Economic Impact of Interest Rates and the Japanese Economy

Economic Impact of Interest Rates
There is a tendency to forget that for every borrower there is a lender and that interest rates work both ways. Less interest paid by borrowers means less interest received by lenders. When interest rates rise or fall, total disposable income doesn’t change; it simply redistributes.

Effect of rising interest rates on consumers
1. Consumer demand declines because the forced reduction in consumption by the greater number of borrowers is greater than the increased consumption of the lesser number of lenders.
2. Reduced demand is said to dampen inflationary impact of rising prices.
3. Budget-strapped families are forced to work extra hours or family member to seek part-time work.
4. The subsequent increase in availability of labour reduces pressure on wage demands.


Effect of interest rates rise on highly leveraged businesses
1. Profitability of highly leveraged businesses is reduced by their high cost of debt. Main impact on profitability is felt by exporters.
2. More foreign capital inflows are attracted by the higher interest rates which increases the exchange rate, consequently reducing the value of exports in the domestic currency.
3. Lower export output means reduced demand for labour and consequent further restraint on wage increases.
4. Higher exchange rate also means that the lower cost of imports will reduce prices
5. Reduced labour demand in industries competing with imported goods stabilizes costs by again increasing the availability of labour.


Effect of falling interest rates
1. Debtors are rewarded and more inclined to be financially irresponsible.
2. Those who have been prudent in accumulating savings in interest-bearing securities are penalized and less inclined to be prudent in the future. (Given the impact of a 40 percent tax rate and 3 percent inflation on an interest rate of 5 percent, the zero return (5 percent x 60 percent – 3 percent) provides zero incentive for prudence.)
3. Although serving short-term political objectives and rescuing overleveraged debtors, the longer-term effects of artificially low interest rates have proven to be undesirable.

Low Interest rates and The Japanese Economy
Any doubt about the effectiveness of low interest rates to stimulate the real economy should have been dispelled by the well-publicised Japanese experience. In spite of having interest rates close to zero and the government running a huge annual deficit, thus leaving more disposable income in the hands of the consumers, Japan has suffered a lingering recession since 1990.


The Nikkei 225 index’s loss of one-third of its value in the past 20 years can only be attributed to the low profitability of Japan’s corporations. Even with the leverage of close to zero interest rates, the ROE of Japan’s large nonfinancial firms fell from 8.2 percent in 1988 to an average of 3.1 percent between 1992 and 1999. It has since recovered to roughly 10 percent in 2007, but still lags a long way behind higher-interest-rate countries.


The real determinant of economic viability, ROFE (Returns on Funds Employed), would obviously be considerably lower than the quoted ROEs. When debt servicing is of no concern, inefficiencies creep into the business and the economic viability of capex becomes less important.
The prices of those wonderful products we buy from Japan are subsidized by shareholders of Japanese corporations. Little wonder that Buffett, when asked about investing in Japan in 2007, wryly commented that the profitability of Japanese companies was too low for Berkshire’s liking.


Although Japanese corporate profitability is improving, by Western standards most of its major corporations have not been economically viable in the past, and if required to pay equitable rates of interest, would be in serious financial difficulty.


The high Nikkei index PE ratio in 2007 of 18 (price-to-book value of 1.9) on average ROEs of 10 percent is influenced by the meager average dividend yield of 1.1 percent still being better than leaving money in the bank.


With so little incentive to invest and debt so cheap, it is not surprising that in 2005 Japan was the world’s largest consumer of luxury goods, accounting for 41 percent. Rather than working in favour of Japanese investors, low interest rates over the past 20 years have decimated their funds. Although low domestic rates persist, demand for Japanese stocks will remain high and they will therefore continue to be grossly overpriced.

The reason Japan keeps rates so low is to encourage an outflow of capital to dampen the yen exchange rate to help its exporters. In other words, domestic employment is the prime motivation. If Japan’s trade surplus were repatriated, rather than being left abroad, the US dollar would crumble and the yen appreciate to a level that would make life even tougher, perhaps impossible, for many Japanese exporters.

Here is a simple question to see whether you have been following the argument.
Given a Nikkei index figure of 16,500 and the abovementioned ROE (10 percent) and price to book value (1.9), what would the Nikkei index need to be to achieve a 10 percent return from an index fund that replicated it? Answer: 8684

When ROE and RR (Rate of Return) are equal, value is equal to book value. Therefore, 16,500 / 1.9 (price to book value) = 8684.

These are the sorts of things to consider when thinking about investing in international funds.


Related article: 20.11.2008 - KLSE MARKET PE

Berkshire Hathaway's Stock Price

Compound Annual Growth Rate from 1990 to 1996 approximately: 26%

Compound Annual Growth Rate from 1996 to 2000 approximately: 18%

Compound Annual Growth Rate from 2001 to 2005 approximately
(still positive CAGR but well below Buffett's goal of 15%): 4%

Compound Annual Growth Rate from 2006 to Mid 2008 approximately: 31%
Berkshire Hathaway played a serious game of catchup during this short time frame.

Compound Annual Growth Rate from 1990 to Mid 2008 approximately: 17%
Berkshire Hathaway has exceeded the goal of 15% CAGR over a 17.5 year period.

----------

Of course there are some companies that exceeded 100% CAGR on their stock price during the 1990's.

It is interesting to note that RedHat (ticker: RHT) had more than a 14000% CAGR from August 11, 1999 until December 9, 1999 when the share price went from $54.50 to $286.25.
Of course it also had a very bad CAGR of -89% from December 9, 1999 until September 18, 2001.
During this time the stock had a 2 for 1 stock split on January 10, 2000. On a split adjusted basis, the stock went from $143.12 to $3.02 per share.

Educational experience with an outcome other than expected

During bull markets owning stocks and calls on underpriced stocks should increase the value of the portfolio.

Bear markets should benefit positions in your portfolio that are either short overpriced companies or own puts on the overpriced stock.

Income may be generated by selling covered calls or credit spreads during a neutral market.

Please note that I have made extensive use of the words "should" and "may". Please do not invest any money that you can not afford to lose. Everyone has a different tolerance for risk. It is important that you do your own homework and take responsibility for any decisions that you make.

When investing, it doesn't take very long to have an educational experience with an outcome other than expected.

http://hyperdiversification.com/default.aspx

In Warren Buffet's 1992 letter to the share holders he discussed the following:

• During 1992, their Book Value had increased by 20.3%
  
• Between 1964 and 1992 book value per share (BVPS) had increased from $19 to $7745 resulting in a CAGR of 23.6%.
  
• Used book value for intrinsic value.
  
