Before getting into how to use value in your stock selection criteria, let me tell you what I think about being a "value investor."

When it comes to being a value investor, you must first decide how to value a company. The problem lies in being able to adequately determine real value and having access to enough of the right data to make such a determination. There are significant and polar opposite arguments on how to properly determine value and how relative it is to the current market. A lot has been written, and will continue to be written, on whether the market or a stock is overvalued or undervalued. I submit to you that, other than how I use PE ratios in the selection of stocks, it really doesn't matter whether a company or a stock or a sector or an industry or an entire market is undervalued, overvalued, or properly valued.

As bizarre as this may sound, I do not believe in value investing. Not that value investing is wrong. Quite the contrary—for the Warren Buffetts of the world, value investing makes a ton of sense. If you have the resources that Warren Buffett has, where you could know the inner workings of a company, its immediate and long-term prospects, the real ability of the management team, the goals of the board members, the products in the pipeline, the expected acquisitions, the real position of the company in the marketplace and/or the competitive landscape, and a hundred other very important elements associated with making a true value assessment, then, I would say you should be a value investor.

This is not to say that I don't believe in using value to help determine which stock to buy. I just don't rely exclusively on value to make my buying or selling decisions.

At one end of the spectrum is the person who is the "less-than-average" investor. He does a mediocre to poor job of investing and is frustrated and unhappy with his choices more times than not. My goal is to help you become the "better-than-average" investor. I want you to be able to make good choices and to be satisfied with them more times than not.

But how do we go about finding the best stocks if all you have at your disposal are the monthly and annual reports on the company, along with an analyst review or two. It is my belief that you do not have enough access to the right kinds of information to adequately be a true value investor.

Many so-called value investors try to outguess the market by using a value analysis to determine which stocks to own. Unfortunately, high-value stocks often fall precipitously in share price. These investors invariably attempt to defend why the market has improperly valued a stock when this happens. Remember, the market is never wrong. You will often hear market pundits and stock market mavens rail about how the market has missed something or that the market is wrong. But I say, "The market is what it is." To be a successful stock market investor, you must work with the market, not against it. If you ever get to a point where you believe the market is wrong, it only means that you are not in sync with the market.

Is it important to include value in your stock selection criteria? Absolutely. But my advice is to leave the bulk of value investing to the Warren Buffetts of the world. Let's stick with a much more reasona ble approach that any investor can use to significantly outperform the market. You will learn how to use one simple element of value, the PE ratio, to make small but important decisions about which one of a small handful of stocks is better to buy when the Demand Fundamentals (Rule 1) are the same for each stock in the group.

With regard to the market, I mentioned above that it is important to "stay in sync with the market." To do otherwise means that the market has moved in the opposite direction to where you thought it was going to move. This happens when you buy a stock, assuming it is going to move higher in price, and it then moves lower in price. This happens when you believe that an entire group of stocks (e.g., energy-related stocks) will move lower and yet that group of stocks defies your logic and moves higher, thwarting your investment strategy in those stocks. When this happens, the result is all too obvious: You will lose money. The only way to make money in the stock market is to buy stocks that the market wants and to sell stocks that the market doesn't want. To make money in the stock market, you must stay in sync with the market.

To know how to stay in sync with the market is not really that complicated. If the market gives you uptrends, then buy long; if the market gives you downtrends, then sell short. You will learn in Rule 10 how to know exactly when the market is signaling you to buy or sell.

Your job is not to try to determine whether a stock is properly valued, regardless of the basis used for that value determination. Your only job, as a stock market investor, is to know when to buy and when to sell. Everything else is just measuring egos and/or listening to value gurus, which is much like watching a stopped clock. It is going to be right twice a day.

However, if you have enough time and research data and can live long enough, a value theory can make some sense. But, since people don't live forever and most investors don't have nearly enough information to really determine a company's value, we are back to realizing that we should basically ignore value investing and take whatever the market is going to give us.

I will use value to help make a choice between two stocks with equal Demand Fundamental scores. I am, however, very much opposed to using value as the primary condition on which to make stock investment decisions.

So let me show you how to use PE ratios to help you to select the best valued stocks for your portfolio.

