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The Daily Reckoning

Tips for a smart investor in 2011

A guest blogger presents some stock market advice for the year ahead.

By Chris MayerGuest blogger / January 7, 2011

Snow falls on a Wall St. street sign in front of the New York Stock Exchange, Feb. 25. Stock market predictions are an imprecise science at best, but here are some suggestions from guest blogger Chris Mayer.

Brendan McDermid / Reuters / File

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The New Year invites guesses about the year ahead. I thought I wouldn’t bother this year, but then I found myself scribbling out some investment resolutions and predictions on a napkin over breakfast. Here are some of them:

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1. Ignore the “gold is in a bubble crowd.” The mainstream press doesn’t understand gold. They look at the price and think it’s expensive. Instead, they should turn it around and question the value of the dollar. Gold is best thought of as a play on the creditworthiness of paper money. When people worry about the printing presses, gold does well. As most governments have huge deficits to finance, gold shouldn’t collapse.

Besides, on an inflation-adjusted basis, gold is still below its all-time high in 1980. It would have to trade north of $2,000 an ounce to break it.

Gold stocks are the best way to play gold because they are going to put up a stellar year of earnings in 2011. Many will mint money at $1,400 an ounce. Stay long gold stocks.

2. Stick with the fundamentals. People come up with all kinds of crazy indicators to try to predict what the market is going to do. The year 2010 had a couple of really silly ones that got a lot of press. Anyone remember the “Hindenburg Omen?” That people gave any credence to this idea at all makes me wonder about the survivability of our species.

But it wasn’t the only one. I clipped out and saved a column from Barron’s dated July 5, 2010, giving serious ink to the idea of the “Death Cross” – another indicator that cropped up in 2010 and predicted the market would crash. Of course, the market is 25% higher since.

Ignore these contrivances. The future is unpredictable. You’re better off studying businesses and trying to buy only cheap stocks. Move to cash when you can’t find anything to buy and wait. It’s worked for me anyway.

3. Question the “US blue chips are cheap” argument. This one is controversial because you couldn’t find a money manager today who doesn’t think US blue chips – Microsoft, Johnson & Johnson, Kraft and the like – are cheap. Nearly everyone does. That’s the problem. Something is wrong here.

Microsoft trades at only 12 times earnings, but perhaps deserves that multiple. Yes, it generates a lot of cash, but it has done little with it for shareholders’ benefit. The problem is that a lot of these big firms hoard cash, earning nothing, or spend it on value-destroying acquisitions. All that great cash flow these firms generate never gets into shareholders’ pockets.

Microsoft, Hewlett-Packard, Cisco and Intel are examples of companies that throw off lots of cash and carry excess cash…yet pay hardly anything to shareholders.

As Bill Miller, manager of the Legg Mason Value Trust, points out:

“[These companies] all could EASILY pay out 70% of their free cash flows as dividends and still build cash on the balance sheet. If they did so, it is hard (nay, impossible) to believe their stocks would not move dramatically higher. My guess is that at worst they would trade at between a 4% and a 5% dividend yield, about where much-slower-growing utilities trade, providing an immediate gain of over 30% to their owners.”

I agree. If big blue chips were smart allocators, they’d be great investments. Look at what McDonald’s has done. Or even IBM, which trades at a higher price-to-earnings ratio than Microsoft, a notoriously poor allocator of capital.

Until these big blue chips start thinking about shareholders, I don’t think they are especially cheap. They probably trade where they should trade.

Meanwhile, I still find better bargains among smaller-cap stocks, in which the people running the show have skin in the game. I’d rather invest in these names than some giant corporation that hands its executives lush option packages. Over the long haul, I prefer “owners” versus “renters.”