• CAGR goal 15%
  
• The number of outstanding shares has changed very little between 1964 and 1992 (1,137,778 vs. 1,152,547 respectively)
  
• Requiring a significant Margin of Safety (MOS) when purchasing stock in another company as a cornerstone of Berkshire Hathaway's success

My mom bought her first new car back in 1965. It was a Ford Falcon. She really liked the car. I wonder how much higher her networth would be if she would have bought a used car and invested the difference in Berkshire Hathaway. ;) Of course BH is the exception and not the norm. :))

http://hyperdiversification.com/cagr_main.aspx

Learn from:

Our focus is to protect and accumulate wealth for our clients. To do that, we are guided by one core principal. DON'T LOSE MONEY. It seems simple, but is by far one of the most challenging endeavors an investor can undertake.
In order to achieve the goal of capital preservation, the Strategy must protect previously earned gains while allowing an investor to profit from a market rebound after a substantial market decline. In other words, the Strategy wants to profit from bull markets and protect the portfolio in bear markets. http://www.swaninvesting.com/home

High-net-worth Investors & Listed Options
Portfolio Management Strategies for Affluent Investors, Family Offices, and Trust Companies http://www.swaninvesting.com/HighNetWorthInvestors.pdf

What do all Berkshire Hathaway companies have in common?

What do all Berkshire Hathaway companies have in common?



They are profitable, safe and solid.

They are easy to understand with simple business models.

They produce plenty of cash flow to reinvest.

They are unique businesses with strong market positions and franchises.

They have solid, trustworthy management.

They were bought at reasonable prices.



We ordinary value investors can't assemble this kind of portfolio, but we can learn from what makes Berkshire Hathaway and its master tick.


Ref: Berkshire Hathaway's SEC filing
http://www.hoovers.com/free/co/secdoc.xhtml?ID=10206&ipage=6253178

Berkshire Hathaway's Acquisition Criteria: Telling it like it is

Take a look at the following set of "acquisition criteria," straight from the 2006 Berkshire Hathaway Annual report. Straight, clear, to the point - and never before have we seen anything like this - including the commentary - in a shareholder report.

ACQUISITION CRITERIA

We are eager to hear from principals or their representatives about businesses that meet all of the following criteria:

1. Large purchases (at least $75 million of pre-tax earnings unless the business will fit into one of our existing units).
2. Demonstrated consistent earning power (future projections are of no interest to us, nor are "turnaround" situations).
3. Businesses earning good returns on equity while employing little or no debt.
4. Management in place (we can't supply it).
5. Simple businesses (if there's lots of technology, we won't understand it).
6. An offering price (we don't want to waste our time or that of the seller by talking, even preliminary, about a transaction when price is unknown).

The larger the company, the greater will be our interest. We would like to make an acquisition in the $5-20 billion range. We are not interested, however, in receiving suggestions about purchases we may make in the general stock market.

We will not engage in unfriendly takeovers. We can promise complete confidentiality and a very fast answer - customarily within five minutes - as to whether we're interested. We prefer to buy for cash, but will consider issuing stock when we receive as much in intrinsic business value as we give. We don't participate in auctions.

It is not about diversification

Why diversify your portfolio? Is this the key to investing success?

Diversification provides safety in numbers and avoids the eggs-in-one basket syndrome, so it protects the value of a portfolio.

But the masters of value investing have shown that diversification only serves to dilute returns. If you're doing the value investing thing right, you are picking the right companies at the right price, so there's no need to provide this extra insurance. In fact, over-diversification only serves to dilute returns.

However, perhaps diversification isn't a bad idea until you prove yourself a good value investor. Diversification may suggest 'conservative' style, but diversification per se is not a value investing technique.

Margin of Safety in Value Investing

The idea of buying a company at a bargain price is to achieve a margin of safety. This is important to provide a buffer if business events don't turn out exactly as predicted (and they won't).

• The value investing style calls for building in margins of safety by buying at a reasonable price.
• The style also suggests finding margins of safety within the business itself, for instance, so-called "moats" or competitive advantages that differentiate the business from its competitors.
• Also, a large cash hoard or the absence of debt offers a financial margin of safety.

Choosing a Discount Assumption

Choosing a discount assumption

In theory, the discount rate should be your own personal cost of capital for this kind of investment. If you have a million dollars and can invest it with no risk in a Treasury bond at 6 percent, your cost of capital is the risk-free 6 percent you would forgo by not investing in the bond. So the implied cost of your dollars made available to invest in Business XYZ starts at 6 percent. Financial types refer to this opportunity cost as the risk-free cost of capital.

But implicitly, Company XYZ common stock is riskier than the bond investment. Sales, earnings, and myriad other intrinsic things can change, as can markets and the market perception of XYZ’s worth. So an equity premium is added to the risk-free cost of capital rate. In effect, the total cost of capital is your required compensation, or hurdle, for the opportunity you’ve lost by not buying the bond, plus the assumption of risk by investing in XYZ.

Much has gone into identifying appropriate risk premiums and the like. Modern portfolio theory and its reliance on beta – a measure of relative stock price volatility – doesn’t really do much for most value investors. (Remember: Price doesn’t determine value.)

The keep-it-simple-safe (KISS) approach used by most value investors, including Warren Buffett, is to discount at a relatively high rate, usually higher than the growth rate. Buffett uses 15 percent as a discount, or “hurdle” rate – investments must clear a 15 percent “hurdle” before clearing the bar. The 15 percent hurdle incorporates a lot of risk, especially in today’s environment of relatively low interest rate and inflation. Conservative value investors usually use discount rates in the 10 to 15 percent range.

As you build and run models, you’ll see firsthand how the discount rate affects the resulting intrinsic value. Here are a few points to remember:

• The higher the discount rate, the lower the intrinsic value – and vice versa.
• The second-stage discount rate should always be higher than the first stage. Risk increases the farther out you go.
• If you choose an aggressive growth rate, it makes sense also to choose a higher discount rate. Risk of failure is higher with high growth rates.
• If the discount rate exceeds the growth rate, intrinsic value will be low and implode more quickly the larger the gap. Aggressive growth assumptions with low discount rates yield very high intrinsic values.

If you’re worried about earnings and earnings growth consistency and want to factor it in somehow, but don’t want to do a deep statistical analysis on a zillion numbers, Value Line does one for you. At the bottom right corner of the Value Line Investment Survey sheet is a figure called “Earnings Predictability” if the Survey covers the company you’re evaluating.

It’s really a statistical predictability score normalised to 100 (100 is best, 0 is worst). A score of 80 and higher indicates relative safety; below 80 means that you may want to attenuate growth rates or bump up the discount rate to account for uncertainty.

Here again is the set of growth and discount assumptions used for an example. Consistency is important, but growth rates will vary for each company, and discount rates may change also with differing risk assessments.
First-stage growth 10%
Second-stage growth 5%
First-stage discount rate 12%
Second-stage discount rate 15%

Ref: Intrinsic Value Model

Intrinsic Value Model

Intrinsic value is driven by current and especially future earnings. Projecting future growth in these earnings is vital to determining intrinsic value.

First-stage growth
Near-term growth is by nature easier to model, and as a result of the discounting process, they contribute more towards the final result anyway. So intrinsic value models are set up to specifically value a first stage in detail, year-by-year. Typically, the first stage is 10 years, although in some analyses it may be more or less.
More often than not, the first stage is assumed to have a higher growth rate and a lower discount rate than the second stage.

Second-stage growth
The second stage covers the more nebulous period of business life beyond the first stage. Second-stage returns are harder to project accurately, so intrinsic value models use one of two assumptions to estimate what’s known as continuing value:

• Indefinite life: The indefinite life model assumes ongoing returns and uses a mathematical formula to project returns over an indefinite period and assign a value to those returns.
  
