Warren Buffett once joked that he spent 6% of his net worth buying his wife Susie an engagement ring, thus depriving himself of immeasurable millions in future gains.
Indeed, Buffett once was seen picking up a penny on an elevator on his way to the office and remarked to the stunned witnesses, "the beginning of the next billion."
To Warren, a $100 bill lying on a sidewalk should not be valued on its present-day worth or on the present-day efforts needed to accumulate it, but on the future value of the greenback. Suppose, for example, that Buffett could compound $100 at 25% annual rates. In 10 years, his $100 discovery would be worth $931. After 30 years, it would be worth $80,779, unadjusted for inflation.
To understand Buffett's frugal convictions, one must view them from the point of view of mathematics and by using the types of calculation just shown. To Buffett, every dollar not accumulated now or spent needlessly could have productively been turned into numerous dollars later.
Thus, everything you buy or do not buy has the potential to greatly increase or decrease your net worth, depending on the rate of return you can obtain on investments. This principle applies whether you spend money on a poorly chosen investment or on an unnecessary personal expense or luxury item.
Buffett has to make such choices because of his high opportunity costs. In contrast, a household that has no opportunity costs, that is, it doesn't invest or derives no returns from investments, may be just as well off making the various types of purchases.
A household with zero oppoortunity costs can be a net consumer with no detrimental impact to its long-term fortune, but, to Buffett, money saved is money compounded. He has been known buy 50 12-packs of Coca-Cola at once from the grocery store to get a volume discount. Each year, the money he saves buying cases of pop will ultimately increase his net worth by thousands of dollars.
Sunday, 13 September 2009
Opportunity costs of our investments
Every dollar spent on a single item is a dollar unavailable for other items. That dollar must provide a suitable return - measured against what you could have earned on tha dollar somewhere else.
Investors should look at their investments similarly.
Because the market tempts us with thousands of potential investments each day, we tend to screen our stock choices until we find those that meet our risk and return characteristics. Likewise, we've learned to benchmark our investments by comparing their performance against the S&P 500 index or some other proxy.
If your portfolio rose just 8% in a year in which the S&P 500 index rose 20%, the opportunity cost on your money was great - you lost the chance at an extra 12 percent a year because the investments you chose did poorly.
Investors should look at their investments similarly.
Because the market tempts us with thousands of potential investments each day, we tend to screen our stock choices until we find those that meet our risk and return characteristics. Likewise, we've learned to benchmark our investments by comparing their performance against the S&P 500 index or some other proxy.
If your portfolio rose just 8% in a year in which the S&P 500 index rose 20%, the opportunity cost on your money was great - you lost the chance at an extra 12 percent a year because the investments you chose did poorly.
Look at all spending decisions as opportunities - won or lost
Most individuals these days are astute enough to understand the power of time and understand the need to fund their own retirement rather than to rely on government programs whose long-term viability don't seem guaranteed anymore.
However, compounding works two ways.
An investment that compounds at, say, 20% annual rates, will swell into a tremendous amount after 30 years.
Conversely, a missed opportunity that could have compounded at 20% a year has the opposite effect on your portfolio. A poorly chosen stock tha rises just 5% a year ultimately costs you tens of thousands of dollars in lost opportunities.
Money that is misspent today and not invested can have the same injurious effect on your future net worth.
At any given moment, you have tens of thousands of investment opportunities worldwide from which to choose. You may decide to put your available cash into shares of Intel or into a home remodeliing project. You may decide to spend $50 at a restaurant, or on a new pair of slacks, or on a new golf putter. You may be faced with the choice of buying a new automobile or funding a college account for a chld. No matter how you choose, every possible use of your money must bring a return - tangible or intangible - or else you should not spend the money. When making the choice of buying, say, shares of Intel or new carpeting, you must think about the opportunity costs of the money spent.
As an investor, you must also look at all spending decisions as opportunities - won or lost. Every dollar spent on a single item is a dollar unavailable for other items. That dollar must provide a suitable return - measured against what you could have earned on that dollar somewhere else.
However, compounding works two ways.
An investment that compounds at, say, 20% annual rates, will swell into a tremendous amount after 30 years.
Conversely, a missed opportunity that could have compounded at 20% a year has the opposite effect on your portfolio. A poorly chosen stock tha rises just 5% a year ultimately costs you tens of thousands of dollars in lost opportunities.
Money that is misspent today and not invested can have the same injurious effect on your future net worth.
At any given moment, you have tens of thousands of investment opportunities worldwide from which to choose. You may decide to put your available cash into shares of Intel or into a home remodeliing project. You may decide to spend $50 at a restaurant, or on a new pair of slacks, or on a new golf putter. You may be faced with the choice of buying a new automobile or funding a college account for a chld. No matter how you choose, every possible use of your money must bring a return - tangible or intangible - or else you should not spend the money. When making the choice of buying, say, shares of Intel or new carpeting, you must think about the opportunity costs of the money spent.
As an investor, you must also look at all spending decisions as opportunities - won or lost. Every dollar spent on a single item is a dollar unavailable for other items. That dollar must provide a suitable return - measured against what you could have earned on that dollar somewhere else.
Virtually anyone can evolve into a millionaire
Mathematics also shows us that virtually anyone can evolve into a millionaire through patient, diligent investing.
An individual who socks away a few thousand dollars every year starting at the age of 21 can easily amass $1 million by retirement. The power of time and the power of compounding ensure that any individual who can save money consistently can attain a decent degree of wealth by the age of 65 or 70.
If that same individual can manage to save an extra few thousand dollars more each year, the pile of assets attained at retirement would be much larger.
If that individual manages to earn a few extra percentage points of gain each year, either through good stock-picking or wise account management, the amount of money earned at the end is many times greater.
An individual who socks away a few thousand dollars every year starting at the age of 21 can easily amass $1 million by retirement. The power of time and the power of compounding ensure that any individual who can save money consistently can attain a decent degree of wealth by the age of 65 or 70.
