of Economic Research and re-published periodically with updated data is "Stand Still, Little Lambs, to be Shorn!" *

That essay -- most recently updated in January, 2005 -- explains the "hidden tax" of inflation. Using historical data, the authors calculated that -- during the ten years ending in December, 2003 -- individuals paid Federal income taxes of $9.0 trillion, and during the same period Americans who held savings in dollar-denominated assets (including bank accounts, money market funds, and bonds issued by corporations, municipalities, or the Treasury) lost an additional $3.6 trillion to the ravages of inflation.

In other words, the authors explain, the hidden tax of inflation was like a "huge supplementary tax" equal to 40% of the more obvious income taxes charged by the Federal government each year.

By way of enlightening those who felt that, after the runaway inflation of the 1970s was tamed, inflation was now largely "behind us," the AIER showed that the purchasing power of the dollar in 1980 was only 21.1% of the purchasing power of a dollar in 1945, but that by 2003 this figure had fallen even further, to the point that a dollar in 2003 had the purchasing power of only 9.9% of a dollar in 1945!

We have written about the deleterious effects of inflation many times in the past, particularly in our post from July 4, 2008 entitled "Liberty and Property." There we noted that even economist John Maynard Keynes, in his early years, spoke out against the tyranny of inflation, saying: "There is no subtler, no surer means of overturning the basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose."

Today, largely due to the enormous increases in government spending embodied in the current budget, inflation concern is back in the spotlight. Because of this, it is possible that more than "one man in a million" is aware of the danger of future inflation, although few are probably aware at just how large the hidden tax of inflation has been even before these new developments. The possibility that inflation could be even greater in years ahead should cause all investors to take notice.

Inflation indicators are pointing towards higher inflation expectations. The price of gold, which is currently above $950 an ounce, and the shape of the US Treasury yield-curve, which has recently "steepened" dramatically as the demand for longer-term US Treasuries falls and yields rise, are reliable measures that markets are pessimistic about the future purchasing power of the dollar.

The danger of increased inflation is exacerbated by the reliance of the Federal Reserve upon outmoded theories such as the "Phillips curve," which we have discussed in detail in previous posts, such as this one from August of last year.

Unfortunately, few in Congress seem to understand or even care about such arcane details of economic theory.

In an unusual display of economic understanding, not often found inside the halls of the US Congress, one member of the Budget Committee shows that he has clearly taken the time to become fluent in economic issues and recently asked Fed Chairman Bernanke some very pointed questions about the Phillips curve assumptions of the Fed and their potential for leading to greater future inflation. In a question-and-answer session on Wednesday June 3, 2009, Representative Paul Ryan asks Mr. Bernanke about the "output gap," beginning at about 27:44 on this C-span video of the hearing.

The "output gap" is a corollary of the Phillips curve, as explained in this 2008 article from the Cleveland Federal Reserve. Defined as "the percent by which actual output deviates from its potential," the output gap will be greater during times of recession, when there is a "gap" between potential output and actual output. Proponents of the Phillips curve and the output gap believe that slower economic growth -- or the presence of an "output gap" -- naturally tends to dampen inflation.

As we have explained before, the experience of the 1970s and "stagflation," when a slowing economy did nothing to rein-in runaway inflation, should have cured economists of these mistaken notions. Additionally, as Milton Friedman taught, inflation is a monetary phenomenon, and not caused by economic events. It is directly related to excessive monetary stimulus, simply described as "too much money chasing too few goods."

Nonetheless, when pressed by Representative Ryan in the above video, Mr. Bernanke asserts "I think that there clearly is an output gap" and that "the size of the current output gap will be a drag on inflation." Mr. Bernanke also calls the idea that the output gap dampens inflation after a recession "a reliable empirical regularity." He then goes on to assert: "If you look around you for evidence of inflation, inflation expectations, you're not going to find very much."

These assertions indicate that the Fed will likely continue to keep interest rates essentially at zero, although we believe that the Fed should instead begin tightening to prevent future inflation from their current position of emergency stimulus. This problem is all the more troubling when considered in conjunction with the record government spending and record amounts of debt, which will create pressure in the future for the government to either raise taxes or further inflate the currency -- or both.