• Acquisition: Want a convenient way to bypass mathematical approximations? Assume that someone will come along and buy your business after the first stage at a reasonable valuation. Returns include all future payouts, including lump sums, so this method works too, so long as resale value is projected reasonably.
  
  

Summary.

Each stage of a business life has a growth rate and discount rate applicable to that stage. One growth rate and one discount rate is applied to the first stage, and another growth and discount rate to the second. Then, you calculate net future earnings by first compounding growth over the first stage and then discounting that value back to the present. A generalised formula, either indefinite life or acquisition-based, is applied to the second stage. The value attributed to the second stage is called continuing value.

**Appraising the Value of a Business

Appraising the Value of a Business

Investment is most intelligent when it is most business-like.
( Benjamin Graham)

Value investing means treating an investment as though you were buying the entire business. If you were indeed buying a business, you would look for the following:
1. Income: Profits and strong positive operating cash flows exceeding capital requirements are good thing. A company starting at a loss and banking on future profits is starting in the hole, particularly considering the time value of money. Look for companies that produce more capital than they consume.
2. Income Growth: If income and cash flow are steady but unlikely to grow, there can be value. Without growth, time value depreciates earnings value over time. And competition and declining marketplace acceptance can erode the business. There’s little to make a stock price rise unless the market values the steady income stream incorrectly in the first place. Value investors should ignore the common “growth versus value” paradigm and consider growth part of the value equation.
3. Productive Capital Investment: If a company is able to invest additional capital productively – at a greater return than it would get by putting it in the bank – that indicates future value if the capital is available. A company should be able invest capital more productively than you can; otherwise, it makes sense for the company to return the capital to you, and for you to invest the capital elsewhere. If the company doesn’t have productive places to invest but pays you a good return (dividends or share buybacks), the company has value, but growth potential may be in question.
4. Rising Productivity and Falling Expenses: A good business makes increasingly better use of assets and creates more output per unit of input. Businesses that can do so are likely to generate more income sooner.
5. Predictability: Generally, a business with a predictable, steady income stream is more valuable than a company that has erratic or cyclical earnings. The erratic company may return as much money in the long run as the steady company, but the uncertainty surrounding the earnings stream requires a higher discount rate or margin of safety because you just don’t know. The higher discount rate reduces value. Look for simple and steady businesses that you understand.
6. Steady or Rising Asset Values: To the extent that asset values, particularly current assets, are steady or rising, higher returns, if and when paid out to the owners, will ultimately be the result. A company with falling asset values is suspect unless its productivity gains are significant.
7. Favourable Intangibles: Many things can affect or serve as leading indicators of business value. Management effectiveness, market presence, brand strength, customer base, intellectual property, and unique skills and competencies all play a part in driving business value. By nature, these items are hard to quantify but are part of the valuation playing field. Look for companies that do things right in the marketplace.

**A Seven-Step Process for investing in New Assets

Advice for investment accumulators
By Christopher M. Flanagan, J.D.

Published January 1998

React to this article in the Discussion Forum.


Frequently, people make investment decisions based not so much on what they know or what their experiences have been but, rather, on how they acquire assets. In other words, how investors build their portfolios often is driven by how they acquire their investable cash. For example, one might be a partner in a medical or law firm and receive a partnership distribution. Or, perhaps he or she is a corporate executive who receives a yearly bonus. In either case, assets are received in stages or "chunks," and the individual must now determine an investment route for these new assets. The result of this piecemeal approach now is a collection or accumulation of investments. It is a difficult process if you have a goal of being consistent with an overall plan.


A Flawed Investment Process

After receiving that Christmas bonus, or perhaps liquidating part of a business, the accumulator’s investment process typically takes the following path. First, current market trends are considered, e.g., "Blue chip stocks seem to be doing well," or "There are global opportunities, but market volatility is a concern." Ideas are then checked with a knowledgeable person whom the investor respects (stockbroker or relative). Next, the investor reviews his or her current portfolio and considers whether to add to existing investments, e.g., "I might want to add money to my common stock fund." Finally, the money is invested. The process appears logical to the accumulator, but it is flawed in that it typically takes into account only "this year’s" money and not all of the investor’s assets. The result is a collection of investments, rather than a portfolio with a comprehensive strategy.


A Seven-Step Process


While everyone’s situation is unique and financial needs can be met and addressed in a multitude of ways, the process for identifying what those needs are revolves around the same fundamental issues. At the risk of oversimplification, applying the following seven-step process would enable the accumulator to make smarter investment decisions for the long-term and not just for the moment.


Establish an investment goal. Establishing investment goals amounts basically to writing down, in language someone else would understand, one’s personal investment goals. It can be in very general terms, such as "I want to have enough money for a comfortable retirement," or "I want to make sure I can put three children through college," or perhaps, "I never want to run out of money." That’s pretty plain language, but it certainly does the job of identifying an individual’s financial ambitions and concerns.


Determine the ability to tolerate investment risk. Understanding how much risk someone can tolerate is a very personal thing, but one rule of thumb can help an individual know when they’ve exceeded that comfortable level. Again, it is a basic guideline, but one should "never own any investment that will cause you to lose even five minutes’ sleep at night." Investors frequently ignore this guideline in an "up" market.


Calculate the annual return objective: what kind of performance do you need to get from your investments. The next step is to calculate the average annual return the investor needs or wants, and there are a couple of ways to do this. Begin by looking back at the personal investment goals. As an example, let’s use the goal of a college education for three children. If an individual needs $100,000 a year in today’s dollars—and knowing how much he or she has today and how much will be put aside going forward—you can go through the mathematical calculations of figuring out exactly what annual return on the money is needed to reach the goal. The individual can then get a sense for whether his or her expectations are realistic and whether he or she is setting enough aside to invest for future use. Another method is to take a look at the historical performance data, not over a one-year period, but over a ten-, thirty-, and fifty-year period. Studying long-term performance results will help to keep in line the investor’s expectations for future returns.


Select asset allocation among types of investment vehicles. The next step is determining the asset allocation that best meets investment objectives. Arguably, this is the most critical step and one where individuals could benefit from some professional advice. Asset allocation, the buzz words in financial services today, is how assets are apportioned among various asset classes (stocks, bonds, etc.). The goal is to achieve the highest return at a risk level the investor is comfortable with. Achieving the highest return for any given level of risk is an efficient portfolio mix. Generally speaking, we know that between 65 percent and 85 percent of a portfolio’s performance will be dictated by the structure of the portfolio—the mix of asset classes—rather than the specific individual investments that are held within it. Consequently, it is more important to figure out what portion of a portfolio should be in stocks, etc., rather than which stocks to select. Here is where someone might call on expert assistance. Chart first how much risk exists in the current portfolio (it is often more than expected). Next, determine if it is possible to increase potential returns without increasing your risk and identify the ideal mix of investment types, (stocks, bonds, etc.) necessary to accomplish this.


