Building in Room for Error
Related to the Upside-Downside Ratio
by Michael Maiello
12.3.2008
The margin of safety is one of Benjamin Graham and David Dodd’s most enduring contributions to the world of investing. The two coined the term in Security Analysis in 1934, and Graham expanded on the concept in The Intelligent Investor in 1949. The gist of it is that no matter how careful an analyst is, so many variables are involved in calculating a company’s intrinsic value and future sales and earnings that mistakes are inevitable. So buy a stock worth $12 at $10 instead of $11.50, because the wider the gap between the stock’s price and its intrinsic value, the bigger the margin of safety.
How much safety is warranted depends on the company’s quality. A speculative com-pany that’s losing money, carrying a lot of debt or operating in a shrinking industry reasonably demands a larger margin of safety than a profitable company that leads a growing industry and has a solid balance sheet. Graham and Dodd typically looked for a 50-percent margin of safety on speculative companies but would require a margin of only 10 percent for a high-quality issue.
All investors employ the margin of safety differently, since it’s tied both to intrinsic value analysis and an individual’s risk tolerance. BetterInvesting expresses the risk-reward tradeoff as the upside-downside ratio. The goal here is to evaluate the risk and reward potential of a stock over five years, assuming one boom and one recession. This analysis says nothing about the probability of a stock reaching any particular price. Instead, it expresses what a stock’s potential is. BetterInvesting recommends buying a stock only when the upside is at least three times that of the downside.
In calculating the ratio, you first find the extreme upside. For a company with growing earnings, estimate the stock’s highest price-earnings ratio over the next five years. This will represent “as good as it gets.” Then determine the company’s highest earnings per share over this period. Multiply them and that’s your extreme high.
Now do the same on the low end. Multiplying your estimated low P/E by the expected low earnings is a common way to do this. If the stock is already trading below your low forecast, you’ll want to revisit your assumptions.
Finally, take the forecast high and subtract the current price. Then divide that by the current price minus the forecast low. The result is the upside-downside ratio. Anything above 3:1 offers a reasonable margin of safety for growth stocks.
Some investors also like a margin of safety for selling stocks. The upside-downside ratio for existing holdings should be updated to see whether price appreciation has outpaced potential.
The analysts at Morningstar do something similar. They give a “fair value” estimate for every stock. For Wachovia, it’s currently $53. The stock recently traded at $34.60. Morningstar says to consider buying it at any price below $39.80, which is 75 percent of what Morningstar thinks the stock is worth.
If you buy the stock, Morningstar says not to consider selling it until it reaches $68.90. In other words, Morningstar believes Wachovia’s stock could increase by 30 percent beyond what it now considers the stock’s fair value. The answer to the selling conundrum in this case is that if Wachovia reaches its fair value, the investor has to analyze the stock again to see whether there’s room left for the stock to run.
BetterInvesting’s Online Tools
The Stock Selection Guide, the primary stock study tool of BetterInvesting members, helps you identify stocks that are reasonably priced. Our new online tool will walk you through evaluating a company using the SSG. Click on the Online Tools & Software link under the Tools & Resources menu on the BetterInvesting homepage. Your membership may already include access to the tool; if not, you can upgrade your membership to use it.
Michael Maiello, who wrote "Fly With the Fundamentals" for the January 2006 issue, is the author of Buy the Rumor, Sell the Fact (McGraw-Hill, 2004).
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/0408fundamentalpublic.htm
Saturday 12 September 2009
The Perils of High-P/E Stocks
The Perils of High-P/E Stocks
The Higher They Are, the Harder They Fall
by Michael Maiello
30.7.2008
Financial journalist Jason Zweig has a well-known interest in behavioral finance, the study of how investors’ minds work — sometimes against their best interests. In his latest book, Your Money & Your Brain, he deals with the “story stock,” the must-have equity of the moment that only investors with the strongest convictions can avoid.
Think Krispy Kreme, which went public in 2000 after the market crash and climbed from $23 to over $100 a share. Yes, a doughnut company had a price-earnings ratio above 80. A doughnut company.
Krispy Kreme is losing money now and trades for just over $3 a share. But at the time it had exactly what investors craved — a simple business model, a good (some would say addictive) product, room to grow from a regional to a national chain and the attention of both the media and Wall Street analysts.
These are the types of stocks that play well in the human mind, Zweig says. Investors are naturally risk-averse and wary of potential surprises. High-profile companies that get a lot of attention and are mentioned on the nightly news and on financial websites seem less likely to surprise us. They seem safer.
There’s also a perceived safety in numbers. No matter how often we’re told that 50,000 people can indeed be wrong, we’re afraid to be seen as out of step with our neighbors. To be wrong while acting as part of a group is understandable. To be wrong on your own is just plain embarrassing.
The result of this, writes Zweig, is that a stock might do well for the wrong reasons in the short run. But eventually the fundamentals will catch up with it.
Remember, it’s negative surprises that send most investors fleeing, and when they seek safety, they wind up buying stocks that today are telling happy stories of high growth. This means the effects of any negative news about these stocks are amplified. And when the story turns ugly, it turns in a hurry.
Zweig calculates that if a growth company misses its earnings forecast by as little as 3 cents a share, its stock will drop two to three times faster compared with a value stock reporting the same bad news. When a high-growth company misses earnings, it can cause a crisis of confidence. Many analysts, for example, believe there’s no such thing as one bad quarter; when a high-growth company stumbles, investors fear more bad news is on the way.
But over time, less-popular, lower-P/E stocks do outperform. In his updated edition of Stocks for the Long Run, Wharton professor Jeremy Siegel measured the performances of low-P/E and high-P/E stock portfolios between 1957 and the end of 2006. The portfolio with $1,000 invested in stocks with the lowest P/E ratios was worth $700,000, for a 14.3 percent annual return. The portfolio with $1,000 invested in the highest-P/E stocks was worth $65,000, for a return of 8.9 percent a year.
What’s more, during the first 10 years the high- and low-P/E portfolios traded places a few times, depending on market conditions. But once the experiment passed the decade mark, returns on the low-P/E stocks were always higher.
Of course, it’s important to put P/Es in context. You should compare a stock’s P/E with that of its peers and to the rest of the market and remember that some stocks deserve a higher valuation.
Growth and value also go in and out of favor; cycles usually last five years to seven years. But investors with time on their side would do well to be wary of trendy story stocks because they can turn in an instant.
Michael Maiello, who wrote "Fly With the Fundamentals" for the January 2006 issue, is the author of Buy the Rumor, Sell the Fact (McGraw-Hill, 2004).
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/0808fundamentalspublic.htm
The Higher They Are, the Harder They Fall
by Michael Maiello
30.7.2008
Financial journalist Jason Zweig has a well-known interest in behavioral finance, the study of how investors’ minds work — sometimes against their best interests. In his latest book, Your Money & Your Brain, he deals with the “story stock,” the must-have equity of the moment that only investors with the strongest convictions can avoid.
Think Krispy Kreme, which went public in 2000 after the market crash and climbed from $23 to over $100 a share. Yes, a doughnut company had a price-earnings ratio above 80. A doughnut company.
Krispy Kreme is losing money now and trades for just over $3 a share. But at the time it had exactly what investors craved — a simple business model, a good (some would say addictive) product, room to grow from a regional to a national chain and the attention of both the media and Wall Street analysts.
These are the types of stocks that play well in the human mind, Zweig says. Investors are naturally risk-averse and wary of potential surprises. High-profile companies that get a lot of attention and are mentioned on the nightly news and on financial websites seem less likely to surprise us. They seem safer.
There’s also a perceived safety in numbers. No matter how often we’re told that 50,000 people can indeed be wrong, we’re afraid to be seen as out of step with our neighbors. To be wrong while acting as part of a group is understandable. To be wrong on your own is just plain embarrassing.
The result of this, writes Zweig, is that a stock might do well for the wrong reasons in the short run. But eventually the fundamentals will catch up with it.
Remember, it’s negative surprises that send most investors fleeing, and when they seek safety, they wind up buying stocks that today are telling happy stories of high growth. This means the effects of any negative news about these stocks are amplified. And when the story turns ugly, it turns in a hurry.
Zweig calculates that if a growth company misses its earnings forecast by as little as 3 cents a share, its stock will drop two to three times faster compared with a value stock reporting the same bad news. When a high-growth company misses earnings, it can cause a crisis of confidence. Many analysts, for example, believe there’s no such thing as one bad quarter; when a high-growth company stumbles, investors fear more bad news is on the way.
But over time, less-popular, lower-P/E stocks do outperform. In his updated edition of Stocks for the Long Run, Wharton professor Jeremy Siegel measured the performances of low-P/E and high-P/E stock portfolios between 1957 and the end of 2006. The portfolio with $1,000 invested in stocks with the lowest P/E ratios was worth $700,000, for a 14.3 percent annual return. The portfolio with $1,000 invested in the highest-P/E stocks was worth $65,000, for a return of 8.9 percent a year.
What’s more, during the first 10 years the high- and low-P/E portfolios traded places a few times, depending on market conditions. But once the experiment passed the decade mark, returns on the low-P/E stocks were always higher.
Of course, it’s important to put P/Es in context. You should compare a stock’s P/E with that of its peers and to the rest of the market and remember that some stocks deserve a higher valuation.
Growth and value also go in and out of favor; cycles usually last five years to seven years. But investors with time on their side would do well to be wary of trendy story stocks because they can turn in an instant.
Michael Maiello, who wrote "Fly With the Fundamentals" for the January 2006 issue, is the author of Buy the Rumor, Sell the Fact (McGraw-Hill, 2004).
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/0808fundamentalspublic.htm
Use Binaries to Choose Among Options
The Forks in the Road to Investing Success
Use Binaries to Choose Among Options
by Angele McQuade
I’m sure you’ve heard the chestnut that the hardest choice isn’t the one between right and wrong but the one between two rights. When you’re faced with a decision between two potentially profitable investment strategies, how do you find the clarity that will leave you content with your selection? Although I can’t help you work through all your weighty life choices, I can channel a little investing guidance from Clark Winter, author of The Either/Or Investor: How to Succeed in Global Investing, One Decision at a Time.
As director of portfolio strategy and managing director of Goldman Sachs, Winter has surely faced a fair number of challenging choices. He believes binaries simplify the decision-making process: If you can whittle your options to two, you can begin to gather the necessary information and assess that data. “I realized that smart people approach problems as dichotomies — either/or decisions,” he explains in the preface. “If this, then not that. If yes, if no, then what?”
