Sunday, 23 December 2012

Use Stock Volume to Your Benefit

So how can you use volume to your advantage?

1.  Remind yourself that traders only determine the short term price not the value.

2.  Use the volume to help predict the right time to buy more assets or change into a better position.

Large volume (relatively speaking) means the price is at a peak or valley.  You are either at the top or the bottom of the chart, you need to determine this.

What is Stock Volume?

In this lesson, we learned the importance of stock volume. Although volume won’t help intelligent investors learn the intrinsic value of a company, it can be used as a tool to help predict market behaviour.

Many times investors can be fooled into believing that the market price of a stock is determined by all the shareholders. This idea is false.

When we look at the volume of a company on an given day, we can quickly get a sense of how many traders are actually determining the price of a stock when we compare this number to the shares outstanding. This ratio, volume/shares outstanding, provides a good idea how many traders are moving away from the company and how many are coming into the company.

  • When the company trades at a very low volume, we can generally say that the shareholder agree with the market price. 
  • Likewise, if the volume is very high, we can generally say that shareholders disagree with the market price.

We demonstrated this principal with Wells Fargo (WFC). When we looked at the historical market price for WFC, we learned that on the day where the volume was the highest in ten years, the market price was at an all time low. This idea of shareholders disagreeing with the market price when volume is relatively high is an important point that stock traders can use to their advantage. 

Always remember, volume can mean that the stock is over priced or underpriced. The peak or valley is for you to discern.

When to Sell Stock like Warren Buffett

1.  When a higher return is expected by trading to another asset (to include the loss incurred by capital gains tax).

2.  When the company changes its fundamentals.

When to Sell Stock like Warren Buffett


In this lesson, we learned the importance of always understanding the consequences of our actions. Buying and selling stock can have an enormous impact on our success as an investor. The most important thing to learn from this lesson is the emotional decisions when selling stock can often lead to very poor results.

We learned that there are two major rules for knowing when to sell stock:

1. We sell stock when we can trade the capital into an investment that will produce a larger return after accounting for the capital gains tax paid (state and federal). In addition, you’ll want to ensure the risk assumed is comparable for the return received.

2. We sell stock when the business changes its fundamentals. This could mean the way they manage debt. The future outlook for earnings is decreasing…etc

How to use a cash flow statement to identify strong versus risky companies

What is a Cash Flow Statement
This important document is used to help determine how money flows through a business. Prior to 1987, investors could only examine the health of a company from the income statement and balance sheet. Due to stricter regulations, publicly traded companies are now required to also disclose the cash flow statement.

The cash flow statement is broken down into three categories. 
1. Operating Activities: This is probably the most important section of the statement because it shows the money that's flowing into the business from the product or service that the company produces. Positive revenues listed on the cash flow statement from other activities are not sustainable in the long term, so that's why this section is so important. 
2. Investing Activities: A negative number listed in this section would mean that the company is investing money. A positive number in this section would mean that the company sold an asset in order to generate money. Obviously its better to see a negative number show-up under this section because it implies that the company is continuing to invest the revenues that it produces. 
3. Financing Activities: In this section, an investor can identify whether the business is try to raise money or pay off debts. A positive number in this section means the company is incurring debt or dilute the value of their shares. A negative number means the company is paying off debt or increasing the value of their shares (through a share buy back). Generally speaking its good to see a negative number under this section because it means the company is removing their leverage and creating a stronger position for their shareholders.
The Cash flow is a great document to help look at trends and how money flows through a business. Although the balance sheet and income statement are very useful documents for determining the intrinsic value of a stable company, the cash flow statement gives potential investors a glimpse into the current conditions of the company and how they manage their resources.

How to read the cash flow statement

Income Investing: How do you plan to pay for your retirement?

Imagine that you're 65 years old and you're looking to retire.

If you have $500,000 in savings, how long will that money last?

If you spend $50,000 a year and your saving grows at 7% a year, you'll be broke by age 80.

The savings and investments can only support you for 15 years from the age of 65!!!

What is Income Investing?

Income investing is purchasing stable stocks and bonds that pay dividends and coupons.  If enough stocks and bonds are acquired, the dividends and coupons will provide income for the owner during retirement.

If the income is enough to meet spending requirements, then the equity and par value of the investments will remain or grow with time as income payments continue to grow as well.

How can you invest in companies that will provide benefits now and into retirement?  

Invest in stable companies with low debt/equity ratio that pay dividends.

Always purchase assets that will increase your cash flow next month.  Income investing has a compounding effect in increasing your cash flow.  Using this approach will provide increasing liquidity (dividends) each month, so you can invest in the most undervalued security (either stocks, bonds, or preferred shares).