If that same individual can manage to save an extra few thousand dollars more each year, the pile of assets attained at retirement would be much larger.
If that individual manages to earn a few extra percentage points of gain each year, either through good stock-picking or wise account management, the amount of money earned at the end is many times greater.
Columbus's four voyages to the Caribbean
The Joys of Compounding
In Buffett's annual report to partners for the year ending in 1962, he broke cadence from his routine review of the market to discuss "The Joys of Compounding." Anyone reading this passage, even four decades after Buffett penned it, could see the raw-boned logic behind the 32-year-old Buffett's stubborn frugality. As he saw it, every dollar put to productive use magnifies the benefit to society by virtue of compounding. Wasting that dollar had serious long-term ramifications - for him, his partners, even for society at large. What if, Buffett mused in his letter, Spain had decided not to finance Christopher Columbus? The results would be staggering.
In financial terms, Columbus's four voyages to the Caribbean yielded very little for the crown, except to pave the way for generations of future navigators. Think how that $30,000 (cost of the voyage Isabella originally underwrote for Columbus), if spent more judiciously by Spain in the late 15th century, could have greatly increased the wealth of the Spanish people. By 1999, 37 years after Buffett made the analogy, Isabella's $30,000 expenditure could have compounded into more than $8 trillion, nearly the total annual economic output of the United States. Spain would be a world economic powerhouse today.
On this topic, Buffett is behaving as any rational CEO would. If a company generates a high return on its assets, it should withhold dividends to investors and plow as much money as it can each year back into the business. Only when it can no longer generate a strong internal return should a company think about returning money to shareholders.
It's very doubtful that recipients of his wealth could have compounded their largesse at the rate Buffett did. Isn't it better, Buffett believes, to forego conspicuous consumption today if it means leaving even larger amounts for society tomorrow?
"My money represents an enormous number of claims checks on society. It's like I have these little pieces of paper that I can turn into consumption," Buffett told Esquire magazine in 1988. "If I wanted to, I could hire 10,000 people to do nothing but paint my picture every day for the rest of my life. And the (Gross Domestic Product) would go up. But the utility of the product would be zilch, and I would be keeping those 10,000 people from doing AIDS research, or teaching or nursing."
In Buffett's annual report to partners for the year ending in 1962, he broke cadence from his routine review of the market to discuss "The Joys of Compounding." Anyone reading this passage, even four decades after Buffett penned it, could see the raw-boned logic behind the 32-year-old Buffett's stubborn frugality. As he saw it, every dollar put to productive use magnifies the benefit to society by virtue of compounding. Wasting that dollar had serious long-term ramifications - for him, his partners, even for society at large. What if, Buffett mused in his letter, Spain had decided not to finance Christopher Columbus? The results would be staggering.
In financial terms, Columbus's four voyages to the Caribbean yielded very little for the crown, except to pave the way for generations of future navigators. Think how that $30,000 (cost of the voyage Isabella originally underwrote for Columbus), if spent more judiciously by Spain in the late 15th century, could have greatly increased the wealth of the Spanish people. By 1999, 37 years after Buffett made the analogy, Isabella's $30,000 expenditure could have compounded into more than $8 trillion, nearly the total annual economic output of the United States. Spain would be a world economic powerhouse today.
On this topic, Buffett is behaving as any rational CEO would. If a company generates a high return on its assets, it should withhold dividends to investors and plow as much money as it can each year back into the business. Only when it can no longer generate a strong internal return should a company think about returning money to shareholders.
It's very doubtful that recipients of his wealth could have compounded their largesse at the rate Buffett did. Isn't it better, Buffett believes, to forego conspicuous consumption today if it means leaving even larger amounts for society tomorrow?
"My money represents an enormous number of claims checks on society. It's like I have these little pieces of paper that I can turn into consumption," Buffett told Esquire magazine in 1988. "If I wanted to, I could hire 10,000 people to do nothing but paint my picture every day for the rest of my life. And the (Gross Domestic Product) would go up. But the utility of the product would be zilch, and I would be keeping those 10,000 people from doing AIDS research, or teaching or nursing."
Letting money compound productively creates an enormous economic benefit.
Postulating the value of assets into the future holds meaning for investors who, if they're fortunate, can live many decades. Letting money compound productively creates an enormous economic benefit, not only to investors but also to their benefactors and to society at large.
Buffett is occasionally criticized for not donating more of his wealth to foundations and charities, as many other tycoons have. Buffett's reasoning, however, is perfectly consistent with his investing philosophy. As long as he can continue to compound money at great rates, society would be better off if he didn't give away money now.
He told Ted Koppel in a 1999 Nighline interview, for example, that if he had donated most of his money 20 years ago, society would have been $100 million richer. Because he chose not to donate, society will one day receive more than $30 billion.
Had he given away $100 million in the 1970s, it's very doubtful that recipients could ahve produced $30 billion in economic benefits for society becasue few people alive can compound money as Buffett can.
One day, the value of Buffett's foundation grants will certainly surpass $100 billion and then $200 billion, which would make Buffett's fortune the largest ever donated to charity.
Buffett is occasionally criticized for not donating more of his wealth to foundations and charities, as many other tycoons have. Buffett's reasoning, however, is perfectly consistent with his investing philosophy. As long as he can continue to compound money at great rates, society would be better off if he didn't give away money now.
He told Ted Koppel in a 1999 Nighline interview, for example, that if he had donated most of his money 20 years ago, society would have been $100 million richer. Because he chose not to donate, society will one day receive more than $30 billion.
Had he given away $100 million in the 1970s, it's very doubtful that recipients could ahve produced $30 billion in economic benefits for society becasue few people alive can compound money as Buffett can.
One day, the value of Buffett's foundation grants will certainly surpass $100 billion and then $200 billion, which would make Buffett's fortune the largest ever donated to charity.
Let time work to your advantage
Choosing good companies at fair prices seldom has produced losses for investors willing to wait patiently for the stock price to track the growth of the company.
"Time is the friend of the good business, the enemy of the poor," Buffett has said many times.