Choose specific investments. Based on the investment types identified, it is now time to choose the specific investments that are most appropriate. This is where most of the investment "clutter" happens: comparing which stocks did better than others, which funds outperformed benchmarks, etc. And it is here that one needs to have a well-diversified portfolio. Once again, though, while investment selection undeniably impacts the overall performance of a portfolio, it is more important that those investment selections are diversified within the investment types that best support the investor’s long-term investment strategy.


Monitor portfolio performance quarterly. While it isn’t necessary to get mired in every single week’s or month’s worth of statements, it is important to review results on a quarterly basis. Take a hard look at the percentage returns on the entire portfolio during the past quarter. How do those results compare to the annual percentage return objective and to the long-term goal? Were performance expectations met, and were they realistic? Does the investment strategy need to be adjusted?


Revisit steps 1-5 annually. Once a year, walk through the above steps for making smarter decisions. Revisit (perhaps revise) investment goals, as they can and should change over time. With the current appetite for risk in mind, calculate the annual percentage return objectives. Accurately select the asset allocation that will help to meet those goals, and the result will be a successfully structured portfolio.


Ironically, "investment accumulators" usually don’t appreciate how successful they truly are. Because they didn’t inherit their money or win a lottery, but rather just worked for it a little at a time over the years, they don’t think of themselves as "wealthy" or even financially successful. Consequently, they may not be giving their investment portfolio the respect it deserves.


Christopher M. Flanagan, J.D., is a regional manager for Mellon Private Asset Management, a service mark of Mellon Bank Corporation and its subsidiaries.



http://www.physiciansnews.com/finance/198.html

Is now the time to bail out?

Is now the time to bail out?
A volatile market isn't necessarily a bad market. But selling when stocks are down is usually a bad idea.

By the Mole, Money Magazine's undercover financial planner

October 29, 2008: 5:47 AM ET

NEW YORK (Money) -- Question: I know market timing is a loser's game. However, I do think there is abundant evidence that the next 12-18 months are going to be very difficult for equities. Do you see any merit in trimming some equity holdings, parking the proceeds in short-term bonds or cash, and committing to immediately dollar-cost averaging back into the market on a monthly fixed schedule?

The Mole's Answer: Your question is a very sophisticated way of asking whether you should bail from the market right now. While I don't know your total situation, I can tell you that selling after equities are down by 40% is usually a bad thing.

First of all, I wholeheartedly agree with your statement that market timing is a loser's game. Many studies have shown the systematically bad job that individual investors do of timing the market.

We are constantly testing the market winds. When conditions are favorable, we increase our exposure. When conditions become so far from favorable that they're in another zip code, such as what we're currently experiencing, we decrease our exposure.

Unfortunately, we tend to do both of these things after the fact. Truth be told, we all want stock returns during bull markets and money market returns in bear markets. But as much as we may want them, no one really knows exactly how to get them, since we can't predict when bear markets and bull markets are beginning or ending.

Second, when you state that the next 12-18 months are likely to be "difficult" for equities, I'm not sure I agree with you. If by "difficult," you mean volatile, then you are probably right.

The last few weeks in the stock market has set all sorts of records for volatility. Emotions are running wild and there is a likelihood that this volatility will not end anytime soon.

But I would not agree that this translates into a bad period for the stock market. Primarily because the stock market is a better buy today than it was last year. In fact, I can quantify it by saying it's a 40% better value.

Which begs the question, why wasn't I getting as many inquiries about selling last year when the market was hitting new highs?

But that's a rhetorical question - the answer is that we humans have a tendency to predict the future based on the recent past.

This "recency bias," as it's known in the financial planning world, has us thinking inside the box of current events. If the market is thriving, as it was between 2003 and 2007, then we believe it will always be thriving. And in times like these when the sustained market dive is giving us all nose bleeds, we believe we'll never pull out of it.

Onto your question of whether you should sell now with a commitment to buy back in with periodic purchases, also known as dollar-cost averaging. As sophisticated and well thought out as this sounds, it still means selling your equities after they are down by 40%, and still equals market timing.

A better time to consider selling would have been last year after equities had more than doubled.

I can't tell you how the stock market will perform over the next 12 -18 months. No one can. It may very well turn out to be the right thing to do but the odds are very much against you.

Studies actually quantify that we pay an average penalty of 1.5% annually for timing the stock market and chasing the hot performers. Many of us come up with all sorts of rationale for doing what we're doing, but it ultimately just results in outsmarting ourselves.

The fact that you say you will commit to buying back periodically is a bit confusing. I'm glad you realize the market doesn't signal to us that we have hit bottom and that now is the time to buy, but it also hasn't sent you a signal that now is the time to sell.

Systematic rebalancing would have had you selling some of your stocks between 2002 and 2007, as they were skyrocketing. Now is probably when you should be buying.

My advice: Find an asset allocation that is right for you and stick to it. Try to rebalance in times like these, which actually means buying more stocks. Remember that investing during a rough economy can be the right thing to do. If someone tells you that you can have the upside of the market without the risk, don't believe them.

The Mole is a certified financial planner and certified public accountant who - in the interest of fairness - thinks you should know what goes on behind the scenes in financial planning. Want to make contact? E-mail him at http://money.cnn.com/2008/10/28/pf/Ask_the_mole.moneymag/mailto:themole@moneymail.com. Send feedback to Money Magazine



Find this article at: http://money.cnn.com/2008/10/28/pf/Ask_the_mole.moneymag/index.htm

Focus on Return on Equity

The Key to Finding Stocks that Will Make You Rich? Focus on Return on Equity
By Joshua Kennon, About.com

Countless successful investors, businessmen, and financiers have emphatically stated, and proven through their own career, over long periods of time, the performance of a stock most closely correlates with the return earned on shareholders’ equity.

As one well known investor put it, even if you buy a business at a huge discount, if you hold the stock for five, ten years or more, it’s going to be highly unlikely that you will be able to earn more than the ROE generated by the underlying enterprise.

Likewise, even a more reasonable price or a slightly higher price-to-earnings ratio for a better business that earns, say sixteen or seventeen percent on capital, you’re going to have very, very good results over a twenty or thirty year period.

An excellent example is Johnson & Johnson. According to the company’s most recent annual report, “In 2006, we logged our 74th year of sales increases, our 23rd consecutive year of earnings increases adjusted for special charges and our 44th consecutive year of dividend increases. This is a record matched by very few, if any, companies in history.” The firm is diversified throughout the medical supplies, pharmaceutical, and consumer product fields. These include household names such as Tylenol, Band-Aid, Stayfree, Carefree, K-Y, Splenda, Neutrogena, Benadryl, Sudafed, Listerine, Visine, Lubriderm, and Neosporin, not to mention the eponymous baby care products such as powder, lotion, and oil. Compared to the S&P 500, the stock currently trades at a lower p/e ratio, a lower price to cash flow ratio, a lower price to book ratio, and boasts a higher cash dividend yield, all while earning a much higher return on assets and return on equity than the average publicly traded company!