Most investors recognize that the lower the PE for a stock, the higher its value. In other words, the lower the PE, the less it costs you to, in effect, buy the company's earnings. And, as we learned in the previous rule, investor demand increases almost in direct proportion to a company's increasing rate of growth in earnings.

But when comparing one stock to another, you have to be very careful when using PE as a decision factor.

The key to understanding this concept can be illustrated with a candy bar and a gallon of gasoline.

If I made the following statement to you, you would think I was nuts (and you would be right): "You should buy more candy bars because one candy bar costs a lot less than one gallon of gasoline. The better value, therefore, is in the candy bar."

You know, of course, that it is ridiculous to compare candy bars to gasoline when making a purchase decision. Even if you melted the candy bar into a liquid, so that you could compare one gallon of candy bar to one gallon of gasoline, it still is an asinine comparison. Okay, then, let's compare miles per gallon. How many miles can you travel on a gallon of gasoline, as compared to the number of miles you can travel on a gallon of candy bars? I know—this is getting more and more ludicrous. Why would anyone ever make a buying decision on candy bars or gasoline by comparing the prices of the two products?

But I suspect that is exactly what you are doing when you use PE ratios as criteria for buying stocks when the two stocks are totally unrelated.

It is likely that you believe that comparing PE ratios is a good way to determine value, where value is the same thing as saying you are getting more for your dollar. The more earnings you can buy for the same dollar, the better. Right? Yes, that statement is true, but that does not mean you should always buy the stock with the lower PE when comparing one stock to another.

When using PE ratios to make a buying decision between two stocks that have equal or nearly equal Demand Fundamentals, you must make sure the two stocks are from the same industry. It might be reasonable to compare price per gallon of gasoline to the price per gallon of diesel when trying to make a decision on which vehicle to buy. Both of these commodities come from the same industry; in this example, they are both transportation fuels.

This probably makes some intuitive sense to you, but there is a subtlety here that I don't want you to miss.

When buying stocks, the market has determined what it believes to be "reasonable PE ranges" for a certain type (industry) of stock. Investors will buy Google, with a PE of 38, and not bat an eye. But they would never buy JP Morgan with a PE of 38. That would be outrageously expensive. How can that be? Why would investors refuse to buy JPM if its PE was 38 (which it is not, of course) but would (and do) buy GOOG with a PE of 38? After all, a dollar of earnings is a dollar of earnings. What is the difference between a dollar of JPM earnings and a dollar of GOOG earnings? The answer is, "Nothing." Why, then, will investors pay more for a dollar of GOOG earnings than a dollar of JPM earnings?

Sometimes, there is just not a good answer. Most investors would say it is because the ability of Google to generate more earnings in the future is higher than JP Morgan's ability to generate earnings in the future. And that may be true. But, still, we are just talking about what it costs to buy a dollar of earnings, which is what the PE tells us.

Here is the subtlety that I want you to grasp: The market determines acceptable and reasonable PE ranges based on nothing more than what the market will bear to pay. If the market determines that an acceptable PE range for a certain industry is 20 to 200, then a PE of 50 is not unreasonable. However, if the market has determined that an acceptable range of PE is 2 to 20 for a specific industry, a PE of 50 is completely unreasonable.

I have a good friend who writes a lot of articles on finance. He is often published in various journals and newspapers and on the Internet. I won't use his name for fear of either embarrassing him or receiving a bad review for my book—neither of which I want. I'll use a fictitious name for reference. I will call him "Joe."

One day, in my e-mail inbox, an article that Joe had written suddenly appeared. I like reading Joe's articles. They are almost always very insightful. In his e-mail, he was reporting on the overbought condition of the market. He was stating a lot of historical statistics on the average PE of the S&P 500. He went on and on explaining how investors were getting sucked into buying more and more expensive stocks because the average PE of the S&P 500 had moved from about 14 to over 16. He was extolling the merits of looking for stocks that had PEs in the subteens.

I was astounded at his complete disregard for the average PE by industry. He had, in one broad stroke of his pen (or, in this instance, keyboard), lumped all stocks into the same comparison criteria, where a stock that had a PE of 10 had a much better value than one of 20 or 30, regardless of its industry. As you will see, he was completely wrong in this comparison.