Strong enterprises see their intrinsic value rise consistently, lifting the stock every step of the way. Over a period of 5 years or more, there should be a very close correlation between the change in the value of the company and the change in the stock. Watching great companies increase their sales and earnings consistently is a dream come true for an investor.
The power of compounding begins working its magic as the years progress and allows your net worth to gather momentum and increase (in dollar value) by greater and greater amounts.
What happens to money that is allowed to sit and grow at different rates? Two principles should be readily apparent:
1. Time has a tremendous effect on terminal wealth. The longer that money can compound, the larger the sum will be.
2. The rate of return attained acts as a lever that magnifies or minimises your ultimate wealth. Adding just a few extra percentage points a year to your overall returns can have unfathomable consequences to your wealth. An investor who compounds $1 at 6 percent annual rates has $5.74 in his pocket at the end of 30 years. The same investor who can find ways to obtain higher returns (the purpose of posting all these materials here :-) ) walks away with much more. If you can obtain a 10 percent annual return, your $1 compounds into $17.45 in 30 years. Compounding $1 at 20 percent annual rates compounds into $237.
The mathematics of compounding excited Buffett in his earliest years, and stories abound of how he memorised compounding and annuity tables to help him calculate an investment's merit and to keep his personal portfolio on a straight upward track.
"Time is the friend of the good business, the enemy of the poor," Buffett has said many times.
Strong enterprises see their intrinsic value rise consistently, lifting the stock every step of the way. Over a period of 5 years or more, there should be a very close correlation between the change in the value of the company and the change in the stock. Watching great companies increase their sales and earnings consistently is a dream come true for an investor.
The power of compounding begins working its magic as the years progress and allows your net worth to gather momentum and increase (in dollar value) by greater and greater amounts.
What happens to money that is allowed to sit and grow at different rates? Two principles should be readily apparent:
1. Time has a tremendous effect on terminal wealth. The longer that money can compound, the larger the sum will be.
2. The rate of return attained acts as a lever that magnifies or minimises your ultimate wealth. Adding just a few extra percentage points a year to your overall returns can have unfathomable consequences to your wealth. An investor who compounds $1 at 6 percent annual rates has $5.74 in his pocket at the end of 30 years. The same investor who can find ways to obtain higher returns (the purpose of posting all these materials here :-) ) walks away with much more. If you can obtain a 10 percent annual return, your $1 compounds into $17.45 in 30 years. Compounding $1 at 20 percent annual rates compounds into $237.
The mathematics of compounding excited Buffett in his earliest years, and stories abound of how he memorised compounding and annuity tables to help him calculate an investment's merit and to keep his personal portfolio on a straight upward track.
If the Indians wanted to buy back Manhattan
There's the story that, if the Indians wanted to buy back Manhattan, they would have had to pay more than $2.5 trillion by January 1, 2000. That's what the $24 sale price in 1626 would have compounded into at 7 percent annual rates. And the clock keeps ticking.
Next year, Manhattan's theoretical value jumps by $175 billion (7 percent of $2.5 trillion). The following year, another $187 billion is added. The year after that, $200 billion, and so on.
Letting wealth accumulate and compound unfettered and, if possible, untaxed is a potent formula individuals should use to increase their standard of living.
It goes without saying that to an investor, the power of compounding is paramount.
Next year, Manhattan's theoretical value jumps by $175 billion (7 percent of $2.5 trillion). The following year, another $187 billion is added. The year after that, $200 billion, and so on.
Letting wealth accumulate and compound unfettered and, if possible, untaxed is a potent formula individuals should use to increase their standard of living.
It goes without saying that to an investor, the power of compounding is paramount.
The Power of Compounding
No force exerts more influence on your portfolio than time. Time takes a bigger toll on your terminal wealth than do taxes, inflation and poor stock-picking combined. Time magnifies the effects of these critical issues.
A poorly chosen stock may cost you only $2,000 in losses today, but over time that one suspect decision could cost $50,000 in lost opportunities.
Trading frequently for short-term gains may net you strong gains periodically, but the overall result, validated by time, is to create an enormous tax burden that could have been avoided.
Likewise, persistent inflation exacts a weighty toll on your portfolio becasue it destroys value at increasing rates.
Means and end should not be confused. Buffett once wrote to his partners, "The end is to come away with the largest after-tax rate of compound."
A poorly chosen stock may cost you only $2,000 in losses today, but over time that one suspect decision could cost $50,000 in lost opportunities.
Trading frequently for short-term gains may net you strong gains periodically, but the overall result, validated by time, is to create an enormous tax burden that could have been avoided.
Likewise, persistent inflation exacts a weighty toll on your portfolio becasue it destroys value at increasing rates.
Means and end should not be confused. Buffett once wrote to his partners, "The end is to come away with the largest after-tax rate of compound."
Lost Opportunities
A poorly chosen stock may cost you only $2,000 in losses today, but over time that one suspect decision could cost $50,000 in lost opportunities.
Saturday, 12 September 2009
The margin of safety related to the Upside-Downside Ratio
Building in Room for Error
Related to the Upside-Downside Ratio
by Michael Maiello
12.3.2008
The margin of safety is one of Benjamin Graham and David Dodd’s most enduring contributions to the world of investing. The two coined the term in Security Analysis in 1934, and Graham expanded on the concept in The Intelligent Investor in 1949. The gist of it is that no matter how careful an analyst is, so many variables are involved in calculating a company’s intrinsic value and future sales and earnings that mistakes are inevitable. So buy a stock worth $12 at $10 instead of $11.50, because the wider the gap between the stock’s price and its intrinsic value, the bigger the margin of safety.
How much safety is warranted depends on the company’s quality. A speculative com-pany that’s losing money, carrying a lot of debt or operating in a shrinking industry reasonably demands a larger margin of safety than a profitable company that leads a growing industry and has a solid balance sheet. Graham and Dodd typically looked for a 50-percent margin of safety on speculative companies but would require a margin of only 10 percent for a high-quality issue.
