Help for Mounting 401(k) Losses
by Walter Updegrave
Thursday, November 27, 2008
Question: I'm retired and my 401(k) has lost approximately 35% over the past year. My financial adviser tells me to stay the course, but the losses keep mounting. What should I do? -Dale Marcos, Lafayette, Indiana
Answer: For starters, you should demand a better answer from your financial adviser. Just telling someone to "stay the course" isn't an adequate answer any time an investor expresses doubt or confusion about an investing or planning strategy, and it's certainly not an acceptable reply given the virtually unprecedented turmoil and uncertainty we're experiencing today.
More from CNNMoney.com: • How to Bet on Emerging Markets • 4 Lessons From the Financial Crisis • Whatever You Do, Don't Buy Sears
You can't blame your adviser for not foreseeing the severity of this downturn before it occurred. Nobody's crystal ball is that clear. But an adviser, or at least a good one, is supposed to help you create an investing strategy and retirement plan that can see you through a variety of economic and market scenarios.
Your adviser can't immunize you against losses altogether. That would be unrealistic if you also want your retirement savings to grow and support you for the rest of your life. But the plan should balance upside potential with some measure of downside protection that makes sense given your age, risk tolerance and your financial resources.
Most important, your adviser should be willing to get together with you in times like these to go over the plan, see if it's working as expected and discuss whether or not it needs to be revised.
On the face of it, a 35% decline over the past 12 months seems a bit much for someone who's retired. Given that stocks are down about 40% over that period and the broad bond market is flat to slightly up, that suggests a stock allocation somewhere between 80% and 90%. That strikes me as pretty risky for a retiree. But without more information about your overall finances - like whether the decline you cite includes withdrawals, what other investments you own and how heavily you'll be relying on your 401(k) for living expenses - I can't say for sure whether your 401(k) is invested too aggressively.
Ask for More Transparency
Whatever the particulars of your situation, this much is clear: You are upset about the performance of your account and you aren't getting enough feedback from your adviser to know whether the path he wants you to stay on is the right one.
Here's what I recommend. Go back to your adviser and explain that you need to know what course it is exactly that you are on and why you should stick to it. I'd ask to see how my portfolio is divvied up between stocks and bonds (as well as among different types of stocks and bonds) and I'd want an explanation of why that allocation makes sense given today's conditions.
I'd also want to see some sort of analysis that shows how much income I can reasonably expect throughout retirement from my investments, Social Security and pensions, if any, and how that income compares to my projected living expenses.
Move On
If your adviser can't or won't do this, you have two choices. You can take this kind of comprehensive look at your retirement finances on your own by revving up an online tool like Fidelity's Retirement Income Planner or T. Rowe Price's Retirement Income Calculator.
Or you can switch to an adviser who is willing to do this type of assessment for you. If you do move on to another adviser, be careful. There are lots of people with impressive-sounding credentials who really operate more as a salesman than financial adviser, looking to take advantage of fearful investors in uncertain times like these. To find a reputable adviser, search the Financial Planning Association Web site or the Garrett Planning Network.
Who knows, maybe your adviser has already revisited the advice he or she gave to you and other clients and crunched the numbers again. Perhaps that's why your adviser can so confidently tell you to stay the course. But if I were as worried as you seem to be, I'd want more convincing (and maybe a look at some alternatives) before I went along.
E-mail Updegrave at wupdegrave@moneymail.com.
Copyrighted, CNNMoney. All Rights Reserved.
http://finance.yahoo.com/focus-retirement/article/106216/Help-for-Mounting-401(k)-Losses;_ylt=ApmNvqTpXRlKoIp6cJnk1T67YWsA?mod=retirement-401k
Friday 28 November 2008
Thursday 27 November 2008
**Understanding the Power of Compounding
Understanding the Power of Compounding
Compounding in Action
The investment rate assumes a return net of taxes and fees.
The effect of inflation on the purchasing power of the FV can be offset by increasing your annual contributions by a like percentage. As your income increases, so too should your investment contributions.
-----
The Future Value of investing $1,000 per annum, when compounded by the annual rate of 6% for the number of years are as shown below:
Rate 6%
Years... FV
10 years 13,181
20 years 36,786
30 years 70,058
40 years 154,762
50 years 290,336
The once-only lump sum invested at the same annual rate for the years to provide the same FV as the corresponding sum are as shown here:
Years... Initial once-only lump sum
10 years 7,360
20 years 11,470
30 years 13,765
40 years 15,046
50 years 15,762
A lump sum of $7360 invested for 10 years at 6 percent will produce the same FV ($13,181) as $1000 a year for 10 years.
-----
The Future Value of investing $1,000 per annum, when compounded by the annual rate of 8% for the number of years are as shown below:
Rate 8%
Years... FV
10 years 14,487
20 years 45,762
30 years 113,283
40 years 259,057
50 years 573,770
The once-only lump sum invested at the same annual rate for the years to provide the same FV as the corresponding sum are as shown here:
Years... Initial once-only lump sum
10 years 6,710
20 years 9,818
30 years 11,258
40 years 11,925
50 years 12,233
A lump sum of $6,710 invested for 10 years at 8 percent will produce the same FV ($14,487) as $1000 a year for 10 years.
-----
The Future Value of investing $1,000 per annum, when compounded by the annual rate of 10% for the number of years are as shown below:
Rate 10%
Years... FV
10 years 15,937
20 years 57,275
30 years 164,494
40 years 442,593
50 years 1,163,909
The once-only lump sum invested at the same annual rate for the years to provide the same FV as the corresponding sum are as shown here:
Years... Initial once-only lump sum
10 years 6,145
20 years 8,514
30 years 9,427
40 years 9,779
50 years 9.915
A lump sum of $6,145 invested for 10 years at 10 percent will produce the same FV ($15,937) as $1000 a year for 10 years.
-----
The Future Value of investing $1,000 per annum, when compounded by the annual rate of 12% for the number of years are as shown below:
Rate 12%
Years... FV
10 years 17,549
20 years 72,052
30 years 241,333
40 years 767,091
50 years 2,400,018
The once-only lump sum invested at the same annual rate for the years to provide the same FV as the corresponding sum are as shown here:
Years... Initial once-only lump sum
10 years 5,650
20 years 7,469
30 years 8,055
40 years 8,244
50 years 8,304
A lump sum of $5,650 invested for 10 years at 15 percent will produce the same FV ($17,549) as $1000 a year for 10 years.
-----
The Future Value of investing $1,000 per annum, when compounded by the annual rate of 15% for the number of years are as shown below:
Rate 15%
Years... FV
10 years 20,304
20 years 102,444
30 years 434,745
40 years 1,779,090
50 years 7,217,716
The once-only lump sum invested at the same annual rate for the years to provide the same FV as the corresponding sum are as shown here:
Years... Initial once-only lump sum
10 years 5,019
20 years 6,259
30 years 6,566
40 years 6,642
50 years 6,661
A lump sum of $5,019 invested for 10 years at 15 percent will produce the same FV ($20,304) as $1000 a year for 10 years.
-----
Note:
It is not so much the increase in FV over the early 10-year periods of the savings plan, but the increase over the final 10-year period that yields the big bucks.
For instance, if we reference the compounding at 10 percent, FV increased by $41,338 between years 10 and 20, while the increase between years 40 and 50 was $721,316.
Thereafter, if you start your investment plan at age 30 rather than 20, the $1,000 a year you spent before that rather than invested will have cost you $721,316.
The greatest deterrent to an investment plan is not so much the fortitude to put aside a small percentage of income, but the willpower not to steal from the fund until your regular employment income ceases. Anyone can become rich if they start an investment plan early in life.
Of course, the more you love your work, the longer you will be employed and the more savings you will accumulate. If you find the thought of working until you are 70 abhorrent, then the thought of working at 30 or 40 years of age will be even less attractive; in which case, investing is probably irrelevant because you’re going to have a miserable or unfulfilled life anyway. People who hate working are more likely to become welfare dependent.