I wrote him about the article and pointed out what I believe is the fallacy of using the average PE of the S&P 500 as a benchmark from which to compare overvalued or undervalued conditions of equities. I expected him to be somewhat defensive, but his response to my approach to PE analysis was, "Good point."

Don't forget, your objective is to buy and sell stocks at the right time for the right price. So you should only consider buying a stock that has given you a strong technical buy signal, which you will learn in Rule 3 and Rule 10; has strong Demand Fundamentals, which you learned in Rule 1; and is supported by strong money flows into the stock's industry, which is explained in Rule 10.

Your first step is to execute Rule 1 on your universe of stocks. Executing Rule 1 means you have selected a group of stocks that pass your requirement for Demand Fundamentals.

Let's assume you have two stocks with identical Demand Fundamentals and both stocks are in the same industry, but you can buy only one of them. Now, you must choose between them. This is a situation you will encounter often. It is very common that when one stock in an industry is showing strong Demand Fundamentals, there will also be others that are just as strong.

The theory behind Rule 2 is that, with everything else being equal, comparing the PE of one stock to another is a good way to determine which stock is the better value, so long as both stocks belong to the same industry. Owning the stock with the better value means you are paying the least amount for the stock with the best Demand Fundamentals.

Now it is critically important that you understand that all of the following must be true:

For this discussion, I have selected two stocks that have (as of this writing) identical Demand Fundamentals and both belong to the electrical utilities industry. The names of these two stocks are CEG and GXP. According to their most recent quarterly reports and the then-current market price of the stocks, the PE ratios are:

If I could only own one of these two stocks, GXP is a better value since its PE is lower. "Better value" means I can spend less money per share to get the same amount of earnings. The more earnings I can buy with fewer dollars, the better. Why? Because earnings is one of the best metrics for evaluating the strength and growth potential of a company. The more earnings a company makes, the better the company. Investors want to own shares in strong, growing companies. Therefore, investors look at a company's earnings and then how much it costs per share to, in effect, buy those earnings. The objective is to buy the most earnings for the fewest dollars. To know which of two companies has the most value—meaning which of two companies has more earnings for every dollar it costs you to buy shares in those companies—all you have to do is to take the current share price and divide it by the most recently reported company earnings per share (EPS). Once again, the formula is price per share divided by earnings per share equals the "PE ratio." The smaller this number, the better. Why? You want to spend the least amount possible for the most earnings possible. Why? Because the market (the entire community of people and institutions who buy and sell stock) will pay more money for more earnings. Increasing corporate earnings is one of the most important Demand Fundamentals.

This probably makes reasonable sense to you, but let me take you through another example. In this case, I am going to—wrongly and without regard to industry—select two stocks from entirely different industries (Stock A and Stock B). This, surprisingly enough, is the standard practice of most investors, where they use PE to make a value judgment on a stock, while completely ignoring the fact that the stocks come from separate industries. You see, most investors know only the average PE of the S&P 500, which at the time of this writing is about 16. Because so many of the talking heads on TV use this as some kind of magical standard from which all stocks should be compared, many investors wrongly assume that a PE lower than the average of the S&P 500 is better than a PE that is higher than the average. This misconception will get you in trouble if you let it.

Following is an example that typifies this wrong way of thinking about PEs.

Based on this information, which is the better stock to buy, assuming they have identical Demand Fundamentals?

If you are thinking that Stock B is the stock with the better value since its PE is far lower than Stock A, you would be wrong.

It is true that 35 is lower than 50, but in the case of Stock B, its peer group (industry) range of PE is from a low of 16 to a high of 35.

For Stock A, its PE peer group range is from a low of 35 to a high of 166. Stock A, with a PE of 50 is near the middle of its peer group and is fairly valued.

Stock B, however, is at the high end of its peer group and, as such, is highly overvalued.

In this example, Stock A with a PE of 50 is a far better value and, therefore, much less expensive than Stock B with a PE of 35.

Looking back to our example using CEG and GXP, the two stocks were from the same industry (electric utilities), and both had identical Demand Fundamentals. By comparing the PE ratios, it becomes even more easily recognizable which one is the better value of the two. We chose GXP because its PE was lower.

So, to this point, when deciding between two stocks of equal or nearly equal Demand Fundamentals, consider only value from within each stock's peer group (industry). Do not consider a PE ratio without considering it from within the stock's industry range of PE ratios.

