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Study done in 2007

After being away from the market for 3 days and visiting 25+ different businesses in Niagara Falls. It became very clear to me that some business owners had marketed their business intelligently and other businesses are really run poorly. I realized that investing is "much easier" than we make it. If you combine a great business (a ROC of at least 20% over the past 3 years and a ROE of at least 26% in the past 3 years) with a fairly priced stock ( 16 or less times last years earnings) and you combined these 2 traits with investors major advantage (being able to increase your position when the price drops) and then you sell position only when the ROC or ROE drop under 20 and 26 percent respectively over the past 3 years or the stock's PE is over 30. Logically you should be able to outperform the market and achieve great returns, Right? Let's see what we found.

Using the Dow Jones 30, 4 stocks out of 30 qualified from 2000-2006 and 1 more "qualified" in 2007. You can "test" this theory on any stock but since I am a "large cap" guy and am "too cheap" to purchase value line we will just study how this system worked since 2000. Altria (NYSE:MO) was purchased after the annual report was issued EVERY year from 2000-2006 at an average price (post Kraft (KFT) split) of 49.08. During 2002 3 "average down" purchases which are "2 units” instead of 1 after a 15% drop from the original purchase. After each purchase your "reentry price is 85% of the last price. In 2002 those three 2-unit purchases had a basis of 38.62. The original purchase in 2002 was $53, after the three 2-unit "average downs" your basis is lowered to $40.67. Like Mae West said "too much of a good thing is wonderful". Today those shares are worth $93.67 (counting the KFT spinoff) and still "qualify" to be held.

The power of "averaging" down is illustrated in our next example. Merck was purchased originally in 2002 at $50.24 and was purchased the next 4 years at $50.24, $45.25, $34.25 and $35.75 respectively. Many gurufocus readers get "impatient" when their value plays don't "move up fast enough" and contemplate selling them. The 5 "1 unit" purchases "have a basis of $43.196 which with a 3 year average holding period is not very good. However here comes the power of "averaging down and adding to your position". In 2002 an average down was done at $42.70. 2 years later in 2004 3 "average downs" were done at $38.46, $32.69 and $27.78. The last purchase was done at almost 50% below the original entry point 2 years ago. How many of you would be "panicking" now? But a look of the previous 3 years ROC was almost 33% and the ROE was almost 40%. 2003 earnings were 2.92 per share. Your 3 "average down" purchases had a basis of $32.97 which is 11times last year’s earnings along with the "lights out" ROC and ROE levels. Having the "ballz" to not only not sell but increase your position separates the "men" from the "boys". (My averaging down of Altria which I have mentioned in other articles was responsible for almost 70% of my net worth today). Your original purchase price was $50.24 but after your "average downs" your basis ends up at $37.164.Your holding period was about 3 years. With dividends Merck ended up with an annual return of over 12% despite the fact the stock is LOWER now than your original purchase price 5 years ago. This stock is not presently a buy but since the ROE and ROC is still favorable the stock is still in our portfolio

The last 2 stocks were bought but sold after the ROC and ROE dropped "under our parameters. IBM (NYSE:IBM) was bought in 2002 at $69.6 and "averaged down” at $59.16 a few months later (lowering our basis to $62.64). After the annual report came out in 2003 IBM's ROC 3 year average dropped under 20% and the position was closed out in 2003 at 80 dollars a share. Almost 30% in less than a year is a favorable return, although IBM is at an all time high. Keeping the stock would have made us less than 7.5% annually.

Pfizer (NYSE:PFE) is the last stock that was purchased and is a "favorite" of many gurufocus readers. The stock was purchased first at $28 and then "averaged down" at $23.8. In 2005 it was purchased at $27.25 and averaged down at $23.16. 6 units total were invested at a basis of $24.86. In 2006 after the annual report came out Pfizer fell under the parameters for BOTH ROC and ROE and the position was liquidated at $24.50. With dividends this stock returned under 3% annually during a 1.5 year holding period. The stock is slightly under where we liquidated the position last year.

The total 39 units invested of $1553.12 turned into $2523.27 with an average holding period of about 3 years. With dividends included the patient value investor (oxymoron there) averaged over 21% annually compound return which is remarkable considering we bought large caps and all 4 stocks dropped a minimum of 20% at some point after buying them and 2 of those dropped over 40%. For you value investors out there consider this fact. Warren Buffett's billion dollar or more purchases of Coca Cola (NYSE:KO), Wells Fargo (NYSE:WFC), and Anheuser Busch (NYSE:BUD) and Johnson and Johnson (NYSE:JNJ) ALL qualified under these parameters. Just something to think about.

So by combining a great business (ROC of 20% or more and ROE 26% or more over the previous 3 years) the "right price" (16 times last year’s earnings or less) and the ability and "ballz" to average down (2 units on each average down) you have the best of ALL 3 worlds. Sell ONLY when the stocks PE is over 30 or the 3 year average ROC is under 20% or ROE is 26%. In 2007 there has been only one selection. You guessed it, Johnson and Johnson. In the first quarter of 2007 Warren Buffett put in about $1.5 Billion