Great investing is really about understanding how to evaluate facts, Winter continues — “how to make reasonable suppositions about the things you don’t know, how to account for the uncertainties that impede decision-making, and finally how to do all that rapidly enough so that you can gain an advantage over competitors and thus the market.” At 27 pages the introduction might be longer than many book chapters, but it’s more illuminating than many, too. I found it very compelling reading and one of my favorite parts of the book.
Winter didn’t want to write yet another tome about investing but instead one about sound decision-making, with investing as the object, not the subject. Winter’s purpose is to “link the two skill sets, investing and decision-making.” Though he assesses markets using hundreds of binaries, he focuses here on the 21 he says can explain just about all investment thinking.
Most chapters in The Either/Or Investor are based on these dichotomies, with their titles identifying the decision-making lesson you’ll discover: “Here Versus There,” “The Developed World Versus the Developing World,” “Preservation Versus Growth,” “Fad Versus Trend,” “Conventional Wisdom Versus Anomalies” — you get the idea.
“In investing, the first and most important binary is fear or greed,” Winter says, and sure enough you can learn why by reading Chapter 7, called — of course — “Fear Versus Greed.” You might read his chapters hoping for universal right or wrong answers, but Winter wants you to learn to ask what the available information tells you to do. And although he can’t answer that question, he does give a firm enough push in the direction of information gathering and analysis to help you build some momentum in your process.
The Either/Or Investor disputes the popular belief that all the average inves-tor needs to achieve the returns of a spectacularly successful investor is to follow that master’s strategy. Winter even takes on books that model famous investors’ methods (ones you’ve probably read about right here, in fact). His beef isn’t so much with these experts but with what he considers the misapplication of perfect math (assuming, for example, the reader will achieve an average annual return of 11 percent) and readers’ inability to accept the idea that they won’t ever match the very best money managers’ returns. Winter is determined to promote this daring, provocative position even though it’s a hard reality for most investors — not to mention the publishers of all those investment books — to acknowledge.
The subprime mortgage crisis hit full force after Winter submitted The Either/Or Investor to Random House but before the book was published. He seized the opportunity to update his manuscript and address more directly the problems of easy credit. This revision makes the book feel even more relevant, especially for investors concerned about today’s economic uncertainties.
Can you endure a few final binaries? Plausible vs. forgettable: My answer? Highly plausible — quite convincing, too. Read it vs. skip it: Read it, definitely.
Here’s one more piece of information, if it will help your assessment: The Either/Or Investor is high on my list of the most thought-provoking, assumption-challenging, instructive books of 2008. And that’s one determination I didn’t have a bit of trouble making.
Have a question about this month’s book? Want to share your own recent financial favorites? Write to Angele at angemc
quade@betterinvesting.net.
Angele McQuade is the author of two books, including Investment Clubs for Dummies. You can find her online at angelemcquade.com.
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/1008publicbv.htm
Use Binaries to Choose Among Options
by Angele McQuade
I’m sure you’ve heard the chestnut that the hardest choice isn’t the one between right and wrong but the one between two rights. When you’re faced with a decision between two potentially profitable investment strategies, how do you find the clarity that will leave you content with your selection? Although I can’t help you work through all your weighty life choices, I can channel a little investing guidance from Clark Winter, author of The Either/Or Investor: How to Succeed in Global Investing, One Decision at a Time.
As director of portfolio strategy and managing director of Goldman Sachs, Winter has surely faced a fair number of challenging choices. He believes binaries simplify the decision-making process: If you can whittle your options to two, you can begin to gather the necessary information and assess that data. “I realized that smart people approach problems as dichotomies — either/or decisions,” he explains in the preface. “If this, then not that. If yes, if no, then what?”
Great investing is really about understanding how to evaluate facts, Winter continues — “how to make reasonable suppositions about the things you don’t know, how to account for the uncertainties that impede decision-making, and finally how to do all that rapidly enough so that you can gain an advantage over competitors and thus the market.” At 27 pages the introduction might be longer than many book chapters, but it’s more illuminating than many, too. I found it very compelling reading and one of my favorite parts of the book.
Winter didn’t want to write yet another tome about investing but instead one about sound decision-making, with investing as the object, not the subject. Winter’s purpose is to “link the two skill sets, investing and decision-making.” Though he assesses markets using hundreds of binaries, he focuses here on the 21 he says can explain just about all investment thinking.
Most chapters in The Either/Or Investor are based on these dichotomies, with their titles identifying the decision-making lesson you’ll discover: “Here Versus There,” “The Developed World Versus the Developing World,” “Preservation Versus Growth,” “Fad Versus Trend,” “Conventional Wisdom Versus Anomalies” — you get the idea.
“In investing, the first and most important binary is fear or greed,” Winter says, and sure enough you can learn why by reading Chapter 7, called — of course — “Fear Versus Greed.” You might read his chapters hoping for universal right or wrong answers, but Winter wants you to learn to ask what the available information tells you to do. And although he can’t answer that question, he does give a firm enough push in the direction of information gathering and analysis to help you build some momentum in your process.
The Either/Or Investor disputes the popular belief that all the average inves-tor needs to achieve the returns of a spectacularly successful investor is to follow that master’s strategy. Winter even takes on books that model famous investors’ methods (ones you’ve probably read about right here, in fact). His beef isn’t so much with these experts but with what he considers the misapplication of perfect math (assuming, for example, the reader will achieve an average annual return of 11 percent) and readers’ inability to accept the idea that they won’t ever match the very best money managers’ returns. Winter is determined to promote this daring, provocative position even though it’s a hard reality for most investors — not to mention the publishers of all those investment books — to acknowledge.
The subprime mortgage crisis hit full force after Winter submitted The Either/Or Investor to Random House but before the book was published. He seized the opportunity to update his manuscript and address more directly the problems of easy credit. This revision makes the book feel even more relevant, especially for investors concerned about today’s economic uncertainties.
Can you endure a few final binaries? Plausible vs. forgettable: My answer? Highly plausible — quite convincing, too. Read it vs. skip it: Read it, definitely.
Here’s one more piece of information, if it will help your assessment: The Either/Or Investor is high on my list of the most thought-provoking, assumption-challenging, instructive books of 2008. And that’s one determination I didn’t have a bit of trouble making.
Have a question about this month’s book? Want to share your own recent financial favorites? Write to Angele at angemc
quade@betterinvesting.net.
Angele McQuade is the author of two books, including Investment Clubs for Dummies. You can find her online at angelemcquade.com.
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/1008publicbv.htm
Defining Value: Are You an Investor or a Speculator?
Defining Value
Are You an Investor or a Speculator?
Value, like beauty, is in the eye of the beholder. As “a beggar’s dime is worth more than a king’s gold,” seeking value in the stock market is often subjective. Some investors think that a value stock should be a mature company; some think it has to trade at a low price-earnings ratio; and some believe that a high dividend yield is key.
by Ronald W. Chan and Brian C. Lui
29.10.08
In our first article on the subject, we’ll define value investing and how it’s applied. Before we begin, however, we must ask ourselves who we are when we purchase a stock — investors or speculators?
Investing and gambling traditionally have been viewed as being at the opposite ends of the spectrum, with speculating in between. An investor, through fine calculation, gains profit and earns dividends; the less reputable speculator or gambler, by skill or luck, gains only profit.
Benjamin Graham, the father of value investing, distinguished between investment and speculation: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
Graham disciple Warren Buffett believes investing intrinsically encompasses the notion of value. In a letter to shareholders, he wrote: “The very term ‘value investing’ is redundant. What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value — in the hope that it can soon be sold for a still-higher price — should be labeled speculation.”
A low earnings multiple and high dividend yield aren’t necessarily the determining factors of a value stock, Buffett said. A stock with a high P/E can also be cheap as long as its value is higher than its stock price.
People often separate value investing from growth investing as if they’re opposing practices. This distorts the true nature of what value investors do. “The whole concept of dividing it up into ‘value’ and ‘growth’ strikes me as twaddle,” says Charlie Munger, Buffett’s business partner. “It’s convenient for a bunch of pension fund consultants to get fees prattling about and a way for one adviser to distinguish himself from another. But to me, all intelligent investing is value investing.”
Buffett spoke of value and growth in a softer tone and united the two strategies: “The two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.”
Simply put, value investing means buying a stock when it’s trading at less than its fair value. In practice, investors must bear in mind that a stock certificate means part ownership of a company. Therefore, to be a good investor, one needs to think like a good businessman.
Imagine that an investor wants to buy out an entire business. He obviously doesn’t want to overpay, so the company’s fair value is crucial. Stock investors should apply the same mentality.
In value investing terms, determining the fair value — commonly known as intrinsic value — is the first step to successful investing. A stock’s intrinsic value is calculated from the economic value of its underlying business. Thus, a value investor needs to delve into a company’s financial statements and analyze its competitive position, considering both tangible and intangible attributes.
Although there are many different models for deriving intrinsic value, the most common method involves the concept of discounted cash flow. This model measures the cash that can be taken out of a business during the remainder of its life and discounts the cash flow at an appropriate interest rate.
Intrinsic value calculations can vary widely depending on the growth and interest rates assumed. So value investors should treat intrinsic value more as a rough estimate than as a precise figure. In our next article, we’ll explore intrinsic value’s technical aspects. After all, value investing is half art and half science; therefore, a true investor needs to be prepared mentally and mathematically.
That said, Albert Einstein put it well: “Try not to be a person of success, but rather, a person of value!”
Ronald Chan and Brian Lui operate Chartwell Capital Limited, an asset management firm based in Hong Kong.
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/1008public1.htm
Are You an Investor or a Speculator?
Value, like beauty, is in the eye of the beholder. As “a beggar’s dime is worth more than a king’s gold,” seeking value in the stock market is often subjective. Some investors think that a value stock should be a mature company; some think it has to trade at a low price-earnings ratio; and some believe that a high dividend yield is key.
by Ronald W. Chan and Brian C. Lui
29.10.08
In our first article on the subject, we’ll define value investing and how it’s applied. Before we begin, however, we must ask ourselves who we are when we purchase a stock — investors or speculators?
Investing and gambling traditionally have been viewed as being at the opposite ends of the spectrum, with speculating in between. An investor, through fine calculation, gains profit and earns dividends; the less reputable speculator or gambler, by skill or luck, gains only profit.
