Following Seven Rules of Frugality will improve your performance in the stock market

The 25 year bull market which began in 1982 and ended in 2007 greatly distorted the premiums that investors should be putting on those companies that have a high percentage of ownership by the insiders and the management of a public company.  The theory is that the management of those companies who have large ownership stakes are generally much more frugal than those which management does not have a significant ownership.  After all the managers of a public company can only serve one of two masters.  Its either the almighty dollar or the big bonus or the significant appreciation in the value of their shares.  Back in the 1970s the first thing that I learned is to use common sense by taking a look at the following seven rules or questions before making any investment in a startup or in the shares of a publicly traded company:

1)     Does the management team of the public company or does the entrepreneur asking for the investment have a significant stake of more than 5% in the company?   If the entrepreneur has a small percentage of ownership does he or she have relatives or close friends who have also invested in their start up?  If not, run for cover.  GM went out bankrupt because its management team has not had a significant equity stake for more than 40 years.  If the management of a business does not have a significant equity stake they will make decisions that protect their salaries instead of the price of the shares.  Its just that simple.

2)     What kind of house does this person live in?  If the company is a start up and he or she lives in a mansion run for cover.  This also goes for a fast growing emerging company. 

3)     Is the person married and if so for how long?  Has he or she ever been divorced and if so how long have they been remarried?  Divorce generally means that he or she has a tendency to cut and run when things get down and out.  The general rule in the 70s was to not invest in someone who has been divorced.    

4)     Does the person have any other businesses or fall back positions should the business that he or she is asking you to invest “equity” in fail?  If they do not have a fall back position this is a good sign because he or she will do everything to keep the business from failing.  If they do have a successful business and are willing to put it up as collateral this is even better. 

5)     What kind of car does the person drive?  Again, if it’s a late model luxury auto and the company is a start up run for cover.  If its an emerging public company which is not yet profitable this rule also is applicable. 

6)     How about the office furniture?  If the office is furnished with expensive furniture run for cover.  This applies to both existing fully operational companies and also to start ups.  John Thain, the former CEO of Merrill Lynch who invested over $1.0 million to furnish his office is a good example on why this rule should be followed.     

7)     Are there holes in the soles of their shoes?  Spit polished shoes for an entrepreneur who is seeking investment capital is not a good sign.  The same would apply to jewelry and most especially Rolex watches.  If the shoes are worn this is a good sign.  If he or she has holes in the soles of their shoes that is even better.  You should consider investing because this indicates that they are working so hard on building the business that they have little time in getting their shoes repaired and their teeth fixed, etc.  The lack of flash could also indicate that they are lean and mean and this is also a good sign.

In the 1980s, I used these simple rules to avoid a public company that was going out of business and to also identify a start up that grew to $100 million in annualized revenue from zero in less than 18 months.  While working for Donaldson Lufkin & Jenrette in 1981, I was invited to a due diligence meeting for Nucorp Energy, a company that was seeking to raise capital.  At the end of the meeting they gave away gold writing Cross pens to all of the brokers and analysts who attended.  I distinctly remember that the appetizers after the meeting included biggest and most tasty shrimp cocktails that I had ever had.  Based on my frugal logic I passed on Nucorp.  My rationale was how could a company afford to give out so much?  Nucorp was successful with their raise.  Yet they went bankrupt 18 months later for dubious reasons.  Following the rules had enabled me to dodge a bullet. 

In the mid 1980s, I participated in HQ Office Supplies, Inc., which after going public was named by Barron’s as being one of the three companies to own in the office supplies business.  The other two were Office Depot and Staples.  When HQ had less than $10 million in annual revenue I remember visiting their headquarters in California.  I was dumbfounded when I saw vendors lined up in the hall outside their door to get into an office of less than 500 square feet.  The furniture was cheap and it was worn.  Within 12 months HQ’s revenue multiplied by ten times to $100 million.

The Super Bear Market will insure that those businesses who are frugal will better chance of success.  Those investors who invest in such frugal businesses will have a higher chance of success and a lower probability of failure.  Investors and shareholders alike should welcome the bear and also use these rules for the next bull.  For more information on the Super Bear Market go to www.BearMarketNavigator.com.