Lump sum investing
A lump sum of $7,360 invested for 10 years at 6 percent will produce the same FV ($13,181) as $1,000 a year for 10 years.
A lump sum of $9,779 invested for 40 years at 10 percent will produce the same FV ($442,593) as $1,000 a year for 40 years.
If the same lump sum were invested 10 years earlier – that is, allowed to compound for 50 years, rather than 40 – the nest egg will be boosted by a further $705,372 to $1,147,965.
Have you ever thought about putting something aside for your kids that they can’t touch for 50 years?
Sentiment and moral gratification usually centre on diminishing their incentive to achieve their own sense of self-satisfaction by helping them when they get married or want to buy a house.
If they are like 98 percent of people, the time they really need financial help is after they have lived the good life and have limited savings and no career income.
Material assets are not so important when you have the greatest asset of all: youth.
Related readings:
Oriental Holdings Bhd: The Buy-Hold Advantage
http://www.horizon.my/2008/11/oriental-holdings-bhd-the-buy-hold-advantage/
Oriental Holdings Berhad - What if You had Bought and Held? I happened to be reading the Annual Report of Oriental Holdings Berhad (ORIENT) the other day and came across a statement by Chairman Dato Loh Cheng Yean:
“A holding of 1,000 stocks in Oriental when it was listed in 1964 would translate into 40,255 Oriental stocks worth RM263,670, based on the share price of RM6.55 at the end of 2007. In addition the stocks would have earned a total gross dividend of RM137,660. The gross dividends received and the appreciation in value is equivalent to a remarkable average rate of return of 14.60% for each of the 44 years.”
This sounds pretty good… see once again we’re talking 40 years. I find Oriental Holdings to be quite “remarkable” because it is such a diverse collection of different businesses which include auto assembly, auto parts manufacturing, oil palm, hotels, property etc. But 85% of its RM498 million Operating Profit is from auto and oil palm.
The Story of Anne Scheiber
http://www.horizon.my/2008/11/the-story-of-anne-scheiber/
Maxwell recounts the story of Anne Scheiber, an elderly and thrifty lady who lived in New York and worked for the Inland Revenue Service. When Scheiber retired at age fifty-one, she was only making $3,150 a year. She was treated poorly by her employer and was never promoted. Yet when Anne Scheiber died in 1995 at the age of 101, it was discovered that she left an estate to Yeshiva University worth US$22 million!
How did a public service worker with minimal salary accumulate such a staggering wealth?
Comments by: banking88 on November 25th, 2008 12:13 pm
yes, the key is to invest for the long-term…your wealth would multiply with componding returns…now it’s a good time to enter the market using the dollar cost averaging method…
Compounding in Action
The investment rate assumes a return net of taxes and fees.
The effect of inflation on the purchasing power of the FV can be offset by increasing your annual contributions by a like percentage. As your income increases, so too should your investment contributions.
-----
The Future Value of investing $1,000 per annum, when compounded by the annual rate of 6% for the number of years are as shown below:
Rate 6%
Years... FV
10 years 13,181
20 years 36,786
30 years 70,058
40 years 154,762
50 years 290,336
The once-only lump sum invested at the same annual rate for the years to provide the same FV as the corresponding sum are as shown here:
Years... Initial once-only lump sum
10 years 7,360
20 years 11,470
30 years 13,765
40 years 15,046
50 years 15,762
A lump sum of $7360 invested for 10 years at 6 percent will produce the same FV ($13,181) as $1000 a year for 10 years.
-----
The Future Value of investing $1,000 per annum, when compounded by the annual rate of 8% for the number of years are as shown below:
Rate 8%
Years... FV
10 years 14,487
20 years 45,762
30 years 113,283
40 years 259,057
50 years 573,770
The once-only lump sum invested at the same annual rate for the years to provide the same FV as the corresponding sum are as shown here:
Years... Initial once-only lump sum
10 years 6,710
20 years 9,818
30 years 11,258
40 years 11,925
50 years 12,233
A lump sum of $6,710 invested for 10 years at 8 percent will produce the same FV ($14,487) as $1000 a year for 10 years.
-----
The Future Value of investing $1,000 per annum, when compounded by the annual rate of 10% for the number of years are as shown below:
Rate 10%
Years... FV
10 years 15,937
20 years 57,275
30 years 164,494
40 years 442,593
50 years 1,163,909
The once-only lump sum invested at the same annual rate for the years to provide the same FV as the corresponding sum are as shown here:
Years... Initial once-only lump sum
10 years 6,145
20 years 8,514
30 years 9,427
40 years 9,779
50 years 9.915
A lump sum of $6,145 invested for 10 years at 10 percent will produce the same FV ($15,937) as $1000 a year for 10 years.
-----
The Future Value of investing $1,000 per annum, when compounded by the annual rate of 12% for the number of years are as shown below:
Rate 12%
Years... FV
10 years 17,549
20 years 72,052
30 years 241,333
40 years 767,091
50 years 2,400,018
The once-only lump sum invested at the same annual rate for the years to provide the same FV as the corresponding sum are as shown here:
Years... Initial once-only lump sum
10 years 5,650
20 years 7,469
30 years 8,055
40 years 8,244
50 years 8,304
A lump sum of $5,650 invested for 10 years at 15 percent will produce the same FV ($17,549) as $1000 a year for 10 years.
-----
The Future Value of investing $1,000 per annum, when compounded by the annual rate of 15% for the number of years are as shown below:
Rate 15%
Years... FV
10 years 20,304
20 years 102,444
30 years 434,745
40 years 1,779,090
50 years 7,217,716
The once-only lump sum invested at the same annual rate for the years to provide the same FV as the corresponding sum are as shown here:
Years... Initial once-only lump sum
10 years 5,019
20 years 6,259
30 years 6,566
40 years 6,642
50 years 6,661
A lump sum of $5,019 invested for 10 years at 15 percent will produce the same FV ($20,304) as $1000 a year for 10 years.
-----
Note:
It is not so much the increase in FV over the early 10-year periods of the savings plan, but the increase over the final 10-year period that yields the big bucks.
For instance, if we reference the compounding at 10 percent, FV increased by $41,338 between years 10 and 20, while the increase between years 40 and 50 was $721,316.
Thereafter, if you start your investment plan at age 30 rather than 20, the $1,000 a year you spent before that rather than invested will have cost you $721,316.
The greatest deterrent to an investment plan is not so much the fortitude to put aside a small percentage of income, but the willpower not to steal from the fund until your regular employment income ceases. Anyone can become rich if they start an investment plan early in life.
Of course, the more you love your work, the longer you will be employed and the more savings you will accumulate. If you find the thought of working until you are 70 abhorrent, then the thought of working at 30 or 40 years of age will be even less attractive; in which case, investing is probably irrelevant because you’re going to have a miserable or unfulfilled life anyway. People who hate working are more likely to become welfare dependent.
Lump sum investing
A lump sum of $7,360 invested for 10 years at 6 percent will produce the same FV ($13,181) as $1,000 a year for 10 years.
A lump sum of $9,779 invested for 40 years at 10 percent will produce the same FV ($442,593) as $1,000 a year for 40 years.
If the same lump sum were invested 10 years earlier – that is, allowed to compound for 50 years, rather than 40 – the nest egg will be boosted by a further $705,372 to $1,147,965.
Have you ever thought about putting something aside for your kids that they can’t touch for 50 years?
Sentiment and moral gratification usually centre on diminishing their incentive to achieve their own sense of self-satisfaction by helping them when they get married or want to buy a house.
If they are like 98 percent of people, the time they really need financial help is after they have lived the good life and have limited savings and no career income.
Material assets are not so important when you have the greatest asset of all: youth.