Income investing provides quarterly payments during retirement.

Income investing provides a constant stream of cash so you can continually take advantage of changing market conditions.

As a rule of thumb, I like to find companies that pay 1/3 of their earnings through a dividend and the other 2/3 into the book value growth of the business (this is growth I don't pay taxes on).

----->  Option 1  ----->  Retained or Pay down debts ---->  Increase in Book Value or Equity
----->  Option 2 ------>  Dividends

Most companies retain some earnings (e.g. 2/3)  and also distribute some as dividends  (e.g. 1/3).

How can I employ Income Investing Techniques

Summary of this lesson

By employing the techniques of income investing, one can prepare themselves properly for retirement. Since income investing is the process of picking stable stocks and bonds that pay decent dividends and coupons, the investor can benefit from the cash flow that’s produced by these securities.
The first way income investing provides benefits to the investor is through liquidity. Since the investor will continually receive dividends or coupons, they then have the opportunity to reinvest that cash flow into the most undervalued asset each month. This compounding cash flow is truly the essence of investing like Warren Buffett. With an ever increasing cash flow, investors can take advantage of market conditions during spikes and valleys.
The second way income investing provides benefits to the investor is during retirement. Since most retirees may need to sell their investments in order to pay their monthly lifestyle expenses, income investing offers an alternative approach. Since the retiree will receive quarterly and semi annual payments from these types of investments, they will continue to have a steady cash flow to meet their lifestyle expenses. Although some retirees may need to pull from the principal, income investing will minimize that withdrawal.
In the end, Income Investing creates more cash flow for the individual employing the technique. It’s Warren Buffett’s opinion that purchasing dividend paying stocks is a very wise decision because of the continued and consistent cash flow that provides liquidity to reinvest your earnings.

Warren Buffett Intrinsic Value Calculator - Determine if Stock is Undervalued or Not.

Warren Buffett's 4 Rules:
1.  Vigilant Leaders
2.  Long Term Prospects
3.  Stock Stability
4.  Undervalued

Non-Predictable Company (Andrew :-) )
  1. Lots of Debt
  2. No Long Term Prospects
  3. Not Stable
  4. Price ? - Can't be determined due to stability
Predictable Company (Linda :-) )
  1. Manageable Debt
  2. Long-term Prospects
  3. Stable 
  4. Market Price = $44.33  Intrinsic Value = ?

Lesson Objective 1: How do we calculate the intrinsic value of a stock
Lesson Objective 2: How do we use the intrinsic value calculator

Summary of this lesson

In this lesson, students learned that the intrinsic value can be defined as the discounted value of the cash that can be taken out of a business during it's remaining life. For us, we've defined the life as the next ten years. This way, we can discount that cash by the 10 year federal note. The Cash that we are taking out of the business is simply the dividends and the book value growth during the next 10 years. Since these numbers need to be estimated, it's very important to ensure that Warren Buffett's third rule (a stock must be stable and understandable) is met.
When a company doesn't have a history of linear growth, estimating the cash that they will produce for the next ten years becomes more speculative. When we look at the root of the intrinsic value calculator, it operates off of the same principals as a bond calculator. Instead of using coupons, we substitute dividends. And instead of using par value (or value at maturity) we estimate the book value of the business in 10 years. The value that we use to discount the summation of the cash is simply the 10 year federal note.
Although the previous paragraph might sound confusing to some, it's application is fairly straight forward. The reason Buffett says, "Two people looking at the same set of facts, will almost inevitably come up with at least slightly different intrinsic value figures," is due to a difference in opinion of the future cash flows. Since some investors are more conservative than others, their estimates of book value growth or dividend payments may be lower. This will immediately change the intrinsic value. Your job as an intelligent investor is to determine your own tolerance for risk and conservative estimates on how much money you will receive while owning the stock for a 10 year period.

Intrinsic Value Calculator

"Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life." - Warren Buffett
Therefore, the sum of cash that can be taken out of the business over the next ten years is going to be the dividends plus the equity growth. The discounted value is the current value of the 10 year federal note. To start, we'll determine how much a company's book value is growing.
"In other words, the percentage change in book value in any given year is likely to be reasonably close to that year's change in intrinsic value."- Warren Buffett

Click here for the Intrinsic Value Calculator:  

Would you rather be with Andrew or Linda? Businesses manage their finances just like individual people. :-)

Predicting the future networth of these individuals.

Andrew: Risky to Predict

Linda: Less Risky to Predict

Just because a business has volatile numbers doesn't mean it won't make a lot of money in the future.

It's just more difficult to predict and value = RISK.

Buffett Rule: A Stock must be stable and understandable.

