Wednesday, 25 December 2013

The Most Successful Dividend Investors of all time

Dividend investing is as sexy as watching paint dry on the wall. Defining an entry criteria that selects quality dividend stocks with rising dividends over time and then patiently reinvesting these dividends while sitting on your hands is not exciting. While active traders have a plethora of hedge fund managers on the covers of Forbes magazine there are not many well-publicized successful dividend investors. Even value investing has its own superstars – Ben Graham and Warren Buffett.

I did some research and uncovered several successful dividend investors, whose stories provide reassurance that the traits of successful dividend investing I outlined in a previous post are indeed accurate.

The first investor is Anne Scheiber, who turned a $5,000 investment in 1944 into $22 million by the time of her death at the age of 101 in 1995. Anne Scheiber worked as an IRS auditor for 23 years, never earning more than $3150/year. The one important lesson she learned auditing tax returns was that the surest way to become rich in America is by accumulating stocks. She accumulated stocks in brand name companies she understood and then reinvested dividends for decades. She never sold, in order to avoid paying taxes and commissions. She also never sold even during the 1972-1974 bear market as well as the 1987 market crash because she had high conviction in her stocks picks. She also held a diversified portfolio of almost 100 individual securities in brand names such as Coca-Cola (KO), PepsiCo (PEP), Bristol-Myers (BMY), Schering Plough (acquired by Pfizer in 2009). She read annual reports with the same inquisitive mind she audited tax returns during her tenure at the IRS and also attended annual shareholders meetings. Anne Scheiber did her own research on stocks, and was focusing her attention on strong franchises which have the opportunity to increase earnings and pay higher dividends over time.

In her later years she reinvested her dividends into tax free municipal bonds, which is why her portfolio had a 30% allocation to fixed income at the time of her death. At the time of her death, her portfolio was throwing off $750,000 in dividend and interest income annually. She donated her whole fortune to Yeshiva University, even though she never attended it herself.

The second investor is Grace Groner, who turned a small $180 investment in 1935 into $7 million by the time of her death in 2010. Ms Groner, who worked as a secretary at Abbott Laboratories for 43 years invested $180 in 3 shares of Abbott Laboratories (ABT) in 1935. She then simply reinvested the dividends for the next 75 years. She never sold, but just held on to her shares.

She was frugal, having grown up in the depression era, and was the classical millionaire next door type of person who was not interested in keeping up with the Joneses. Grace Groner left her entire fortune to her Alma Mater. Her $7 million donation is generating approximately $250,000 in annual dividend income.

The reason why dividend investors are not highly publicized is because dividend investing is not sexy enough to be featured in the financial mainstream media. In addition to that, it is not profitable for Wall Street to sell you into the idea that ordinary investors can invest on their own. Compare this to mutual funds, annuities and other products which generate billions in commissions for Wall Street, despite the fact that they might not be in the best interest of small investors.

The third dividend investor is Warren Buffett, the Oracle of Omaha himself. In a previous article I have outlined the reasoning behind my belief that Buffett is a closet dividend investor. He explicitly noted in his 2009 letter that "the best businesses by far for owners continue to be those that have high returns on capital and that require little incremental investment to grow". His investment in See's Candy is the best example of that.

Some of Buffett's best companies/stock that he has owned such as Geico, Coca Cola , See's Candy are exactly the types of investments mentioned above. He has mentioned that at Berkshire he tries to stick with businesses whose profit picture for decades to come seems reasonably predictable. Per Buffett the best businesses by far for owners continue to be those that have high returns on capital and that require little incremental investment to grow. In addition, his 2011 letter discussed his dividend income from all of Berkshire Hathaway investments, including his prediction that Coca Cola dividends will keep on increasing, based on the pattern of historical dividend increases.

In this article I outlined three dividend investors, who managed to turn small investments into cash machines that generated large amounts of dividends. They were able to accomplish this through identifying quality dividend growth companies at attractive valuations, patiently reinvesting distributions and in two out of three cases maintaining a diversified portfolio of stocks. These are the lessons that all investors could profit from.

Friday, 20 December 2013

Temporary Price Fluctuations is to be expected. It is not possible to avoid random short-term market volatility.

Relevance of Temporary Price Fluctuations 

In addition to the probability of permanent loss attached to an investment, there is also the possibility of interim price fluctuations that are unrelated to underlying value. 

Many investors consider price fluctuations to be a significant risk: if the price goes down, the investment is seen as risky regardless of the fundamentals.

But are temporary price fluctuations really a risk?  

-  Not in the way that permanent value impairments are and then only for certain investors in specific situations. 

-  It is, of course, not always easy for investors to distinguish temporary price volatility, related to the short-term forces of supply and demand, from price movements related to business fundamentals.

-  The reality may only become apparent after the fact. 

-  While investors should obviously try to avoid overpaying for investments or buying into businesses that subsequently decline in value due to deteriorating results, it is not possible to avoid random short-term market volatility.

-  Indeed, investors should expect prices to fluctuate and should not invest in securities if they cannot tolerate some volatility. 

If you are buying sound value at a discount, do short-term price fluctuations matter? 

-  In the long run they do not matter much; value will ultimately be reflected in the price of a security.

-  Indeed, ironically, the long-term investment implication of price fluctuations is in the opposite direction from the near-term market impact. 

-  For example, short-term price declines actually enhance the returns of long-term investors.

There are,however, several eventualities in which near-term price fluctuations do matter to investors. 

1. Security holders who need to sell in a hurry are at the mercy of market prices. 

- The trick of successful investors is to sell when they want to, not when they have to.

2.  Near-term security prices also matter to investors in a troubled company. 

-  If a business must raise additional capital in the near term to survive, investors in its securities may have their fate determined, at least in part, by the prevailing market price of the company's stock and bonds.

3. The third reason long-term-oriented investors are interested in short-term price fluctuations is that Mr. Market can create very attractive opportunities to buy and sell. 