All investors employ the margin of safety differently, since it’s tied both to intrinsic value analysis and an individual’s risk tolerance. BetterInvesting expresses the risk-reward tradeoff as the upside-downside ratio. The goal here is to evaluate the risk and reward potential of a stock over five years, assuming one boom and one recession. This analysis says nothing about the probability of a stock reaching any particular price. Instead, it expresses what a stock’s potential is. BetterInvesting recommends buying a stock only when the upside is at least three times that of the downside.
In calculating the ratio, you first find the extreme upside. For a company with growing earnings, estimate the stock’s highest price-earnings ratio over the next five years. This will represent “as good as it gets.” Then determine the company’s highest earnings per share over this period. Multiply them and that’s your extreme high.
Now do the same on the low end. Multiplying your estimated low P/E by the expected low earnings is a common way to do this. If the stock is already trading below your low forecast, you’ll want to revisit your assumptions.
Finally, take the forecast high and subtract the current price. Then divide that by the current price minus the forecast low. The result is the upside-downside ratio. Anything above 3:1 offers a reasonable margin of safety for growth stocks.
Some investors also like a margin of safety for selling stocks. The upside-downside ratio for existing holdings should be updated to see whether price appreciation has outpaced potential.
The analysts at Morningstar do something similar. They give a “fair value” estimate for every stock. For Wachovia, it’s currently $53. The stock recently traded at $34.60. Morningstar says to consider buying it at any price below $39.80, which is 75 percent of what Morningstar thinks the stock is worth.
If you buy the stock, Morningstar says not to consider selling it until it reaches $68.90. In other words, Morningstar believes Wachovia’s stock could increase by 30 percent beyond what it now considers the stock’s fair value. The answer to the selling conundrum in this case is that if Wachovia reaches its fair value, the investor has to analyze the stock again to see whether there’s room left for the stock to run.
BetterInvesting’s Online Tools
The Stock Selection Guide, the primary stock study tool of BetterInvesting members, helps you identify stocks that are reasonably priced. Our new online tool will walk you through evaluating a company using the SSG. Click on the Online Tools & Software link under the Tools & Resources menu on the BetterInvesting homepage. Your membership may already include access to the tool; if not, you can upgrade your membership to use it.
Michael Maiello, who wrote "Fly With the Fundamentals" for the January 2006 issue, is the author of Buy the Rumor, Sell the Fact (McGraw-Hill, 2004).
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/0408fundamentalpublic.htm
Related to the Upside-Downside Ratio
by Michael Maiello
12.3.2008
The margin of safety is one of Benjamin Graham and David Dodd’s most enduring contributions to the world of investing. The two coined the term in Security Analysis in 1934, and Graham expanded on the concept in The Intelligent Investor in 1949. The gist of it is that no matter how careful an analyst is, so many variables are involved in calculating a company’s intrinsic value and future sales and earnings that mistakes are inevitable. So buy a stock worth $12 at $10 instead of $11.50, because the wider the gap between the stock’s price and its intrinsic value, the bigger the margin of safety.
How much safety is warranted depends on the company’s quality. A speculative com-pany that’s losing money, carrying a lot of debt or operating in a shrinking industry reasonably demands a larger margin of safety than a profitable company that leads a growing industry and has a solid balance sheet. Graham and Dodd typically looked for a 50-percent margin of safety on speculative companies but would require a margin of only 10 percent for a high-quality issue.
All investors employ the margin of safety differently, since it’s tied both to intrinsic value analysis and an individual’s risk tolerance. BetterInvesting expresses the risk-reward tradeoff as the upside-downside ratio. The goal here is to evaluate the risk and reward potential of a stock over five years, assuming one boom and one recession. This analysis says nothing about the probability of a stock reaching any particular price. Instead, it expresses what a stock’s potential is. BetterInvesting recommends buying a stock only when the upside is at least three times that of the downside.
In calculating the ratio, you first find the extreme upside. For a company with growing earnings, estimate the stock’s highest price-earnings ratio over the next five years. This will represent “as good as it gets.” Then determine the company’s highest earnings per share over this period. Multiply them and that’s your extreme high.
Now do the same on the low end. Multiplying your estimated low P/E by the expected low earnings is a common way to do this. If the stock is already trading below your low forecast, you’ll want to revisit your assumptions.
Finally, take the forecast high and subtract the current price. Then divide that by the current price minus the forecast low. The result is the upside-downside ratio. Anything above 3:1 offers a reasonable margin of safety for growth stocks.
Some investors also like a margin of safety for selling stocks. The upside-downside ratio for existing holdings should be updated to see whether price appreciation has outpaced potential.
The analysts at Morningstar do something similar. They give a “fair value” estimate for every stock. For Wachovia, it’s currently $53. The stock recently traded at $34.60. Morningstar says to consider buying it at any price below $39.80, which is 75 percent of what Morningstar thinks the stock is worth.
If you buy the stock, Morningstar says not to consider selling it until it reaches $68.90. In other words, Morningstar believes Wachovia’s stock could increase by 30 percent beyond what it now considers the stock’s fair value. The answer to the selling conundrum in this case is that if Wachovia reaches its fair value, the investor has to analyze the stock again to see whether there’s room left for the stock to run.
BetterInvesting’s Online Tools
The Stock Selection Guide, the primary stock study tool of BetterInvesting members, helps you identify stocks that are reasonably priced. Our new online tool will walk you through evaluating a company using the SSG. Click on the Online Tools & Software link under the Tools & Resources menu on the BetterInvesting homepage. Your membership may already include access to the tool; if not, you can upgrade your membership to use it.
Michael Maiello, who wrote "Fly With the Fundamentals" for the January 2006 issue, is the author of Buy the Rumor, Sell the Fact (McGraw-Hill, 2004).