Benjamin Graham, the father of value investing, distinguished between investment and speculation: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”
Graham disciple Warren Buffett believes investing intrinsically encompasses the notion of value. In a letter to shareholders, he wrote: “The very term ‘value investing’ is redundant. What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value — in the hope that it can soon be sold for a still-higher price — should be labeled speculation.”
A low earnings multiple and high dividend yield aren’t necessarily the determining factors of a value stock, Buffett said. A stock with a high P/E can also be cheap as long as its value is higher than its stock price.
People often separate value investing from growth investing as if they’re opposing practices. This distorts the true nature of what value investors do. “The whole concept of dividing it up into ‘value’ and ‘growth’ strikes me as twaddle,” says Charlie Munger, Buffett’s business partner. “It’s convenient for a bunch of pension fund consultants to get fees prattling about and a way for one adviser to distinguish himself from another. But to me, all intelligent investing is value investing.”
Buffett spoke of value and growth in a softer tone and united the two strategies: “The two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.”
Simply put, value investing means buying a stock when it’s trading at less than its fair value. In practice, investors must bear in mind that a stock certificate means part ownership of a company. Therefore, to be a good investor, one needs to think like a good businessman.
Imagine that an investor wants to buy out an entire business. He obviously doesn’t want to overpay, so the company’s fair value is crucial. Stock investors should apply the same mentality.
In value investing terms, determining the fair value — commonly known as intrinsic value — is the first step to successful investing. A stock’s intrinsic value is calculated from the economic value of its underlying business. Thus, a value investor needs to delve into a company’s financial statements and analyze its competitive position, considering both tangible and intangible attributes.
Although there are many different models for deriving intrinsic value, the most common method involves the concept of discounted cash flow. This model measures the cash that can be taken out of a business during the remainder of its life and discounts the cash flow at an appropriate interest rate.
Intrinsic value calculations can vary widely depending on the growth and interest rates assumed. So value investors should treat intrinsic value more as a rough estimate than as a precise figure. In our next article, we’ll explore intrinsic value’s technical aspects. After all, value investing is half art and half science; therefore, a true investor needs to be prepared mentally and mathematically.
That said, Albert Einstein put it well: “Try not to be a person of success, but rather, a person of value!”
Ronald Chan and Brian Lui operate Chartwell Capital Limited, an asset management firm based in Hong Kong.
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/1008public1.htm
The Oracle of Omaha Exhorts Investors to Buy
Buffett’s Advice Always Fit to Print
The Oracle of Omaha Exhorts Investors to Buy
by Kenneth S. Janke
7.1.2009
Most of the time, I preferred to read the college newspaper, keeping track of our football and cross country teams as they both went on to win national championships that fall. The one big disappointment I had with the Times was that there were no comic strips. How in the world could a newspaper not have comic strips and devote the sports section to the Yankees and Giants, seldom mentioning games in the Midwest?
A few years ago, I succumbed again and subscribed to the Sunday edition. But I soon realized that I read only the financial section and was turned off by the rest of the reporting. There still weren’t any comic strips, but I unsuccessfully attempted to complete the crossword puzzle and developed a dislike for the puzzle editor. I had stopped reading any part of the Times until Warren Buffett’s opinion piece published on Oct. 16. (As of early December the article, “Buy American. I Am,” was still available for free at the newspaper’s website. Use the site’s search function for quick access to it.)
Since I’ve always enjoyed reading Buffett’s remarks in the Berkshire Hathaway annual reports and listening to him talk about his approach to investing, I read the article carefully. Now, keep in mind that this was written a full month before the heavy gyrations (mostly down) in the stock market through the first three weeks of November. During that span it wasn’t unusual to see daily moves in the Dow Jones industrial average of 300 points and more. Although you wouldn’t call him bullish, he explained his analytical outlook and said he was buying American stocks in his personal account.
The reason he was buying was covered in a couple of paragraphs:
“A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.
“Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.”
We already know he’s an investing genius, but Mr. Buffett also has an extraordinary talent to succinctly state in a few words his approach to investing. It’s commonsense advice we should follow. Oh, by the way, The New York Times still doesn’t have any comic strips.
Kenneth S. Janke, Sr., is a chairman emeritus of the NAIC/BetterInvesting board of directors and a member of the magazine’s Editorial Advisory and Securities Review Committee.
http://www.betterinvesting.org/NR/exeres/AD099AF4-F179-403D-9B30-8DBB0FD9DB29.htm
The Oracle of Omaha Exhorts Investors to Buy
by Kenneth S. Janke
7.1.2009
Most of the time, I preferred to read the college newspaper, keeping track of our football and cross country teams as they both went on to win national championships that fall. The one big disappointment I had with the Times was that there were no comic strips. How in the world could a newspaper not have comic strips and devote the sports section to the Yankees and Giants, seldom mentioning games in the Midwest?
A few years ago, I succumbed again and subscribed to the Sunday edition. But I soon realized that I read only the financial section and was turned off by the rest of the reporting. There still weren’t any comic strips, but I unsuccessfully attempted to complete the crossword puzzle and developed a dislike for the puzzle editor. I had stopped reading any part of the Times until Warren Buffett’s opinion piece published on Oct. 16. (As of early December the article, “Buy American. I Am,” was still available for free at the newspaper’s website. Use the site’s search function for quick access to it.)
Since I’ve always enjoyed reading Buffett’s remarks in the Berkshire Hathaway annual reports and listening to him talk about his approach to investing, I read the article carefully. Now, keep in mind that this was written a full month before the heavy gyrations (mostly down) in the stock market through the first three weeks of November. During that span it wasn’t unusual to see daily moves in the Dow Jones industrial average of 300 points and more. Although you wouldn’t call him bullish, he explained his analytical outlook and said he was buying American stocks in his personal account.
The reason he was buying was covered in a couple of paragraphs:
“A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.
“Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.”
We already know he’s an investing genius, but Mr. Buffett also has an extraordinary talent to succinctly state in a few words his approach to investing. It’s commonsense advice we should follow. Oh, by the way, The New York Times still doesn’t have any comic strips.
Kenneth S. Janke, Sr., is a chairman emeritus of the NAIC/BetterInvesting board of directors and a member of the magazine’s Editorial Advisory and Securities Review Committee.
http://www.betterinvesting.org/NR/exeres/AD099AF4-F179-403D-9B30-8DBB0FD9DB29.htm
Risk Tolerance: Mood, Recent Events Can Change Your Point of View
What’s Your Tolerance for Risk?
Mood, Recent Events Can Change Your Point of View
by Alexandra Armstrong CFP, CCPS and Karen Preysnar CFP
8.4.2009
The dictionary defines risk as “the possibility of suffering harm or loss; danger.” But many people think of risk as the possibility of making money more than the potential of losing it. Or at least they did before experiencing the market of 2008. We’re willing to bet that you’d answer the question of how much risk you’re willing to take differently today than you would have in December 2007 when the current recession started.
The losses we saw in the stock market in 2008 as measured by the Standard & Poor’s 500 index1 surpassed previous annual losses since 1825 with the exception of 1931, reports Value Square Asset Management and Yale University. Last year’s losses weren’t confined to stocks, since corporate bonds lost value as well. Recently a money manager told us that in October, if you wanted to sell a bond position, it was difficult to find a buyer at any price. If you were invested during the last quarter of 2008, there was no place to hide — except in cash or U.S. Treasury securities.
The whole issue of risk is a difficult one to discuss. Unlike measuring height or weight, there’s no unit of measurement for risk tolerance. Your risk tolerance can be measured only relative to others on a constructed scale in much the same way an IQ is measured. Even the meaning of the word risk can depend on the situation. When individuals talk about risk as they experience it in their financial affairs, they aren’t talking about the same thing as investment researchers discussing the risk of a particular kind of investment.
As we mentioned in our November 2008 article, we provide our clients with a risk tolerance questionnaire with 20 questions. But this only gives us an idea of what degree of risk people are willing to take at the time they’re completing the questionnaire.
We have to recognize that your risk tolerance changes and can be easily influenced by recent information and even your moods. It’s easy to rate yourself as an aggressive risk-taker when you think home values and stock prices can only go up. When they come crashing down again, though, people tend to become very conservative very fast.
We think there are two basic ways of looking at risk-taking. The first is to assess the amount of financial risk you can afford to take. The second is to assess the amount of emotional risk you’re willing to take.
When assessing the level of financial risk you can afford to take, consider your age as well as the amount of assets you have. For instance, if you’re relatively young and part of a two-earner couple who don’t spend all your income, you should be able to afford to take more risk with your investments because you have time on your side. Even if your investments don’t work out as you hoped, you can make other investments in the future.
Those who are retired and need to live on the income from their investments, however, can’t afford to take as much risk. With retirees living longer than they did in previous generations, this has become more of an issue, particularly for those who don’t have a pension providing them with regular income.
The size of your total assets influences your attitude toward risk as well. People who have more assets than needed to maintain their lifestyle usually are willing to take more risk with at least some of their investments.
During the tech debacle of 2000-2002, values of homes were increasing. Assuming you hadn’t invested all your portfolio in tech stocks, even though the stock market was down as measured by the major indexes, you didn’t feel as poor because your house was worth more. Thus, you could tolerate riding out the down market of 2000-2002.
Between 2003 and 2007, your patience was rewarded, and hopefully you saw your investments grow in value. At the same time, the value of your home continued to go up. In some cases, during this period some retirees became complacent and withdrew more than the recommended 5 percent from their portfolios because they could do so. After all, they reassured themselves that their principal was intact. This past year’s market decline has changed all that. Now investors realize that markets really do go down as well as up and their investments can decline in value.
Once you’ve figured out how much financial risk you can afford to take, you need to measure your emotional attitude toward risk-taking. If your parents or grandparents lost all their money in 1929, or if your father wasn’t good at managing money, you may have difficulty taking risk with your own money. This is a very human reaction. It’s important to realize that these negative family experiences can have a lasting negative effect on your attitudes.
In addition, your attitude toward taking risk can vary over time based on your most recent experiences (either positive or negative) when you took risks. For example, some new clients will say they’re highly risk-averse, but when we examine their portfolios, they own some speculative investments. When we ask about this apparent inconsistency, they usually reply that they used to be risk-takers, but these investments didn’t work out well, so now they’re less willing to take risk. Obviously, the reverse can be true. If your experiences with taking risks were rewarded in the past, you’ll probably be more willing to take chances in the future.