-  If you hold cash, you are able to take advantage of such opportunities. 

-  If you are fully invested when the market declines, your portfolio will likely drop in value, depriving you of the benefits arising from the opportunity to buy in at lower levels.

-  This creates an opportunity cost, the necessity to forego future opportunities that arise
-  If what you hold is illiquid or unmarketable, the opportunity cost increases further; the illiquidity precludes your switching to better bargains.

Tuesday, 17 December 2013

Buffett investment thought process

Answering the following questions will guide you through the Buffett investment thought process.


1.  Does the company have an identifiable durable competitive advantage?

2.  Do you understand how the product works?

3.  If the company in question does have a durable competitive advantage and you understand how it works, then what is the chance that it will become obsolete in the next twenty years?

4.  Does the company allocate capital exclusively in the realm of its expertise?

5.  What is the company's per share earnings history and growth rate?

6.  Is the company consistently earning a high return on equity?

7.  Does the company earn a high return on total capital?

8.  Is the company conservatively financed?

9.  Is the company actively buying back its shares?

10.  Is the company free to raise prices with inflation?

11.  Are large capital expenditures required to update plant and equipment?


12.  Is the company's stock price suffering from a market panic, a business recession, or an individual calamity that is curable?

13.  What is the initial rate of return on the investment and how does it compare to the return on risk free Treasury Bonds?

14.  What is the company's projected annual compounding return as an equity/bond?

15.  What is the projected annual compounding return using the historical annual per share earnings growth?

Making investing enjoyable, understandable and profitable… A Simple and Obvious Approach

Making investing enjoyable, understandable and profitable…

Is it not true, that the really big fortunes from common stocks have been garnered by those 
  • who made a substantial commitment in the early years of a company in whose future they had great confidence and who held their original shares unwaveringly while they increased 10-fold or 100-fold or more in value?

The answer is "Yes."

Saturday, 14 December 2013

Most valuations (even good ones) are wrong

Now this can be shocking to you if you spend a lot of time arriving at that magical number (intrinsic value) that helps you ascertain whether you must buy a stock or not.
Damodaran talks about three kinds of errors that cause most valuations – even the ones “meticulously” calculated – to go wrong:
  1. Estimation error…that occurs while converting raw information into forecasts.
  2. Firm-specific uncertainty…as the firm may do much better or worse than you expected it to perform, resulting in earnings and cash flows to be quite different from your estimates.
  3. Macro uncertainty…which can be a result of drastic shifts in the macro-economic conditions that can also impact your company.
The year 2008 is one classic example when most valuations – even the good ones – went horribly wrong owing to the last two factors – firm-specific and macro uncertainties.
As Damodaran writes…
While precision is a good measure of process in mathematics or physics, it is a poor measure of quality in valuation.
So, to value or not value?
Knowing that your valuation could be wrong (and in most cases, it would be) despite any kind of precision you employ in your calculations, it should not lead you to a refusal to value a business at all.
This makes no sense, since everyone else looking at the business faces the same uncertainty.
Instead what you must do to increase the probability of getting your valuations right is…
  1. Stay within your circle of competence and study businesses you understand. Simply exclude everything that you can’t understand in 30 minutes.
  2. Write down your initial view on the business – what you like and not like about it – even before you start your analysis. This should help you in dealing with the “I love this company” bias.
  3. Run your analysis through your investment checklist. A checklist saves life…during surgery and in investing.
  4. Avoid “analysis paralysis”. If you are looking for a lot of reasons to support your argument for the company, you are anyways suffering from the bias mentioned above.
  5. Calculate your intrinsic values using simple models, and avoid using too many input variables. In fact, use the simplest model that you can while valuing a stock. If you can value a stock with three inputs, don’t use five. Remember, less is more.
  6. Use the most important concept in value investing – ‘margin of safety’. Without this, any valuation calculation you perform will be useless.
At the end of it, Damodaran writes…
Will you be wrong sometimes? Of course, but so will everyone else. Success in investing comes not from being right but from being wrong less often than everyone else.
So don’t justify the purchase of a company just because it fits your valuation. Don’t fool yourself into believing that every cheap stock will yield good returns. A bad company is a bad investment no matter what price it is.
Charlie Munger explains that – “a piece of turd in a bowl of raisins is still a piece of turd”…and…“there is no greater fool than yourself, and you are the easiest person to fool.”
So, get going on valuing stocks…but when you find that the business is bad, exercise your options.
Not a call or a put option, but a “No” option.
Have you ever avoided buying a stock you “loved” because its valuations were not right?

2 Bitter Truths of Stock Valuation

1. All valuations are biased
2. Most valuations (even good ones) are wrong

How to find “conservative” investments? The ones with the greatest probability of preserving your purchasing power and with the least amount of risk.

Buffett resisted buying large and popular companies because he thought this category was valued irrationally by investors. But then, he was not in favour of buying small, unproven companies as well. As he wrote in his 2010 letter…
At Berkshire, we make no attempt to pick the few winners that will emerge from an ocean of unproven enterprises. We’re not smart enough to do that, and we know it.
Instead, we try to apply Aesop’s 2,600-year-old equation to opportunities in which we have reasonable confidence as to how many birds are in the bush and when they will emerge (a formulation that my grandsons would probably update to “A girl in a convertible is worth five in the phonebook.”).
Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount. We try, therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners.
Even so, we make many mistakes: I’m the fellow, remember, who thought he understood the future economics of trading stamps, textiles, shoes and second-tier department stores.
This reiterates Buffett’s key definition of conservatism over these years – conservatism depends on how you choose and not what you choose.
In other words, investing conservatively is not about simply identifying large well-known businesses, but going through a process that identifies why a particular company qualifies as a conservative investment.
As Buffett would want you to understand, there is one simple way to look at a conservative investment.
Conservative investment = Preservation of capital
A conservative investment is one that has the greatest probability of preserving your purchasing power and with the least amount of risk.
This probability can in turn arise from the process that you follow to identify such opportunities that will preserve your purchasing power in the future.
So, where most investors fail in attempting to invest “conservatively” is blindly assuming that by purchasing any security that qualifies as a conservative investment, they are in fact, conservative investors.
In other words, such investors are thinking conservatively, but not acting conservatively.
If you indulge in such things, it could prove to be a costly affair.