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/0408fundamentalpublic.htm
The Perils of High-P/E Stocks
The Perils of High-P/E Stocks
The Higher They Are, the Harder They Fall
by Michael Maiello
30.7.2008
Financial journalist Jason Zweig has a well-known interest in behavioral finance, the study of how investors’ minds work — sometimes against their best interests. In his latest book, Your Money & Your Brain, he deals with the “story stock,” the must-have equity of the moment that only investors with the strongest convictions can avoid.
Think Krispy Kreme, which went public in 2000 after the market crash and climbed from $23 to over $100 a share. Yes, a doughnut company had a price-earnings ratio above 80. A doughnut company.
Krispy Kreme is losing money now and trades for just over $3 a share. But at the time it had exactly what investors craved — a simple business model, a good (some would say addictive) product, room to grow from a regional to a national chain and the attention of both the media and Wall Street analysts.
These are the types of stocks that play well in the human mind, Zweig says. Investors are naturally risk-averse and wary of potential surprises. High-profile companies that get a lot of attention and are mentioned on the nightly news and on financial websites seem less likely to surprise us. They seem safer.
There’s also a perceived safety in numbers. No matter how often we’re told that 50,000 people can indeed be wrong, we’re afraid to be seen as out of step with our neighbors. To be wrong while acting as part of a group is understandable. To be wrong on your own is just plain embarrassing.
The result of this, writes Zweig, is that a stock might do well for the wrong reasons in the short run. But eventually the fundamentals will catch up with it.
Remember, it’s negative surprises that send most investors fleeing, and when they seek safety, they wind up buying stocks that today are telling happy stories of high growth. This means the effects of any negative news about these stocks are amplified. And when the story turns ugly, it turns in a hurry.
Zweig calculates that if a growth company misses its earnings forecast by as little as 3 cents a share, its stock will drop two to three times faster compared with a value stock reporting the same bad news. When a high-growth company misses earnings, it can cause a crisis of confidence. Many analysts, for example, believe there’s no such thing as one bad quarter; when a high-growth company stumbles, investors fear more bad news is on the way.
But over time, less-popular, lower-P/E stocks do outperform. In his updated edition of Stocks for the Long Run, Wharton professor Jeremy Siegel measured the performances of low-P/E and high-P/E stock portfolios between 1957 and the end of 2006. The portfolio with $1,000 invested in stocks with the lowest P/E ratios was worth $700,000, for a 14.3 percent annual return. The portfolio with $1,000 invested in the highest-P/E stocks was worth $65,000, for a return of 8.9 percent a year.
What’s more, during the first 10 years the high- and low-P/E portfolios traded places a few times, depending on market conditions. But once the experiment passed the decade mark, returns on the low-P/E stocks were always higher.
Of course, it’s important to put P/Es in context. You should compare a stock’s P/E with that of its peers and to the rest of the market and remember that some stocks deserve a higher valuation.
Growth and value also go in and out of favor; cycles usually last five years to seven years. But investors with time on their side would do well to be wary of trendy story stocks because they can turn in an instant.
Michael Maiello, who wrote "Fly With the Fundamentals" for the January 2006 issue, is the author of Buy the Rumor, Sell the Fact (McGraw-Hill, 2004).
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/0808fundamentalspublic.htm
The Higher They Are, the Harder They Fall
by Michael Maiello
30.7.2008
Financial journalist Jason Zweig has a well-known interest in behavioral finance, the study of how investors’ minds work — sometimes against their best interests. In his latest book, Your Money & Your Brain, he deals with the “story stock,” the must-have equity of the moment that only investors with the strongest convictions can avoid.
Think Krispy Kreme, which went public in 2000 after the market crash and climbed from $23 to over $100 a share. Yes, a doughnut company had a price-earnings ratio above 80. A doughnut company.
Krispy Kreme is losing money now and trades for just over $3 a share. But at the time it had exactly what investors craved — a simple business model, a good (some would say addictive) product, room to grow from a regional to a national chain and the attention of both the media and Wall Street analysts.
These are the types of stocks that play well in the human mind, Zweig says. Investors are naturally risk-averse and wary of potential surprises. High-profile companies that get a lot of attention and are mentioned on the nightly news and on financial websites seem less likely to surprise us. They seem safer.
There’s also a perceived safety in numbers. No matter how often we’re told that 50,000 people can indeed be wrong, we’re afraid to be seen as out of step with our neighbors. To be wrong while acting as part of a group is understandable. To be wrong on your own is just plain embarrassing.
The result of this, writes Zweig, is that a stock might do well for the wrong reasons in the short run. But eventually the fundamentals will catch up with it.
Remember, it’s negative surprises that send most investors fleeing, and when they seek safety, they wind up buying stocks that today are telling happy stories of high growth. This means the effects of any negative news about these stocks are amplified. And when the story turns ugly, it turns in a hurry.
Zweig calculates that if a growth company misses its earnings forecast by as little as 3 cents a share, its stock will drop two to three times faster compared with a value stock reporting the same bad news. When a high-growth company misses earnings, it can cause a crisis of confidence. Many analysts, for example, believe there’s no such thing as one bad quarter; when a high-growth company stumbles, investors fear more bad news is on the way.
But over time, less-popular, lower-P/E stocks do outperform. In his updated edition of Stocks for the Long Run, Wharton professor Jeremy Siegel measured the performances of low-P/E and high-P/E stock portfolios between 1957 and the end of 2006. The portfolio with $1,000 invested in stocks with the lowest P/E ratios was worth $700,000, for a 14.3 percent annual return. The portfolio with $1,000 invested in the highest-P/E stocks was worth $65,000, for a return of 8.9 percent a year.
What’s more, during the first 10 years the high- and low-P/E portfolios traded places a few times, depending on market conditions. But once the experiment passed the decade mark, returns on the low-P/E stocks were always higher.
Of course, it’s important to put P/Es in context. You should compare a stock’s P/E with that of its peers and to the rest of the market and remember that some stocks deserve a higher valuation.
Growth and value also go in and out of favor; cycles usually last five years to seven years. But investors with time on their side would do well to be wary of trendy story stocks because they can turn in an instant.