Investing is a game of weighing odds and reducing risk. Can you guarantee that you will beat the market? No. You can, however, increase the chances of that happening by focusing on companies that have comparable profiles – established histories, management with huge financial interest in the company, a history of executing well, discipline in returning excess capital to shareholders through cash dividends and share repurchases, as well as a focused pipeline of opportunities for future growth. These are the stocks that have better chances of compounding uninterrupted, meaning less of your money goes to commissions, market maker spread, capital gains taxes, and other frictional expenses. That small advantage can lead to enormous gains in your net worth; only 3% more each year, over an investing lifetime (say, fifty-years), is triple the wealth!

The biggest challenge is the fact that very few firms are actually able to maintain high returns on equity over substantial stretches of time because of the breathtaking ruthlessness of capitalism. Of course, as consumers, we all benefit from this in the form of a higher standard of living through lower costs, but for owners, it can mean volatility and financial setback. That’s why you must settle inside of yourself the question of exactly how large a company’s competitive “moat” is, factoring that into your valuation. Do you think someone will be able to unseat Coca-Cola as the dominant soft drink company in the world? How about Microsoft? The latter would certainly seem more vulnerable than the former, but both are much better off than a marginal steel company trying to eek out a profit in a commodity-like business with little or no pricing power and few, if any, barriers of entry.

http://beginnersinvest.about.com/od/investstrategiesstyles/a/aa110107a_roe.htm

Four Investment Objectives Define Strategy

Four Investment Objectives Define Strategy
By Ken Little, About.com

In broad terms, four main investment objectives cover how you accomplish most financial goals.
These investment objectives are important because certain products and strategies work for one objective, but may produce poor results for another objective.

It is quite likely you will use several of these investment objectives simultaneously to accomplish different objectives without any conflict.

Let’s examine these objectives and see how they differ.

Capital Appreciation

Capital appreciation is concerned with long-term growth. This strategy is most familiar in retirement plans where investments work for many years inside a qualified plan.

However, investing for capital appreciation is not limited to qualified retirement accounts. If this is your objective, you are planning to hold the stocks for many years.

You are content to let them grow within your portfolio, reinvesting dividends to purchase more shares. A typical strategy employs making regular purchases.

You are not very concerned with day-to-day fluctuations, but keep a close eye on the fundamentals of the company for changes that could affect long-term growth.

Current Income

If your objective is current income, you are most likely interested in stocks that pay a consistent and high dividend. You may also include some top-quality real estate investment trusts (REITs) and highly-rated bonds.

All of these products produce current income on a regular basis.

Many people who pursue a strategy of current income are retired and use the income for living expenses. Other people take advantage of a lump sum of capital to create an income stream that never touches the principal, yet provides cash for certain current needs (college, for example).

Capital Preservation

Capital preservation is a strategy you often associate with elderly people who want to make sure they don’t outlive their money.

Retired on nearly retired people often use this strategy to hold on the detention has.

For this investor, safety is extremely important – even to the extent of giving up return for security.

The logic for this safety is clear. If they lose their money through foolish investment and are retired, it is unlike they will get a chance to replace it.

Investors who use capital preservation tend to invest in bank CDs, U.S. Treasury issues, savings accounts.

Speculation

The speculator is not a true investor, but a trader who enjoys jumping into and out of stocks as if they were bad shoes.

Speculators or traders are interested in quick profits and used advanced trading techniques like shorting stocks, trading on the margin, options and other special equipment.

They have no love for the companies they trade and, in fact may not know much about them at all other than the stock is volatile and ripe for a quick profit.

Speculators keep their eyes open for a quick profit situation and hope to trade in and out without much thought about the underlying companies.

Many people try speculating in the stock market with the misguided goal of getting rich. It doesn’t work that way.

If you want to try your hand, make sure you are using money you can afford to lose. It’s easy to get addicted, so make sure you understand the real possibilities of losing your investment.

Conclusion

Your investment style should match you financial objectives. If it doesn’t, you should see professional help in dealing with investment choices that match you financial objectives.

http://stocks.about.com/od/investingstrategies/a/021906technque.htm

Preparing Your Portfolio Is the Most Important Action You Can Take

The One Factor Stock Investors Can Control

Preparing Your Portfolio Is the Most Important Action You Can Take
By Ken Little, About.com

When the stock market is running very hot or very cold, it is on everyone’s mind and few conversations last very long before turning to the latest numbers.

Whether it is the dot.com boom of the 1990s or the credit crisis of 2007, when the market is erratic and volatile, people are engaged.

The factors that lead to a boom-bust cycle in the market are important. Investment professionals and regulators spend a great deal of time trying to understand what happens in the market during these periods.

Individual investors have little influence on the market. While it is important to understand what happens and why, that is not the most important consideration for individual investors.

Stock Investors Important Influence

The most important influence on how your portfolio performs is how well you have prepared it. Preparation is the only factor you can influence.

Preparation means adopting a reasonable allocation between stocks, bonds and cash. It also means diversifying you holdings by industry sector, company size and growth and value stocks.

Most investors should consider a bond allocation equal to their age. For example, a 45 year-old investor should have 55 percent in stocks and 45 percent in bonds.

You can’t know with any assurance which turns the market will take - even industry professionals don’t know.

However, if you have five or more years before you need to convert holdings to cash, the odds are good that your portfolio will do as well as possible if you maintain a reasonable allocation.
There are no guarantees in investing. You assume that over the long-term your holdings will grow, however an assumption, even one based on historical truths, is not a guarantee.

Establishing an Allocation

Establishing an allocation and maintaining it is a challenging exercise. Here’s why:

Assume your allocation was 60 percent stocks and 40 percent bonds. If stocks are shooting up, the temptation is to put more money into the hot side of your allocation - ride the gains up.
What this often means is investors pay inflated prices. When the boom collapses as they all do, investors are either stuck with stock worth much less than they paid or they bail out with a loss.

The rational way to approach a rapidly expanding market is to watch your allocation and when it becomes out of balance, sell off stocks and add to bonds. This may let you take profits, but you may miss out on some future gains.

In a rapidly dropping market, investors should consider buying stocks to maintain balance. You may be able to buy stocks at depressed prices, which increases the odds of significant gains when the market returns.

Many investors would find their losses were lower and their gains higher if they would maintain a reasonable allocation regardless of what the market does.

If you can take a long-term approach, you could look at your holdings once a year (or maybe once a quarter in very volatile markets) and make adjustments.

The remainder of the time avoid the temptation to buy during a boom or sell during a bust.

http://stocks.about.com/od/investingstrategies/a/102608portfolio.htm

A Look at Growth, Income and Value Investing

Investing Philosophies - Part One
A Look at Growth, Income, and Value Investing
By Ken Little, About.com

Developing an investing philosophy may seem like an academic exercise, however over time, it will help shape your thinking about the types of stocks that work for your portfolio.

This first of a two-part series looks at the three main investing philosophies:
Growth
Value
Income

Most investors fall into one or a combination of these investing philosophies.


Growth Investors

As the name implies, growth investors look for the rising stars. They are interested in companies that have high potential for earning growth. High earning growth invariable leads to high stock prices – at least in theory. Growth investors are willing to bet on young companies that show promise of becoming leaders in their industry.