Here is what Buffett wrote in 1965…
Truly conservative actions arise from intelligent hypotheses, correct facts and sound reasoning. These qualities may lead to conventional acts, but there have been many times when they have led to unorthodoxy. In some corner of the world they are probably still holding regular meetings of the Flat Earth Society.
We derive no comfort because important people, vocal people, or great numbers of people agree with us. Nor do we derive comfort if they don’t. A public opinion poll is no substitute for thought. When we really sit back with a smile on our face is when we run into a situation we can understand, where the facts are ascertainable and clear, and the course of action obvious. In that case – whether other conventional or unconventional – whether others agree or disagree – we feel – we are progressing in a conservative manner.
The above may seem highly subjective. It is. You should prefer an objective approach to the question. I do. My suggestion as to one rational way to evaluate the conservativeness of past policies is to study performance in declining markets.

Emotional Intelligence

You don’t need to be a rocket scientist. 

Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ.

This is also what Buffett says. 
Of course, some knowledge about finance is important before investing in the stock markets, but this knowledge alone won’t be of any help to you.

What you also need is emotional intelligence while investing in stock.

Emotional intelligence is the ability to identify, assess, and control your own emotions.

A true value investor is likely to perform better in a bear market than in a bull market.

Patience is a virtue for value investors

The last part of Buffett’s 1957 letter carries a very important lesson in patience for value investor. Here is what he wrote…
To some extent our better than average performance in 1957 was due to the fact that it was a generally poor year for most stocks. Our performance, relatively, is likely to be better in a bear market than in a bull market so that deductions made from the above results should be tempered by the fact that it was the type of year when we should have done relatively well. In a year when the general market had a substantial advance I would be well satisfied to match the advance of the Averages.

Despite calling ourselves “value investors”, a lot of us lose patience when stock prices are falling and get elated when they are rising.
But as Buffett wrote, a true value investor is likely to perform better in a bear market than in a bull market.

This is simply because when you are value investor, you buy good quality stocks and that too only at reasonable margin of safety (around 30-50%).
So when stock prices fall in a bear market, your good quality stocks bought at reasonable margin of safety may earn you lesser losses than the broader markets.
On the other hand, in a bull market, when even garbage is considered a dessert, and people are lapping up everything that’s rising in price, Mr. Market usually ignores good quality “boring” businesses which you hold in your portfolio…
and thus you must be happy to earn just as much as the broader markets. That’s when you must not try to ride the bull but instead tell those riding it – “I’ll see you in the next bear market!”
This wouldn’t be arrogance on your part. This would be sensibility, as Buffett has proved over the past six decades.

Unlocking value. Sooner or later, a stock will rise to its value (Benjamin Graham)

 “But I am no Buffett!”
You might wonder – “Buffett was able to unlock value in Sanborn simply because he earned a seat on the board and then spun off the investment portfolio. I can’t buy enough shares to get on the board of a company that I think holds a value unlocking potential! So how could I profit like Buffett did?”
Well, what if I say that you are more empowered than Buffett of 1960?
Yes it’s true! The Information Age empowers you, dear investor.
If you can find a value unlocking potential like Sanborn (though it’s difficult to find such a bargain in a period when information spreads so fast…but just in case), all you need to do is own the stock and then spread the word around.
Sure, nobody may notice your analysis or even care about it at first, but then have faith in what Graham said, “Sooner or later a stock would rise to value.”
As long as your intention is not to find a greater fool to unload your junk upon (which means you are not trying to create a fake market in a junk stock), go out and tell the world about your analysis.
Your (genuine) story will spread, sooner than later. That will lead to value unlocking.
There have been several cases of value unlocking in various markets that have earned investors a good amount of money.
So there’s a potential to earn good returns in this space of value unlocking through special situations.

Property - London’s lure dimmed by capital gains tax

London’s lure dimmed by capital gains tax
Published: 2013/12/10

LONDON: London’s status as a magnet for foreign property investment was burnished in the years after the financial crisis by an investor-friendly tax regime and the falling value of the pound. That may be changing.

A new capital-gains tax on homes sold by people living abroad and a growing British economy that’s lifting the currency may dull the capital city’s appeal to property buyers from abroad.

The government “will put people off by changing the rules constantly and making it less tax-friendly for buyers,” Andrew Sneddon, head of tax law at Trowers & Hamlins, said by phone. “If these wealthy buyers choose to go to Monaco, Paris or New York to spend their summers and their money, what’s that going to cost the U.K. economy?”

Investors from the Middle East to Asia have been splurging on London homes, buying everything from multi million-pound mansions to apartments in Battersea and the City of London. That’s driving prices beyond the reach of many British buyers and sparking a development surge that’s increasingly dependent on non-U.K. investors buying homes before they’re completed.

South Asian buyers account for two-thirds of new London homes sold before completion, according to Land Securities Group Plc, the largest U.K. real estate investment trust. The high-end market is dependent on pre-sales to overseas buyers to help get development finance and deal with rising land costs, Michael Lister, a lecturer at University of Westminster, said in a Nov. 22 interview.

‘International Hiccup’

The market “only needs a bit of an international hiccup for the buyers to hold back, and then you’re really stuck,” said Lister, a former head of U.K. property lending at Bank of Ireland Plc. “You can’t possibly afford to sell to the domestic buyers because they can’t afford to pay those figures.”

Battersea Power Station Holding Co. raised a 790 million- pound ($1.3 billion) syndicated loan to develop and refurbish the first phase of the site after it pre-sold about $1 billion of apartments and townhouses in May, the company said in a Nov. 21 statement. The record of pre-sales was reflected in the terms of the financing, it said.

