Every morning around 8:00am, I exit the Standard Oil building in downtown Baltimore, walk to the edge of my block, insert 50 cents in the newspaper box, and I pull out one copy of the Baltimore Sun.

Not the entire stack of freshly printed papers, mind you. Only one copy, just as you and most other dedicated readers in America do.

Unless you’ve fallen on hard, rock-bottom times and hope to make a few bucks by pilfering the entire stack of papers for black-market gains, then what purpose is served by grabbing more than one newspaper?

Economists call this phenomenon the law of diminishing marginal utility. Simply put, the marginal utility (satisfaction) of a good or service decreases as the quantity of the good increases.

Said differently…

The first sip of wine is always better than the last. The more we drink, the better we feel…and the better we feel, the more we drink. But consumption, like most things, comes at a price. For the fourth glass of wine, you pay with a headache. For spending more than you make, you pay with interest.

But the gods orchestrating the strings of modern finance offer us a short-term solution. They say Mr. Consumer can punt the headache. They convince his lesser half that his voracious consumption was driven in a moment of weakness…it was an aberration, they say. No worries…you can pay us back next month.

But next month the neighbor bought a brand new Hummer. And now Sally can’t be seen in the ole ‘03 Suburban. So Mr. Consumer goes back to Mr. Banker to ask that he turn his head just one more time.

“Sure,” he says. “Why not? The 2003 Chevy Suburban is so, well, 2003.”

Mr. Consumer feels much better. Wife and banker are now both happy.

The cycle continues until our hero wakes up to find himself burdened with debt. Then the banker comes in to claim his pound of flesh.

This is the game that caters to a new American generation…an entitlement class of children playing children’s games…a generation weaned on bottle of instant gratification.

They’ve been told to expect more for less… They’ve been assured that it’s O.K. to spend more than you make…because in the end, the government will be there to brace your fall.

Unfortunately, mommy and daddy are broke. And so is Uncle Sam. But the American family keeps spending despite the fact that consumer savings rate for all of 2006 remained a negative 1%.

The 2006 figure proudly surpassed the negative 0.4% savings rate in 2005. These two years produced the most reckless lack of savings since the negative 1.5% savings rate in 1933 during the Great Depression.

So while most Americans woefully stare at double-digit APR’s as they cut another check for the minimum monthly payment, the debt continues to rise.

It won’t be long before the notion of keeping you’re financial head above water will soon require more effort than signing one’s name on the back of yet another new credit card.

But wait a second. How did we get here to begin with, you ask? If the law of diminishing marginal utility states that the satisfaction of a good or service decreases as the quantity of the good increases, why do we keep consuming more than we could ever hope to utilize?

I would venture to guess that he distance between economic theory and economic reality in most cases is somewhere between one and two feet. That’s the approximate distance from your brain to your heart.

As Bill Bonner points out in his latest book Mobs, Messiahs, and Markets, “people’s convictions arise not from proofs supplied by the brain but prejudices amplified by the heart.”

Most modern economic theory remains based on the premise that man is a rational being. Anyone who’s spent more than five minutes on planet Earth knows that man is rarely a rational being. As Bonner explains: “Human beings are neither good nor bad, they’re merely subject to influence.”

The reason seems simple. People find comfort in knowing lots of other people have made the same choices…like fans routing for a sports team. Human beings naturally gravitate towards the crowd. And “crowds cannot think. They can only feel and act.”

So their behavior only seems rational in the fact that “everybody’s doing it.” That was the rationale explained to me the first time someone offered me a cigarette.

You see, it’s time to separate yourself from the masses… It’s time to grow up. It’s time to step back from the crowd. Find a good business and determine its intrinsic value. Then simply wait for the mob to overreact or under react to news, and buy the stock when the market prices the share for less than it’s worth.

That’s basically it. So the next time you find yourself drawn to either 11 West 53rd or 117 Sandusky Street…take a step inside. Fight your way through the 150 silent, confused faces with their heads tilted slightly to the side and take a good, long hard look at that simple red dot adorned on white canvas. Remark to those in your immediate vicinity how both circle and canvas exquisitely embody the golden ratio…let them know that Leonardo da Vinci himself could not have done it any better. Then simply walk away. You know it’s time to ask for the refund.

