Tuesday, 27 December 2011
Margin of Safety
Even after you think you have a good handle on what a stock should be worth, it is important to buy at a discount to this estimated fair value to give an adequate margin of safety.
After all, no projection about the future is foolproof, and protecting yourself from unforeseen events is entirely prudent.
For instance, if a company's new product falls flat and profit growth doesn't materialize, you want to be protected.
It is also important to realise that some companies are riskier and harder to predict than others. In general, the riskier a company is, the larger the margin of safety should be.
The bottom line is that if you don't use a lot of discipline and conservatism in figuring out the prices you are willing to pay for stocks, you will regret it eventually.
You might be able to sell some of your overvalued shares to some sucker who is willing to pay an even more inflated price, but in the end, this kind of speculating is the investing equivalent of musical chairs, with the last one holding the stock the loser. Don't let it be you.
Buy at a price below fair value with an adequate margin of safety and sleep well at night.
After all, no projection about the future is foolproof, and protecting yourself from unforeseen events is entirely prudent.
For instance, if a company's new product falls flat and profit growth doesn't materialize, you want to be protected.
It is also important to realise that some companies are riskier and harder to predict than others. In general, the riskier a company is, the larger the margin of safety should be.
The bottom line is that if you don't use a lot of discipline and conservatism in figuring out the prices you are willing to pay for stocks, you will regret it eventually.
You might be able to sell some of your overvalued shares to some sucker who is willing to pay an even more inflated price, but in the end, this kind of speculating is the investing equivalent of musical chairs, with the last one holding the stock the loser. Don't let it be you.
Buy at a price below fair value with an adequate margin of safety and sleep well at night.
Waiting for the Fat Pitch
How do I make sure I don't overpay for something?
The answer: If the pitcher doesn't throw one right down the middle, you don't have to swing the bat. Unlike in baseball, there is no penalty for being patient in investing.
You should spend a fair amount of time placing a value on a stock before you even think about buying it, and only buy stocks that you are confident are undervalued.
Learning how to value a stock takes work, but it can be done.
The answer: If the pitcher doesn't throw one right down the middle, you don't have to swing the bat. Unlike in baseball, there is no penalty for being patient in investing.
You should spend a fair amount of time placing a value on a stock before you even think about buying it, and only buy stocks that you are confident are undervalued.
Learning how to value a stock takes work, but it can be done.
Price Matters
Price matters in the stock market.
Just like you wouldn't run out and pay $10 a gallon for gasoline, why would you pay 100 times earnings for a company that is growing 15% a year?
Do you think the people who paid $212 for Yahoo YHOO in January 2000 are ever going to get their money back?
Yahoo's a good company, but it may take a very long time for the stock to get back to its old highs.
The same could be said of many other technology stocks and also even those technology companies with moats around them that got clobbered in post 2000.
Remember - the single greatest determinant of a company's return in your portfolio is the price you pay for its shares.
As important as it is to understand the quality of a company - its growth prospects, competitive position, and so forth - it is even more vital that you pay a fair price for the firm's shares.
You'll make a lot more money buying decent firms with low valuations than by paying premium prices for premium companies. Why? Because the future is uncertain, and low valuations leave a lot more room for error.
Just like you wouldn't run out and pay $10 a gallon for gasoline, why would you pay 100 times earnings for a company that is growing 15% a year?
Do you think the people who paid $212 for Yahoo YHOO in January 2000 are ever going to get their money back?
Yahoo's a good company, but it may take a very long time for the stock to get back to its old highs.
The same could be said of many other technology stocks and also even those technology companies with moats around them that got clobbered in post 2000.
Remember - the single greatest determinant of a company's return in your portfolio is the price you pay for its shares.
As important as it is to understand the quality of a company - its growth prospects, competitive position, and so forth - it is even more vital that you pay a fair price for the firm's shares.
You'll make a lot more money buying decent firms with low valuations than by paying premium prices for premium companies. Why? Because the future is uncertain, and low valuations leave a lot more room for error.