Chancellor of the Exchequer George Osborne announced the new capital-gains tax in a statement to Parliament on Dec. 5. It will apply to “future gains” after the tax goes into effect in April 2015, he said without specifying the size of the levy. Capital-gains tax rates for second homes of U.K. residents currently range from 18 percent to 28 percent.

Building Luxury

Luxury-home developers plan to build more than 20,000 properties in London with a value of about 50 billion pounds in the next decade, Mark Farmer, head of residential property at consulting firm EC Harris LLP wrote in a Nov. 25 report. As well as a strengthening pound, the developers face rising building costs and a risk that investors will grow weary of repeated sales exhibitions, he said.

“You’ll see softening in pricing, at the bottom end of the luxury-housing market,” Farmer said. Investors will remain interested though they will “drive a harder deal.” EC Harris defines the lower-end of the luxury homes market as 1,250 pounds to 1,700 pounds a square foot.

In central London, about 28 percent of home buyers in the two years to June didn’t live in the U.K., according to broker Knight Frank LLP. That rises to about 49 percent for new homes. In Greater London, 10 percent to 15 percent of new homes are bought by non-residents, Knight Frank estimated in October.

Moving Goalposts

Singapore and Hong Kong, two destinations also favored by south Asian buyers, have introduced measures to cool property prices and curb speculation. Singapore linked borrowers’ maximum debt levels to their incomes and raised transaction and capital- gains taxes. Hong Kong has increased minimum down payments six times in fewer than three years and in February doubled stamp- duty taxes for all properties over HK$2 million ($258,000).

Transactions in Hong Kong will probably drop as much as a third this year compared with 2012, Knight Frank estimated. In Singapore, home-price declines accelerated in October from a month earlier to 1.2 percent.

The frequency of changes to U.K. property-tax law and the possibility of further levies are also seen as a hindrance to homebuyers from abroad. Osborne raised a transaction tax known as stamp duty to 7 percent from 5 percent for properties priced at more than 2 million pounds in March 2012.

Labour Party leader Ed Miliband and Nick Clegg, head of the Liberal Democrats, which govern in a coalition with Prime Minister David Cameron’s Conservative Party, support an annual levy on houses valued at more than 2 million pounds known as the mansion tax. Cameron opposes the idea.

Missed Opportunity

“The government had a chance to review property taxes in 2012 and they fudged it,” Rob Perrins, managing director of U.K. homebuilder Berkeley Group Holdings Plc said in a telephone interview. “Our real concern is that the government will keep playing around and changing the tax every six months. Property is a long-term acquisition and people deserve to know where they stand.”

About 30 percent of Berkeley’s customers are foreign, Perrins said.

The capital-gains tax will affect prices at the lower-end of the prime central London homes market where “speculators” who didn’t intend to live in the properties are more involved said Alex Michelin, a founder of luxury developer Finchatton Ltd. “It’s not going to switch off the tide. The marginal investor will say ‘this no longer makes it as attractive for me and I will stop doing it.’”

Top End

The tax won’t affect the superprime market, he said, as buyers there are more likely to live in their homes. Superprime homes are valued at 5 million pounds or more, according to broker Savills Plc.

“It’s not an unfair tax. It brings London in line with Paris and New York,” he said. “This is just trying to say we want to make it fair for everyone.”

U.K. economic growth is increasing more rapidly than previously expected, Osborne said last week. That may affect property investors from abroad more than the new tax as it puts pressure on the Bank of England to raise interest rates, boosting a pound that has already been rising.

The pound plummeted against a basket of major currencies after the collapse of Lehman Brothers Holdings Inc., making London homes a relative bargain for wealthy investors and buyers from emerging Asian economies. The Singapore dollar gained 60 percent against the pound from September 2007 to June this year and the Malaysian ringgit climbed by 50 percent. Since then, the pound has risen 6.8 percent and 12 percent respectively against the Asian currencies.

“One of the key drivers around demand in that market, particularly from the Far East, has been the relative weakness of sterling over the last three or four years,” said Farmer of EC Harris. “The improving economy is good for U.K. Plc but it might make residential investment slightly less competitive or good value in the eyes of the international community.” -- BLOOMBERG

Read more: London’s lure dimmed by capital gains tax

Investing heavily in your best ideas

While this may be a scary choice to make – concentrating your investments in a few stocks – that is what the young Buffett was doing in 1960s.
Sanborn, for instance, formed about 35% of Buffett’s portfolio in 1960. Plus it was a small company with an illiquid stock (just 105,000 shares outstanding).
Despite these attributes that can scare any investor, Buffett saw a great opportunity and invested heavily in Sanborn. He later did the same thing with See’s Candy in the 1970s.
Let’s me be clear here. I am not suggesting that you put 30-40% of your money in any one stock or investment. However, if you really believe in an idea, you may be willing to take it to around 10-15% of your portfolio.
Too many people over-diversify – allocating the same amount of money to their best ideas as to their worst ones. But then, as they say, “Concentrate to grow your wealth and diversify to preserve it.
So while you may buy a number of stocks for your portfolio, it pays in the long run to put most of your money in your best ideas.

Thursday, 12 December 2013

Margin of safety: from basic tenet to most of the strategy

Main points:

1.  Investors should not target a rate of return, but rather make the goal simply one of acquiring undervalued assets.

2.  Klarman suggests always moving on to new assets so as to always hold the most undervalued securities available. No investment is considered sacred when a better one comes along.

3.  Valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods.

4.   Investors must be aware that the world can change unexpectedly and sometimes dramatically; the future may be very different from the present or recent past. Investors must be prepared for any eventuality.  

5.  Buying with an optimal margin of safety should be your primary, and in some sense your only, investment goal.  

6.  Most investment approaches do not focus on loss avoidance or on an assessment of the real risks of an investment compared with its return. Only one that I know does: value investing.