Best Video Explanation of the Yield Curve and how this can help your investing

What is a Yield Curve?

What are the 3 financial risks in an investment?

What causes financial risks in an investment?

1.  Excessive debt
"Only when the tide goes out do you discover who's been swimming naked."  - Warren Buffett. 
Companies incur debts because they want to speed up time.  They can own assets now instead of waiting for them later.  Why is speeding up time a bad thing?
These are often the companies and people with a lot of debts when the market collapses.

2.  Overpaying for an investment.
Price is what you pay.  Value is what you get.  - Warren Buffett
The asset quality has not changed.  The market conditions has not changed.  The poor investment was based on the initial price paid, not the quality of the asset.  The investor overpaid to own the asset or stock.

3.  Not knowing what you're doing.
"Risk comes from not knowing what you're doing." - Warren Buffett.
Why do people value the ownership of a house but not value the ownership of a company?
People understand how to value a house.  Many people do not understand how to value a company or stock.  They definitely do not understand the value of the company when they are broken down into many shares.  So, that is the true risk here and if you are the type of person who buys company shares and never look at what they are worth and buying on the basis that "well I like this company", you are probably setting up yourself up for buying too high above the true value of the share.

Greed and Fear. Who do you think is ultimately determining the market price in the long run?

What are instincts?

Any behaviour is instinctive if it is performed without being based upon prior experience or knowledge.

Since most investors base their investing on emotions and instinct, they follow the mindset of Mr. Market.  (Instinct = without knowledge).

Solution .. become knowledgeable.  Base your decisions on facts opposed to emotions.

Greed Cycle
People are chasing prices ... not value.
Mindset:  A quick buck is about to be made.

Fear Cycle
People are scared they'll lose everything.
Mindset:  I don't k now the value of these stocks, so I'm outa' here.

How do we know how much the stock is worth?  This is a tough question.

The knowledge of a stock's value allows an investor to determine if Mr. Market is Greedy or Fearful.  (That's why we are here.  :-)  )

The key is to be greedy when others are fearful and fearful when others are greedy.  - Warren Buffett.

The name of the game really is between Accumulating Shares versus Trading Shares.  You want to be the person who is accumulating shares.

The stock market behaves like a voting machine, but in the long term it acts like a weighing machine. - Benjamin Graham.

Short Term:   Anyone can price the stock.
Long Term:  The Value becomes absolute.

Who do you think is ultimately determining the market price in the long run?

Benjamin Graham's Mr. Market, a stubborn business partner who sometimes offer great deals or very expensive prices.

As buyers and sellers move the market price of a stock, the market will offer great deals or very expensive prices. This idea is represented by Benjamin Graham's Mr. Market. Graham used the idea of Mr. Market to represent a stubborn business partner that sometimes offers great deals or horrible prices. Your job as an intelligent investor is to determine which deals are of great value.

Benjamin Graham's Mr. Market

Mr. Market is your emotionally disturbed business partner.
You can't change his behaviour  ... but you can react to it!
Mr. Market is your servant, not your guide.

Mr. Market:  "Hey Guys!!!  Buy some stocks ... everyone's make money ... you can too.  I am making a lot of money, so are my friends."

Mr. Market:  "Watch out, I'll take your money.  The outlook for tomorrow is even worse, so don't ask!  If you think you can make money in the stock market, you are just kidding yourself."

Never follow Mr. Market's changing emotions.
Instead, remain calm and competent, and take advantage of the opportunities Mr. Market presents.

Mr. Market is your servant, not your guide. - Warren Buffett

The Reasons for Selling and for Buying a Stock

For every single trade, there is always a buyer and a seller.

The Reasons for Selling

Seller:  "This stock stinks.  I can make more money somewhere else."

Seller:  "I need money for my new car."

The Reasons for Buying

Buyer:  "This company is going to make me some money."

Buyer:  "This company is going to make me some money."

There are a few reasons for selling a stock, but there is usually only one reason for buying a stock.  :-)

The seller thinks the stock stinks, whereas the buyer thinks the company is great.
The seller thinks the stock is still good but he needs the money, and the buyer bought because he thinks the company is great.

Thousands of orders a day cause the market price of a company to move up and down.  However, the market price of a stock is determined only by a small number of players and not by all of the people.

How does the Stock Market work for the Value Investor?

Amy the Seller put a stop order to sell a company share at $65 per share.
Linda the Buyer put a market order to buy.
The transaction was matched.
The market price of the stock is now displayed on the board at $65 per share.

Does this mean the company IS worth $65 a share?


Did a couple of people trade it for $65 a share?