Buying at a Discount to Fair Value
Even though you know about economic moats and have perhaps uncovered a company that has at least one good-sized moat, unfortunately, your work is only half done at this point. (Quality & Management)
You cannot just go out and pay whatever the market is asking for this stock until you calculate what it's worth (the intrinsic value). (Valuation)
Otherwise, you might end up having to hold the stock for many, many years to get a decent return on your money.
And in some cases, you might never get one.
You cannot just go out and pay whatever the market is asking for this stock until you calculate what it's worth (the intrinsic value). (Valuation)
Otherwise, you might end up having to hold the stock for many, many years to get a decent return on your money.
And in some cases, you might never get one.
Using Free Cash Flow
Company ABC.
1995 Earnings $100,000 FCF -$7.0 million
1996 Earnings $5.9 million FCF -$28.0 million
1997 Earnings $12.3 million FCF -$57.4 million
Nice growth in earnings, right?
FCFs also grew - but in the opposite direction as earnings.
Company ABC's capital spending as a percentage of its long-term assets has been as high as 43%.
Company OPQ.
1997 Earnings $6,945 million FCF +$5,507 million
1998 Earnings $6,068 million FCF +$5,634 million
1999 Earnings $7.932 million FCF +$7,932 million
Nice growth in earnings, right?
FCFs also grew - but in this case, in tandem or the same direction as earnings.
Company OPQ has an annual capital spending of $3 billion or so, and its long-term assets are about $12 billion. That spending works out to 25% of its long-term assets, a pretty high figure.
Company DEF
1996 Earnings $1,473 million FCF - $2,532million
1997 Earnings $787 million FCF - $2,347 million
1998 Earnings $ 28 million FCF - $2,187 million
Company DEF's revenues actually declined during this period.
FCFs were consistently negative for the same period.
Company DEF spends an amount equal to about 20% of its long-term assets in a single year.
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How to use Free Cash Flow (FCF)?
Think of FCF as another bottom line.
Good and great companies generate lots of positive FCFs.
Negative FCF isn't necessarily bad, but it suggests you're dealing with either a speculative investment (such as Company ABC) or an underperformer (such as Company DEF).
Above all, negative FCF or a high level of capital spending naturally raises other questions.
If you are a careful investor, you'll want to know the answers to those questions before letting the company spend your money.
1995 Earnings $100,000 FCF -$7.0 million
1996 Earnings $5.9 million FCF -$28.0 million
1997 Earnings $12.3 million FCF -$57.4 million
Nice growth in earnings, right?
FCFs also grew - but in the opposite direction as earnings.
Company ABC's capital spending as a percentage of its long-term assets has been as high as 43%.
Company OPQ.
1997 Earnings $6,945 million FCF +$5,507 million
1998 Earnings $6,068 million FCF +$5,634 million
1999 Earnings $7.932 million FCF +$7,932 million
Nice growth in earnings, right?
FCFs also grew - but in this case, in tandem or the same direction as earnings.
Company OPQ has an annual capital spending of $3 billion or so, and its long-term assets are about $12 billion. That spending works out to 25% of its long-term assets, a pretty high figure.
Company DEF
1996 Earnings $1,473 million FCF - $2,532million
1997 Earnings $787 million FCF - $2,347 million
1998 Earnings $ 28 million FCF - $2,187 million
Company DEF's revenues actually declined during this period.
FCFs were consistently negative for the same period.
Company DEF spends an amount equal to about 20% of its long-term assets in a single year.
-----
How to use Free Cash Flow (FCF)?
Think of FCF as another bottom line.
Good and great companies generate lots of positive FCFs.
Negative FCF isn't necessarily bad, but it suggests you're dealing with either a speculative investment (such as Company ABC) or an underperformer (such as Company DEF).
Above all, negative FCF or a high level of capital spending naturally raises other questions.
- If the company is spending so much money, is it at least earning a high premium on that capital?
- And is all that spending paying off in rapid sales and profit growth?
If you are a careful investor, you'll want to know the answers to those questions before letting the company spend your money.
When Capital Spending Doesn't Generate Cash Flow
Company ABC.