8 Nov 2011 by Jim Fickett.

While all value investors claim “buy below true worth” as a basic principle, Klarman turns this into most of a strategy. For example, he advocates always holding the most undervalued assets, even if this means selling other things “too soon”. And he makes the intriguing proposal that one should not target a rate of return, but rather make the goal simply one of acquiring undervalued assets.
As illustrated in the recent post Margin of safety, the idea of buying well below true worth is fundamental to value investing as implemented by a number of famous practitioners. Klarman, however, takes this principle to a new level. Whereas Grantham discussed waiting until full value was realized before selling, and Buffett buys companies to hold them forever, Klarman suggests always moving on to new assets so as to always hold the most undervalued securities available:
Value investors continually compare potential new investments with their current holdings in order to ensure that they own only the most undervalued opportunities available. Investors should never be afraid to reexamine current holdings as new opportunities appear, even if that means realizing losses on the sale of current holdings. In other words, no investment should be considered sacred when a better one comes along.
He admits that buying with the best possible margin of safety is a challenge:
If you cannot be certain of value, after all, then how can you be certain that you are buying at a discount? The truth is that you cannot. …
Should investors worry about the possibility that business value may decline? Absolutely. … First, since investors cannot predict when values will rise or fall, valuation should always be performed conservatively, giving considerable weight to worst-case liquidation value as well as to other methods. …
Value investing is simple to understand but difficult to implement. Value investors are not supersophisticated analytical wizards who create and apply intricate computer models to find attractive opportunities or assess underlying value. The hard part is discipline, patience, and judgment. Investors need discipline to avoid the many unattractive pitches that are thrown, patience to wait for the right pitch, and judgment to know when it is time to swing.
Nevertheless, he suggests that buying with an optimal margin of safety should be your primary, and in some sense your only, investment goal:
One of the recurrent themes of this book is that the future is unpredictable. No one knows whether the economy will shrink or grow (or how fast), what the rate of inflation will be, and whether interest rates and share prices will rise or fall. Investors intent on avoiding loss consequently must position themselves to survive and even prosper under any circumstances. Bad luck can befall you; mistakes happen. The river may overflow its banks only once or twice in a century, but you still buy flood insurance on your house each year. Similarly we may only have one or two economic depressions or financial panics in a century and hyperinflation may never ruin the U.S. economy, but the prudent, farsighted investor manages his or her portfolio with the knowledge that financial catastrophes can and do occur. Investors must be willing to forego some near-term return, if necessary, as an insurance premium against unexpected and unpredictable adversity.
Choosing to avoid loss is not a complete investment strategy; it says nothing about what to buy and sell, about which risks are acceptable and which are not. A loss-avoidance strategy does not mean that investors should hold all or even half of their portfolios in U.S. Treasury bills or own sizable caches of gold bullion. Rather, investors must be aware that the world can change unexpectedly and sometimes dramatically; the future may be very different from the present or recent past. Investors must be prepared for any eventuality.
Many investors mistakenly establish an investment goal of achieving a specific rate of return.
Rather than targeting a desired rate of return, even an eminently reasonable one, investors should target risk. Treasury bills are the closest thing to a riskless investment; hence the interest rate on Treasury bills is considered the risk-free rate. Since investors always have the option of holding all of their money in T-bills, investments that involve risk should only be made if they hold the promise of considerably higher returns than those available without risk. This does not express an investment preference for T-bills; to the contrary, you would rather be fully invested in superior alternatives. But alternatives with some risk attached are superior only if the return more than fully compensates for the risk.
Most investment approaches do not focus on loss avoidance or on an assessment of the real risks of an investment compared with its return. Only one that I know does: value investing.
Klarmsn's success is a strong argument for these views. But each person has to find his own way, and there are two areas where I have a hard time reconciling this strategy with my own view of the world.

Wednesday, 11 December 2013

The LONGER a stock remains seriously UNDERVALUED and the LONGER they DONT' RETURN TO NORMAL VALUE, the BETTER it is for the investor

A Margin of Safety BOOSTS Returns Rather than Just Providing Protection

The longer the stock remains undervalued, the better it is for shareholders, because their reinvested dividends, or their new purchases, or management’s share buybacks, continue to accumulate undervalued shares.  Thumbs Up Thumbs Up Thumbs Up

It actually becomes a demonstrably negative scenario for a long term investor when their stocks go up above fair value.
  Thumbs Up Thumbs Up Thumbs Up

That’s how Buffett made 30-50% returns in his early days. 

He wasn’t investing in companies that were growing earnings by 30-50% per year; he was investing in companies that were seriously undervalued.

Eventually, those stocks will return to normal values, and the longer they don’t, the better it is for the investor.  Thumbs Up Thumbs Up Thumbs Up

A most important point.
As a value investor, you should be happy for the stock market to be down.
It is only then, you can find the bargains you wish.
As you will be a net investor in stocks for the future and for the long term, you should welcome a down market, so that you can buy stocks at bargain prices.
Yet, in many forums, everyone is cheering for the prices of stocks to rise. 

Tuesday, 10 December 2013

Lessons from a Secret Multi-Millionaire

Lessons from a Secret Multi-Millionaire
How Anne Scheiber Amassed $22 Million From Her Apartment

By Joshua Kennon

In the mid 1940’s, Anne Scheiber retired from the IRS where she worked as an auditor. Using a $5,000 lump sum she had saved, and a pension of roughly $3,150, over the next 50+ years, she built a fortune from her tiny New York apartment that exceeded $22,000,000 upon her death in 1995 when she left the funds to Yeshiva University for a scholarship designed to help support deserving women. Here are some of the lessons we can learn from this ordinary woman that achieved extraordinary wealth.

1. Do your own research

Sheiber was burnt by brokers during the 1930’s so she resolved to never rely on anyone for her own financial future. Using her experience with the Internal Revenue Service, she analyzed stocks, bonds, and other assets. The result: She owned only companies with which she was comfortable. When markets collapse, one of the best ways to stay the course and maintain your investment program is to know why you own a stock, how much you think it is worth, and if the market is undervaluing it in your opinion.