Related readings:
Oriental Holdings Bhd: The Buy-Hold Advantage
http://www.horizon.my/2008/11/oriental-holdings-bhd-the-buy-hold-advantage/
Oriental Holdings Berhad - What if You had Bought and Held? I happened to be reading the Annual Report of Oriental Holdings Berhad (ORIENT) the other day and came across a statement by Chairman Dato Loh Cheng Yean:
“A holding of 1,000 stocks in Oriental when it was listed in 1964 would translate into 40,255 Oriental stocks worth RM263,670, based on the share price of RM6.55 at the end of 2007. In addition the stocks would have earned a total gross dividend of RM137,660. The gross dividends received and the appreciation in value is equivalent to a remarkable average rate of return of 14.60% for each of the 44 years.”
This sounds pretty good… see once again we’re talking 40 years. I find Oriental Holdings to be quite “remarkable” because it is such a diverse collection of different businesses which include auto assembly, auto parts manufacturing, oil palm, hotels, property etc. But 85% of its RM498 million Operating Profit is from auto and oil palm.
The Story of Anne Scheiber
http://www.horizon.my/2008/11/the-story-of-anne-scheiber/
Maxwell recounts the story of Anne Scheiber, an elderly and thrifty lady who lived in New York and worked for the Inland Revenue Service. When Scheiber retired at age fifty-one, she was only making $3,150 a year. She was treated poorly by her employer and was never promoted. Yet when Anne Scheiber died in 1995 at the age of 101, it was discovered that she left an estate to Yeshiva University worth US$22 million!
How did a public service worker with minimal salary accumulate such a staggering wealth?
Comments by: banking88 on November 25th, 2008 12:13 pm
yes, the key is to invest for the long-term…your wealth would multiply with componding returns…now it’s a good time to enter the market using the dollar cost averaging method…
To Upgrade the Quality of Your Portfolio
To upgrade the quality of your portfolio
For those who already hold a portfolio of stocks that may have been selected without reference to value, a culling approach to upgrade the quality of your portfolio by replacing overpriced stocks with those offering better value, would be suggested.
Although it is probable that you hold some stocks that should be sold immediately, in making that determination you must be sure of what you are doing and not act with undue haste.
Solicit advice and input from others you respect, but keep your own counsel and do not be influenced by those whose knowledge is unlikely to be superior to your own.
Let’s also consider some basic selling issues:
Tax
Let’s say you buy a stock for $5 and it rises to $15 when its value is $11. If you sell it for $15 and the $10 profit was subject to 40 percent tax, you would be left with $11. If you consider that $11 would be a good price at which to buy the stock, there is not much point in selling at the same net price.
Management
Great businesses with sound corporate management are quite rare. If you are invested in such a company, selling and attempting to find a replacement with similar management qualities is likely to be difficult. Buffett says he is wary of the risk in switching allegiance to people less well known to him.
Fear of not being able to buy back at a better price.
For those who already hold a portfolio of stocks that may have been selected without reference to value, a culling approach to upgrade the quality of your portfolio by replacing overpriced stocks with those offering better value, would be suggested.
Although it is probable that you hold some stocks that should be sold immediately, in making that determination you must be sure of what you are doing and not act with undue haste.
Solicit advice and input from others you respect, but keep your own counsel and do not be influenced by those whose knowledge is unlikely to be superior to your own.
Let’s also consider some basic selling issues:
Tax
Let’s say you buy a stock for $5 and it rises to $15 when its value is $11. If you sell it for $15 and the $10 profit was subject to 40 percent tax, you would be left with $11. If you consider that $11 would be a good price at which to buy the stock, there is not much point in selling at the same net price.
Management
Great businesses with sound corporate management are quite rare. If you are invested in such a company, selling and attempting to find a replacement with similar management qualities is likely to be difficult. Buffett says he is wary of the risk in switching allegiance to people less well known to him.
Fear of not being able to buy back at a better price.
Think Availability of Opportunities
Think Availability of Opportunities; Not Diversification or Acting Contrary to the Market
Portfolio Diversification
Towards the end of a bull market, when selling presents more opportunities than buying, the cash and interest-bearing securities will be quite high. In the tail-end of a bear market, when opportunities are more plentiful, the cash and interest-bearing securities might be close to zero.
The amount of cash and interest-bearing securities you carry will depend on several factors, not the least important of which is your comfort level with the price volatility of equities.
Think of the Availability of Opportunities
Conventional wisdom tells us a portfolio should be spread over a diversified range of industries on the premise that a downturn in one sector of the economy will only affect a portion of your portfolio. A contrarian would argue that you should only buy into an industry that is suffering a downturn because prices will be cheap.
However, think not in terms of diversification or acting contrary to the market, but of the availability of opportunities.
Remember Mae West’s words: “Too much of a good thing can be wonderful”. Mae, however, was a woman of experience with the ability to know a good thing. Lacking that same experience, or the necessary time to acquire it, it’s easier to recognize and avoid what is not a good thing.
This approach will not guarantee that every selection will be wonderful. It may even eliminate a few stocks that may have turned out to be wonderful, but in eliminating most of what is likely to be a lot less than wonderful, it should deliver above-average results.
Portfolio Diversification
There can be no hard and fast rules about diversifying. However, a portfolio should contain a certain amount of cash and interest-bearing securities. These should be weighted towards
- higher yielding secure preference shares that have no downside price risk on conversion and
- property trusts or REITS that have low profit and price volatility.
Towards the end of a bull market, when selling presents more opportunities than buying, the cash and interest-bearing securities will be quite high. In the tail-end of a bear market, when opportunities are more plentiful, the cash and interest-bearing securities might be close to zero.
The amount of cash and interest-bearing securities you carry will depend on several factors, not the least important of which is your comfort level with the price volatility of equities.
Think of the Availability of Opportunities
Conventional wisdom tells us a portfolio should be spread over a diversified range of industries on the premise that a downturn in one sector of the economy will only affect a portion of your portfolio. A contrarian would argue that you should only buy into an industry that is suffering a downturn because prices will be cheap.
However, think not in terms of diversification or acting contrary to the market, but of the availability of opportunities.
Remember Mae West’s words: “Too much of a good thing can be wonderful”. Mae, however, was a woman of experience with the ability to know a good thing. Lacking that same experience, or the necessary time to acquire it, it’s easier to recognize and avoid what is not a good thing.
This approach will not guarantee that every selection will be wonderful. It may even eliminate a few stocks that may have turned out to be wonderful, but in eliminating most of what is likely to be a lot less than wonderful, it should deliver above-average results.
How many stocks should you hold?
How many stocks should you hold?
The proprietor or manager of a business is likely to have only one investment, his or her business – nothing wrong with that.
Most equity funds hold many stocks – nothing wrong with that either. In recognizing its limitations, management is minimizing the impact of mistakes. The last thing you want if someone who doesn’t know what he or she is doing investing your money in a handful of stocks.
As an individual investor, having a few hundred dollars in each of very many stocks is obviously not economical in terms of brokerage fees, administration and time devoted to following each stock. Availability of worthwhile opportunities, aversion to risk, size of portfolio and level of expertise all contribute to the number of stocks you should hold.
If you know what you are doing and have the time to do research, as a rough guide, the maximum stocks to be held should be the lesser of 15 or the square root (to the nearest whole number) of the collective market prices of the portfolio divided by 1000. So a portfolio priced at $9000 would contain 3 stocks. (Square root of 9000/1000 = square root of 9 = 3)
For example:
Value of portfolio…. Maximum Number of stocks
$4000……..2
$9000……..3
$16,000…….4
$25,000…….5
$36,000…….6
$49,000…....7
$64,000…....8
$81,000…....9
$100,000…..10
$121,000…..11
$144,000…..12
$169,000…..13
$196,000…..14
$225,000+…..15 (Maximum)
The proprietor or manager of a business is likely to have only one investment, his or her business – nothing wrong with that.
Most equity funds hold many stocks – nothing wrong with that either. In recognizing its limitations, management is minimizing the impact of mistakes. The last thing you want if someone who doesn’t know what he or she is doing investing your money in a handful of stocks.