Throughout this rule, there are some underlying assumptions: You do not have unlimited financial resources, and you cannot buy every stock you want to buy.

I am going to assume that, at this point, you have examined your personal finances enough to have made an assessment as to how much money you want to use, put at risk, or invest into the buying and selling of stock in the stock market. You should already know how many stocks you should own at any one time, and that number is a fixed number—meaning it doesn't fluctuate all the time.

If these two assumptions (how much money and how many stocks) are not clear in your mind, they will be by the time you finish reading Rule 8 on diversification and Rule 9 on asset allocation later in this book.

Thus, the bottom line is that you have to know how much money you are going to use to build your stock portfolio. You have to know how many stocks you will possibly own at any one time. You must set these limits and have the discipline to stick to these limits.

Too many investors have no set strategy for buying stock. Many of them just buy a stock based on how much money they are comfortable spending at that particular time. I have seen individual investors who own stocks in over 100 different companies. They are overwhelmed with the number of different companies, and have no idea how to manage such a large group of stocks.

You may be in this position right now—too many stocks and too little time. After you read this book, you will know exactly how many stocks you need to have in your portfolio, and you will know exactly which kinds of stocks to own at any one time. Then, as you manage your world-class portfolio, you will find many situations where Rule 2 will help you choose between two similar stocks because you cannot own both of them.

Each year when we attend the Las Vegas Money Show,^[10] we get to drive over Hoover dam. We have driven over the dam many times, but the sheer size and stark landscape surrounding the beautiful Lake Mead never cease to amaze me.

As you may know, a bypass bridge^[11] is being built by the states of Nevada and Arizona and the U.S. federal government, just downstream from the dam. It is scheduled to be completed in 2010. At this writing, the bridge is just beginning to take shape.

The project is a civil engineer's dream, and even though I much prefer investing in the stock market to building bridges, I must confess that every time I drive down into that canyon and see the enormous structure being built, I am envious of the engineers involved in the project. Just this year (2008) we drove over the dam and saw the amazing spectacle unfolding.

You may be wondering why I would bring the topic of building of this bridge to your attention. It is because the building of this bridge is an excellent analogy to what I am teaching you in this book.

You see, each of these 10 rules must be considered integral building blocks to a total investment strategy and methodology. To single out one of these rules to the exclusion of the others would be like attempting to just build a highway across the Colorado River canyon below Hoover Dam without any support or structure to hold it up.

This is a great picture to illustrate my point (see page 51). You can see they have just completed the last of the columns that will support the highway from the foundation poured into the solid granite face of the canyon. And just below that foundation, you see the next step beginning. This is where they are slip-forming the massive arch that will extend from one side of the canyon to the other. Undoubtedly, they will be positioning other columns between the arch and the deck of the highway above. This is truly an engineering marvel.

But, just like this structure must be methodically constructed, with one careful step after another, so are we constructing an investment strategy and lifelong methodology for making consistent profits in the stock market.

To bring this point home to Rule 2, we have just learned why and how to properly use PE ratios as a part of your stock selection process. It would be no more right just to use this rule by itself than it would to use just the part of the bridge you see in the photo. If the engineers quit at this point on the bridge, it would be useless. If they said, "Let's just concentrate on these wonderful columns and ignore the great arch that is now being built," a bridge would never span the chasm. Before we will be able to drive across this bridge, all the components must be completed and tied together in proper order and with the proper dependency one upon the other.

Just like the engineers who are building this incredible, towering structure, you are now building your structure for investment success. There are 10 major components. Each one is required and each one is dependent upon the other. Do not consider any one of these rules to be not as important as another. Just like the building of the massive arch across the canyon, that part of the bridge might be the most challenging. But the lowly piece of rebar buried in the base of one of the column foundations is no less important to the total success of the final structure. Read and study these rules with that in mind. When you complete these 10 rules, you will see how beautiful a structure you have created, but instead of something that you drive across, it will be something you can use to drive into the future as you build and grow your financial security and create wealth for you and your family.

I would like to suggest that you go get a second cup of coffee before we start the next rule, where I will teach you how to trade like a technician. You have absorbed a lot so far and would probably like to have a fresh mind. Go ahead. It's okay with me!