2. Buy shares of excellent companies

When you’re really in this for the long-haul, you want to own excellent businesses that have durable competitive advantages, generate lots of cash, high returns on capital, have owner-oriented management, and strong balance sheets. Think about everything that has changed in the past one hundred years! We went from horse and buggies to cars to space travel, the Internet, nuclear knowledge, and a whole lot more. Yet, people still drink Coca-Cola. They still shave with Gillette razors. They still chew Wrigley gum. They still buy Johnson & Johnson products.

3. Reinvest your dividends

One of the biggest flaws with both professional and amateur investors is that they focus on changes in market capitalization or share price only. With most mature, stable companies, a substantial part of the profits are returned to shareholders in the form of cash dividends. That means you cannot measure the ultimate wealth created for investors by looking at increases in the stock price.

Famed finance professor Jeremy Siegel called reinvested dividends the “bear market protector” and “return accelerator” as they allow you to buy more shares of the company when markets crash. Over time, this drastically increases the equity you own in the company and the dividends you receive as those shares pay dividends; it’s a virtuous cycle. In most cases, the fees or costs for reinvesting dividends are either free or a nominal few dollars. This means that more of your return goes to compounding and less to frictional expenses.

4. Don’t be afraid of asset allocation

According to some sources, Anne Scheiber died with 60% of her money invested in stocks, 30% in bonds, and 10% in cash. For those of you who are unfamiliar with the concept of asset allocation, the basic idea is that it is wise for non-professional investors to keep their money divided between different types of securities such as stocks, bonds, mutual funds, international, cash, and real estate. The premise is that changes in one market won’t ripple through your entire net worth.

5. Add to your investments regularly

Regular saving and investing is important because it allows you to pick up additional stocks that fit your criteria. In addition to the first investment Scheiber made, she regularly contributed to her portfolio from the small pension she received.

6. Let your money compound uninterrupted for a very long time

Probably the biggest reason Anne Scheiber was able to amass such as substantial fortune was that she allowed the money to compound for of half a century. No, that doesn’t mean you have to live the life of a monk or deny yourself the things you want. What it means is that you learn to let your money work for you instead of constantly striving to scrape by, barely meeting expenses and maintaining your standard of living.

To learn about the power of compounding, read Pay for Retirement with a Cup of Coffee and an Egg McMuffin. With only small amounts, time can turn even the smallest sums into princely treasures.

Pay for Retirement with a Cup of Coffee and an Egg McMuffin

Pay for Retirement with a Cup of Coffee and an Egg McMuffin
$3 a Day Can Add Up to a Serious Nest Egg

By Joshua Kennon

How many times have you swung by McDonalds on your way to work for a cup of coffee and an Egg McMuffin? It may seem like small change, but the $3 a day it is costing you to buy your breakfast can fund your retirement. Don't believe it? Let's take a look at the numbers.

The stock market has historically averaged a return of around twelve percent. If you began investing $3 a day at twenty five years old and earned the same rate of return, by the day you reached sixty-five, you would have saved a total of $381,437 before taxes. That's a pretty substantial nest egg by anyone's standards. The results are even more spectacular if you start younger (a sixteen year old would save $789,896 pretax by retirement).

Why such the drastic difference between the 16 and the 25 year old? Compounding. When you invest or save, your money earns more money in the form of interest or dividends. If you reinvest these, you earn interest on your interest. Here's how it works: You put $100 in a savings account that earns 4% annually. At the end of the first year, you earn $4 in interest. Let's say you keep that $4 in the savings account. At the end of the second year, you would earn 4% on the $104 (instead of the original $100). This would result in your interest payments higher each subsequent year as you kept reinvesting your interest.

For those of you who are thinking, "Well, I'm 30, 40, 50, or 60+ years old. What can I do?", don't worry! No matter when you start, if you are diligent and intelligent in your investing, you will end up with more money than you would have had otherwise. A fifty year old could still put aside more than $36,013 by following the three-dollar-a-day plan.

The next time you bite into that sausage egg and cheese breakfast sandwich, keep in mind you may be eating your retirement.

Monday, 9 December 2013

Warren Buffett Market-Beating Skills Revealed: Cutting Research

Warren Buffett Market-Beating Skills Revealed: Cutting Research
By Simon Kennedy - Dec 6, 2013

Warren Buffett isn’t just a great investor. He’s the best investor, an economic study has found.

An index measuring returns adjusted by price fluctuations shows the billionaire chairman and chief executive officer of Berkshire Hathaway Inc. has done better than every long-lived U.S. stock and mutual fund.

The study said Warren Buffett, chief executive officer of Berkshire Hathaway Inc., is willing to take on borrowing to finance investment, then picks stocks that have low volatility, are cheap -- with low price-to-book ratios -- and are high quality, meaning they are profitable and have high payouts.

Looking at all U.S. stocks from 1926 to 2011 that have been traded for more than 30 years, a paper published this week by the National Bureau of Economic Research calculated that Buffett’s so-called Sharpe ratio is 0.76 since 1976. That was about twice the stock market’s 0.39.

The ratio is also larger than all 196 U.S. mutual funds that have been around for 30 years. The median Sharpe ratio for them is 0.37.

The review of Buffett’s investments concluded he has been rewarded for his use of leverage, coupled with a focus on cheap, safe, quality shares.

The study said Buffett is willing to take on borrowing to finance investment, then picks stocks that have low volatility, are cheap -- with low price-to-book ratios -- and are high quality, meaning they are profitable and have high payouts.

By breaking down Berkshire Hathaway’s portfolio into ownership of publicly traded stocks versus wholly owned private companies, the authors also found the tradable equities performed best. That suggested to them that Buffett’s returns are due more to stock selection than to the pressure he puts on companies he has stakes in to improve their management.