After you’ve assessed how much risk you can afford to take and how much risk you’re comfortable taking, you should focus on risk reduction techniques. It’s important to start with the basic premise that it’s virtually impossible to avoid risk altogether. For instance, when you cross the street, you run the risk of being hit by a car. But there are ways you can reduce your risk. If you cross the street at a marked intersection when the light clearly indicates it’s safe for you to walk, you’ve greatly lessened your risk of being hit. If instead you’re jaywalking, you’re taking more risk.
When investing, the first way to control the negative impact of risk-taking to some extent is by doing your homework. There’s a difference between taking educated risks and speculating. Speculating is equivalent to racetrack betting if you put all your money on one horse with the name you like or the color of silks you prefer.
As a BetterInvesting member, you’re familiar with this concept of educating yourself. A company might have a wonderful product, but you need to check out its competition, the amount of debt the company has, its record of earnings and the relationship of earnings to the stock’s current price before deciding to invest in it.
We believe you can also reduce the risk you take with investments by diversifying your portfolio among different kinds of investments (international/U.S. stocks, bonds, cash) and within asset categories (small-cap, large-cap and so on). If you diversify, one investment might not work out as well as expected, but others may do well so that overall your total portfolio is worth more than the amount you invested.
For example, let’s compare two investors. Mary invests $100,000 that earns 8 percent annually. At the end of 20 years, her portfolio is worth $466,096. On the other hand, Jane invests her $100,000 among five different investments — $20,000 each. After 20 years she assesses her situation. The first investment is a total loss, while she gets her money back with the second. With the third investment, she received an average annual return of 5 percent; the fourth, 10 percent; and the fifth, 15 percent. At the end of 20 years, she would have $534,947 — almost $100,000 more than Mary does (see table, below).
Another way you can control your risk is to work with an experienced financial adviser. Although this isn’t necessarily a panacea, the adviser can show you different investment alternatives and explain both the risk and return potential of each choice. That way you can construct a portfolio that matches your risk tolerance.
We explain to clients that there’s no right or wrong attitude toward risk. What’s important is that you’re honest with both yourself and your adviser about your risk tolerance and construct your investment portfolio accordingly.
Rank your own risk temperament on a scale of 1 (risk-averse) to 10 (willing to take a high degree of risk) and then make sure you communicate this information to your adviser. If you’re married, are you more or less of a risk-taker than your spouse? We’ve often seen instances in which one spouse is willing to take a lot of risk and the other is willing to take few risks. This can lead to family conflict. You need to discuss this issue with each other, and some compromises may have to be made. For instance, the spouse who’s more willing to take risk might invest part of her portfolio in more aggressive investments than her partner.
After experiencing the 2008 stock market, many investors are shellshocked and may vow to avoid investing altogether, thus trying to avoid taking any risk. We don’t think this is a wise decision. Although this past year’s experience has been very difficult for everyone, it may have some good long-term results. Perhaps people will realize that you can’t make fortunes overnight, that you should avoid being heavily in debt, that you shouldn’t spend all your income, that it’s important to accumulate a cash reserve for a rainy day and that you really need to investigate before you invest. In other words, they may start believing all those maxims that financial planners have been preaching for years!
Although taking some risk is essential to making money, it has been our experience that you don’t have to be a speculator to build wealth successfully. We advocate controlling the amount of risk you take through self-education, portfolio diversification and consultation with a good adviser.
Having been in the investment business for over 40 years, we really believe that ultimately the pendulum will turn and selecting and holding good-quality investments will reward patient investors. We encourage you to take a deep breath, take educated risks and make sound decisions that aren’t based on emotions.
Keep in mind the tortoise and hare race. We believe the slow, steady, consistent approach works every time.
1 The S&P 500 index is an unmanaged index comprising widely held securities considered to be representative of the stock market in general. Performances of the indexes are not indicative of any particular investment. Individuals cannot invest directly in any index. Past performance is no guarantee of future results.
2 Diversification doesn’t guarantee against loss. It’s a method used to manage risk.
Alexandra Armstrong is co-author of the fourth edition of On Your Own: A Widow’s Passage to Emotional and Financial Well-Being. She is a Certified Financial Planner practitioner and chairman of Armstrong, Fleming & Moore, Inc., a registered investment advisory firm in Washington, D.C. Securities are offered through Common-wealth Financial Network, member FINRA/SIPC. Investment advisory services are offered through Armstrong, Fleming & Moore, Inc., an SEC-registered investment adviser not affiliated with Commonwealth Financial Network.
Karen Preysnar, Certified Financial Plan-ner practitioner, co-author of this article, is vice president in charge of financial planning at Armstrong, Fleming & Moore, Inc., and a registered representative with Common-wealth Financial Network.
Individuals should contact a financial planner, tax adviser or attorney when considering these issues. Commonwealth Financial Network does not give tax or legal advice. Consult your personal adviser before making any decisions. The authors cannot answer individual inquiries, but they welcome suggestions for article topics.
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/0509fppublic.htm
Mood, Recent Events Can Change Your Point of View
by Alexandra Armstrong CFP, CCPS and Karen Preysnar CFP
8.4.2009
The dictionary defines risk as “the possibility of suffering harm or loss; danger.” But many people think of risk as the possibility of making money more than the potential of losing it. Or at least they did before experiencing the market of 2008. We’re willing to bet that you’d answer the question of how much risk you’re willing to take differently today than you would have in December 2007 when the current recession started.
The losses we saw in the stock market in 2008 as measured by the Standard & Poor’s 500 index1 surpassed previous annual losses since 1825 with the exception of 1931, reports Value Square Asset Management and Yale University. Last year’s losses weren’t confined to stocks, since corporate bonds lost value as well. Recently a money manager told us that in October, if you wanted to sell a bond position, it was difficult to find a buyer at any price. If you were invested during the last quarter of 2008, there was no place to hide — except in cash or U.S. Treasury securities.
The whole issue of risk is a difficult one to discuss. Unlike measuring height or weight, there’s no unit of measurement for risk tolerance. Your risk tolerance can be measured only relative to others on a constructed scale in much the same way an IQ is measured. Even the meaning of the word risk can depend on the situation. When individuals talk about risk as they experience it in their financial affairs, they aren’t talking about the same thing as investment researchers discussing the risk of a particular kind of investment.
As we mentioned in our November 2008 article, we provide our clients with a risk tolerance questionnaire with 20 questions. But this only gives us an idea of what degree of risk people are willing to take at the time they’re completing the questionnaire.
We have to recognize that your risk tolerance changes and can be easily influenced by recent information and even your moods. It’s easy to rate yourself as an aggressive risk-taker when you think home values and stock prices can only go up. When they come crashing down again, though, people tend to become very conservative very fast.
We think there are two basic ways of looking at risk-taking. The first is to assess the amount of financial risk you can afford to take. The second is to assess the amount of emotional risk you’re willing to take.
When assessing the level of financial risk you can afford to take, consider your age as well as the amount of assets you have. For instance, if you’re relatively young and part of a two-earner couple who don’t spend all your income, you should be able to afford to take more risk with your investments because you have time on your side. Even if your investments don’t work out as you hoped, you can make other investments in the future.
Those who are retired and need to live on the income from their investments, however, can’t afford to take as much risk. With retirees living longer than they did in previous generations, this has become more of an issue, particularly for those who don’t have a pension providing them with regular income.
The size of your total assets influences your attitude toward risk as well. People who have more assets than needed to maintain their lifestyle usually are willing to take more risk with at least some of their investments.
During the tech debacle of 2000-2002, values of homes were increasing. Assuming you hadn’t invested all your portfolio in tech stocks, even though the stock market was down as measured by the major indexes, you didn’t feel as poor because your house was worth more. Thus, you could tolerate riding out the down market of 2000-2002.
Between 2003 and 2007, your patience was rewarded, and hopefully you saw your investments grow in value. At the same time, the value of your home continued to go up. In some cases, during this period some retirees became complacent and withdrew more than the recommended 5 percent from their portfolios because they could do so. After all, they reassured themselves that their principal was intact. This past year’s market decline has changed all that. Now investors realize that markets really do go down as well as up and their investments can decline in value.
Once you’ve figured out how much financial risk you can afford to take, you need to measure your emotional attitude toward risk-taking. If your parents or grandparents lost all their money in 1929, or if your father wasn’t good at managing money, you may have difficulty taking risk with your own money. This is a very human reaction. It’s important to realize that these negative family experiences can have a lasting negative effect on your attitudes.
In addition, your attitude toward taking risk can vary over time based on your most recent experiences (either positive or negative) when you took risks. For example, some new clients will say they’re highly risk-averse, but when we examine their portfolios, they own some speculative investments. When we ask about this apparent inconsistency, they usually reply that they used to be risk-takers, but these investments didn’t work out well, so now they’re less willing to take risk. Obviously, the reverse can be true. If your experiences with taking risks were rewarded in the past, you’ll probably be more willing to take chances in the future.
After you’ve assessed how much risk you can afford to take and how much risk you’re comfortable taking, you should focus on risk reduction techniques. It’s important to start with the basic premise that it’s virtually impossible to avoid risk altogether. For instance, when you cross the street, you run the risk of being hit by a car. But there are ways you can reduce your risk. If you cross the street at a marked intersection when the light clearly indicates it’s safe for you to walk, you’ve greatly lessened your risk of being hit. If instead you’re jaywalking, you’re taking more risk.
When investing, the first way to control the negative impact of risk-taking to some extent is by doing your homework. There’s a difference between taking educated risks and speculating. Speculating is equivalent to racetrack betting if you put all your money on one horse with the name you like or the color of silks you prefer.
As a BetterInvesting member, you’re familiar with this concept of educating yourself. A company might have a wonderful product, but you need to check out its competition, the amount of debt the company has, its record of earnings and the relationship of earnings to the stock’s current price before deciding to invest in it.
We believe you can also reduce the risk you take with investments by diversifying your portfolio among different kinds of investments (international/U.S. stocks, bonds, cash) and within asset categories (small-cap, large-cap and so on). If you diversify, one investment might not work out as well as expected, but others may do well so that overall your total portfolio is worth more than the amount you invested.