1995 Earnings $100,000 FCF -$7.0 million
1996 Earnings $5.9 million FCF -$28.0 million
1997 Earnings $12.3 million FCF -$57.4 million
Nice growth in earnings, right?
FCFs also grew - but in the opposite direction as earnings.
Company ABC's capital spending as a percentage of its long-term assets has been as high as 43%.
Company OPQ.
1997 Earnings $6,945 million FCF +$5,507 million
1998 Earnings $6,068 million FCF +$5,634 million
1999 Earnings $7.932 million FCF +$7,932 million
Nice growth in earnings, right?
FCFs also grew - but in this case, in tandem or the same direction as earnings.
Company OPQ has an annual capital spending of $3 billion or so, and its long-term assets are about $12 billion. That spending works out to 25% of its long-term assets, a pretty high figure.
Company DEF
1996 Earnings $1,473 million FCF - $2,532million
1997 Earnings $787 million FCF - $2,347 million
1998 Earnings $ 28 million FCF - $2,187 million
Company DEF's revenues actually declined during this period.
FCFs were consistently negative for the same period.
Company DEF spends an amount equal to about 20% of its long-term assets in a single year.
What really hurts is when a company spends aggressively but its performance stinks.
If a company is spending like mad, it had better be increasing its sales - and its profits - at a rapid rate.
Company ABC and Company OPQ pass that test.
Company DEF doesn't.
Company DEF is a mature company and for it to generate such meager free cash flows is bad enough.
But when a company spends an amount equal to about 20% of its long-term assets in a single year, you expect to see rapid growth. Yet, Company DEF's revenues actually declined during this period; the company's long-term record of growth is poor when you consider how much money gets plowed into the company.
1995 Earnings $100,000 FCF -$7.0 million
1996 Earnings $5.9 million FCF -$28.0 million
1997 Earnings $12.3 million FCF -$57.4 million
Nice growth in earnings, right?
FCFs also grew - but in the opposite direction as earnings.
Company ABC's capital spending as a percentage of its long-term assets has been as high as 43%.
Company OPQ.
1997 Earnings $6,945 million FCF +$5,507 million
1998 Earnings $6,068 million FCF +$5,634 million
1999 Earnings $7.932 million FCF +$7,932 million
Nice growth in earnings, right?
FCFs also grew - but in this case, in tandem or the same direction as earnings.
Company OPQ has an annual capital spending of $3 billion or so, and its long-term assets are about $12 billion. That spending works out to 25% of its long-term assets, a pretty high figure.
Company DEF
1996 Earnings $1,473 million FCF - $2,532million
1997 Earnings $787 million FCF - $2,347 million
1998 Earnings $ 28 million FCF - $2,187 million
Company DEF's revenues actually declined during this period.
FCFs were consistently negative for the same period.
Company DEF spends an amount equal to about 20% of its long-term assets in a single year.
What really hurts is when a company spends aggressively but its performance stinks.
If a company is spending like mad, it had better be increasing its sales - and its profits - at a rapid rate.
Company ABC and Company OPQ pass that test.
Company DEF doesn't.
Company DEF is a mature company and for it to generate such meager free cash flows is bad enough.
But when a company spends an amount equal to about 20% of its long-term assets in a single year, you expect to see rapid growth. Yet, Company DEF's revenues actually declined during this period; the company's long-term record of growth is poor when you consider how much money gets plowed into the company.
Big Capital Spending and Cash Flow Can Work Together
Company ABC.
1995 Earnings $100,000 FCF -$7.0million
1996 Earnings $5.9million FCF -$28.0million
1997 Earnings $12.3million FCF -$57.4million
Nice growth in earnings, right?
FCFs also grew - but in the opposite direction as earnings.
Company OPQ.
1997 Earnings $6,945million FCF +$5,507million
1998 Earnings $6,068million FCF +$5,634million
1999 Earnings $7.932million FCF +$7,932million
Nice growth in earnings, right?
FCFs also grew - but in this case, in tandem or the same direction as earnings.