As an individual investor, having a few hundred dollars in each of very many stocks is obviously not economical in terms of brokerage fees, administration and time devoted to following each stock. Availability of worthwhile opportunities, aversion to risk, size of portfolio and level of expertise all contribute to the number of stocks you should hold.
If you know what you are doing and have the time to do research, as a rough guide, the maximum stocks to be held should be the lesser of 15 or the square root (to the nearest whole number) of the collective market prices of the portfolio divided by 1000. So a portfolio priced at $9000 would contain 3 stocks. (Square root of 9000/1000 = square root of 9 = 3)
For example:
Value of portfolio…. Maximum Number of stocks
$4000……..2
$9000……..3
$16,000…….4
$25,000…….5
$36,000…….6
$49,000…....7
$64,000…....8
$81,000…....9
$100,000…..10
$121,000…..11
$144,000…..12
$169,000…..13
$196,000…..14
$225,000+…..15 (Maximum)
Wednesday 26 November 2008
Dollar cost averaging investor
By investing equal amounts of cash each year, fewer stocks will be acquired when prices are higher and more when prices are lower. It is therefore an ideal way of investing for those with a regular savings plan.
In disaster years when the market was down, the price value of the investor's holding bottomed, but it was the additional units bought in these disaster years when prices were low that enabled a positive overall return. A particular year that was considered to be a great year for the stock market, was also the worst year for our dollar cost averaging investor.
By investing a portion of annual income once a year in good businesses, young investors need not care what happens to the price. Rather than cause for gloom, market crashes are a reason for celebration.
In disaster years when the market was down, the price value of the investor's holding bottomed, but it was the additional units bought in these disaster years when prices were low that enabled a positive overall return. A particular year that was considered to be a great year for the stock market, was also the worst year for our dollar cost averaging investor.
By investing a portion of annual income once a year in good businesses, young investors need not care what happens to the price. Rather than cause for gloom, market crashes are a reason for celebration.
Slow consistent accumulation through the power of compounding
Investing is not about making a quick kill, but slow and consistent accumulation through the power of compounding.
Sometimes, exceptional results will occur through the catch-up process of buying underpriced stocks or excessive market pricing, but unless you really know what you are doing, never gamble on chasing quick returns by being enticed to buy on margin.
Most individuals trading in highly leveraged futures are eventually wiped out by their lack of staying power when exceptional price volatility extinguishes their small percentage of equity. Losing a bet in which you can be 100 percent right with your choice but 1 percent wrong with the timing doesn't seem very good odds. Making money is nice, but peace of mind is much more valuable.
Sometimes, exceptional results will occur through the catch-up process of buying underpriced stocks or excessive market pricing, but unless you really know what you are doing, never gamble on chasing quick returns by being enticed to buy on margin.
Most individuals trading in highly leveraged futures are eventually wiped out by their lack of staying power when exceptional price volatility extinguishes their small percentage of equity. Losing a bet in which you can be 100 percent right with your choice but 1 percent wrong with the timing doesn't seem very good odds. Making money is nice, but peace of mind is much more valuable.
Best companies to invest in
Positive attributes to look for
So long as ROE is not overly leveraged by too much interest-bearing debt, the best companies in which to invest have a high ROE and a proven ability to reinvest a good proportion of profits without negatively affecting their ROE.
A company with a high ROE that distributes all, or close to all, profits is telling you that while it's a good business, it lacks the opportunity to grow. For instance, the sole local newspaper might be highly profitable by virtue of its monopoly, but opportunities to start a new paper or to buy an existing paper at a favourable price are likely to be rare. Profit growth is therefore limited to circulation growth. Such companies have the investment characteristics of an interest-bearing security - yield, but little or no growth - and must be valued accordingly.
Businesses that have historically long-term high ROEs with a high reinvestment rate have a sustainable competitive advantage that is difficult to duplicate. They have established brand-name products or services, patent rights, an established market niche or an innovative business model.
Although businesses with these qualities will not be selling at bargain prices, we can afford to pay a premium for a great business and still achieve a high return in the long term. The club of great businesses is not a closed shop, so watch out for new additions among smaller, less recognized companies that display these attributes.
So long as ROE is not overly leveraged by too much interest-bearing debt, the best companies in which to invest have a high ROE and a proven ability to reinvest a good proportion of profits without negatively affecting their ROE.
A company with a high ROE that distributes all, or close to all, profits is telling you that while it's a good business, it lacks the opportunity to grow. For instance, the sole local newspaper might be highly profitable by virtue of its monopoly, but opportunities to start a new paper or to buy an existing paper at a favourable price are likely to be rare. Profit growth is therefore limited to circulation growth. Such companies have the investment characteristics of an interest-bearing security - yield, but little or no growth - and must be valued accordingly.
Businesses that have historically long-term high ROEs with a high reinvestment rate have a sustainable competitive advantage that is difficult to duplicate. They have established brand-name products or services, patent rights, an established market niche or an innovative business model.
Although businesses with these qualities will not be selling at bargain prices, we can afford to pay a premium for a great business and still achieve a high return in the long term. The club of great businesses is not a closed shop, so watch out for new additions among smaller, less recognized companies that display these attributes.
Tuesday 25 November 2008
Ben Graham Checklist for Finding Undervalued Stocks
In addition to identifying and quantifying important value components, Graham left us with an assortment of general stock selection rules. He created a number of checklists at different times in his career to serve different investment objectives and portfolio strategies. The checklists review different aspects of a company's financial strength, intrinsic value, and the realtionship with price.
Here is a
Ben Graham Checklist for Finding Undervalued Stocks
Criterias
Risk
1. Earnings to price (the inverse of P/E) is double the high-grade corporate bond yield. If the high-grade bond yields 7%, then earnings to price should be 14%.
2. P/E ratio that is 0.4 times the highest average P/E achieved in the last 5 years.
3. Dividend yield is 2/3 the high-grade bond yield.
4. Stock price of 2/3 the tangible book value per share.
5. Stock price of 2/3 the net current asset value.
Financial strength
6. Total debt is lower than tangible book value.
7. Current ratio (current assets/current liabilities) is greater than 2.
8. Total debt is no more than liquidation value.
Earnings stability
9. Earnings have doubled in most recent 10 years.
10. Earnings have declined no more than 5% in 2 of the past 10 years.
If a stock meets 7 of the 10 criteria, it is probably a good value, according to Graham.
If you're income oriented, Graham recommended paying special attention to items 1 through 7.
If you're concerned about growth and safety, items 1 through 5 and 9 and 10 are important.
If you're concerned with aggressive growth, ignore item 3, reduce the emphasis on 4 through 6, and weigh 9 and 10 heavily.
Again, these checklists are a guideline and example, not a cookbook recipe you should follow precisely. They are a way of thinking and an example of how you may construct your own value investing system.
The criteria mentioned above are probably more focussed on dividends and safety than even today's value investors choose to be. But today's value investing practice owes an immense debt to this type of financial and investment analysis.
Spreadsheet for finding Undervalue Stocks
http://spreadsheets.google.com/pub?key=tZGNWHLD2d2nTgCcxSKyoCA&output=html
Reference: 20.11.2008 - KLSE MARKET PE
Here is a
Ben Graham Checklist for Finding Undervalued Stocks
Criterias
Risk
1. Earnings to price (the inverse of P/E) is double the high-grade corporate bond yield. If the high-grade bond yields 7%, then earnings to price should be 14%.
2. P/E ratio that is 0.4 times the highest average P/E achieved in the last 5 years.
3. Dividend yield is 2/3 the high-grade bond yield.
4. Stock price of 2/3 the tangible book value per share.
5. Stock price of 2/3 the net current asset value.
Financial strength
6. Total debt is lower than tangible book value.
7. Current ratio (current assets/current liabilities) is greater than 2.
8. Total debt is no more than liquidation value.
Earnings stability
9. Earnings have doubled in most recent 10 years.
10. Earnings have declined no more than 5% in 2 of the past 10 years.
If a stock meets 7 of the 10 criteria, it is probably a good value, according to Graham.