“Buffett’s performance appears not to be luck, but an expression that value and quality investing can be implemented,” said Andrea Frazzini and David Kabiller of AQR Capital Management LLC and Lasse H. Pedersen of Copenhagen Business School. “If you travel back in time and pick one stock in 1976, Berkshire would be your pick.”

Saturday, 30 November 2013

Notes from Seth Klarman's Margin of Safety


How to use a Margin of Safety when Investing

How to use a Margin of Safety when Investing

A fundamental part of value investing is to ensure that there is a margin of safety with your investments.
What this means is that you buy a stock when its price is not only lower than or equal to your calculated fair price, but that it’s significantly lower. This provides you with some gray area where your assumptions about the company can be a little bit off, and yet the investment will still turn out okay over the long run.
The margin of safety means that your assumptions would have to be significantly off course for that investment not to work out. But even then, by diversifying across 20+ companies and into other asset classes, the scenario becomes statistical in nature. For example, if you invest in 20 companies, and you only invest when a stock is trading at least 15% below your calculated fair price, then one or two of them can go bad while your overall portfolio will still perform admirably.
Margin of Safety

In the example of this chart, the time to buy would be when the stock price (red line) falls below the intrinsic fair value (blue line). It’s easier said than done, because you won’t have the benefit of seeing the rest of the chart in front of you, and the intrinsic fair value (blue line) is your calculated estimate of what the stock is worth rather than an absolute truth.
By sticking to sound value investing principles, however, you can do well. As can be seen in the chart, the fair value of a healthy company will be far less volatile than the stock price can potentially be, with only minor adjustments occurring each year based on new information.

How to Calculate Intrinsic Value

In order to buy at an undervalued price, you’d first have to know what the fair price is. This combines art and science. The science is that given perfect company estimates and your target rate of return, you can easily calculate the objective fair value of any business or asset that produces cash flow. The art is that of course you don’t have the perfect estimates, you only have your imperfect approximations. You can make estimates based on historical growth rates, or based on future trends that could shape those growth rates, based on analysis of how the company is spending its cash, or based on realistic management projections and a pattern of meeting those projections.
Discounted Cash Flow Analysis (DCFA) is the fundamental stock valuation methodfor any asset or business that produces cash flows. When this method is applied on a share-by-share basis of a dividend stock, then it’s called either the Dividend Discount Model or Method (generally), or the Gordon Growth Model (under expectations of a perpetual static growth rate).
DCFA and the associated DDM produce perfect fair values given perfect inputs, although of course you’re always going to have imperfect inputs. And the longer the actual stock price remains under the calculated fair value, the better it is for an investor assuming that you’re reinvesting dividends, buying more shares, or the company is repurchasing its own shares.

How Big of a Margin of Safety is Sufficient?

The size of the margin of safety will vary based on investor preference and the type of investing that she or he does.
“Deep Value Investing” refers to buying stock in seriously undervalued businesses. The goal is to find significant mismatches between the current stock prices and the intrinsic value of those stocks. Due to the degree of difference, these companies are often either small, or in bad shape. If they were well known and in good shape, then there would hardly ever be a serious mismatch of value and price except possibly for major macroeconomic deterioration such as during the local market bottom of early 2009. So deep value investing requires guts. You’ve got to pick through the rubble and find value where others aren’t seeing it. You have to see information that others are not seeing, or you have to interpret and act on information that others have, but are misinterpreting or failing to act on. Needless to say, deep value investing requires a considerably large margin of safety to invest with and isn’t for most casual investors.
“Growth at a Reasonable Price (GARP) Investing” refers to a more balanced approach. With this investing method, you pick companies that have positive growth rates that are also trading somewhat below your intrinsic fair value calculation. Dividend Growth Investing falls closer to GARP investing than deep value investing, because dividend growth investing relies on selecting companies with wide moats, strong balance sheets, the ability to grow dividends through recessions, and a product or service that you can see existing and indeed flourishing 10 or 20 years from now. With GARP investing or Dividend Growth Investing, it’s important to have at least a 10% margin of safety, but it’s not very often that you’re going to find enormous differences between price and value which allows you to buy with a huge margin of safety. They’re more stable and less contrarian selections. So rather than investing with access to better information or interpretations than others, you’re merely investing with a different time horizon. While others may be fretting about a quarterly report or something Congress did or a jobs report, you’re focusing on your passive income goals a 5-10 years from now.

How to Find Undervalued Stocks

Earlier this year I published the Dividend Toolkit for readers, which along with a comprehensive investing guide, includes the spreadsheet that I developed for myself to use to calculate the fair price of stocks.
If you want to calculate the fair value of a stock using the Dividend Discount Model (which is explained in significantly more detail in the book), and you estimate that the dividend will grow by 5% per year, and you’re using 12% as your discount rate. First, you put the simple inputs into the Dividend Discount Model spreadsheet tool:
Dividend Book Input Example
And the tool instantly updates the output chart to tell you the fair value of the stock:
Dividend Book Output Example
This output chart will not only tell you the fair stock value based on those inputs, but will also tell you the fair stock value based on nearby inputs. In this example, in addition to calculating the results for 5% dividend growth and a 12% discount rate, it will automatically show what the fair value is if it turns out that the stock only grows its dividend by 4%, or if you use a discount rate of 11% instead.
There are four different tools in the spreadsheet tool, including DCFA and DDM models. All of them focus on showing what kind of margin of safety you have based on your inputs, and the static-growth models also show what kind of rate of return you can expect given certain growth outcomes.
Besides the Toolkit, there are other ways to calculate fair price as well. You can do the simplest versions with a calculator or with free online tools. You can develop your own model if you have the time and desire.