For example, let’s compare two investors. Mary invests $100,000 that earns 8 percent annually. At the end of 20 years, her portfolio is worth $466,096. On the other hand, Jane invests her $100,000 among five different investments — $20,000 each. After 20 years she assesses her situation. The first investment is a total loss, while she gets her money back with the second. With the third investment, she received an average annual return of 5 percent; the fourth, 10 percent; and the fifth, 15 percent. At the end of 20 years, she would have $534,947 — almost $100,000 more than Mary does (see table, below).
Another way you can control your risk is to work with an experienced financial adviser. Although this isn’t necessarily a panacea, the adviser can show you different investment alternatives and explain both the risk and return potential of each choice. That way you can construct a portfolio that matches your risk tolerance.
We explain to clients that there’s no right or wrong attitude toward risk. What’s important is that you’re honest with both yourself and your adviser about your risk tolerance and construct your investment portfolio accordingly.
Rank your own risk temperament on a scale of 1 (risk-averse) to 10 (willing to take a high degree of risk) and then make sure you communicate this information to your adviser. If you’re married, are you more or less of a risk-taker than your spouse? We’ve often seen instances in which one spouse is willing to take a lot of risk and the other is willing to take few risks. This can lead to family conflict. You need to discuss this issue with each other, and some compromises may have to be made. For instance, the spouse who’s more willing to take risk might invest part of her portfolio in more aggressive investments than her partner.
After experiencing the 2008 stock market, many investors are shellshocked and may vow to avoid investing altogether, thus trying to avoid taking any risk. We don’t think this is a wise decision. Although this past year’s experience has been very difficult for everyone, it may have some good long-term results. Perhaps people will realize that you can’t make fortunes overnight, that you should avoid being heavily in debt, that you shouldn’t spend all your income, that it’s important to accumulate a cash reserve for a rainy day and that you really need to investigate before you invest. In other words, they may start believing all those maxims that financial planners have been preaching for years!
Although taking some risk is essential to making money, it has been our experience that you don’t have to be a speculator to build wealth successfully. We advocate controlling the amount of risk you take through self-education, portfolio diversification and consultation with a good adviser.
Having been in the investment business for over 40 years, we really believe that ultimately the pendulum will turn and selecting and holding good-quality investments will reward patient investors. We encourage you to take a deep breath, take educated risks and make sound decisions that aren’t based on emotions.
Keep in mind the tortoise and hare race. We believe the slow, steady, consistent approach works every time.
1 The S&P 500 index is an unmanaged index comprising widely held securities considered to be representative of the stock market in general. Performances of the indexes are not indicative of any particular investment. Individuals cannot invest directly in any index. Past performance is no guarantee of future results.
2 Diversification doesn’t guarantee against loss. It’s a method used to manage risk.
Alexandra Armstrong is co-author of the fourth edition of On Your Own: A Widow’s Passage to Emotional and Financial Well-Being. She is a Certified Financial Planner practitioner and chairman of Armstrong, Fleming & Moore, Inc., a registered investment advisory firm in Washington, D.C. Securities are offered through Common-wealth Financial Network, member FINRA/SIPC. Investment advisory services are offered through Armstrong, Fleming & Moore, Inc., an SEC-registered investment adviser not affiliated with Commonwealth Financial Network.
Karen Preysnar, Certified Financial Plan-ner practitioner, co-author of this article, is vice president in charge of financial planning at Armstrong, Fleming & Moore, Inc., and a registered representative with Common-wealth Financial Network.
Individuals should contact a financial planner, tax adviser or attorney when considering these issues. Commonwealth Financial Network does not give tax or legal advice. Consult your personal adviser before making any decisions. The authors cannot answer individual inquiries, but they welcome suggestions for article topics.
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/0509fppublic.htm
Inflation and Your Portfolio
Inflation’s Deflating Effect on Stocks
No Free Lunch With Looser Credit, Increased Government Spending
by Virginia B. Morris
13.5.2009
As unemployment increases and retail sales falter, the threat of inflation isn’t getting much attention. Instead, the government is focused on trying to stimulate spending as a way to end the recession. Using the primary tool at its disposal, the Federal Reserve has kept the federal funds rate between 0 percent and 0.25 percent since the end of 2008. By comparison, the rate was 5.25 percent in summer 2007, before the meltdown in the subprime mortgage market and the subsequent credit crisis.
Perhaps the most immediate effect of the Fed’s decision is the reduced rates on conventional mortgages available to borrowers with high credit scores. In many areas of the country, those rates are lower than they’ve been since 1965, according to Freddie Mac. Car dealers are offering even lower rates — though sometimes with strings attached — to get moribund vehicle sales moving.
But even with the added liquidity that low rates provide, there’s been relatively little economic growth. One reason is that people concerned about losing their jobs are reluctant to make major financial commitments, including
discretionary or large purchases. Similarly, businesses that may be able to borrow more cheaply, or hire talented workers more easily, than they could six months ago
may be reluctant to expand when the timeline for an economic recovery is uncertain.
Meanwhile, if the Fed’s looser credit policy works — and we have to hope it does — the downside is that it could kick off a new inflationary spiral.
The spiral typically works like this: On the consumer front, increasing demand for a range of products would drive prices up because months of production cuts have reduced supply. On the business side, the increased costs of adding new employees and new equipment to meet demand would result in higher prices for new products. More problematic, an expanding economy typically increases demand for energy, which can ratchet up costs across the board.
Inflation and Your Portfolio
As if paying more for almost everything weren’t enough, rising inflation can also create problems for your stock portfolio. An old rule of thumb is that when inflation threatens, stock prices suffer.
One explanation for falling stock prices in an inflationary period is that interest rates also often inflate as the Fed tightens the money supply to rein in borrowing. When the rate investors can earn on insured bank CDs is high enough, they tend to move out of stocks and into CDs. The thinking is that there’s no reason to risk losing principal when you can realize a higher return with no risk.
In addition, investors may be concerned that the higher earnings companies report in inflationary periods may result from artificially high prices rather than productivity gains. In that case, investors may be unwilling to pay the current price for the stock or, if they own it already, decide it’s time to sell. Similarly, if they sense that inflation is getting out of hand, they may anticipate that the Fed will reverse course and tighten its credit policy. In that case, companies that have become too dependent on easy credit are likely to lose traction as borrowing becomes more expensive. As their expectations falter, their stock prices are likely to fall.
The Deficit and Stock Prices
Another, more serious threat to stock prices may be the increased federal deficits that result from the programs designed to jump-start the economy and put more money into circulation. To meet its obligations, if the Treasury needs to raise rates on its issues to attract investors, those higher rates will attract money that might otherwise have gone into stocks, pushing equity prices lower.
At the same time, if unemployment remains high, the country could witness a replay of the stagflation — high inflation in a stagnant economy — that plagued the United States in the 1970s and early 1980s. In 1980, for example, the inflation rate topped 13 percent — more than 10 percentage points above the historical annual average of 3 percent.
Yet as concerned as stock investors may be about prospective inflation, it pays to remember that the early 1980s were followed by the longest bull market in U.S. history. Although this isn’t a prediction of what may happen over the next few years, history may provide some assurance that stocks have the potential to rebound even from the toughest times.
Virginia B. Morris is the Editorial Director for Lightbulb Press.
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/060709abpublic.htm
No Free Lunch With Looser Credit, Increased Government Spending
by Virginia B. Morris
13.5.2009
As unemployment increases and retail sales falter, the threat of inflation isn’t getting much attention. Instead, the government is focused on trying to stimulate spending as a way to end the recession. Using the primary tool at its disposal, the Federal Reserve has kept the federal funds rate between 0 percent and 0.25 percent since the end of 2008. By comparison, the rate was 5.25 percent in summer 2007, before the meltdown in the subprime mortgage market and the subsequent credit crisis.
Perhaps the most immediate effect of the Fed’s decision is the reduced rates on conventional mortgages available to borrowers with high credit scores. In many areas of the country, those rates are lower than they’ve been since 1965, according to Freddie Mac. Car dealers are offering even lower rates — though sometimes with strings attached — to get moribund vehicle sales moving.
But even with the added liquidity that low rates provide, there’s been relatively little economic growth. One reason is that people concerned about losing their jobs are reluctant to make major financial commitments, including
discretionary or large purchases. Similarly, businesses that may be able to borrow more cheaply, or hire talented workers more easily, than they could six months ago
may be reluctant to expand when the timeline for an economic recovery is uncertain.
Meanwhile, if the Fed’s looser credit policy works — and we have to hope it does — the downside is that it could kick off a new inflationary spiral.
The spiral typically works like this: On the consumer front, increasing demand for a range of products would drive prices up because months of production cuts have reduced supply. On the business side, the increased costs of adding new employees and new equipment to meet demand would result in higher prices for new products. More problematic, an expanding economy typically increases demand for energy, which can ratchet up costs across the board.
Inflation and Your Portfolio
As if paying more for almost everything weren’t enough, rising inflation can also create problems for your stock portfolio. An old rule of thumb is that when inflation threatens, stock prices suffer.
One explanation for falling stock prices in an inflationary period is that interest rates also often inflate as the Fed tightens the money supply to rein in borrowing. When the rate investors can earn on insured bank CDs is high enough, they tend to move out of stocks and into CDs. The thinking is that there’s no reason to risk losing principal when you can realize a higher return with no risk.
In addition, investors may be concerned that the higher earnings companies report in inflationary periods may result from artificially high prices rather than productivity gains. In that case, investors may be unwilling to pay the current price for the stock or, if they own it already, decide it’s time to sell. Similarly, if they sense that inflation is getting out of hand, they may anticipate that the Fed will reverse course and tighten its credit policy. In that case, companies that have become too dependent on easy credit are likely to lose traction as borrowing becomes more expensive. As their expectations falter, their stock prices are likely to fall.
The Deficit and Stock Prices
Another, more serious threat to stock prices may be the increased federal deficits that result from the programs designed to jump-start the economy and put more money into circulation. To meet its obligations, if the Treasury needs to raise rates on its issues to attract investors, those higher rates will attract money that might otherwise have gone into stocks, pushing equity prices lower.
At the same time, if unemployment remains high, the country could witness a replay of the stagflation — high inflation in a stagnant economy — that plagued the United States in the 1970s and early 1980s. In 1980, for example, the inflation rate topped 13 percent — more than 10 percentage points above the historical annual average of 3 percent.