As a value investor, the answer is the latter.  The $65 is the trading price.  Just because a couple of people traded the share for $65 a share, this doesn't mean that the company is actually worth $65 a share.

Value investing is all about determining what the value of that share is worth and looking at what the price people are willing to buy it for or sell it for, and capitalize on these.

Saturday, 22 December 2012

Why is stock investing so lucrative?

Emotion trading offers really cheap prices and really expensive prices.

Your job is to always calculate the intrinsic value of the business regardless of the size, then compare the value to the price it trades for.

P/E Ratio

P/E Ratio

This ratio is a comparison between the price you would pay to buy a stock and how much profit you may see from 1 share in 1 year.

Learn How to Invest like Warren Buffett (38 videos)

How Warren Buffett hedges himself against Inflation

17 minutes into the video: Warren Buffett talks about investing and inflation.
Good businesses are the cheapest investment to acquire by far.
Buffett: "I love owning businesses."

Calculating a College Degree's True Value

How much is a college diploma actually worth? The perennial question asked by every former English, philosophy, and art history major now has an answer in some states. For University of Virginia students, it pays to major in engineering—$60,300, on average, 18 months after graduation—rather than sociology ($33,154), or worse, biology ($27,209). In Tennessee, a graduate of Dyersburg State Community College with an associate’s degree in health earns an average $5,000 more than someone who majored in health and picked up a bachelor’s at the University of Tennessee at Knoxville, the state’s flagship school.
With tuition and student debt skyrocketing and dim job prospects awaiting many graduates, states are trying to show residents what kind of return they can realistically expect for investing in a degree from a public college or university. That’s why Virginia, Tennessee, and Arkansas are collecting salary data on their graduates and posting it online at, a website run by a former education official in the Bush administration. The database, which doesn’t reveal any names or other identifying information, shows students how much money they can expect to earn based on the major and school they choose. Colorado, Nevada, and Texas will also begin using it in early 2013.
“What we want is for students to make informed decisions,” says Tod Massa, director of policy research and data warehousing at Virginia’s State Council of Higher Education. Massa, who’d been pushing for such a database for years, had little success until 2011, when the Virginia legislature passed a law mandating that the state publish salary data for graduates of all colleges and universities, public and private. Schools “need to coordinate their level of student borrowing with [students’] likely ability to repay,” Massa says. Virginia shares its information with CollegeMeasures and operates its own website, publishing data for graduates up to five years out of school.

Chinese Stocks Lose Their Luster

The average price-earnings ratio of Chinese stocks sank 76 percent over the past decade as growth cooled and investors soured on the lumbering state-owned enterprises that dominate the country’s main equity index.

In a World Full of Risk, Why Are Investors So Calm?

Leuthold’s monthly Risk Aversion Index, which bakes together various credit and swap spreads, commodity and currency prices, and relative asset returns to offer a broad gauge of skittishness, is at a record low going back to 1980. That span includes the Crash of ’87, the rolling emerging-market contagions of the 1990s, and the multiple human and financial calamities of the past decade.

How does this overwhelming calm jibe with the prevailing uncertainty of our times?
“The so-called Bernanke put—or, more accurately, global central bank put—is suppressing most of the risk and fear gauges,” says Leuthold’s Chun Wang. “And just about all asset classes, risky or risk-free, have been bid up.” Wang finds that low-fear backdrops like this historically last much longer than high-fear ones, and that increasing signs that housing and China are on the mend only add to the general chill-out.
It’s been a paradoxical climate for investors, who have seen the rather unique confluence of low economic growth with double-digit global equity returns—something that normally doesn’t happen in the absence of post-recession relief rallies and/or significant interest-rate declines.
Some are already conflating all this calm with complacency, warning that danger lies ahead.

How to select the better company to invest in? Comparing Companies.

If the companies you wish to compare are in different industries, you should use the industry as another subjective criterion.  You can compare investments in different industries if you're interested in the best investment opportunity.  Some criteria; e.g., profit margins, differ from industry to industry so you will want to overlook those items.  You may find one industry to be more appealing to you than another and should allow that criterion to help with your decision.

The criteria you should use for comparison are not limited to the "value" and "quality" criteria.  The most important criteria are those that address "quality."  Beyond that, the price-sensitive "value" criteria will address the potential rewards and risk.  However, such items as the industry or company size may have a bearing on your decision as well, although they are less critical than some of the others.

For comparison, you should select no more than 5 companies.  More than five companies becomes a "screening" exercise and becomes unwieldy.  While companies may be in a variety of industries, some comparison criteria such as profit margins may be valid only when comparing companies in the same industry.