If you're income oriented, Graham recommended paying special attention to items 1 through 7.
If you're concerned about growth and safety, items 1 through 5 and 9 and 10 are important.
If you're concerned with aggressive growth, ignore item 3, reduce the emphasis on 4 through 6, and weigh 9 and 10 heavily.
Again, these checklists are a guideline and example, not a cookbook recipe you should follow precisely. They are a way of thinking and an example of how you may construct your own value investing system.
The criteria mentioned above are probably more focussed on dividends and safety than even today's value investors choose to be. But today's value investing practice owes an immense debt to this type of financial and investment analysis.
Spreadsheet for finding Undervalue Stocks
http://spreadsheets.google.com/pub?key=tZGNWHLD2d2nTgCcxSKyoCA&output=html
Reference: 20.11.2008 - KLSE MARKET PE
Impact of Interest Rates on Stock Prices
Impact of Interest Rates on Stock Prices
Warren Buffett highlighted the impact of interest rates on the Dow in a speech he gave on the stock market in July 1999. To demonstrate the correlation between interest rates and stock prices, with the exception of the inflation figures, he provided the data below which depicts two 17-year periods, between 1964 and 1981, and 1981 to 1998.
31st December
Gain in GNP over each 17 year period (%)
1964 – 1981…..373
1981 – 1998…..177
DJIA
1964—874
1981-- 875
1998--9181
Interest on long term government bonds (%)
1964-- 4.20
1981-- 13.65
1998-- 5.09
Increase in consumer price index over each 17 year period (%)
1964 – 1981…..201
1981 – 1998……74
Note:
The inflationary effect on asset values together with retained profits and new capital issues would have significantly increased the book values of the companies comprising the Dow during the first period 1964 – 1981. Yet, in spite of the huge increase in GNP, the 1964 index figure was basically the same 17 years later. Prices had been subdued by a more than threefold increase in interest rates.
In the second 17-year period from 1981 to 1998, in spite of GNP growth and inflation being less than 50 percent of the first period, the Dow increased by 949 percent. The driving factor was declining interest rates that diverted money out of interest-bearing securities into equities.
Interest rates increase at times of high inflation partly to offset the diminishing value of money and the government’s desire to curb demand in what is seen to be, as measured by GNP, a fast-growing economy. Conversely, when inflation subsided in the second 17-year period, interest rates declined.
Warren Buffett highlighted the impact of interest rates on the Dow in a speech he gave on the stock market in July 1999. To demonstrate the correlation between interest rates and stock prices, with the exception of the inflation figures, he provided the data below which depicts two 17-year periods, between 1964 and 1981, and 1981 to 1998.
31st December
Gain in GNP over each 17 year period (%)
1964 – 1981…..373
1981 – 1998…..177
DJIA
1964—874
1981-- 875
1998--9181
Interest on long term government bonds (%)
1964-- 4.20
1981-- 13.65
1998-- 5.09
Increase in consumer price index over each 17 year period (%)
1964 – 1981…..201
1981 – 1998……74
Note:
The inflationary effect on asset values together with retained profits and new capital issues would have significantly increased the book values of the companies comprising the Dow during the first period 1964 – 1981. Yet, in spite of the huge increase in GNP, the 1964 index figure was basically the same 17 years later. Prices had been subdued by a more than threefold increase in interest rates.
In the second 17-year period from 1981 to 1998, in spite of GNP growth and inflation being less than 50 percent of the first period, the Dow increased by 949 percent. The driving factor was declining interest rates that diverted money out of interest-bearing securities into equities.
Interest rates increase at times of high inflation partly to offset the diminishing value of money and the government’s desire to curb demand in what is seen to be, as measured by GNP, a fast-growing economy. Conversely, when inflation subsided in the second 17-year period, interest rates declined.
Economic Impact of Interest Rates and the Japanese Economy
Economic Impact of Interest Rates
There is a tendency to forget that for every borrower there is a lender and that interest rates work both ways. Less interest paid by borrowers means less interest received by lenders. When interest rates rise or fall, total disposable income doesn’t change; it simply redistributes.
Effect of rising interest rates on consumers
1. Consumer demand declines because the forced reduction in consumption by the greater number of borrowers is greater than the increased consumption of the lesser number of lenders.
2. Reduced demand is said to dampen inflationary impact of rising prices.
3. Budget-strapped families are forced to work extra hours or family member to seek part-time work.
4. The subsequent increase in availability of labour reduces pressure on wage demands.
Effect of interest rates rise on highly leveraged businesses
1. Profitability of highly leveraged businesses is reduced by their high cost of debt. Main impact on profitability is felt by exporters.
2. More foreign capital inflows are attracted by the higher interest rates which increases the exchange rate, consequently reducing the value of exports in the domestic currency.
3. Lower export output means reduced demand for labour and consequent further restraint on wage increases.
4. Higher exchange rate also means that the lower cost of imports will reduce prices
5. Reduced labour demand in industries competing with imported goods stabilizes costs by again increasing the availability of labour.
Effect of falling interest rates
1. Debtors are rewarded and more inclined to be financially irresponsible.
2. Those who have been prudent in accumulating savings in interest-bearing securities are penalized and less inclined to be prudent in the future. (Given the impact of a 40 percent tax rate and 3 percent inflation on an interest rate of 5 percent, the zero return (5 percent x 60 percent – 3 percent) provides zero incentive for prudence.)
3. Although serving short-term political objectives and rescuing overleveraged debtors, the longer-term effects of artificially low interest rates have proven to be undesirable.
Low Interest rates and The Japanese Economy
Any doubt about the effectiveness of low interest rates to stimulate the real economy should have been dispelled by the well-publicised Japanese experience. In spite of having interest rates close to zero and the government running a huge annual deficit, thus leaving more disposable income in the hands of the consumers, Japan has suffered a lingering recession since 1990.
The Nikkei 225 index’s loss of one-third of its value in the past 20 years can only be attributed to the low profitability of Japan’s corporations. Even with the leverage of close to zero interest rates, the ROE of Japan’s large nonfinancial firms fell from 8.2 percent in 1988 to an average of 3.1 percent between 1992 and 1999. It has since recovered to roughly 10 percent in 2007, but still lags a long way behind higher-interest-rate countries.
The real determinant of economic viability, ROFE (Returns on Funds Employed), would obviously be considerably lower than the quoted ROEs. When debt servicing is of no concern, inefficiencies creep into the business and the economic viability of capex becomes less important.
The prices of those wonderful products we buy from Japan are subsidized by shareholders of Japanese corporations. Little wonder that Buffett, when asked about investing in Japan in 2007, wryly commented that the profitability of Japanese companies was too low for Berkshire’s liking.
Although Japanese corporate profitability is improving, by Western standards most of its major corporations have not been economically viable in the past, and if required to pay equitable rates of interest, would be in serious financial difficulty.
The high Nikkei index PE ratio in 2007 of 18 (price-to-book value of 1.9) on average ROEs of 10 percent is influenced by the meager average dividend yield of 1.1 percent still being better than leaving money in the bank.
With so little incentive to invest and debt so cheap, it is not surprising that in 2005 Japan was the world’s largest consumer of luxury goods, accounting for 41 percent. Rather than working in favour of Japanese investors, low interest rates over the past 20 years have decimated their funds. Although low domestic rates persist, demand for Japanese stocks will remain high and they will therefore continue to be grossly overpriced.
The reason Japan keeps rates so low is to encourage an outflow of capital to dampen the yen exchange rate to help its exporters. In other words, domestic employment is the prime motivation. If Japan’s trade surplus were repatriated, rather than being left abroad, the US dollar would crumble and the yen appreciate to a level that would make life even tougher, perhaps impossible, for many Japanese exporters.