Yet as concerned as stock investors may be about prospective inflation, it pays to remember that the early 1980s were followed by the longest bull market in U.S. history. Although this isn’t a prediction of what may happen over the next few years, history may provide some assurance that stocks have the potential to rebound even from the toughest times.
Virginia B. Morris is the Editorial Director for Lightbulb Press.
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/060709abpublic.htm
Six Defensive Moves in a Down Market
Six Defensive Moves in a Down Market
A Great Time for Regular Investing
by CraneAmyButtell
24.12.2008
Market volatility is enough to give any investor heartburn these days. Although there have been some notable gains — the Dow Jones industrial average’s 889.4 point gain on Oct. 28 being one of the most impressive ever — most of the volatility has been on the downside.
With the media delivering one grim story after another about the economy, most observers aren’t expecting to see the market stabilize soon. Unemployment is up, banks aren’t lending, big corporations are teetering on the brink of bankruptcy and banks are failing at a rapid clip, news that doesn’t exactly inspire confidence.
Still, with so much riding on your investments, including your retirement and your kids’ college savings, you might feel it’s time to position yourself somewhat defensively given how long this downturn might last. You don’t want to stop investing, because there’s no way to know when the market will rebound; you have too much to lose by being out of the market at the wrong time. But here are some steps you can take to lessen the pain and position yourself as best you can.
Dollar-Cost-Average Your Contributions
You’re most likely already doing a lot of dollar-cost averaging — investing a set amount regularly — if you’re contributing to a 401(k) or college savings plan. This is a good strategy no matter what the market is doing because when you dollar-cost average, you buy more shares when prices are lower and fewer shares when prices are higher, keeping your overall cost basis down.
If you can employ this technique with your other investment accounts, do so. By dollar-cost averaging in a volatile market, you keep your cost basis down. If prices fall farther, you’ll benefit more by spreading your purchases out over a longer period than if you just invested a lump sum all at once.
For example, if you have an individual retirement account and plan to invest the maximum allowable of $5,000 annually, you could arrange to have $416.66 transferred from your bank account to your IRA every month and have that invested in the stock, mutual fund or bond of your choice. Or you could invest the money all at once in your IRA at the beginning of the year, then dollar-cost average it out yourself over a year.
Consider Stop-Losses?
Stop-losses aren’t a good idea for most investors in most long-term investing situations. But if you absolutely cannot afford to lose more than a certain amount of money in your investment accounts, this strategy is worth considering.
You might fall into this category if you’re a retiree on a fixed income with only a certain amount of assets in your retirement account besides your Social Security. To implement this strategy, you either call your broker or go into your online investment account and set a floor on some of your investments. When the prices of the securities you select reach those floors, your brokerage will automatically sell them.
Keep in mind, however, that in falling markets the price can blow right by your stop-loss order and you may be sold out at a much lower price. This is why you should employ this strategy cautiously. (Editor’s note: Many investors don’t like stop-loss orders because of their automated nature and because they might cause you to sell high-quality stocks that drop for reasons unrelated to their fundamentals.)
Save More
In a difficult economy, it makes sense to hunker down and cut your expenses where you can. Unemployment is rising, and you never know when you or your spouse might be out of a job. If you do hang on to your job, later on you can invest some of your excess cash for your retirement, your children’s college education or any other long-term goals you have.
Below are the extra savings you can expect to generate for differing saving rates. The following assumes you’ll reap 8 percent annual compound interest, pay 25 percent in federal taxes and 6.5 percent in state taxes, and see an average inflation rate of 3 percent:
• by saving $50 a month for 30 years, you increase your savings by $25,970
• by saving $100 a month for 30 years, you increase your savings by $51,940
• by saving $200 a month for 30 years, you increase your savings by $103,880
Stretch Out the Long Term
Change your attitude on what constitutes the long term and remember that stocks historically have averaged an annual return of 10 percent or more. Think of the long term as 20 or 30 years, or even more, rather than five or 10 years.
Because stocks increased so much in the 1990s and in the 2000s after the end of the dot-com bust, the law of averages dictates that the market will then have a number of average or subpar return years at some point.
Large returns are nice, but there’s no guarantee they’ll continue in the short run. History shows that the stock market has produced many years of ugly returns, even consecutively, or returns that have gone essentially nowhere over a number of years. Think about the late 1920s and 1930s as well as the mid-to-late 1970s and early 1980s.
Surviving a negative or sideways market that lasts for years takes a lot of patience. In those circumstances, continue dollar-cost averaging, work on bolstering your cash cushion and save every dime you can get your hands on.
If you’re getting close to retirement age, consider staying on the job a few years longer to shore up your nest egg. If that isn’t a possible, consult or take on a part-time job.
Just about the worst thing you can do is start drawing your assets down when the market is tanking, as it will be difficult for your investments to recover sufficiently to fund the rest of your retirement, given lengthening life spans.
Check Your Asset Allocation
With stocks and below-investment-grade bonds taking substantial hits in the last few months, it’s likely that your target asset allocation is out of whack. Take a look at your investment accounts and determine what you need to do to get back to your target allocations.
Financial planners generally recommend that you reallocate assets periodically, with once a year being a good benchmark. At this annual reallocation, you should move investment funds from asset classes that have done well, or at least have not done as badly as others, and move them into those that have declined, such as stocks.
Given the uncertainty of the markets, it might make sense to reallocate gradually rather than all at once. For example, if your investment accounts total $100,000 and your target allocation is 60 percent stock, 20 percent bonds and 10 percent cash, you could move funds out of bonds and cash gradually to bolster your stock allocation up to the preferred target.
Such a gradual shift could work in several ways. For example, you could move money out of bonds into cash all at once, then gradually dollar-cost average into stocks over the next six months or year or so. (Editor’s note: Be careful with asset allocation so that you’re not trying to time the market, an often disappointing venture. Many investors believe that for a long-term portfolio, there’s little reason to own anything except stocks.)
Expand Your Cash Cushion
Cash is an important bulwark in a falling market and during what’s shaping up to be a potentially long recession. When you have enough cash to last out the ups and downs of the markets without having to sell any of your investments, you can respond to market developments rather than react to them.
Financial planners recommend that employed workers have six months of living expenses squirreled away. Retirees should have at least two years of cash, preferably more, so that they can ride out a bear market of several years without having to sell investments at fire-sale prices for living expenses.
If you’re still working, see where you can trim your expenses and direct those savings into a bank savings or money market account. Interest rates on these savings vehicles aren’t great, but the ease of access to these funds is the most important factor.
With an expanded cash cushion, there’s less danger that you’ll need to tap your investment accounts for funds, whether by liquidating taxable mutual funds, stocks or bonds or by arranging to borrow from your 401(k) account.
No Time to Cash Out
When positioning your portfolio, it makes sense to play both defense and offense. Just remember not to give in to your emotions and get out of the market altogether, no matter how dire the markets and the economy may seem today. The next upturn is impossible to predict.
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/0109mfmpublic.htm
Explaining the Mark-to-Market Controversy
Fair Game for Asset Values
Explaining the Mark-to-Market Controversy
by Virginia B. Morris
If you want to know what a stock sells for, you look at its current market price. That price might be different from what it was yesterday or what it will be later today or tomorrow. But it’s what the stock is worth right now because it’s what you could sell it for. The value of an investment, in this sense, is determined by how interested other investors are in owning it at this moment.
The market price of a mutual fund share is also clear — although it’s determined by the value of its underlying investments and the number of outstanding shares in the fund, rather than by what people are willing to pay for fund shares. Once a day a fund, using a process known as mark-to-market, finds the closing prices of the securities in its portfolio. Then it calculates the fund’s net asset value, which is its per-share price for the next 24 hours.
Futures contracts, which tend to be significantly more volatile than either stocks or mutual funds, are also marked-to-market every day to make those markets more transparent.
The Fairness of a Fair Value Price
In effect, mark-to-market is a widely recognized method for determining the fair market value of an investment. If that’s the case, why do some people want regulators to suspend this established accounting practice amid the current financial uncertainty?
For starters, it helps to know about rule FAS 157, which U.S. government regulators introduced in 2007. This rule requires publicly traded financial companies to report the value of some, though not all, of their assets and liabilities by marking them to market. The controversy arises because the assets that must be marked-to-market are those that either trade infrequently or don’t trade at all, basically because nobody wants to buy them.
If you own something you can’t sell, what’s its value? Often, it isn’t worth what you paid for it. And if you borrowed money to buy the asset, it could be worth less than you owe. That’s the predicament many homeowners face as housing values have dropped and credit has dried up.
This problem of owning assets whose value has shrunk is magnified for financial companies, partly because so much money is at stake. In addition, these companies are required to keep a certain amount of capital on hand to meet their obligations.
If cash is running short — perhaps because clients pull their money out — these companies have to sell whatever assets they can, at whatever prices they can get, to have adequate funds on hand. These fire-sale prices become the new valuation for similar assets that the company retains and for comparable assets owned by other firms.
When these diminished values are reported on a company’s balance sheet, as they must be under the rules, the firm’s financial situation appears significantly less healthy than it would be if the assets’ purchase prices were being reported instead. And the less value a company’s balance sheet shows, the harder it is for that company to borrow, potentially threatening its ability to survive.
To Mark or Not to Mark
Would relaxing or eliminating the mark-to-market rules loosen up credit and help trigger an economic recovery? Advocates of this approach insist that in bad times, assets can be hard to value and harder to sell. Further, they argue that firms shouldn’t have to value long-term assets for what they could be sold for immediately, especially if the companies don’t want or need to sell them.
Opponents of relaxing the rule are equally adamant. They maintain that transparency is essential for a strong and healthy economy and that the current financial problems aren’t the result of mark-to-market rules. Rather, they point out, many of the companies at risk were eager for outsized profits, so they invested in innovative and perhaps fatally flawed products whose true value was never established.
One of the first things you learn as an investor is that you should avoid securities you don’t understand and that a thinly traded product puts you at increased risk. So you may wonder why these investment basics seem to have escaped the notice of so many experienced financial professionals.
Virginia B. Morris is the Editorial Director for Lightbulb Press.
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/0109abpublic.htm
Explaining the Mark-to-Market Controversy
by Virginia B. Morris
If you want to know what a stock sells for, you look at its current market price. That price might be different from what it was yesterday or what it will be later today or tomorrow. But it’s what the stock is worth right now because it’s what you could sell it for. The value of an investment, in this sense, is determined by how interested other investors are in owning it at this moment.