The lesson of this discussion, and of the classic essay "Stand still, little lambs," is that citizens should be very aware of the real and corrosive threat posed by inflation. Most important to understand is that ownership of good businesses, through common stock, has historically been a solid foundation for preservation of purchasing power. We have discussed why this is so in many previous articles, especially this one entitled "The Inflationary Fed," in which we linked to studies showing that ownership in companies is superior even to real estate or gold in defending your purchasing power against the ravages of inflation.

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* Editor's note, 12/13/2012: In the years since this post was first published, AIER has again updated this important essay, and the version linked in the above post is no longer available on their website.  The latest version, updated in 2010, can be found here.
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The Airplane and the Tetherball

There is a key distinction between the market price of a stock and the business underneath that market price, which investors would do well to always keep in the forefront of their mind.

To highlight this distinction, Ben Graham created a famous metaphor, which he introduced in his 1949 edition of The Intelligent Investor as an illustration "in the nature of a parable."

He asked readers to imagine a small private business in which you own a share, and to further imagine that you have an irrational business partner, "Mr. Market." Mr. Market, Graham said, often "lets his enthusiasm or his fears run away with him" (42).

Every day he proposes to tell you what your business is worth, and to either buy your share from you or to sell you more of the same, at a valuation that "seems to you a little short of silly," in the words of Mr. Graham. Graham was drawing the distinction between the business itself and the market price for that business.

Several years ago, we also developed a metaphor to help investors to understand the distinction between the market price of a business and the underlying business itself, called "The Airplane and the Tetherball." Imagine a high-performance jet aircraft, and attached to this aircraft by a long bungee-cord arrangement is a small yellow tetherball. As the airplane climbs and dives, the tetherball will be tugged along behind the aircraft. At the same time, it is buffeted about by the winds, in a most unpredictable manner.

In this illustration, the airplane represents the underlying business, and the tetherball represents the market price of that business at any given moment -- for a publicly-traded company, this price is the stock price on the exchange.

Based on the fickle nature of the winds and air currents, the tetherball can sometimes be higher or lower in altitude than the airplane itself. This is because the market sometimes over-values or under-values a business, based on a variety of external factors, many of which have nothing to do with the fundamental performance of the business itself. In Graham's "Mr. Market" analogy, he attributed these factors to Mr. Market's "enthusiasm or his fears" which often "run away with him."

Predicting the direction of the tetherball is almost impossible. However, one thing is certain: because it is attached to the airplane, if that airplane continues to climb in altitude for several years in a row, the ball eventually will be dragged higher by the airplane. It still may be overvalued or undervalued relative to the airplane itself, but it will be higher than it was before.

In the diagram above, we have depicted a hypothetical business, marked by an airplane climbing on a trajectory indicated by the dotted blue line. The stock price of that business, represented by the solid red line, fluctuates quite erratically, sometimes being above the line of the airplane 's trajectory and sometimes below.

There can be a long lag between business performance (a climbing airplane, or a diving airplane) and the stock price (the tetherball, attached by a long elastic bungee-cord). Studies indicate that the longer the period, the greater the correlation between fundamental factors (such as operating earnings) and stock price.

The important lesson for investors is to focus on the underlying business (the airplane) and its trajectory, which is the "primary mover" in the illustration, rather than the market price (the tetherball), which is secondary. This advice seems obvious, but the reason it is difficult to follow is that the wild daily movement of the tetherball gets an enormous amount of attention. Also, a huge percentage of those in the "investment" industry pursue strategies that is based on some sort of timing of the movements of the market, rather than a strategy of owning businesses through the various short-term market fluctuations.

This is why our discussion of buying shares in businesses, as well as selling them, emphasizes the performance and prospects for the business itself, rather than the market's movements. Your analysis should be focused on determining which businesses are climbing at strong rates or are likely to do so, and you should be prepared to sell companies when you determine that they are leveling off in their trajectories, or even turning over and beginning to dive.

Incidentally, fundamental analysis of businesses using the criteria that we have used for many years and discussed in various places on this blog indicate to us that there are more good companies with market prices well below the fundamental value of their businesses than at almost any time in recent history.

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