The technology stocks, especially during the late 1990s, were the perfect example of growth stocks. Many of these young companies started with an idea and nothing more and now are large successful companies.

Of course, a great many more of those same technology companies started out with an idea and nothing more and ended up where they started. Which is to say that growth investing carries the risk that some of your investments are going to fail. As much as Americans like success stories, there are more failures than successes when it comes to market leadership.

Value Investors

Value investors look for the stocks that the market has overlooked. Value doesn’t mean cheap as in low per share price, but under priced relative to the value of the company.

These are stocks the market has passed over while chasing some other industry sector or more glamorous investments. The value investor looks for stocks with a low price/earnings ratio meaning the market is not willing to pay much in the way of a premium for the stock.

Of course, the value investor needs to make sure there in nothing wrong with the company that would warrant a low stock price other than neglect or market inattention. Assuming the company is solid, the value investor’s strategy is to buy and hold the stock, anticipating the future time when the market will recognize the company’s worth and bid the stock up to its true value.

Income Investors

Income investing is the most straight-forward of all philosophies and the most conservative. Income is the motivation and investors target companies paying high and consistent dividends.

People near or in retirement are fond of this strategy for obvious reasons. The companies that qualify for the income investor tend to be large and well-established. There is always some risk involved in investing in stocks, however this remains the most conservative of the investing philosophies.

If the stock price increases, that’s icing on the cake for the income investor who would probably trade some capital appreciation for a higher dividend.

Conclusion

These three investing philosophies take in a large number of investors, however it is not required that you fall purely in one camp or another. As a practical matter, you will likely modify your investing philosophy as your life circumstances change.


http://stocks.about.com/od/investingphilisophies/a/Investphilone.htm

Three Main Influences on Stock Prices

Three Main Influences on Stock Prices
By Ken Little, About.com

There are three main areas of influence that move a stock’s price up or down. If you understand these influences, it will help you decide whether the price movement is a buy, sell or sit tight signal.

Fundamentals

Clearly, the most direct influence on a stock’s price is a change in the economic fundamentals of the business.

If revenues and profits are on a steep upward trend with no indication of leveling off, you can expect to see the stock price rise as investors bid up this attractive company.

On the other hand, if the profit picture is flat or, worse, declining with no change in sight, look for investors to abandon the stock and the price to fall.

These are simple examples of changes in fundamentals. Other, more complex and subtle changes can occur that may not dramatically affect the stock price immediately (increased debt, a poor acquisition and so on can also trigger price changes).

The point is that changes in the underlying business have a direct impact on the stock’s price. Smart investors spot the subtle changes before they become price-movers and take the appropriate action.

Sector Changes

Changes in the stock’s sector can have positive or negative affects on price too. Some sectors or industries are cyclical in nature and you should know that would affect price.

However, when whole sectors catch of fire (think dot.com stocks) or burn up (think dot.com stocks, again), even those companies that have solid fundamentals are pulled along with the rest of the sector.

You may hold a stock that is a victim of “guilt by association” when an industry falls out of favor. Likewise, stocks can see prices artificially inflated if they find themselves in the right industry at the right time.

Market Swings

The market goes up and the market goes down. That’s about all you can say with certainty concerning the stock market.

As the market moves up and down, your stock may move with or against it. Most large-cap stocks will follow the market to some degree, but smaller companies may not get the same push every time.

In general, a strong market move either up or down will carry more stocks with it than not, so your stock may be up or down for no other reason than the market was up or down.

Conclusion

How do you use this information?

A change in fundamentals may be an opportunity to buy more shares of a growing company or it may signal the time to sell if the changes are for the worse.

A change in the sector is usually temporary so most long-term investors will ride out dips due to these factors. However, if something drastically changes in the stock’s industry due to regulation or a new technology, for example, you may want to reevaluate your position. Is the company capable of adapting or do you own a dinosaur?

Market swings that move your stock’s price can be opportunities to buy additional shares (assuming all the company’s fundamentals still checkout). If the rising market pushes up your stock’s price, it may be time to take a profit on part of your holdings and wait for the price to come back down to earth to reinvest.

http://stocks.about.com/od/evaluatingstocks/a/0317threefact.htm

The Myth of EPS Growth

The myth of EPS growth

Impact of Retained earnings on EPS
When EPS growth is entirely due to profits from retained earnings, the increased EPS percentage measures the impact of ROE on those retained earnings.

For instance,
Half of profit is retained: If ROE is 20 percent, half the profit is retained and ROE in the following year remains steady at 20 percent, EPS will increase by 10 percent.
All profit is retained: If all profit is retained and reinvested at 20 percent, EPS will increase by 20 per cent.
All profit is distributed: If all profit were distributed, irrespective of ROE, EPS growth would be zero.


Impact of borrowings (debt) on EPS
Increasing borrowings (debt) on EPS: However, even if all profits were distributed as dividends and the business increased its borrowings, EPS would increase. So an increase in EPS might simply signify an increase in debt.
Decreasing borrowings (debt) on EPS: Conversely, if borrowings were reduced and ROFE exceeded the cost of debt, EPS would decline.


Impact of new capital issues on EPS
When equity per share increases by virtue of new capital issues that exceed the current equity per share, EPS can increase when the business performance (ROE) declines.

So the positive news of an increase in EPS might disguise the fact that value has declined by virtue of diminished profitability.

Because management seems to be as equally ignorant of this factor as the market, focusing on EPS growth can make bad capital-allocation (acquisitions) decisions appear beneficial.

When new shares are issued at a price that exceeds the book value of equity per share, the EPS of a company with a modest business performance can increase quite dramatically.

For instance, a company with a ROE of 10 per cent, $500 million equity and 100 million shares on issue will have an EPS of $0.50 on its equity of $5.00 per share. Given a P/E ratio of 15, the $5.00 equity per share will be priced at $7.50 ($0.50 x 15).

New shares are issued at a price > the book value of equity per share: If the company issues a further 100 million shares at its market price of $7.50, raising $750 million, the 200 million shares on issue will have an equity of $1.25 billion or $6.25 per share.

If the modest ROE of 10 percent is maintained on the increased capital, EPS will grow by 25 percent. That is: equity $1.25 billion / 10% = $125 million / 200 million shares = EPS of 62.5c.

If the P/E ratio of 15 is maintained, the shares will now be priced at 62.5c x 15 = $9.36.

New shareholders whose generosity increased the original shareholders’ equity by 25 per cent to $6.25 a share, having paid $7.50 for stock now priced at $9.36, will be under the impression they made a sound investment decision.

When a company regularly issues shares at prices that exceed the current equity per share, the false impressions of EPS growth will give support and impetus to its share price.

New shares are issued at a price = the book value of equity per share: If the new shares had been issued with the $5.00 equity per share, a price that is closer to the value, EPS would have remained unchanged and EPS growth would be zero.

Does this mean that the lack of EPS growth diminishes the value of the business? Of course not, it is still the same business.

New shares issued at a price > the book value of equity per share, but the ROE declines: When new capital issues are made at prices that exceed the equity per share, EPS will not necessarily decline when the business performance declines. If ROE declined to 8 percent in the example given, EPS will be unchanged: equity $6.25 x ROE 8 percent = EPS 50c.