Michael Maiello, who wrote "Fly With the Fundamentals" for the January 2006 issue, is the author of Buy the Rumor, Sell the Fact (McGraw-Hill, 2004).
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/0808fundamentalspublic.htm
Use Binaries to Choose Among Options
The Forks in the Road to Investing Success
Use Binaries to Choose Among Options
by Angele McQuade
I’m sure you’ve heard the chestnut that the hardest choice isn’t the one between right and wrong but the one between two rights. When you’re faced with a decision between two potentially profitable investment strategies, how do you find the clarity that will leave you content with your selection? Although I can’t help you work through all your weighty life choices, I can channel a little investing guidance from Clark Winter, author of The Either/Or Investor: How to Succeed in Global Investing, One Decision at a Time.
As director of portfolio strategy and managing director of Goldman Sachs, Winter has surely faced a fair number of challenging choices. He believes binaries simplify the decision-making process: If you can whittle your options to two, you can begin to gather the necessary information and assess that data. “I realized that smart people approach problems as dichotomies — either/or decisions,” he explains in the preface. “If this, then not that. If yes, if no, then what?”
Great investing is really about understanding how to evaluate facts, Winter continues — “how to make reasonable suppositions about the things you don’t know, how to account for the uncertainties that impede decision-making, and finally how to do all that rapidly enough so that you can gain an advantage over competitors and thus the market.” At 27 pages the introduction might be longer than many book chapters, but it’s more illuminating than many, too. I found it very compelling reading and one of my favorite parts of the book.
Winter didn’t want to write yet another tome about investing but instead one about sound decision-making, with investing as the object, not the subject. Winter’s purpose is to “link the two skill sets, investing and decision-making.” Though he assesses markets using hundreds of binaries, he focuses here on the 21 he says can explain just about all investment thinking.
Most chapters in The Either/Or Investor are based on these dichotomies, with their titles identifying the decision-making lesson you’ll discover: “Here Versus There,” “The Developed World Versus the Developing World,” “Preservation Versus Growth,” “Fad Versus Trend,” “Conventional Wisdom Versus Anomalies” — you get the idea.
“In investing, the first and most important binary is fear or greed,” Winter says, and sure enough you can learn why by reading Chapter 7, called — of course — “Fear Versus Greed.” You might read his chapters hoping for universal right or wrong answers, but Winter wants you to learn to ask what the available information tells you to do. And although he can’t answer that question, he does give a firm enough push in the direction of information gathering and analysis to help you build some momentum in your process.
The Either/Or Investor disputes the popular belief that all the average inves-tor needs to achieve the returns of a spectacularly successful investor is to follow that master’s strategy. Winter even takes on books that model famous investors’ methods (ones you’ve probably read about right here, in fact). His beef isn’t so much with these experts but with what he considers the misapplication of perfect math (assuming, for example, the reader will achieve an average annual return of 11 percent) and readers’ inability to accept the idea that they won’t ever match the very best money managers’ returns. Winter is determined to promote this daring, provocative position even though it’s a hard reality for most investors — not to mention the publishers of all those investment books — to acknowledge.
The subprime mortgage crisis hit full force after Winter submitted The Either/Or Investor to Random House but before the book was published. He seized the opportunity to update his manuscript and address more directly the problems of easy credit. This revision makes the book feel even more relevant, especially for investors concerned about today’s economic uncertainties.
Can you endure a few final binaries? Plausible vs. forgettable: My answer? Highly plausible — quite convincing, too. Read it vs. skip it: Read it, definitely.
Here’s one more piece of information, if it will help your assessment: The Either/Or Investor is high on my list of the most thought-provoking, assumption-challenging, instructive books of 2008. And that’s one determination I didn’t have a bit of trouble making.
Have a question about this month’s book? Want to share your own recent financial favorites? Write to Angele at angemc
quade@betterinvesting.net.
Angele McQuade is the author of two books, including Investment Clubs for Dummies. You can find her online at angelemcquade.com.
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/1008publicbv.htm
Use Binaries to Choose Among Options
by Angele McQuade
I’m sure you’ve heard the chestnut that the hardest choice isn’t the one between right and wrong but the one between two rights. When you’re faced with a decision between two potentially profitable investment strategies, how do you find the clarity that will leave you content with your selection? Although I can’t help you work through all your weighty life choices, I can channel a little investing guidance from Clark Winter, author of The Either/Or Investor: How to Succeed in Global Investing, One Decision at a Time.
As director of portfolio strategy and managing director of Goldman Sachs, Winter has surely faced a fair number of challenging choices. He believes binaries simplify the decision-making process: If you can whittle your options to two, you can begin to gather the necessary information and assess that data. “I realized that smart people approach problems as dichotomies — either/or decisions,” he explains in the preface. “If this, then not that. If yes, if no, then what?”
Great investing is really about understanding how to evaluate facts, Winter continues — “how to make reasonable suppositions about the things you don’t know, how to account for the uncertainties that impede decision-making, and finally how to do all that rapidly enough so that you can gain an advantage over competitors and thus the market.” At 27 pages the introduction might be longer than many book chapters, but it’s more illuminating than many, too. I found it very compelling reading and one of my favorite parts of the book.
Winter didn’t want to write yet another tome about investing but instead one about sound decision-making, with investing as the object, not the subject. Winter’s purpose is to “link the two skill sets, investing and decision-making.” Though he assesses markets using hundreds of binaries, he focuses here on the 21 he says can explain just about all investment thinking.
Most chapters in The Either/Or Investor are based on these dichotomies, with their titles identifying the decision-making lesson you’ll discover: “Here Versus There,” “The Developed World Versus the Developing World,” “Preservation Versus Growth,” “Fad Versus Trend,” “Conventional Wisdom Versus Anomalies” — you get the idea.
“In investing, the first and most important binary is fear or greed,” Winter says, and sure enough you can learn why by reading Chapter 7, called — of course — “Fear Versus Greed.” You might read his chapters hoping for universal right or wrong answers, but Winter wants you to learn to ask what the available information tells you to do. And although he can’t answer that question, he does give a firm enough push in the direction of information gathering and analysis to help you build some momentum in your process.