Here is a simple question to see whether you have been following the argument.
Given a Nikkei index figure of 16,500 and the abovementioned ROE (10 percent) and price to book value (1.9), what would the Nikkei index need to be to achieve a 10 percent return from an index fund that replicated it? Answer: 8684
When ROE and RR (Rate of Return) are equal, value is equal to book value. Therefore, 16,500 / 1.9 (price to book value) = 8684.
These are the sorts of things to consider when thinking about investing in international funds.
Related article: 20.11.2008 - KLSE MARKET PE
There is a tendency to forget that for every borrower there is a lender and that interest rates work both ways. Less interest paid by borrowers means less interest received by lenders. When interest rates rise or fall, total disposable income doesn’t change; it simply redistributes.
Effect of rising interest rates on consumers
1. Consumer demand declines because the forced reduction in consumption by the greater number of borrowers is greater than the increased consumption of the lesser number of lenders.
2. Reduced demand is said to dampen inflationary impact of rising prices.
3. Budget-strapped families are forced to work extra hours or family member to seek part-time work.
4. The subsequent increase in availability of labour reduces pressure on wage demands.
Effect of interest rates rise on highly leveraged businesses
1. Profitability of highly leveraged businesses is reduced by their high cost of debt. Main impact on profitability is felt by exporters.
2. More foreign capital inflows are attracted by the higher interest rates which increases the exchange rate, consequently reducing the value of exports in the domestic currency.
3. Lower export output means reduced demand for labour and consequent further restraint on wage increases.
4. Higher exchange rate also means that the lower cost of imports will reduce prices
5. Reduced labour demand in industries competing with imported goods stabilizes costs by again increasing the availability of labour.
Effect of falling interest rates
1. Debtors are rewarded and more inclined to be financially irresponsible.
2. Those who have been prudent in accumulating savings in interest-bearing securities are penalized and less inclined to be prudent in the future. (Given the impact of a 40 percent tax rate and 3 percent inflation on an interest rate of 5 percent, the zero return (5 percent x 60 percent – 3 percent) provides zero incentive for prudence.)
3. Although serving short-term political objectives and rescuing overleveraged debtors, the longer-term effects of artificially low interest rates have proven to be undesirable.
Low Interest rates and The Japanese Economy
Any doubt about the effectiveness of low interest rates to stimulate the real economy should have been dispelled by the well-publicised Japanese experience. In spite of having interest rates close to zero and the government running a huge annual deficit, thus leaving more disposable income in the hands of the consumers, Japan has suffered a lingering recession since 1990.
The Nikkei 225 index’s loss of one-third of its value in the past 20 years can only be attributed to the low profitability of Japan’s corporations. Even with the leverage of close to zero interest rates, the ROE of Japan’s large nonfinancial firms fell from 8.2 percent in 1988 to an average of 3.1 percent between 1992 and 1999. It has since recovered to roughly 10 percent in 2007, but still lags a long way behind higher-interest-rate countries.
The real determinant of economic viability, ROFE (Returns on Funds Employed), would obviously be considerably lower than the quoted ROEs. When debt servicing is of no concern, inefficiencies creep into the business and the economic viability of capex becomes less important.
The prices of those wonderful products we buy from Japan are subsidized by shareholders of Japanese corporations. Little wonder that Buffett, when asked about investing in Japan in 2007, wryly commented that the profitability of Japanese companies was too low for Berkshire’s liking.
Although Japanese corporate profitability is improving, by Western standards most of its major corporations have not been economically viable in the past, and if required to pay equitable rates of interest, would be in serious financial difficulty.
The high Nikkei index PE ratio in 2007 of 18 (price-to-book value of 1.9) on average ROEs of 10 percent is influenced by the meager average dividend yield of 1.1 percent still being better than leaving money in the bank.
With so little incentive to invest and debt so cheap, it is not surprising that in 2005 Japan was the world’s largest consumer of luxury goods, accounting for 41 percent. Rather than working in favour of Japanese investors, low interest rates over the past 20 years have decimated their funds. Although low domestic rates persist, demand for Japanese stocks will remain high and they will therefore continue to be grossly overpriced.
The reason Japan keeps rates so low is to encourage an outflow of capital to dampen the yen exchange rate to help its exporters. In other words, domestic employment is the prime motivation. If Japan’s trade surplus were repatriated, rather than being left abroad, the US dollar would crumble and the yen appreciate to a level that would make life even tougher, perhaps impossible, for many Japanese exporters.
Here is a simple question to see whether you have been following the argument.
Given a Nikkei index figure of 16,500 and the abovementioned ROE (10 percent) and price to book value (1.9), what would the Nikkei index need to be to achieve a 10 percent return from an index fund that replicated it? Answer: 8684
When ROE and RR (Rate of Return) are equal, value is equal to book value. Therefore, 16,500 / 1.9 (price to book value) = 8684.
These are the sorts of things to consider when thinking about investing in international funds.
Related article: 20.11.2008 - KLSE MARKET PE
Berkshire Hathaway's Stock Price
Compound Annual Growth Rate from 1990 to 1996 approximately: 26%
Compound Annual Growth Rate from 1996 to 2000 approximately: 18%
Compound Annual Growth Rate from 2001 to 2005 approximately
(still positive CAGR but well below Buffett's goal of 15%): 4%
Compound Annual Growth Rate from 2006 to Mid 2008 approximately: 31%
Berkshire Hathaway played a serious game of catchup during this short time frame.
Compound Annual Growth Rate from 1990 to Mid 2008 approximately: 17%
Berkshire Hathaway has exceeded the goal of 15% CAGR over a 17.5 year period.
Berkshire Hathaway has exceeded the goal of 15% CAGR over a 17.5 year period.
----------
Of course there are some companies that exceeded 100% CAGR on their stock price during the 1990's.
It is interesting to note that RedHat (ticker: RHT) had more than a 14000% CAGR from August 11, 1999 until December 9, 1999 when the share price went from $54.50 to $286.25.
Of course it also had a very bad CAGR of -89% from December 9, 1999 until September 18, 2001.
During this time the stock had a 2 for 1 stock split on January 10, 2000. On a split adjusted basis, the stock went from $143.12 to $3.02 per share.
Educational experience with an outcome other than expected
During bull markets owning stocks and calls on underpriced stocks should increase the value of the portfolio.
Bear markets should benefit positions in your portfolio that are either short overpriced companies or own puts on the overpriced stock.
Income may be generated by selling covered calls or credit spreads during a neutral market.
Please note that I have made extensive use of the words "should" and "may". Please do not invest any money that you can not afford to lose. Everyone has a different tolerance for risk. It is important that you do your own homework and take responsibility for any decisions that you make.
When investing, it doesn't take very long to have an educational experience with an outcome other than expected.
http://hyperdiversification.com/default.aspx
Bear markets should benefit positions in your portfolio that are either short overpriced companies or own puts on the overpriced stock.
Income may be generated by selling covered calls or credit spreads during a neutral market.
Please note that I have made extensive use of the words "should" and "may". Please do not invest any money that you can not afford to lose. Everyone has a different tolerance for risk. It is important that you do your own homework and take responsibility for any decisions that you make.
When investing, it doesn't take very long to have an educational experience with an outcome other than expected.
http://hyperdiversification.com/default.aspx
In Warren Buffet's 1992 letter to the share holders he discussed the following:
- During 1992, their Book Value had increased by 20.3%
- Between 1964 and 1992 book value per share (BVPS) had increased from $19 to $7745 resulting in a CAGR of 23.6%.
- Used book value for intrinsic value.