You should circle a value if it's better than most of the others.  Circle the values that are better than most for each criterion.  It may be more than one - or all - if they are close enough not to be obviously ruled out.  All you can hope to accomplish by circling the criteria is to sharpen your judgement and separate the chaff from the wheat.

Pick a winner on the basis of your overall subjective assessment.  Base your decision on your overall subjective assessment, using the number of circles as a guide and the more subjective items such as the industry the company is in, the size of the company, etc. as tie breakers.  The number of circles is important only as a starting place and guide; and should be tempered with your assessment and "gut feeling" about the company when the numbers are close.  

Good quality company but trading at high price - Add this to your "watch list."

If the price is too high, you should add the company to your "watch list."  You have found the company to be a good quality company but the price is too high.  If it's much too high, put it on your "watch list" and wait for it to come down.

In rare circumstances, you may wish to put in a market order; but you will not want to do this in every case.

The "buy price" is the price at which both your risk and reward criteria are met.  This is the highest price you can pay and realize both a Total Return that will double your money every five years and where the risk of loss is less than one third of the potential gain.

The reward should be at least three times the risk.  Even though you may sometimes accept a total return of less than 15% because of the contribution that the stock can make to your portfolio's stability, you don't want to accept a Risk index of much above 25%.

If the Risk index is zero or negative, you should question your assumptions about the quality issues.  You will want to question why the price of the stock is so low.  What do others know about the company that you don't know?  If you're a new investor, you should move on to another candidate.  If you can satisfy yourself that the price is depressed for no good reason, then you can be a contrarian and buy the stock.

Additional note:

Definition of 'Market Order'

An order that an investor makes through a broker or brokerage service to buy or sell an investment immediately at the best available current price. A market order is the default option and is likely to be executed because it does not contain restrictions on the buy/sell price or the timeframe in which the order can be executed.

A market order is also sometimes referred to as an "unrestricted order."

Investopedia explains 'Market Order'

A market order guarantees execution, and it often has low commissions due to the minimal work brokers need to do. Be wary of using market orders on stocks with a low average daily volume: in such market conditions the ask price can be a lot higher than the current market price (resulting in a large spread). In other words, you may end up paying a whole lot more than you originally anticipated! It is much safer to use a market order on high-volume stocks.

Read more:

Calculating the Risk Index

Risk Index
= (Current Price - Potential Low Price) / (Potential High Price - Potential Low Price)

The result is the risk index, the percentage of the deal that is risk.
We look for a risk index of 25 percent or less, meaning that only a quarter of the proposition or less is risk.
We would then have at least 75 percent to gain versus at most 25 percent to lose; so the reward is at least three times the risk.

Be conservative in your estimates for future growth.

Never estimate future earnings growth:

  • to exceed the growth of sales
  • to exceed 20 percent
  • to exceed its historical growth rate
  • to exceed the analysts' estimates.

Be conservative in your estimates for future growth.  It's always better to underestimate than to overestimate.

Beware that the worse a company performs, the better value its stock will appear to be.

The worse a company performs, the better value its stock will appear to be.

Because declining fundamentals will prompt a company's shareholders to sell, the price will decline.  This will cause all the value indicators to show that the price has become a bargain.  It's not.

Friday, 21 December 2012

Confine your study to companies with good sales or earnings growth.

Don't bother to continue with a stock study if sales or earnings growth is inadequate.

Sales growth is inadequate if it is below the guidelines for the size of the company you are studying (ranging from around 7 percent for a large company to 12 percent for a smaller one).

Earnings growth should be around 15 percent or better; but you can accept slower growth from companies whose dividends contribute substantially to the total return.

Why you shouldn't invest in companies whose business you don't understand?

You shouldn't invest in companies whose business you don't understand because you won't be able to judge their future potential and vulnerabilities.

While intimacy with a company's business is not essential to making a decision to buy the stock, later "hold" or "sell" decisions may be clearer if you understand its competitive position in the marketplace, the value of its products or services, and the character of its industry's problems.  These are common-sense issues for which a simple understanding of the business will suffice.

Warren Buffett on how to obtain superior profits from stocks.

     An investor cannot obtain superior profits from stocks by simply committing to a specific investment category or style.  He can earn them only by carefully evaluating facts and continuously exercising discipline. 

     Common stocks are the most fun.  When conditions are right that is, when companies with good economics and good management sell well below intrinsic business value - stocks sometimes provide grand-slam home runs.  

  • We often find no equities that come close to meeting our tests.  
  • We do not predict markets, we think of the business.  
  • We have no idea - and never have had - whether the market is going to go up, down, or sideways in the near- or intermediate term future.