The market price of a mutual fund share is also clear — although it’s determined by the value of its underlying investments and the number of outstanding shares in the fund, rather than by what people are willing to pay for fund shares. Once a day a fund, using a process known as mark-to-market, finds the closing prices of the securities in its portfolio. Then it calculates the fund’s net asset value, which is its per-share price for the next 24 hours.
Futures contracts, which tend to be significantly more volatile than either stocks or mutual funds, are also marked-to-market every day to make those markets more transparent.
The Fairness of a Fair Value Price
In effect, mark-to-market is a widely recognized method for determining the fair market value of an investment. If that’s the case, why do some people want regulators to suspend this established accounting practice amid the current financial uncertainty?
For starters, it helps to know about rule FAS 157, which U.S. government regulators introduced in 2007. This rule requires publicly traded financial companies to report the value of some, though not all, of their assets and liabilities by marking them to market. The controversy arises because the assets that must be marked-to-market are those that either trade infrequently or don’t trade at all, basically because nobody wants to buy them.
If you own something you can’t sell, what’s its value? Often, it isn’t worth what you paid for it. And if you borrowed money to buy the asset, it could be worth less than you owe. That’s the predicament many homeowners face as housing values have dropped and credit has dried up.
This problem of owning assets whose value has shrunk is magnified for financial companies, partly because so much money is at stake. In addition, these companies are required to keep a certain amount of capital on hand to meet their obligations.
If cash is running short — perhaps because clients pull their money out — these companies have to sell whatever assets they can, at whatever prices they can get, to have adequate funds on hand. These fire-sale prices become the new valuation for similar assets that the company retains and for comparable assets owned by other firms.
When these diminished values are reported on a company’s balance sheet, as they must be under the rules, the firm’s financial situation appears significantly less healthy than it would be if the assets’ purchase prices were being reported instead. And the less value a company’s balance sheet shows, the harder it is for that company to borrow, potentially threatening its ability to survive.
To Mark or Not to Mark
Would relaxing or eliminating the mark-to-market rules loosen up credit and help trigger an economic recovery? Advocates of this approach insist that in bad times, assets can be hard to value and harder to sell. Further, they argue that firms shouldn’t have to value long-term assets for what they could be sold for immediately, especially if the companies don’t want or need to sell them.
Opponents of relaxing the rule are equally adamant. They maintain that transparency is essential for a strong and healthy economy and that the current financial problems aren’t the result of mark-to-market rules. Rather, they point out, many of the companies at risk were eager for outsized profits, so they invested in innovative and perhaps fatally flawed products whose true value was never established.
One of the first things you learn as an investor is that you should avoid securities you don’t understand and that a thinly traded product puts you at increased risk. So you may wonder why these investment basics seem to have escaped the notice of so many experienced financial professionals.
Virginia B. Morris is the Editorial Director for Lightbulb Press.
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/0109abpublic.htm
Using Book Value in Making Investment Decisions
Going by the Book
Using Book Value in Making Investment Decisions
by Virginia B. Morris
Heading the list of questions investors sometimes struggle to answer is the perennial “What’s this stock worth?” The response is never simple, since there are several ways of assessing value. One of the most reliable ways is to use a combination of ratios, also called multiples. The BetterInvesting methodology employs the price-earnings ratio, which compares the stock’s price with its earnings per share.
Investors also measure a company’s stock price in relation to entries on its balance sheet. One of those ratios is price-to-book, or a stock’s market price divided by book value per share.
A stock’s book value, also called its net asset value and sometimes its shareholder equity, is key to figuring its price-to-book. Even if you don’t use price-to-book in your analysis, you should understand what book value is because it’s part of the calculation of return on equity, a key measure of management performance on the Stock Selection Guide.
Basically, book value is the company’s assets minus its liabilities, divided by the number of outstanding shares. The liabilities include the obligations the company has to its bondholders and preferred stockholders.
Some stock research companies report price-to-book over time, such as 10 years, as well as percentage growth in book value. You can also calculate book value on your own, using the company’s financial reports. You find net assets by subtracting the company’s short- and long-term liabilities from its assets. Then divide net assets by the number of outstanding shares to find the per-share results.
Two cautions: Check what’s being counted as assets. If intangibles such as goodwill or brand value are being included, those amounts should be subtracted to determine net assets. Also, as a related point, book value is more meaningful for companies that have actual physical assets that can be valued.
What P/B Tells You
Book value is important because it can help you determine whether a stock you may be interested in is underpriced and therefore potentially worth purchasing.
If the market price of a stock and its book value are the same, its price-to-book value is said to be 1. In that case, investors are paying exactly the value of the company’s reported assets. If the ratio is more than 1, they’re paying for past performance or what they anticipate the company’s future performance will be. That’s quite common, especially for companies with strong earnings.
Conversely, a ratio of less than 1 may indicate investors aren’t convinced that the assets the company is reporting are credible. It also may signal that the company’s performance has been disappointing or the stock is out of favor with investors for some other reason. Questionable valuation of assets, of course, is a reason to steer clear of the stock, while the latter instance, which is remediable, may be a reason to consider buying.
One for the Books
Both book value and price-to-book change constantly as a stock’s market value and the number of its outstanding shares continually fluctuate. As a result, these numbers are “snapshots” that report the present but can’t predict the future.
If you’re just beginning to investigate a stock, however, book value is a useful benchmark to watch as you track the issuing company over time. That’s especially true if you’re looking at a number of stocks in the same sector or industry, since the price-to-book value can be strikingly similar across companies of varying sizes in the same industry. One that’s out of sync may be a stock that merits closer attention.
As you study a stock, putting its price-to-book and percentage growth in book value in a historical context can be helpful in establishing a target price you’re o use this ratio want a sense of where the current price fits in relation to earlier highs and lows in helping them pinpoint a price range that would allow them to realize a satisfactory return.
Putting Value in Perspective
Book value and a price-to-book ratio, by themselves, should never be the single basis for making an investment decision, any more than the ROE, EPS or P/E should be. But each can be a valuable addition to your research toolbox, and used in combination they can provide a valid foundation for choice.
Virginia B. Morris is the Editorial Director for Lightbulb Press.
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/0409abpublic.htm
Using Book Value in Making Investment Decisions
by Virginia B. Morris
Heading the list of questions investors sometimes struggle to answer is the perennial “What’s this stock worth?” The response is never simple, since there are several ways of assessing value. One of the most reliable ways is to use a combination of ratios, also called multiples. The BetterInvesting methodology employs the price-earnings ratio, which compares the stock’s price with its earnings per share.
Investors also measure a company’s stock price in relation to entries on its balance sheet. One of those ratios is price-to-book, or a stock’s market price divided by book value per share.
A stock’s book value, also called its net asset value and sometimes its shareholder equity, is key to figuring its price-to-book. Even if you don’t use price-to-book in your analysis, you should understand what book value is because it’s part of the calculation of return on equity, a key measure of management performance on the Stock Selection Guide.
Basically, book value is the company’s assets minus its liabilities, divided by the number of outstanding shares. The liabilities include the obligations the company has to its bondholders and preferred stockholders.
Some stock research companies report price-to-book over time, such as 10 years, as well as percentage growth in book value. You can also calculate book value on your own, using the company’s financial reports. You find net assets by subtracting the company’s short- and long-term liabilities from its assets. Then divide net assets by the number of outstanding shares to find the per-share results.
Two cautions: Check what’s being counted as assets. If intangibles such as goodwill or brand value are being included, those amounts should be subtracted to determine net assets. Also, as a related point, book value is more meaningful for companies that have actual physical assets that can be valued.
What P/B Tells You
Book value is important because it can help you determine whether a stock you may be interested in is underpriced and therefore potentially worth purchasing.
If the market price of a stock and its book value are the same, its price-to-book value is said to be 1. In that case, investors are paying exactly the value of the company’s reported assets. If the ratio is more than 1, they’re paying for past performance or what they anticipate the company’s future performance will be. That’s quite common, especially for companies with strong earnings.
Conversely, a ratio of less than 1 may indicate investors aren’t convinced that the assets the company is reporting are credible. It also may signal that the company’s performance has been disappointing or the stock is out of favor with investors for some other reason. Questionable valuation of assets, of course, is a reason to steer clear of the stock, while the latter instance, which is remediable, may be a reason to consider buying.
One for the Books
Both book value and price-to-book change constantly as a stock’s market value and the number of its outstanding shares continually fluctuate. As a result, these numbers are “snapshots” that report the present but can’t predict the future.
If you’re just beginning to investigate a stock, however, book value is a useful benchmark to watch as you track the issuing company over time. That’s especially true if you’re looking at a number of stocks in the same sector or industry, since the price-to-book value can be strikingly similar across companies of varying sizes in the same industry. One that’s out of sync may be a stock that merits closer attention.
As you study a stock, putting its price-to-book and percentage growth in book value in a historical context can be helpful in establishing a target price you’re o use this ratio want a sense of where the current price fits in relation to earlier highs and lows in helping them pinpoint a price range that would allow them to realize a satisfactory return.
Putting Value in Perspective
Book value and a price-to-book ratio, by themselves, should never be the single basis for making an investment decision, any more than the ROE, EPS or P/E should be. But each can be a valuable addition to your research toolbox, and used in combination they can provide a valid foundation for choice.
Virginia B. Morris is the Editorial Director for Lightbulb Press.
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/0409abpublic.htm
The Quest for Sustainedable Earnings Growth
The Quest for Railroad-Track Growth
Often a Sign of Good Management, Sometimes Too Good to Be True
by Michael Maiello
Sustainable earnings growth is a Holy Grail sought by investors of all stripes. Value investing guru Benjamin Graham searched for it, choosing stocks based in part on a management team’s ability to generate an upward trend in earnings over many years. Graham was a bit accommodating with this requirement; he’d tolerate flat earnings for a year or two so long as it didn’t look as if earnings were about to break through the floor. He believed stock prices eventually would track growing earnings over time.
Growth investors expect more. BetterInvesting members look for companies that have a consistent history of producing better-than-average earnings growth. In innovation-based industries such as pharmaceuticals and technology, this can often mean double-digit earnings growth even as stocks in the broader market are buffeted by recession.