Company ABC's capital spending as a percentage of its long-term assets has been as high as 43%.
Company OPQ has an annual capital spending of $3 billion or so, and its long-term assets are about $12 billion. That spending works out to 25% of its long-term assets, a pretty high figure.
Both Company ABC and Company OPQ spend vast sums relative to their asset bases. However, we see a big difference when we look at their respective FCFs.
1995 Earnings $100,000 FCF -$7.0million
1996 Earnings $5.9million FCF -$28.0million
1997 Earnings $12.3million FCF -$57.4million
Nice growth in earnings, right?
FCFs also grew - but in the opposite direction as earnings.
Company OPQ.
1997 Earnings $6,945million FCF +$5,507million
1998 Earnings $6,068million FCF +$5,634million
1999 Earnings $7.932million FCF +$7,932million
Nice growth in earnings, right?
FCFs also grew - but in this case, in tandem or the same direction as earnings.
Company ABC's capital spending as a percentage of its long-term assets has been as high as 43%.
Company OPQ has an annual capital spending of $3 billion or so, and its long-term assets are about $12 billion. That spending works out to 25% of its long-term assets, a pretty high figure.
Both Company ABC and Company OPQ spend vast sums relative to their asset bases. However, we see a big difference when we look at their respective FCFs.
- These positive FCFs mean Company OPQ has money left over even after its large capital-spending budgets.
- By contrast, Company ABC, must turn to investors or lenders to make up the difference. Only by selling new shares to the public or taking out a loan can Company ABC fund its aggressive spending.
What free cash flow tells you
What free cash flow (FCF) tells us that earnings don't?
Let us have a look at Company ABC.
From 1995 through 1997, the company posted $100,000, $5.9 million, and $12.3 million in earnings. Nice growth, right?
The company's FCF, by contrast, was negative $7.0 million, negative $28.0 million, and negative $57.4 million. FCFs also grew - but in the opposite direction as earnings.
That's not necessarily bad.
FCF is equal to the cash a company generates minus the amount it invests.
Company ABC is investing a lot, which is why its FCFs are negative.
How much is a lot (of capital expenditure)?
A quick way to tell how quickly a company tears through money is to compare its capital spending with its long-term assets (mostly, its plant and equipment).
While not perfect, the comparison at least gives us an idea of how aggressively a company is spending.
Company ABC's capital spending as a percentage of its long-term assets has been as high as 43%. That's a prolific spender.
At the opposite end of the spectrum would be company like Company XYZ, which cruises along spending an amount equal to about 5% of its long-term assets.
When you see a percentage as high as 30% or 40%, chances are you're dealing with a young company just getting on its feet.
Let us have a look at Company ABC.
From 1995 through 1997, the company posted $100,000, $5.9 million, and $12.3 million in earnings. Nice growth, right?
The company's FCF, by contrast, was negative $7.0 million, negative $28.0 million, and negative $57.4 million. FCFs also grew - but in the opposite direction as earnings.
That's not necessarily bad.
FCF is equal to the cash a company generates minus the amount it invests.
Company ABC is investing a lot, which is why its FCFs are negative.
How much is a lot (of capital expenditure)?
A quick way to tell how quickly a company tears through money is to compare its capital spending with its long-term assets (mostly, its plant and equipment).
While not perfect, the comparison at least gives us an idea of how aggressively a company is spending.
Company ABC's capital spending as a percentage of its long-term assets has been as high as 43%. That's a prolific spender.
At the opposite end of the spectrum would be company like Company XYZ, which cruises along spending an amount equal to about 5% of its long-term assets.
When you see a percentage as high as 30% or 40%, chances are you're dealing with a young company just getting on its feet.
What is Free Cash Flow (FCF)?
FCF represents the cash a firm has generated for its shareholders, after paying its expenses and investing in its growth.
FCF = Total cash flow (Earnings with noncash charges added back in) - capital spending
FCF can be very useful in assessing a company's financial health because it strips away all the accounting assumptions built into earnings.
A company's earnings maybe high and growing, but until you look at FCF, you don't know if the company's really generated money in a given year or not.