Warren Buffett's Investment Objectives


     Our long-term economic goal is to maximize the average annual rate of gain in intrinsic business value on a per-share basis.  We do not measure the economic significance or performance of Berkshire by its size; we measure by per-share progress.  We are certain that the rate of per-share progress will diminish in the future - a greatly enlarged capital base will see to that. We will be disappointed if our rate does not exceed that of the average large American corporation.

2.     Charlie Munger and I can attain our long-standing goal of increasing Berkshire's per-share intrinsic value at an average annual rate of 15%.  We have not retreated from this goal.  We again emphasize that the growth in our capital base makes 15% an ever-more difficult target to hit.

3.     What we have going for us is a growing collection of good-sized operating businesses that possess economic characteristics ranging from good to terrific, run by managers whose performance ranges from terrific to terrific.  You need have no worries about this group.

4.     The capital-allocation work that Charlie and I do at the parent company, using the funds that our managers deliver to us, has a less certain outcome: It is not easy to find new businesses and managers comparable to those we have.

1.  Maximise growth in net worth over the long term.
2.  Aiming for average annual growth rate of 15%.
3.  Collect a group of great companies run by great managers.
4.  Re-allocate the funds generated by these great companies.

Warren Buffett on Arbitrage


     Berkshire’s arbitrage activities differ from those of many arbitrageurs.  First, we participate in only a few, and usually very large, transactions each year.  Most practitioners buy into a great many deals perhaps 50 or more per year.  With that many irons in the fire, they must spend most of their time monitoring both the progress of deals and the market movements of the related stocks.  This is not how Charlie nor I wish to spend our lives.  Because we diversify so little, one particularly profitable or unprofitable transaction will affect our yearly result from arbitrage far more than it will the typical arbitrage operation.  So far, Berkshire has not had a really bad experience.  But we will - and when it happens, we’ll report the gory details to you.

     The other way we differ from some arbitrage operations is that we participate only in transactions that have been publicly announced.  We do not trade on rumors or try to guess takeover candidates.  We just read the newspapers, think about a few of the big propositions, and go by our own sense of probabilities.

     Some offbeat opportunities occasionally arise in the arbitrage field.  I participated in one of these when I was 24 and working in New York for Graham-Newman Corp. Rockwood & Co., a Brooklyn based chocolate products company of limited profitability, had adopted LIFO inventory valuation in 1941 when cocoa was selling for 50 cents per pound.  In 1954, a temporary shortage of cocoa caused the price to soar to over 60 cents.  Consequently Rockwood wished to unload its valuable inventory - quickly, before the price dropped.  But if the cocoa had simply been sold off, the company would have owed close to a 50% tax on the proceeds.

     The 1954 Tax Code came to the rescue.  It contained an arcane provision that eliminated the tax otherwise due on LIFO profits if inventory was distributed to shareholders as part of a plan reducing the scope of a corporation’s business.  Rockwood decided to terminate one of its businesses, the sale of cocoa butter, and said 13 million pounds of its cocoa bean inventory was attributable to that activity.  Accordingly, the company offered to repurchase its stock in exchange for the cocoa beans it no longer needed, paying 80 pounds of beans for each share.

     For several weeks I busily bought shares, sold beans, and made periodic stops at Schroeder Trust to exchange stock certificates for warehouse receipts.  The profits were good and my only expense was subway tokens.

     The architect of Rockwood’s restructuring was an unknown brilliant Chicagoan, Jay Pritzker, then 32.  If you’re familiar with Jay’s subsequent record, you won’t be surprised to hear the action worked out rather well for Rockwood’s continuing shareholders also.  From shortly before the tender until shortly after it, Rockwood stock appreciated from 15 to 100, even though the company was experiencing large operating losses.  In recent years, most arbitrage operations have involved takeovers, friendly and unfriendly.  With acquisition fever rampant and anti-trust challenges almost non-existent, and with bids often ratcheting upward, arbitrageurs have prospered mightily.  In Wall Street the old proverb has been reworded: “Give a man a fish and you feed him for a day.  Teach him how to arbitrage and you feed him forever.”

     To evaluate arbitrage situations you must answer four questions: 
(1) How likely is it that the promised event will indeed occur?  
(2) How long will your money be tied up?  
(3) What chance is there that something still better will transpire - a competing takeover bid, for example?  and 
(4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?