Conclusion:

The coloured bar charts of profit, dividends and EPS growth in an annual report, although correctly stated, can give an entirely misleading impression. The ever-increasing height of the EPS, profit and dividend columns in the bar chart have nothing whatsoever to do with the business performance.

Because both management and market participants fail to recognise the importance of ROE and ROFE, you are unlikely to ever see them depicted by way of a bar chart in the annual report, or for that matter in an analyst’s research. If you do, take a good look at the company because the CEO is likely to be one of that rare breed who truly understands the impact of capital-allocation decisions.

Using Charlie Munger’s terminology, such a CEO can be likened to a two-legged man competing with one-legged men in an arse-kicking contest. Much better for management, so the thinking goes, to treat shareholders like fools by depicting graphs that move in continuous upward direction.

So what does EPS growth tell us? Essentially nothing, and it should therefore, be disregarded as another misleading indicator that leads to erratic pricing.

Growth

There is a huge difference between the business that grows and requires lots of capital to do so and the business that grows and doesn’t require capital. (Warren Buffett, 1994 Berkshire AGM)



Growth


When a company is said to be “growing its business” or simply “growing”, it means that the business is using its retained profits or new capital to expand its existing business or to acquire other ready-made businesses.




Organic growth: Growth is said to be organic when a company is using retained profits and debt to expand its existing operations.

The ability to increase market share or penetrate new markets without compromising profit margins indicates a healthy demand for the company’s products or services. Such businesses therefore normally make good long-term investments.




Growth by acquiring other businesses: Companies with limited potential to expand organically might grow externally by acquiring other businesses using existing resources or new capital.


If profitability or ROFE (return on funds employed) from a new acquisition is less than the ROFE in the existing business, the decline in overall profitability will reduce the per-share value.


Because capital-allocation decisions are the Achilles heel of most businesses, companies on the acquisition trail should be treated with caution.



Acquisitions that come at a price that is hard for seller to refuse, while increasing profit in absolute terms, frequently lead to diminished profitability and therefore loss of per-share value.

Red Flags and Pitfalls for Avoiding Financial Fakery

Aggressive accounting: There are literally dozens of techniques that are perfectly legal and aboveboard, but which have the efect of fooling an observer into thinking that a firm has posted true operational improvements when all it has really done is moved some numbers around. You need to know how to identify what’s known as aggressive accounting so you can avoid the companies that practice it.

Outright fraud: Even worse than aggressive accounting is outright fraud. The hucksters of the world are naturally attracted to the stock market because it is the perfect arena for profiting from the greed and carelessness of others. Knowing the signs of potential fraud can save you a lot of financial pain.

It is not hard either. Although you might need a CPA to understand exactly how an aggressive or fraudulent firm is exaggerating its results, you don’t need to be an expert to recognize the warning signs of accounting chicanery.


SIX (6) Red Flags

Watching for these 6 warning signs will help you avoid maybe two-thirds (2/3) of potential accounting-related blowups.

1. Declining Cash Flow
Watch cash flow. Over time, increases in a company's cash flow from operations should roughly track increases in net income.

2. Serial Chargers
Be wary of firms that take frequent one-time charges and write-downs. Frequent charges are open invitation to accounting hanky-panky because firms can bury bad decisions in a single restructuring charge.

3. Serial Acquirers
Firms that make numerous acquisitions can be problematic - their financials have been restated and rejiggered so many times that it's tough to know which end is up. Acquisitions increase the risk that the firm will report a nasty surprise some time in the future.

4. The Chief Financial Officer or Auditor Leave the Company
Who watches the watchmen? When it comes to financial reporting, those watchmen are the chief financial officer (CFO) and the corporate auditors. If you see a CFO leaves a company that's already under suspicion for accounting issues, you should think very hard about whether there might be more going on than meets the eyes. If a company changes auditors frequently or fires its auditors after some potentially damaging accounting issue has come to light, watch out.

5. The Bills Aren’t Being Paid
You should track how fast the A/R are increasing relative to sales - the two should roughly track each other. A/R measures goods that are sold, but not yet paid for. It is simply not possible for A/R to increase faster than sales for a long time - the company is paying out more money (as finished goods) than it is taking in (through cash payments). On the credit front, watch the "allowance for doubtful accounts."

6. Changes in Credit Terms and Accounts Receivable.
Check the company's filing for any mentions of changes in credit terms for customers, as well as for any explanation by management as to why A/R has jumped.



SEVEN (7) Other Pitfalls to Watch Out for.

Watch out also for the following ways that firms can embellish their financial results.

1. Gains from Investments
An honest company breaks out these sales, and reports them below the “operating income” line on its income statement. The most blatant means of using investment income to boost results is to include it as part of revenue.

2. Pension Pitfalls
Pensions can be a big burden for companies with many retirees because if the assets in the pension plan don't increase quickly enough the firm has to divert profits to prop up the pension.

3. Pension Padding
To find out how much profits decreased because of pension costs or increased because of pension gains, go to the line in the pension footnote labeled either “net pension/postretirement expense,” “net pension credit/loss,” “net periodic pension cost,” or some variation.

4. Vanishing Cash Flow
If you are analyzing a company with great cash flow that also has a high flying stock, check to see how much of that cash flow growth is coming from options-related tax benefits.

5. Overstuffed Warehouses
When inventories rise faster than sales, there’s likely to be touble on the horizon.

6. Change is Bad
Firms can make themselves look better by changing any one of a number of assumptions in their financial statements.

7. To expense or Not to Expense
Companies can fiddle with their costs by capitalizing them.



Investor’s Checklist: Avoiding Financial Fakery

1. The simplest way to detect aggressive accounting is to compare the trend of net income with the trend in cash flow from operations. If net income is growing quickly while cash flow is flat or declining, there is a good chance of trouble lurking.
   
2. Companies that make numerous acquisitions or take many one-time charges are more likely to have aggressive accounting. Be wary if a firm’s chief financial officer leaves or if the firm changes auditors.
   
3. Watch the trend of accounts receivable relative to sales. If accounts receivable is growing much faster than sales, the company may be having trouble collecting cash from its customers.
   
4. Pension income and gains from investments can boost reported net income, but don’t confuse them with solid results from the company’s core operations.

Bernanke May Find Deflation `Back on the Table' as Fed Concern

Bernanke May Find Deflation `Back on the Table' as Fed Concern
By Steve Matthews

Nov. 20 (Bloomberg) -- Five years after Federal Reserve Chairman Ben S. Bernanke helped stamp out the risk of deflation, the threat is returning as the financial crisis and a worsening economic slump pull inflation lower.

Fed policy makers now predict the U.S. economy will contract until the middle of next year, according to minutes of their Oct. 28-29 meeting released yesterday in Washington. Government figures showed that consumer prices excluding food and fuel costs fell for the first time since 1982 last month.

The minutes, along with a slide in financial stocks to the lowest level in 13 years, increased the odds that the Fed will cut its benchmark interest rate next month. Bernanke may also need to revisit the unorthodox policy options, such as purchases of U.S. government debt, that he outlined as a board member in 2003, Fed watchers said.