If you're an owner, FCF is ultimately what you're interested in. FCFs represent real cash. Earnings do not.
FCF = Total cash flow (Earnings with noncash charges added back in) - capital spending
FCF can be very useful in assessing a company's financial health because it strips away all the accounting assumptions built into earnings.
A company's earnings maybe high and growing, but until you look at FCF, you don't know if the company's really generated money in a given year or not.
If you're an owner, FCF is ultimately what you're interested in. FCFs represent real cash. Earnings do not.
When to Sell a Stock
Just as there are no hard-and-fast rules as to when to buy a stock, there are no hard-and-fast rules as to when to sell.
Investors typically spend a lot of their time researching their stock purchases than they spend considering their selling decisions.
Unfortunately, selling decisions are often made in the heat of the moment, after a stock has already taken a beating in the market.
The best way to know when to sell a stock is to know why you own it in the first place.
Don't Sell Based on Price Alone
You will be poorly served if you watch only your stock's price.
When markets go through one of their periodic hiccups, investors who know why they own a stock are less likely to panic and sell after the stock has already tanked. In addition, there are the nasty tax consequences of selling frequently. By making sure every sell decision is justified, you'll inevitably cut down on capital-gains taxes.
Avoiding impulsive selling decisions may be one of the best ways to improve long-term investment returns. While the decision to buy a stock is (or should be) the end result of an extended period of research, the decision to sell is often done in the heat of the moment, after a stock has already been crushed.
But what good does it do to sell after the stock has fallen? Whatever the bad news was, it has already been incorporated into the stock price. At this juncture, investors should ask themselves: why they own this stock. Are the reasons for owning the stock still intact? If so, the more rational reaction to a dropping stock price might be to take advantage of the lower price and buy more. Likewise, investors may actually sell off a gem of a stock just because it has had a great run. But myriad examples show that a great company can outperform the market year after year. The fact is, most of us would be better off if we could block out all those graphs of past stock performance, since they convey no information we can use profitably in the here and now.
Investors typically spend a lot of their time researching their stock purchases than they spend considering their selling decisions.
Unfortunately, selling decisions are often made in the heat of the moment, after a stock has already taken a beating in the market.
The best way to know when to sell a stock is to know why you own it in the first place.
- Did you love the company's fundamentals? Then you should know when they are changing for the worse.
- Was the company the industry leader? Then you should keep a close eye on the competition, and know when it is catching up to your company.
- Did you love the industry? Then you need to watch for an industry downturn.
- Did you buy the stock because it was undervalued? Then you should have a firm idea of what you think fair value is.
Don't Sell Based on Price Alone
You will be poorly served if you watch only your stock's price.
When markets go through one of their periodic hiccups, investors who know why they own a stock are less likely to panic and sell after the stock has already tanked. In addition, there are the nasty tax consequences of selling frequently. By making sure every sell decision is justified, you'll inevitably cut down on capital-gains taxes.
Avoiding impulsive selling decisions may be one of the best ways to improve long-term investment returns. While the decision to buy a stock is (or should be) the end result of an extended period of research, the decision to sell is often done in the heat of the moment, after a stock has already been crushed.
But what good does it do to sell after the stock has fallen? Whatever the bad news was, it has already been incorporated into the stock price. At this juncture, investors should ask themselves: why they own this stock. Are the reasons for owning the stock still intact? If so, the more rational reaction to a dropping stock price might be to take advantage of the lower price and buy more. Likewise, investors may actually sell off a gem of a stock just because it has had a great run. But myriad examples show that a great company can outperform the market year after year. The fact is, most of us would be better off if we could block out all those graphs of past stock performance, since they convey no information we can use profitably in the here and now.
Monday, 26 December 2011
The Five Year Rule for Buying a House
by
When I first considered buying a house, my entire family got involved. I have the luck of being related to real estate agents, investors and other experts that are more than happy to give advice about buying a property — even before you ask.
The first thing they asked me was exactly how long I expected to stay in the house. Most people don’t know these sorts of things for sure, but we wanted to make sure that I’d own the house for at least five years.