     Arcata Corp., one of our more serendipitous arbitrage experiences, illustrates the twists and turns of the business.  On September 28, 1981 the directors of Arcata agreed in principle to sell the company to Kohlberg, Kravis, Roberts & Co. (KKR), then and now a major leveraged-buy out firm.  Arcata was in the printing and forest products businesses and had one other thing going for it: In 1978 the U.S. Government had taken title to 10,700 acres of Arcata timber, primarily old-growth redwood, to expand Redwood National Park.  The government had paid $97.9 million, in several installments, for this acreage, a sum Arcata was contesting as grossly inadequate.  The parties also disputed the interest rate that should apply to the period between the taking of the property and final payment for it.  The enabling legislation stipulated 6% simple interest; Arcata argued for a much higher and compounded rate.  Buying a company with a highly-speculative, large-sized claim in litigation creates a negotiating problem.  To solve this problem, KKR offered $37.00 per Arcata share plus two-thirds of any additional amounts paid by the government for the redwood lands.

     Appraising this arbitrage opportunity, we had to ask ourselves whether KKR would consummate the transaction since, among other things, its offer was contingent upon its obtaining “satisfactory financing.”  A clause of this kind is always dangerous for the seller: It offers an easy exit for a suitor whose ardor fades between proposal and marriage.  However, we were not particularly worried about this possibility because KKR’s past record for closing had been good.  We also had to ask ourselves what would happen if the KKR deal did fall through, and here we also felt reasonably comfortable: Arcata’s management were clearly determined to sell.  If KKR went away, Arcata would likely find another buyer, though the price might be lower.

     Finally, we had to ask ourselves what the redwood claim might be worth.  Your Chairman, who can’t tell an elm from an oak, had no trouble with that one: He coolly evaluated the claim at somewhere between zero and a whole lot.  We started buying Arcata stock, then around $33.50, on September 30 and in eight weeks purchased about 400,000 shares, or 5% of the company.  The initial announcement said that the $37.00 would be paid in January, 1982.  Therefore, if everything had gone perfectly, we would have achieved an annual rate of return of about 40% - not counting the redwood claim, which would have been frosting.

     All did not go perfectly.  In December it was announced that the closing would be delayed a bit.  Nevertheless, a definitive agreement was signed on January 4.  Encouraged, we raised our stake, buying at around $38.00 per share and increasing our holdings to 655,000 shares, or over 7% of the company.  Our willingness to pay up - even though the closing had been postponed - reflected our leaning toward “a whole lot” rather than “zero” for the redwoods.

     Then, on February 25 the lenders said they were taking a “second look” at financing terms “ in view of the severely depressed housing industry and its impact on Arcata’s outlook.”  The stockholders’ meeting was postponed again, to April.  An Arcata spokesman said he “did not think the fate of the acquisition itself was imperiled.”  When arbitrageurs hear such reassurances, their minds flash to the old saying: “He lied like a finance minister on the eve of devaluation.”

     On March 12 KKR said its earlier deal wouldn’t work, first cutting its offer to $33.50, then two days later raising it to $35.00.  On March 15, however, the directors turned this bid down and accepted another group’s offer of $37.50 plus one-half of any redwood recovery.  The shareholders okayed the deal, and the $37.50 was paid on June 4.  We received $24.6 million versus our cost of $22.9 million; our average holding period was close to six months.  Considering the trouble this transaction encountered, our 15% annual rate of return excluding any value for the redwood claim - was more than satisfactory.  But the best was yet to come.  The trial judge appointed two commissions, one to look at the timber’s value, the other to consider the interest rate questions.  In January 1987, the first commission said the redwoods were worth $275.7 million and the second commission recommended a compounded, blended rate of return working out to about 14%.

     In August 1987 the judge upheld these conclusions, which meant a net amount of about $600 million would be due Arcata.  The government then appealed.  In 1988, though, before this appeal was heard, the claim was settled for $519 million.  Consequently, we received an additional $29.48 per share, or about $19.3 million, and another $800,000 in 1989.   

      At year end 1988, our only major arbitrage position was 3,342,000 shares of RJR Nabisco with a cost of $281.8 million and a market value of $304.5 million.  In January we increased our holdings to roughly four million shares and in February we eliminated our position.  About three million shares were accepted when we tendered our holdings to KKR, which acquired RJR, and the returned shares were promptly sold in the market.  Our pre-tax profit was a better-than-expected $64 million.

     Earlier, another familiar face turned up in the RJR bidding contest: Jay Pritzker, who was part of a First Boston group that made a tax-oriented offer.  To quote Yogi Berra; “It was deja vu all over again.” During most of the time when we normally would have been purchasers of RJR, our activities in the stock were restricted because of Salomon’s participation in a bidding group.  Customarily, Charlie and I, though we are directors of Salomon, are walled off from information about its merger and acquisition work.  We have asked that it be that way: The information would do us no good and could, in fact, occasionally inhibit Berkshire’s arbitrage operations.