The Either/Or Investor disputes the popular belief that all the average inves-tor needs to achieve the returns of a spectacularly successful investor is to follow that master’s strategy. Winter even takes on books that model famous investors’ methods (ones you’ve probably read about right here, in fact). His beef isn’t so much with these experts but with what he considers the misapplication of perfect math (assuming, for example, the reader will achieve an average annual return of 11 percent) and readers’ inability to accept the idea that they won’t ever match the very best money managers’ returns. Winter is determined to promote this daring, provocative position even though it’s a hard reality for most investors — not to mention the publishers of all those investment books — to acknowledge.
The subprime mortgage crisis hit full force after Winter submitted The Either/Or Investor to Random House but before the book was published. He seized the opportunity to update his manuscript and address more directly the problems of easy credit. This revision makes the book feel even more relevant, especially for investors concerned about today’s economic uncertainties.
Can you endure a few final binaries? Plausible vs. forgettable: My answer? Highly plausible — quite convincing, too. Read it vs. skip it: Read it, definitely.
Here’s one more piece of information, if it will help your assessment: The Either/Or Investor is high on my list of the most thought-provoking, assumption-challenging, instructive books of 2008. And that’s one determination I didn’t have a bit of trouble making.
Have a question about this month’s book? Want to share your own recent financial favorites? Write to Angele at angemc
quade@betterinvesting.net.
Angele McQuade is the author of two books, including Investment Clubs for Dummies. You can find her online at angelemcquade.com.
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/1008publicbv.htm
Defining Value: Are You an Investor or a Speculator?
Defining Value
Are You an Investor or a Speculator?
Value, like beauty, is in the eye of the beholder. As “a beggar’s dime is worth more than a king’s gold,” seeking value in the stock market is often subjective. Some investors think that a value stock should be a mature company; some think it has to trade at a low price-earnings ratio; and some believe that a high dividend yield is key.
by Ronald W. Chan and Brian C. Lui
29.10.08
In our first article on the subject, we’ll define value investing and how it’s applied. Before we begin, however, we must ask ourselves who we are when we purchase a stock — investors or speculators?
Investing and gambling traditionally have been viewed as being at the opposite ends of the spectrum, with speculating in between. An investor, through fine calculation, gains profit and earns dividends; the less reputable speculator or gambler, by skill or luck, gains only profit.
Benjamin Graham, the father of value investing, distinguished between investment and speculation: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
Graham disciple Warren Buffett believes investing intrinsically encompasses the notion of value. In a letter to shareholders, he wrote: “The very term ‘value investing’ is redundant. What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value — in the hope that it can soon be sold for a still-higher price — should be labeled speculation.”
A low earnings multiple and high dividend yield aren’t necessarily the determining factors of a value stock, Buffett said. A stock with a high P/E can also be cheap as long as its value is higher than its stock price.
People often separate value investing from growth investing as if they’re opposing practices. This distorts the true nature of what value investors do. “The whole concept of dividing it up into ‘value’ and ‘growth’ strikes me as twaddle,” says Charlie Munger, Buffett’s business partner. “It’s convenient for a bunch of pension fund consultants to get fees prattling about and a way for one adviser to distinguish himself from another. But to me, all intelligent investing is value investing.”
Buffett spoke of value and growth in a softer tone and united the two strategies: “The two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.”
Simply put, value investing means buying a stock when it’s trading at less than its fair value. In practice, investors must bear in mind that a stock certificate means part ownership of a company. Therefore, to be a good investor, one needs to think like a good businessman.
Imagine that an investor wants to buy out an entire business. He obviously doesn’t want to overpay, so the company’s fair value is crucial. Stock investors should apply the same mentality.
In value investing terms, determining the fair value — commonly known as intrinsic value — is the first step to successful investing. A stock’s intrinsic value is calculated from the economic value of its underlying business. Thus, a value investor needs to delve into a company’s financial statements and analyze its competitive position, considering both tangible and intangible attributes.
Although there are many different models for deriving intrinsic value, the most common method involves the concept of discounted cash flow. This model measures the cash that can be taken out of a business during the remainder of its life and discounts the cash flow at an appropriate interest rate.
Intrinsic value calculations can vary widely depending on the growth and interest rates assumed. So value investors should treat intrinsic value more as a rough estimate than as a precise figure. In our next article, we’ll explore intrinsic value’s technical aspects. After all, value investing is half art and half science; therefore, a true investor needs to be prepared mentally and mathematically.
That said, Albert Einstein put it well: “Try not to be a person of success, but rather, a person of value!”
Ronald Chan and Brian Lui operate Chartwell Capital Limited, an asset management firm based in Hong Kong.
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/1008public1.htm
Are You an Investor or a Speculator?
Value, like beauty, is in the eye of the beholder. As “a beggar’s dime is worth more than a king’s gold,” seeking value in the stock market is often subjective. Some investors think that a value stock should be a mature company; some think it has to trade at a low price-earnings ratio; and some believe that a high dividend yield is key.
by Ronald W. Chan and Brian C. Lui
29.10.08
In our first article on the subject, we’ll define value investing and how it’s applied. Before we begin, however, we must ask ourselves who we are when we purchase a stock — investors or speculators?
Investing and gambling traditionally have been viewed as being at the opposite ends of the spectrum, with speculating in between. An investor, through fine calculation, gains profit and earns dividends; the less reputable speculator or gambler, by skill or luck, gains only profit.
Benjamin Graham, the father of value investing, distinguished between investment and speculation: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
Graham disciple Warren Buffett believes investing intrinsically encompasses the notion of value. In a letter to shareholders, he wrote: “The very term ‘value investing’ is redundant. What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value — in the hope that it can soon be sold for a still-higher price — should be labeled speculation.”
