Tuesday, 14 December 2010

I Will Tell You How to Become Rich: "Be fearful when others are greedy, and greedy when others are fearful."

I Will Tell You How to Become Rich
By Dan Dzombak
December 6, 2010

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"Be fearful when others are greedy, and greedy when others are fearful."

Warren Buffett gave that timeless advice in his 20s while getting his MBA at Columbia, and he's gone on to do very well with it. He avoided the tech-stock bubble of the late '90s, when everyone and their brother got greedy. And in this past downturn, he was able to snap up preferred shares of Goldman Sachs and GE on the cheap while other large investors ran for the hills.

What are investors greedy for now?
Three areas of the stock market have the majority of investors salivating at present:

Tech stocks. This sector holds many examples of bloated valuations. Chinese search giant Baidu (Nasdaq: BIDU) trades for an extraordinary 93 times trailing earnings! While I think the company is unbeatable, I worry about its valuation as an investment.

Dividend stocks. With interest rates low, people are clamoring for anything with high yields. Stocks such as Chimera (NYSE: CIM) and Annaly (NYSE: NLY) now have a fanatical following. While I've seen the case made for why they could be good investments, I still worry. When people are this greedy, disaster's usually not far off. My colleague Matt Koppenheffer believes dividend investing is a fad, but I'd say a more worrisome fad is...

Bonds. Investors are greedy for safety. They're worried about volatility and the markets, and they just want something safe. They couldn't be more wrong. If interest rates rise, they'll be slaughtered as bond prices fall. In fact, fellow fool Amanda Kish is wondering whether the bond bubble just popped. Intelligent investors should be fearful of the herd's lust for safety.

What do investors fear most now?
The best investment opportunities arise when investors are scared. Europe, especially Ireland, seems to top investors' list of phobias today. That said, Fools should tread carefully here, since Ireland has some serious issues with its economy.

I recommend that interested investors look at Ryanair (Nasdaq: RYAAY), Europe's leading discount airline. The firm paid its first dividend in October, and it has a great management team led by the outspoken Michael O'Leary.

After learning that competitor Aer Lingus had turned down a lowball bid from Ryanair for the company, O'Leary said, "It is doubtful that Ryanair will waste any further management time or resources making another offer for Aer Lingus, as its scale and losses will continue to render it increasingly irrelevant in Europe's airline landscape." That's a relatively mild comment, as far as statements from the outspoken CEO go, but it shows O'Leary's commitment to running his company with his own maverick style.

A world of uncertainty
A strange situation arises when investors are both greedy and fearful, as penny stocks can demonstrate. These equities are tiny for good reason -- feared because the companies behind them usually have a real chance of going out of business. Since they are priced so low, though, people's greed sometimes gets the best of them, and many investors decide to purchase "a lottery ticket."

Every now and then, this gamble pays off. Folks who bought Sirius XM (Nasdaq: SIRI) when it languished between $0.05 and $0.10 a share are sitting pretty now. But the verdict's less clear for YRC Worldwide (Nasdaq: YRCW). While it's no longer a "penny stock" in the traditional sense ,after a 1-for-25 reverse split in October, the company still meets the SEC's definition of a penny stock, which "generally refers to low-priced (below $5), speculative securities."

Be wary! For every Sirius, there are 100 carcasses of dead penny stocks like Ambac, Motors Liquidation (bankrupt GM), and Enron.

"... And invest with a margin of safety"
While Buffett didn't say this last part, "margin of safety" is known as the three most important words in investing. It's a very simple concept. Give your assumptions some breathing room, so if they prove wrong, you don't lose much. If you think a stock is worth $20, for example, and it's trading at $18, that's not much of a margin.

This isn't a hard-and-fast rule. The quality of the business and the brand, the strength of the balance sheet, and the size of its future growth opportunity all affect a stock's margin of safety.

WD-40 (Nasdaq: WDFC) is one quality business that many investors often overlook. Everyone knows WD-40; you probably have it on a shelf in your garage or under your sink right now. Here are three reasons why I like it:

Its products are basically the same as the competition's, but its strong brand allows it to charge more for comparable products, earning high returns on equity.

It's a very dependable business. WD-40 has a place in Americans' minds as being dependable and cheap. This is reflected in WD-40's 80% share of the U.S. consumer oil & lubricants market.

The balance sheet is rock solid. WD-40 has been paying down debt since 2002, leaving nearly none left. Once the debt is gone, the business will be able to reinvest the extra cash or increase its dividend, which currently stands at a healthy 2.7% yield.


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