- CAGR goal 15%
- The number of outstanding shares has changed very little between 1964 and 1992 (1,137,778 vs. 1,152,547 respectively)
- Requiring a significant Margin of Safety (MOS) when purchasing stock in another company as a cornerstone of Berkshire Hathaway's success
My mom bought her first new car back in 1965. It was a Ford Falcon. She really liked the car. I wonder how much higher her networth would be if she would have bought a used car and invested the difference in Berkshire Hathaway. ;) Of course BH is the exception and not the norm. :))
http://hyperdiversification.com/cagr_main.aspx
Learn from:
Our focus is to protect and accumulate wealth for our clients. To do that, we are guided by one core principal. DON'T LOSE MONEY. It seems simple, but is by far one of the most challenging endeavors an investor can undertake.
In order to achieve the goal of capital preservation, the Strategy must protect previously earned gains while allowing an investor to profit from a market rebound after a substantial market decline. In other words, the Strategy wants to profit from bull markets and protect the portfolio in bear markets. http://www.swaninvesting.com/home
High-net-worth Investors & Listed Options
Portfolio Management Strategies for Affluent Investors, Family Offices, and Trust Companies http://www.swaninvesting.com/HighNetWorthInvestors.pdf
Monday 24 November 2008
What do all Berkshire Hathaway companies have in common?
What do all Berkshire Hathaway companies have in common?
They are profitable, safe and solid.
They are easy to understand with simple business models.
They produce plenty of cash flow to reinvest.
They are unique businesses with strong market positions and franchises.
They have solid, trustworthy management.
They were bought at reasonable prices.
We ordinary value investors can't assemble this kind of portfolio, but we can learn from what makes Berkshire Hathaway and its master tick.
Ref: Berkshire Hathaway's SEC filing
http://www.hoovers.com/free/co/secdoc.xhtml?ID=10206&ipage=6253178
They are profitable, safe and solid.
They are easy to understand with simple business models.
They produce plenty of cash flow to reinvest.
They are unique businesses with strong market positions and franchises.
They have solid, trustworthy management.
They were bought at reasonable prices.
We ordinary value investors can't assemble this kind of portfolio, but we can learn from what makes Berkshire Hathaway and its master tick.
Ref: Berkshire Hathaway's SEC filing
http://www.hoovers.com/free/co/secdoc.xhtml?ID=10206&ipage=6253178
Berkshire Hathaway's Acquisition Criteria: Telling it like it is
Take a look at the following set of "acquisition criteria," straight from the 2006 Berkshire Hathaway Annual report. Straight, clear, to the point - and never before have we seen anything like this - including the commentary - in a shareholder report.
ACQUISITION CRITERIA
We are eager to hear from principals or their representatives about businesses that meet all of the following criteria:
1. Large purchases (at least $75 million of pre-tax earnings unless the business will fit into one of our existing units).
2. Demonstrated consistent earning power (future projections are of no interest to us, nor are "turnaround" situations).
3. Businesses earning good returns on equity while employing little or no debt.
4. Management in place (we can't supply it).
5. Simple businesses (if there's lots of technology, we won't understand it).
6. An offering price (we don't want to waste our time or that of the seller by talking, even preliminary, about a transaction when price is unknown).
The larger the company, the greater will be our interest. We would like to make an acquisition in the $5-20 billion range. We are not interested, however, in receiving suggestions about purchases we may make in the general stock market.
We will not engage in unfriendly takeovers. We can promise complete confidentiality and a very fast answer - customarily within five minutes - as to whether we're interested. We prefer to buy for cash, but will consider issuing stock when we receive as much in intrinsic business value as we give. We don't participate in auctions.
ACQUISITION CRITERIA
We are eager to hear from principals or their representatives about businesses that meet all of the following criteria:
1. Large purchases (at least $75 million of pre-tax earnings unless the business will fit into one of our existing units).
2. Demonstrated consistent earning power (future projections are of no interest to us, nor are "turnaround" situations).
3. Businesses earning good returns on equity while employing little or no debt.
4. Management in place (we can't supply it).
5. Simple businesses (if there's lots of technology, we won't understand it).
6. An offering price (we don't want to waste our time or that of the seller by talking, even preliminary, about a transaction when price is unknown).
The larger the company, the greater will be our interest. We would like to make an acquisition in the $5-20 billion range. We are not interested, however, in receiving suggestions about purchases we may make in the general stock market.
We will not engage in unfriendly takeovers. We can promise complete confidentiality and a very fast answer - customarily within five minutes - as to whether we're interested. We prefer to buy for cash, but will consider issuing stock when we receive as much in intrinsic business value as we give. We don't participate in auctions.
It is not about diversification
Why diversify your portfolio? Is this the key to investing success?
Diversification provides safety in numbers and avoids the eggs-in-one basket syndrome, so it protects the value of a portfolio.
But the masters of value investing have shown that diversification only serves to dilute returns. If you're doing the value investing thing right, you are picking the right companies at the right price, so there's no need to provide this extra insurance. In fact, over-diversification only serves to dilute returns.
However, perhaps diversification isn't a bad idea until you prove yourself a good value investor. Diversification may suggest 'conservative' style, but diversification per se is not a value investing technique.
Diversification provides safety in numbers and avoids the eggs-in-one basket syndrome, so it protects the value of a portfolio.
But the masters of value investing have shown that diversification only serves to dilute returns. If you're doing the value investing thing right, you are picking the right companies at the right price, so there's no need to provide this extra insurance. In fact, over-diversification only serves to dilute returns.
However, perhaps diversification isn't a bad idea until you prove yourself a good value investor. Diversification may suggest 'conservative' style, but diversification per se is not a value investing technique.
Margin of Safety in Value Investing
The idea of buying a company at a bargain price is to achieve a margin of safety. This is important to provide a buffer if business events don't turn out exactly as predicted (and they won't).
- The value investing style calls for building in margins of safety by buying at a reasonable price.
- The style also suggests finding margins of safety within the business itself, for instance, so-called "moats" or competitive advantages that differentiate the business from its competitors.
- Also, a large cash hoard or the absence of debt offers a financial margin of safety.
Sunday 23 November 2008
Choosing a Discount Assumption
Choosing a discount assumption
In theory, the discount rate should be your own personal cost of capital for this kind of investment. If you have a million dollars and can invest it with no risk in a Treasury bond at 6 percent, your cost of capital is the risk-free 6 percent you would forgo by not investing in the bond. So the implied cost of your dollars made available to invest in Business XYZ starts at 6 percent. Financial types refer to this opportunity cost as the risk-free cost of capital.
But implicitly, Company XYZ common stock is riskier than the bond investment. Sales, earnings, and myriad other intrinsic things can change, as can markets and the market perception of XYZ’s worth. So an equity premium is added to the risk-free cost of capital rate. In effect, the total cost of capital is your required compensation, or hurdle, for the opportunity you’ve lost by not buying the bond, plus the assumption of risk by investing in XYZ.
Much has gone into identifying appropriate risk premiums and the like. Modern portfolio theory and its reliance on beta – a measure of relative stock price volatility – doesn’t really do much for most value investors. (Remember: Price doesn’t determine value.)
The keep-it-simple-safe (KISS) approach used by most value investors, including Warren Buffett, is to discount at a relatively high rate, usually higher than the growth rate. Buffett uses 15 percent as a discount, or “hurdle” rate – investments must clear a 15 percent “hurdle” before clearing the bar. The 15 percent hurdle incorporates a lot of risk, especially in today’s environment of relatively low interest rate and inflation. Conservative value investors usually use discount rates in the 10 to 15 percent range.
As you build and run models, you’ll see firsthand how the discount rate affects the resulting intrinsic value. Here are a few points to remember:
In theory, the discount rate should be your own personal cost of capital for this kind of investment. If you have a million dollars and can invest it with no risk in a Treasury bond at 6 percent, your cost of capital is the risk-free 6 percent you would forgo by not investing in the bond. So the implied cost of your dollars made available to invest in Business XYZ starts at 6 percent. Financial types refer to this opportunity cost as the risk-free cost of capital.
But implicitly, Company XYZ common stock is riskier than the bond investment. Sales, earnings, and myriad other intrinsic things can change, as can markets and the market perception of XYZ’s worth. So an equity premium is added to the risk-free cost of capital rate. In effect, the total cost of capital is your required compensation, or hurdle, for the opportunity you’ve lost by not buying the bond, plus the assumption of risk by investing in XYZ.