``The Federal Reserve put deflation back on the table as a significant policy concern,'' said Vincent Reinhart, former director of the Fed's Division of Monetary Affairs, who is now a visiting scholar at the American Enterprise Institute in Washington. ``There does not appear to be any barrier to lowering'' main rate below the current 1 percent level, he said.

Deflation, or prolonged declines in prices, hurt the economy by making debts harder to pay off and lenders more reluctant to extend credit. Japan is the only major economy to have suffered the phenomenon in modern times.

`Lesson' for Kohn

``A lesson I take from the Japanese experience is not to let that get ahead of us, to be aggressive,'' Bernanke's deputy, Vice Chairman Donald Kohn, said in answering questions after a speech yesterday in Washington. ``Whatever I thought that risk was four or five months ago, I think it is bigger now even if it is still small.''

Kohn and Bernanke were both at the Fed in 2003, when the central bank's preferred consumer-price gauge reached a low of 1.3 percent, spurring then-Chairman Alan Greenspan to cut the key rate to 1 percent.

Some policy makers saw a risk last month that the inflation rate will fall below their mandated goal of ``price stability.'' ``Aggressive easing should reduce the odds of a deflationary outcome,'' they said, while noting that the low federal funds rate target ``would pose important policy challenges'' in that case.

The Fed's actions so far, including unprecedented injections of liquidity, haven't been enough to spur lending. Banks may make it even harder to get loans as their share prices plummet. Citigroup Inc. closed at a level unseen since 1995. The Standard & Poor's 500 Financials Index fell 12 percent to 139.84.

Hedge-Fund Risk

Fed officials expressed concern at last month's meeting at the risk for ``financial strains to intensify if some investors, such as hedge funds, found it necessary to sell assets and as lending institutions built reserves against losses.''

``Credit availability certainly hasn't increased,'' said Lyle Gramley, a former Fed governor.

``That has to be a major concern for the Fed because historically the way we get out of recessions is having the Fed push down hard on the accelerator. If that is not working very well, we have to look somewhere else for salvation.''

Future action by the central bank might include ``aggressively buying long-term Treasury issues,'' Gramley, now a Washington-based senior economic adviser for Stanford Group Co., said in a Bloomberg Television interview.

Fannie, Freddie

Michael Feroli, a JPMorgan Chase & Co. economist who used to work at the Fed, said the central bank could also purchase the debt of Fannie Mae and Freddie Mac, the mortgage-finance companies seized by the government in September.

``Before ramping up'' such programs, the Fed might ``first communicate to the markets that the nature of the current economic woes should keep rates low for an extended period,'' Feroli wrote in a note yesterday.

The Fed's balance sheet has already doubled to almost $2 trillion as officials introduced programs to inject liquidity into the economy.

``Several'' participants at last month's Federal Open Market Committee meeting judged the extraordinary programs will need to be ``unwound appropriately as the financial situation normalized,'' the minutes said.

Bernanke, a scholar of the Great Depression and former Princeton University professor, detailed possible assets the Fed could buy to fight deflation in a November 2002 speech when he was a governor. ``Sustained deflation can be highly destructive'' and ``should be strongly resisted,'' he said.

Ready to Act

Fed officials at last month's meeting ``agreed to take whatever steps were necessary to support the recovery.''

Policy makers projected the Fed's preferred gauge of inflation at 1.5 percent to 2 percent next year, with a further slowdown in the next two years, reaching 1.3 percent to 1.7 percent in 2011, yesterday's report showed.

Some officials ``suggested that additional policy easing could well be appropriate at future meetings,'' the minutes said.

``The door is wide open for a rate cut of half-a-point at the December 16 meeting,'' said Allen Sinai, chief economist at Decision Economics in New York. He predicts the central bank will pare the main interest rate to 0.25 percent in January.

To contact the reporters on this story: Steve Matthews in Atlanta at smatthews@bloomberg.net Last Updated: November 20, 2008 00:07 EST

http://www.bloomberg.com/apps/news?pid=20601087&sid=aBncZw9DlhRI&refer=worldwide#

To buy a stock, you need confidence in the earnings

Goldman Shares Sink to Lowest Price Since 1999 IPO (Update1)
By Christine Harper and Nick Baker

Nov. 19 (Bloomberg) -- Goldman Sachs Group Inc. closed at its lowest price since the firm first sold shares for $53 apiece to the public in 1999, as the profit outlook darkens for a company that set a record for Wall Street earnings last year.

The stock fell $6.85, or 11 percent, to $55.18 in New York Stock Exchange composite trading, giving the company a market value of $26 billion. The New York-based firm's value reached a high of $105 billion, or $248 per share, on Oct. 31, 2007.

Goldman, which converted from the biggest U.S. securities firm into a bank holding company in September, dropped along with other bank and brokerage stocks including Morgan Stanley and Citigroup Inc. today as investors questioned how the industry can recover from more than $700 billion of writedowns and credit losses as economic growth slows.

``Investors are walking away from financial companies until they have a better idea of the earnings power of the entire sector,'' said David Killian, a portfolio manager at Valley Forge Advisors LLC in King of Prussia, Pennsylvania, which manages $490 million including Goldman shares. ``In order to have confidence to buy a stock you need confidence in the earnings.''
Morgan Stanley, which was the second-biggest U.S. securities firm before becoming a bank holding company alongside Goldman, slid $1.78 today, or 15 percent, to $10.25. Citigroup, the second-biggest U.S. bank by assets, dropped $1.96, or 23 percent, to $6.40. All three companies are based in New York.

Profits Dwindle

Goldman surpassed rivals including Merrill Lynch & Co. and Morgan Stanley since going public in May 1999 to become the largest U.S. securities firm by market value and the most profitable in Wall Street history. On their first day of trading in 1999, Goldman's shares climbed 33 percent to $70.375.

Last year, the company became one of about a dozen in the U.S. with a stock price above $200. This year, profits are down 47 percent in the first nine months and some analysts expect the firm to report its first quarterly loss as a public company.

Morgan Stanley's profit has dropped 41 percent so far this year, while Citigroup has reported four consecutive quarterly losses. Goldman and Morgan Stanley each received $10 billion from the U.S. government last month as part of a rescue plan for the financial industry; Citigroup got $25 billion. In all, nine banks received capital injections.

Investors are concerned that return on equity, a measure of how effectively shareholder money is invested, will shrink because the banks are reducing their leverage, or ratio of assets to equity, to cut their reliance on debt-funding.

``A lot of the selling is questioning the business models of these big banks and investment banks,'' said Noman Ali, a money manager at MFC Global Investment Management in Toronto, which oversees $20 billion of U.S. stocks. ``If you don't know what the business model is going to be like going forward, and clearly it's not going to be levered 40 to one, the days of 30 percent ROE are going to be gone.''

To contact the reporters on this story: Christine Harper in New York at charper@bloomberg.net; Nick Baker in New York at nbaker7@bloomberg.net. Last Updated: November 19, 2008 17:10 EST

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