A Margin of Safety BOOSTS Returns Rather than Just Providing Protection

Value investing or dividend investing may often be thought of as conservative investing methods, and this may be true in many cases. But the purpose of a margin of safety is not just to protect your rate of return, but indeed to improve it.
When you buy a stock below calculated fair value, an expectation is that in some future time, the stock price will go back up to fair value in a rational market. If your growth expectations end up being correct, and you bought at an undervalued price, then you should eventually get a superior rate of return.
Alternatively, the longer the stock remains undervalued, the better it is for shareholders, because their reinvested dividends, or their new purchases, or management’s share buybacks, continue to accumulate undervalued shares. It actually becomes a demonstrably negative scenario for a long term investor when their stocks go up above fair value.
Buffett put it concisely in his 2011 shareholder letter:
Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%. Naturally, what happens to the company’s earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period?
I won’t keep you in suspense. We should wish for IBM’s stock price tolanguish throughout the five years.
Let’s do the math. If IBM’s stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.
If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100 million greater under the “disappointing” scenario of a lower stock price than they would have been at the higher price. At some later point our shares would be worth perhaps $1.5 billion more than if the “high-price” repurchase scenario had taken place.
The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply.
That’s how Buffett made 30-50% returns in his early days. He wasn’t investing in companies that were growing earnings by 30-50% per year; he was investing in companies that were seriously undervalued. Eventually, those stocks will return to normal values, and the longer they don’t, the better it is for the investor.
(Note: Rather than picking large caps like IBM, he was a deep value investor, finding huge mismatches between price and value. As his base of capital grew, it was no longer economical for him to invest in small companies and he either had to buy whole companies or invest primarily in large caps that either have GARP or dividend growth characteristics.)
Margin of Safety Example: 
Here’s an example of how an undervalued stock selection can offer outsized returns.
Suppose you use the Toolkit Spreadsheet or some other Dividend Discount Model tool to determine the fair price of a stock. Let’s use the above example, where it was calculated that a company paying $1.80 in dividends per share this year and growing that dividend by an average of 5% per year into the future, with a discount rate of 12%, is worth $27/share.
What this means is that if the company performs as expected, then buying at $27 should give you long-term returns of around 12% per year. Now, in any given year, the stock may go up or go down; it could fluctuate wildly around that fair value. And of course you’ve got to occasionally adjust your fair value assessment to take into account new information (like how this site re-analyzes the companies I cover on an annual basis). But over the long run, earnings determines price.
For example, let’s say that the stock that pays $1.80 in dividends per share (DPS) this year has $2.50 in earnings per share (EPS) this year. If you pay $27/share for the stock, then you’re paying a price-to-earnings ratio (P/E) of 10.8, and the stock has a dividend yield of 6.67%.
Ten years from now, if it grew earnings and the dividend by 5% per year as expected, then their dividends per share are now $2.93 and the EPS is up to $4.07. This is their fundamental performance, but let’s see two different buying scenarios.
Scenario A: Buy at Fair Value
In this scenario, the investor buys 100 shares at $27, for a total investment of $2,700 and a total dividend income stream of $180/year. If the company grows EPS and the dividend by 5% per year for the next ten years as expected, and if the investor reinvests her dividends each year, then by the end of the 10 year period if the stock remains at fair value for this whole time, she’ll have over 190 shares at a price of nearly $44 each, and so her total investment will be worth $8,385 and her annual dividend income will be $559.
Now, that’s an increase in wealth from $2,700 to $8,385 over a 10 year period, which translates into a 12% annualized rate of return. (The rate of return matched the discount rate that was used to calculate fair value in the first place.) Dividend income rose from $180 to $559, which is also a 12% growth rate (which includes the natural dividend growth and the accumulation of more shares due to dividend reinvestment.)
Scenario B: Buy at 15% Discount to Fair Value
In this scenario, the fundamentals of the stock are identical. The initial EPS and DPS, and their growth rates through the 10 year period are identical to scenario A.
But this time, the market is depressed, and the investor buys shares at a 15% discount to her calculated fair value of $27, which means she buys the shares at $22.95. She can buy 100 shares for $2,295, and will have the same $180 annual dividend stream to reinvest.
Over this ten year period, let’s say the price of the stock gradually increases back up to fair value as the market sees this company continue to perform well. So in the starting period, it’s at a 15% discount, then later only 10%, 5%, and eventually is at fair value. So the price increases from $22.95 to $44. Because shares were cheaper on average over this period but her dividends were the same, she was able to accumulate more shares. By the end, she has around 200 shares at nearly $44 each, for total wealth of $8,768. Her annual dividend income is $584.
So, her investment increased from $2,295 to $8,768 over 10 years, which translates into a 14.3% annualized rate of return. (If she had bought $2,700 worth of shares initially, she could have bought more than 100, and she’d be up to $9,650 or so in wealth.) Her dividend income stream increased from $180 to $584, which is a 12.5% annualized rate of return, and it took significantly less capital to acquire the same income stream (she could have used the initial $2,700 to buy more.)
Same company, same performance, and yet buying at a 15% discount to fair value meant 14.3% annualized returns instead of 12% annualized returns. This means more money in the end, and larger income streams.


As a recap, the purpose of buying with a margin of safety is twofold:
1) It makes your portfolio more conservative because your growth estimates could be a little bit off and the investment will still work out.
2) If your estimates are correct, then your rate of return will be superior over time because the growth rate of the investment is augmented by the additional fact that you bought it at an undervalued price. Over the longest term, your results will be superior either because the market eventually returns the price to its fair value, or because for as long as its under its fair value, your reinvested dividends or the company’s share repurchases will be able to buy more shares for the same amount of money.
To calculate intrinsic fair value, the fundamental way is to use a version of Discounted Cash Flow Analysis, either on the company as a whole or on a share of a dividend paying company. When it’s done in the second way it’s called the Dividend Discount Model. The inputs you’ll need are the current free cash flow or dividend, the estimated growth of that free cash flow or dividend, and a discount rate, which is equal to your target rate of return for practical purposes. When DCFA is understood, then there are shortcuts that allow for reasonable valuation such as basing estimates on P/E, the PEG ratio, or shareholder yield, etc.