And for the record, I don’t smoke.

Until next time,
Christopher Hancock
September 7, 2007

P.S.: Because of this groupthink principle, I look for many offshore investments that aren’t going to find themselves on the front of Wall Street Journal. And believe me, the readers of my newsletter, Free Market Investor, aren’t complaining.

Small-Cap Contrarian Investing was originally featured in the Penny Sleuth.

You’ve followed this winner for three years. You’ve watched the business grow. The 1,000 shares your broker picked up for $15 have soared more than twofold. They’re set to go even higher.

But even though the stock sits anxiously at $99 and change, poised to strike… The undeniable fact remains: Breaking the proverbial high water mark of $100 per share will take much more than some trivial rumor prophesizing another sexy multi-billion international M&A deal.

You see, most investors fear shares trading above the $100 plateau. It scares them.

No one really seems to know why… Rationally speaking, buy and sell decisions should be made relative to some intrinsic value. But as we all know, that seldom seems to be the case.

Everyone in the business seems to have their own magical formula for predicting price movements. Traders stare at charts. The value guys covet balance sheets. And a select few move solely on the word swirling around the office watercooler.

I gravitate towards the balance sheet. But that’s not for everyone. Each investor needs to find his own particular style. Even our blind squirrel perched atop the watercooler finds a nut from time to time.

But despite one’s particular method to his madness, one thing’s for sure. Most independent investors avoid shares trading in triple digits.

I like to call this utterly ridiculous phenomenon the “Little Man Syndrome.”

No one wants to be the little man.

When your neighbor stands over the hedges and proudly boasts that his broker just slipped him into 10,000 shares of some obscure, small-cap nanotechnology company, I understand that you’re justifiably reluctant to respond with: “Well, my broker just secured 100 shares of the world’s third largest steel company!”

No one likes to log on to his discount brokerage account and see the fruits of your ten thousand dollar bonus displayed in 80 shares of PetroChina.

That has the sex appeal of your ’98 Ford Windstar. Sure, it’s practical, reliable, and safe. But you want and edge. You want something that goes 0 to 60 in less than 15.6.

I don’t blame you. No one wants to live in the right lane all his life.

You want to feel like the big boys…to be a part of something. You want to matter.

You want to attend a stockholders meeting for something more than the free drinks and cheap finger foods. You want a say.

You’d rather open your account to find 15,000 shares of some, obscure, cash-burning penny stock whose name you can barely pronounce, running a business even the brightest mind would find difficult to comprehend.

Managements know this. They know you want 20 shares for the price of 10. That’s why they invented the stock split.

The point: Investors prone to the Little Man Syndrome are, by default, also prone to follow small-caps. It’s common sense.

So the next time you’re huddled around the watercooler listening to Doug from marketing spout off about some unknown Argentinean gold mining stock…and the little man conveniently appears on the edge of your shoulder, gently whispering it’s a good idea to park $10,000 of junior’s Princeton fund to snag 20,000 shares…please put down the Kool Aid and walk away.

You see, it’s time to separate yourself from the investing masses.

As an investor, it’s time to protect your assets so they can grow. Successful investing will require a combination of patience, realistic expectations and — most importantly — buying shares of businesses at the right prices, regardless of how high that price may be.

As investors, we’re looking for a margin of safety…companies trading near or below their intrinsic value with an established earning power.

That’s basically it.

I admit that, more often than not, small-caps make for a good story. There’s nothing wrong with a good story. Just make sure the good story stems from a good business at a good price.

Until Next Time,
Christopher Hancock
February 23, 2007

P.S.: Be one of the few to learn about the six “invisible” investments Wall Street’s elite loves to own… Wall Street’s “big dogs” build fortunes using six hidden kinds of investments the rest of us rarely discover.

Small-Cap Investing Strategies was originally featured in the Penny Sleuth.