A low earnings multiple and high dividend yield aren’t necessarily the determining factors of a value stock, Buffett said. A stock with a high P/E can also be cheap as long as its value is higher than its stock price.
People often separate value investing from growth investing as if they’re opposing practices. This distorts the true nature of what value investors do. “The whole concept of dividing it up into ‘value’ and ‘growth’ strikes me as twaddle,” says Charlie Munger, Buffett’s business partner. “It’s convenient for a bunch of pension fund consultants to get fees prattling about and a way for one adviser to distinguish himself from another. But to me, all intelligent investing is value investing.”
Buffett spoke of value and growth in a softer tone and united the two strategies: “The two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.”
Simply put, value investing means buying a stock when it’s trading at less than its fair value. In practice, investors must bear in mind that a stock certificate means part ownership of a company. Therefore, to be a good investor, one needs to think like a good businessman.
Imagine that an investor wants to buy out an entire business. He obviously doesn’t want to overpay, so the company’s fair value is crucial. Stock investors should apply the same mentality.
In value investing terms, determining the fair value — commonly known as intrinsic value — is the first step to successful investing. A stock’s intrinsic value is calculated from the economic value of its underlying business. Thus, a value investor needs to delve into a company’s financial statements and analyze its competitive position, considering both tangible and intangible attributes.
Although there are many different models for deriving intrinsic value, the most common method involves the concept of discounted cash flow. This model measures the cash that can be taken out of a business during the remainder of its life and discounts the cash flow at an appropriate interest rate.
Intrinsic value calculations can vary widely depending on the growth and interest rates assumed. So value investors should treat intrinsic value more as a rough estimate than as a precise figure. In our next article, we’ll explore intrinsic value’s technical aspects. After all, value investing is half art and half science; therefore, a true investor needs to be prepared mentally and mathematically.
That said, Albert Einstein put it well: “Try not to be a person of success, but rather, a person of value!”
Ronald Chan and Brian Lui operate Chartwell Capital Limited, an asset management firm based in Hong Kong.
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/1008public1.htm
The Oracle of Omaha Exhorts Investors to Buy
Buffett’s Advice Always Fit to Print
The Oracle of Omaha Exhorts Investors to Buy
by Kenneth S. Janke
7.1.2009
Most of the time, I preferred to read the college newspaper, keeping track of our football and cross country teams as they both went on to win national championships that fall. The one big disappointment I had with the Times was that there were no comic strips. How in the world could a newspaper not have comic strips and devote the sports section to the Yankees and Giants, seldom mentioning games in the Midwest?
A few years ago, I succumbed again and subscribed to the Sunday edition. But I soon realized that I read only the financial section and was turned off by the rest of the reporting. There still weren’t any comic strips, but I unsuccessfully attempted to complete the crossword puzzle and developed a dislike for the puzzle editor. I had stopped reading any part of the Times until Warren Buffett’s opinion piece published on Oct. 16. (As of early December the article, “Buy American. I Am,” was still available for free at the newspaper’s website. Use the site’s search function for quick access to it.)
Since I’ve always enjoyed reading Buffett’s remarks in the Berkshire Hathaway annual reports and listening to him talk about his approach to investing, I read the article carefully. Now, keep in mind that this was written a full month before the heavy gyrations (mostly down) in the stock market through the first three weeks of November. During that span it wasn’t unusual to see daily moves in the Dow Jones industrial average of 300 points and more. Although you wouldn’t call him bullish, he explained his analytical outlook and said he was buying American stocks in his personal account.
The reason he was buying was covered in a couple of paragraphs:
“A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.
“Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.”
We already know he’s an investing genius, but Mr. Buffett also has an extraordinary talent to succinctly state in a few words his approach to investing. It’s commonsense advice we should follow. Oh, by the way, The New York Times still doesn’t have any comic strips.
Kenneth S. Janke, Sr., is a chairman emeritus of the NAIC/BetterInvesting board of directors and a member of the magazine’s Editorial Advisory and Securities Review Committee.
http://www.betterinvesting.org/NR/exeres/AD099AF4-F179-403D-9B30-8DBB0FD9DB29.htm
The Oracle of Omaha Exhorts Investors to Buy
by Kenneth S. Janke
7.1.2009
Most of the time, I preferred to read the college newspaper, keeping track of our football and cross country teams as they both went on to win national championships that fall. The one big disappointment I had with the Times was that there were no comic strips. How in the world could a newspaper not have comic strips and devote the sports section to the Yankees and Giants, seldom mentioning games in the Midwest?
A few years ago, I succumbed again and subscribed to the Sunday edition. But I soon realized that I read only the financial section and was turned off by the rest of the reporting. There still weren’t any comic strips, but I unsuccessfully attempted to complete the crossword puzzle and developed a dislike for the puzzle editor. I had stopped reading any part of the Times until Warren Buffett’s opinion piece published on Oct. 16. (As of early December the article, “Buy American. I Am,” was still available for free at the newspaper’s website. Use the site’s search function for quick access to it.)
Since I’ve always enjoyed reading Buffett’s remarks in the Berkshire Hathaway annual reports and listening to him talk about his approach to investing, I read the article carefully. Now, keep in mind that this was written a full month before the heavy gyrations (mostly down) in the stock market through the first three weeks of November. During that span it wasn’t unusual to see daily moves in the Dow Jones industrial average of 300 points and more. Although you wouldn’t call him bullish, he explained his analytical outlook and said he was buying American stocks in his personal account.
The reason he was buying was covered in a couple of paragraphs:
“A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.
“Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.”
We already know he’s an investing genius, but Mr. Buffett also has an extraordinary talent to succinctly state in a few words his approach to investing. It’s commonsense advice we should follow. Oh, by the way, The New York Times still doesn’t have any comic strips.
Kenneth S. Janke, Sr., is a chairman emeritus of the NAIC/BetterInvesting board of directors and a member of the magazine’s Editorial Advisory and Securities Review Committee.
http://www.betterinvesting.org/NR/exeres/AD099AF4-F179-403D-9B30-8DBB0FD9DB29.htm
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