Much has gone into identifying appropriate risk premiums and the like. Modern portfolio theory and its reliance on beta – a measure of relative stock price volatility – doesn’t really do much for most value investors. (Remember: Price doesn’t determine value.)
The keep-it-simple-safe (KISS) approach used by most value investors, including Warren Buffett, is to discount at a relatively high rate, usually higher than the growth rate. Buffett uses 15 percent as a discount, or “hurdle” rate – investments must clear a 15 percent “hurdle” before clearing the bar. The 15 percent hurdle incorporates a lot of risk, especially in today’s environment of relatively low interest rate and inflation. Conservative value investors usually use discount rates in the 10 to 15 percent range.
As you build and run models, you’ll see firsthand how the discount rate affects the resulting intrinsic value. Here are a few points to remember:
- The higher the discount rate, the lower the intrinsic value – and vice versa.
- The second-stage discount rate should always be higher than the first stage. Risk increases the farther out you go.
- If you choose an aggressive growth rate, it makes sense also to choose a higher discount rate. Risk of failure is higher with high growth rates.
- If the discount rate exceeds the growth rate, intrinsic value will be low and implode more quickly the larger the gap. Aggressive growth assumptions with low discount rates yield very high intrinsic values.
If you’re worried about earnings and earnings growth consistency and want to factor it in somehow, but don’t want to do a deep statistical analysis on a zillion numbers, Value Line does one for you. At the bottom right corner of the Value Line Investment Survey sheet is a figure called “Earnings Predictability” if the Survey covers the company you’re evaluating.
It’s really a statistical predictability score normalised to 100 (100 is best, 0 is worst). A score of 80 and higher indicates relative safety; below 80 means that you may want to attenuate growth rates or bump up the discount rate to account for uncertainty.
Here again is the set of growth and discount assumptions used for an example. Consistency is important, but growth rates will vary for each company, and discount rates may change also with differing risk assessments.
First-stage growth 10%
Second-stage growth 5%
First-stage discount rate 12%
Second-stage discount rate 15%
Intrinsic Value Model
Intrinsic value is driven by current and especially future earnings. Projecting future growth in these earnings is vital to determining intrinsic value.
First-stage growth
Near-term growth is by nature easier to model, and as a result of the discounting process, they contribute more towards the final result anyway. So intrinsic value models are set up to specifically value a first stage in detail, year-by-year. Typically, the first stage is 10 years, although in some analyses it may be more or less.
More often than not, the first stage is assumed to have a higher growth rate and a lower discount rate than the second stage.
Second-stage growth
The second stage covers the more nebulous period of business life beyond the first stage. Second-stage returns are harder to project accurately, so intrinsic value models use one of two assumptions to estimate what’s known as continuing value:
- Indefinite life: The indefinite life model assumes ongoing returns and uses a mathematical formula to project returns over an indefinite period and assign a value to those returns.
- Acquisition: Want a convenient way to bypass mathematical approximations? Assume that someone will come along and buy your business after the first stage at a reasonable valuation. Returns include all future payouts, including lump sums, so this method works too, so long as resale value is projected reasonably.
Summary.
Each stage of a business life has a growth rate and discount rate applicable to that stage. One growth rate and one discount rate is applied to the first stage, and another growth and discount rate to the second. Then, you calculate net future earnings by first compounding growth over the first stage and then discounting that value back to the present. A generalised formula, either indefinite life or acquisition-based, is applied to the second stage. The value attributed to the second stage is called continuing value.
**Appraising the Value of a Business
Appraising the Value of a Business
Investment is most intelligent when it is most business-like.
( Benjamin Graham)
Value investing means treating an investment as though you were buying the entire business. If you were indeed buying a business, you would look for the following:
1. Income: Profits and strong positive operating cash flows exceeding capital requirements are good thing. A company starting at a loss and banking on future profits is starting in the hole, particularly considering the time value of money. Look for companies that produce more capital than they consume.
2. Income Growth: If income and cash flow are steady but unlikely to grow, there can be value. Without growth, time value depreciates earnings value over time. And competition and declining marketplace acceptance can erode the business. There’s little to make a stock price rise unless the market values the steady income stream incorrectly in the first place. Value investors should ignore the common “growth versus value” paradigm and consider growth part of the value equation.
3. Productive Capital Investment: If a company is able to invest additional capital productively – at a greater return than it would get by putting it in the bank – that indicates future value if the capital is available. A company should be able invest capital more productively than you can; otherwise, it makes sense for the company to return the capital to you, and for you to invest the capital elsewhere. If the company doesn’t have productive places to invest but pays you a good return (dividends or share buybacks), the company has value, but growth potential may be in question.
4. Rising Productivity and Falling Expenses: A good business makes increasingly better use of assets and creates more output per unit of input. Businesses that can do so are likely to generate more income sooner.
5. Predictability: Generally, a business with a predictable, steady income stream is more valuable than a company that has erratic or cyclical earnings. The erratic company may return as much money in the long run as the steady company, but the uncertainty surrounding the earnings stream requires a higher discount rate or margin of safety because you just don’t know. The higher discount rate reduces value. Look for simple and steady businesses that you understand.
6. Steady or Rising Asset Values: To the extent that asset values, particularly current assets, are steady or rising, higher returns, if and when paid out to the owners, will ultimately be the result. A company with falling asset values is suspect unless its productivity gains are significant.
7. Favourable Intangibles: Many things can affect or serve as leading indicators of business value. Management effectiveness, market presence, brand strength, customer base, intellectual property, and unique skills and competencies all play a part in driving business value. By nature, these items are hard to quantify but are part of the valuation playing field. Look for companies that do things right in the marketplace.
Investment is most intelligent when it is most business-like.
( Benjamin Graham)
Value investing means treating an investment as though you were buying the entire business. If you were indeed buying a business, you would look for the following:
1. Income: Profits and strong positive operating cash flows exceeding capital requirements are good thing. A company starting at a loss and banking on future profits is starting in the hole, particularly considering the time value of money. Look for companies that produce more capital than they consume.
2. Income Growth: If income and cash flow are steady but unlikely to grow, there can be value. Without growth, time value depreciates earnings value over time. And competition and declining marketplace acceptance can erode the business. There’s little to make a stock price rise unless the market values the steady income stream incorrectly in the first place. Value investors should ignore the common “growth versus value” paradigm and consider growth part of the value equation.
3. Productive Capital Investment: If a company is able to invest additional capital productively – at a greater return than it would get by putting it in the bank – that indicates future value if the capital is available. A company should be able invest capital more productively than you can; otherwise, it makes sense for the company to return the capital to you, and for you to invest the capital elsewhere. If the company doesn’t have productive places to invest but pays you a good return (dividends or share buybacks), the company has value, but growth potential may be in question.
4. Rising Productivity and Falling Expenses: A good business makes increasingly better use of assets and creates more output per unit of input. Businesses that can do so are likely to generate more income sooner.
5. Predictability: Generally, a business with a predictable, steady income stream is more valuable than a company that has erratic or cyclical earnings. The erratic company may return as much money in the long run as the steady company, but the uncertainty surrounding the earnings stream requires a higher discount rate or margin of safety because you just don’t know. The higher discount rate reduces value. Look for simple and steady businesses that you understand.
6. Steady or Rising Asset Values: To the extent that asset values, particularly current assets, are steady or rising, higher returns, if and when paid out to the owners, will ultimately be the result. A company with falling asset values is suspect unless its productivity gains are significant.
7. Favourable Intangibles: Many things can affect or serve as leading indicators of business value. Management effectiveness, market presence, brand strength, customer base, intellectual property, and unique skills and competencies all play a part in driving business value. By nature, these items are hard to quantify but are part of the valuation playing field. Look for companies that do things right in the marketplace.
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