The Upgrade Cycle
It definitely varies by geographic area — if not by specific neighborhood — but a lot of folks in my area will buy a townhouse or condo as their starter home. After about three years, they’ll start looking for a bigger place to upgrade to, either a bigger townhouse or a standalone home. Depending on the family, that upgrade cycle can go through a couple of times as people work their way up to a house that they are happy with and is big enough for their family.
The thought seems to be that if you’re making a little more money every year, by three years out you’ll be in a position to afford a bigger house. And everyoneknows assumes that buying is more cost-effective than renting — as long as you’re paying down the principal on your mortgage, you’re going to come out ahead.
The thought seems to be that if you’re making a little more money every year, by three years out you’ll be in a position to afford a bigger house. And everyone
But with an upgrade cycle of about three years, you’re actually losing money.
The Five Year Rule
When you purchase a house, the general rule is that you want to be sure to be in the same location for at least five years. Otherwise, financially, you’re probably going to take a hit.
The first hit is your closing costs. Every time you go through closing — buying and selling — money hits the table. Depending on where your house happens to be, the buyers and sellers pay different amounts, but everyone pays something. We can easily be talking about thousands of dollars and limiting how often you have to pay out that kind of money is always a good idea.
But you take a second hit when you look at your mortgage statement to see exactly where those monthly checks you send in are going. The way mortgages are structured, you pay much more interest in the first few years that you own a house. Usually, it isn’t until you’re about five years into paying down that mortgage that you’ve made enough progress on the principal that the math actually works out that you’ve gotten a better deal than paying that monthly check to a landlord.
David’s Note: When you take out a mortgage, you are paying an interest rate on what you owe. So, in the first year, when the principal is highest, the interests you need to pay is the highest as well. However, since the monthly payment is the same through the loan (at least with a fixed rate mortgage anyway), more of the payment will be used to cover the interests payments, and therefore less goes towards the principal. As your principle goes down, your interests payments will go down, leaving more of your check to go towards the principal.
If you can wait at least five years to move, you’re in a better position to be ahead of the game.
Defeating the Five Year Rule
Five years is a generality. If you add in a couple of other factors, you can make buying a house that you don’t plan to stay in long-term a better choice.
The biggest factor is how much you’re going to pay on your mortgage. A lot of people buy as much house as they can afford, according to what lenders offer them. That’s usually the upper end of what you can financially manage. If, however, you buy at the lower end of what you can afford and make extra payments, you can pay off a bigger chunk of the principal. You need to run the numbers for the specific house you’ve got your eye on, but you can often come out ahead.
You may also consider buying a house that you won’t stay in for five years — but that you also won’t turn around and sell. It’s not out of question to purchase a home, start paying it down and fixing it up so that you can turn around and rent it out. You do need to be careful that you’re choosing a house that you can afford even if you don’t have a renter, on top of a mortgage for your next home. There are plenty of other arrangements that can work out similarly, but you need to study up on real estate before making such a choice.
But if you’re buying just on the basis of what the bank says that you can afford and you don’t want to think about it, stay in the rentals until you’re ready to spend at least five years in the same home.
David’s Note: Here is a quick and dirty formula that you can use to help you figure out whether it’s better to buy or sell that works with any duration of ownership. Try to determine the answer to: Seller and Buyer Agent Fees When You Sell + Purchase Price + Maintenance Cost for the Time of Occupancy + Interest Paid on Mortgage + Investment Gains from Your Down Payment + Taxes Paid Such as Property Tax + Closing Costs – Selling Price. This number could come out negative or positive, but if it’s lower than the rents you would have paid during the same time frame, then you would be better off buying. If the number is higher, meaning that the selling price wasn’t high enough to cover all those costs, then renting would be the more cost effective choice.
Of course, the big question mark is your selling price, which you sort of have to estimate. Also, note the obvious that the higher the selling price, the more buying makes sense. The five year rule is actually pretty arbitrary, but if you assume that the long term trend of real estate is up, do you see why buying makes sense the longer you stay in the home?
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