     However, the unusually large commitment that Salomon proposed to make in the RJR deal required that all directors be fully informed and involved.  Therefore, Berkshire’s purchases of RJR were made at only two times: first, in the few days immediately following management’s announcement of buyout plans, before Salomon became involved; and considerably later, after the RJR board made its decision in favor of KKR.  Because we could not buy at other times, our directorships cost Berkshire significant money.

     Considering Berkshire’s good results in 1988, you might expect us to pile into arbitrage during 1989.  Instead, we expect to be on the sidelines.

     We have no idea how long the excesses will last, nor do we know what will change the attitudes of government, lender and buyer that fuel them.  We know that the less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.  We have no desire to arbitrage transactions that reflect the unbridled - and, in our view, often unwarranted - optimism of both buyers and lenders. 

10 Amazing Investment Quotes You've Probably Never Heard

By Morgan Housel
December 13, 2012
There are an uncountable number of articles promising "the best investment quotes of all time," or some variation. Most are good reads; but they've become predictable. You know exactly what they're going to contain: Buffett's line about being fearful when others are greedy, Peter Lynch's deal about buying what you know, and a few classic Ben Graham hits. Same quotes again and again.
So, a while back, I did some digging and found 10 great investing quotes that aren't as popular. Enjoy. 
"Risk is what's left over when you think you've thought of everything." -- Carl Richards
Financial advisors say you should have six months of expenses saved as an emergency fund. That's planning. The average duration of unemployment today is 10 months. That's risk.
"In investing, what is comfortable is rarely profitable." -- Robert Arnott
Think about this: Three years after the book Dow 36,000 was published, stocks were down 40%. Three years after The Great Depression Ahead  was published, stocks had doubled.
"When a possibility is unfamiliar to us, we do not even think about it." -- Nate Silver
The two biggest financial stories of the last 12 years were 9/11, and the financial crisis. Be honest with yourself: How often did you think about the possibility of these two things happening before they actually happened? If you're like 99.9% of people, the answer is never.
"People focus on role models; it is more effective to find antimodels -- people you don't want to resemble when you grow up." -- Nassim Taleb
You want to study the greats -- great investors like Buffett and Lynch, and great companies like Apple (NASDAQ: AAPL  ) and Costco (NASDAQ: COST  ) . But you also want to study the failures. Kodak. General Motors (NYSE: GM  ) . Enron. Long-term Capital Management. Lehman Brothers. You'll probably learn more from the failures than you will from the greats.
"Pundits forecast not because they know, but because they are asked." -- John Kenneth Galbraith
There's zero accountability of financial pundits. In fact, the most popular media faces are almost never right, as websites like are showing. Keep that in mind when sifting through financial news.
"Being slow and steady means that you're willing to exchange the opportunity of making a killing for the assurance of never getting killed." -- Carl Richards
I recently interviewed value investor Mohnish Pabrai, who had dinner a few years ago with Buffett. Pabrai asked Buffett what happened to a former business partner he used to pick stocks with. (I don't want to name him because he's still in business today.) Buffett said they went their separate ways because the former partner was too eager to get rich, which meant leverage and, eventually, margin calls. Meanwhile, Buffett and partner Charlie Munger "always knew they were going to be rich and were in no hurry." Look who came out ahead.
"If you look carefully, almost all Old Money secrets can be traced to a single source: a longer-term outlook." -- Bill Bonner
It's well known that markets have become more short term. So what? No one said you have to become short term. My colleague Jeremy Phillips calls this "time arbitrage," or "the concept of buying a stock from those with a different time horizon, and selling on our own terms."
"No one can foresee the consequences of trivia and accident, and for that reason alone, the future will forever be filled with surprises." -- Dan Gardner
Speaks for itself. Some of the best investors have succeeded not because they've predicted the future, but because they've dealt with surprises better than most. That usually means having more cash and less debt than seems reasonable.
"The stock market is a giant distraction to the business of investing." -- John Bogle
Motley Fool advisor Ron Gross says we should think of the market as a company market, not a stock market. Here's a good example: On May 10, 2010, the Dow Jones (DJINDICES:^DJI  )  briefly fell almost 1,000 points, as high-frequency traders tripped over themselves. But it's safe to say that not a single non-financial business in the world was affected in any measureable way. That's the difference between a company market and a stock market. 
"In the corporate world, if you have analysts, due diligence, and no horse sense, you've just described hell." -- Charlie Munger
Really smart people with Ph.D.s used sophisticated math models to conclude that mortgage lending was sound in 2005. They failed miserably. Country bumpkins who didn't know what a balance sheet was said, "Hey, my brother is broke and just got a $500,000 mortgage. That ain't right." They won.