The managers of the U.S. Trust Focused Large-Cap Growth Fund explain the strategy this way: “Emphasis is placed on selecting high-quality companies having dominant industry positions, strong financials and consistently high earnings growth rates. Such companies tend to be brand name, globally dominant companies in open-ended growth industries such as devices/biotech/ genetics, information technology, global consumer brands and global financial companies.”
Consistent earnings growth implies that a company is in a position to maintain dominance and has the management team to do it. A good example is Johnson & Johnson. Its five-year earnings growth rate is 13.8 percent a year, creating enough steady increases to fund 14 percent growth in dividends over that time and more than 20 percent return on equity. J&J has a diversified product line across pharmaceuticals, home products and consumer goods. Its ability to distribute products around the world is difficult for competitors to match much less beat. This seems to be a company where the past growth is indicative of good management and a dominant market position. (Companies are mentioned in this article for educational purposes only. No investment recommendations are intended.)
Apple has grown earnings at well over 100 percent annually for the last five years, an amazing run as new products such as the iPod and iPhone were brought to market and then allowed to mature. These are widely acknowledged as the products of Steve Jobs’ genius, or at least of the culture of design he implemented and fostered during his tenure at the company. A lot of companies had MP3 players and smart phones before Apple, but only Apple made them cool.
But the Apple example brings us to the pitfall of this style of investing. Apple isn’t exactly like J&J. Apple has a good number of larger competitors (such as Sony and Microsoft) that can, and often do, undersell it. Also, fads change, so although Apple’s proven ability to remain in style is nice to know, investors can’t count on it. Look at what happened to The Gap, which was once a hot brand but hasn’t been in a decade.
Another concern is that consistent earnings growth is extremely hard to produce, so investors should try to learn more when seeing 15 percent growth year after year. Enron is among the most notorious examples of this principle. Between 1997 and 2000 the company’s management team somehow beat analysts’ earnings estimates more than three quarters of the time, an amazing feat we now know was made possible by accounting shenanigans that kept losses and liabilities out of the picture. Enron’s managers were also masters at inorganic growth — boosting earnings through acquisitions and asset sales rather than by improving fundamentals in its business.
Finally, watch out for “earnings smoothing,” the term academics and regulators use to describe cases in which company managers adhere strictly to the letter of generally accepted accounting principles, or GAAP, but not quite to the spirit of it. Some have charged that financial firms used loopholes and oversights in the complicated body of GAAP rules to consistently understate losses and potential losses they faced from subprime mortgage exposure early in the credit crisis. This explains why, as the crisis unfolded, there seemed to be so many new surprises from companies that had supposedly come clean.
One rule of thumb: If the earnings growth doesn’t have a simple explanation behind it, as in the case of, say, J&J, Wal-Mart or Apple, at the very least be skeptical.
BetterInvesting’s Online Tools
The Stock Selection Guide, the primary stock study tool of BetterInvesting members, helps you identify stocks with histories of sales and earnings growth. Our new online tool will walk you through evaluating a company using the SSG. Click on the Online Tools & Software link under the Tools & Resources menu on the BetterInvesting homepage. Your membership may already include access to the tool; if not, you can upgrade your membership to use it.
Michael Maiello, who wrote "Fly With the Fundamentals" for the January 2006 issue, is the author of Buy the Rumor, Sell the Fact (McGraw-Hill, 2004).
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/0809fundamentalpublic.htm
Often a Sign of Good Management, Sometimes Too Good to Be True
by Michael Maiello
Sustainable earnings growth is a Holy Grail sought by investors of all stripes. Value investing guru Benjamin Graham searched for it, choosing stocks based in part on a management team’s ability to generate an upward trend in earnings over many years. Graham was a bit accommodating with this requirement; he’d tolerate flat earnings for a year or two so long as it didn’t look as if earnings were about to break through the floor. He believed stock prices eventually would track growing earnings over time.
Growth investors expect more. BetterInvesting members look for companies that have a consistent history of producing better-than-average earnings growth. In innovation-based industries such as pharmaceuticals and technology, this can often mean double-digit earnings growth even as stocks in the broader market are buffeted by recession.
The managers of the U.S. Trust Focused Large-Cap Growth Fund explain the strategy this way: “Emphasis is placed on selecting high-quality companies having dominant industry positions, strong financials and consistently high earnings growth rates. Such companies tend to be brand name, globally dominant companies in open-ended growth industries such as devices/biotech/ genetics, information technology, global consumer brands and global financial companies.”
Consistent earnings growth implies that a company is in a position to maintain dominance and has the management team to do it. A good example is Johnson & Johnson. Its five-year earnings growth rate is 13.8 percent a year, creating enough steady increases to fund 14 percent growth in dividends over that time and more than 20 percent return on equity. J&J has a diversified product line across pharmaceuticals, home products and consumer goods. Its ability to distribute products around the world is difficult for competitors to match much less beat. This seems to be a company where the past growth is indicative of good management and a dominant market position. (Companies are mentioned in this article for educational purposes only. No investment recommendations are intended.)
Apple has grown earnings at well over 100 percent annually for the last five years, an amazing run as new products such as the iPod and iPhone were brought to market and then allowed to mature. These are widely acknowledged as the products of Steve Jobs’ genius, or at least of the culture of design he implemented and fostered during his tenure at the company. A lot of companies had MP3 players and smart phones before Apple, but only Apple made them cool.
But the Apple example brings us to the pitfall of this style of investing. Apple isn’t exactly like J&J. Apple has a good number of larger competitors (such as Sony and Microsoft) that can, and often do, undersell it. Also, fads change, so although Apple’s proven ability to remain in style is nice to know, investors can’t count on it. Look at what happened to The Gap, which was once a hot brand but hasn’t been in a decade.
Another concern is that consistent earnings growth is extremely hard to produce, so investors should try to learn more when seeing 15 percent growth year after year. Enron is among the most notorious examples of this principle. Between 1997 and 2000 the company’s management team somehow beat analysts’ earnings estimates more than three quarters of the time, an amazing feat we now know was made possible by accounting shenanigans that kept losses and liabilities out of the picture. Enron’s managers were also masters at inorganic growth — boosting earnings through acquisitions and asset sales rather than by improving fundamentals in its business.
Finally, watch out for “earnings smoothing,” the term academics and regulators use to describe cases in which company managers adhere strictly to the letter of generally accepted accounting principles, or GAAP, but not quite to the spirit of it. Some have charged that financial firms used loopholes and oversights in the complicated body of GAAP rules to consistently understate losses and potential losses they faced from subprime mortgage exposure early in the credit crisis. This explains why, as the crisis unfolded, there seemed to be so many new surprises from companies that had supposedly come clean.
One rule of thumb: If the earnings growth doesn’t have a simple explanation behind it, as in the case of, say, J&J, Wal-Mart or Apple, at the very least be skeptical.
BetterInvesting’s Online Tools
The Stock Selection Guide, the primary stock study tool of BetterInvesting members, helps you identify stocks with histories of sales and earnings growth. Our new online tool will walk you through evaluating a company using the SSG. Click on the Online Tools & Software link under the Tools & Resources menu on the BetterInvesting homepage. Your membership may already include access to the tool; if not, you can upgrade your membership to use it.
Michael Maiello, who wrote "Fly With the Fundamentals" for the January 2006 issue, is the author of Buy the Rumor, Sell the Fact (McGraw-Hill, 2004).
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/0809fundamentalpublic.htm
Investing for Beginners
Investing for Beginners
with Joshua Kennon
One on One: Ellis Traub
If you want to take your first walk down Wall Street, Ellis Traub will be happy to show you the way
Ellis Traub
One on one
With four sons about to enter college, Ellis Traub lost everything. Today, he's a widely respected author, Chairman of the NAIC, and CEO of Investware. Learn how you can avoid the same mistakes he did - and save your pocketbook a lot of trouble.
PROFILE
Name: Ellis Traub
Occupation: Author and CEO
Location: Davie, FL
Education: Harvard, Left School to Fight in the Korean War
There are only ten terms that a person needs to know, all of them very intuitive. They can be applied to any company, whether it's General Motors or Lucy's Lemonade stand.".
-Ellis Traub
A Random Walk Down Wall Street: Ellis' Story
JK: You were an airline pilot for thirty-one years. What made you get involved in finance and investing?
Traub: I got involved in finance and investing out of necessity. I made some serious investment mistakes when I had four sons to send to college and lost nearly everything I had. That experience frightened me out of the market for a decade and a half. When I retired from the airline, I needed to take care of my pension and failed again. Fortunately, I stumbled onto the National Association of Investors Corporation (NAIC), a non-profit organization whose mission is to educate amateur investors to be successful. NAIC turned my financial life around.
I was inspired to learn and teach their methods and wrote a software program (to simplify calculations) that ultimately became the organization’s official stock analysis software. From that time forward, I've been dedicated to helping others avoid the same mistakes I made and encouraging them to find out how simple it is to invest successfully in common stocks.
JK: Your first experience with investing is something that a lot of my readers can identify with. One of your mistakes was investing on margin; could you tell us exactly what happened?
Traub: During the 1972 presidential campaign, I met a young fellow who was a broker for a major stockbrokerage firm. Concerned that I wouldn’t have enough to send the kids through school, I asked what I might do to beef up my savings. He recommended that I invest my savings in a hot stock and hold it until two weeks before the election at which time I should sell it for a huge profit. His justification was that the incumbents would continue to pump up the economy prior to the election.
I didn't have a clue and took his advice, selecting the stock that had the biggest daily gain the previous day for my "hot stock."
Needless to say, that was a bad strategy and, when half of Wall Street lost their proverbial shirts, I went along with them, not only having invested all my savings but margining as much as I could and borrowing all I could on my signature. When the dust cleared, I had a house, a car, the debt on them, and fortunately a good job flying airplanes.
JK: Very early on in the book you mention the other mistakes you made as a new investor. Everyday, people write in and they are doing the same things you mention - would you mind repeating them here?
Traub: Those mistakes largely stemmed from my mistaken belief that investing was above and beyond my ability, and the lack of basic investment knowledge.
I didn't start early enough to invest regularly and intelligently. I sought, listened to, and took the advice of someone that wasn't really qualified to offer counsel. I invested without understanding what a share of stock was and what I should expect of it. I sold it without understanding the proper reasons for selling a stock. And I stayed out of the market during my most productive years, losing the best opportunity to make money through long-term stock ownership.
JK: Your first experience with the stock market scared you away for more than fifteen years. Do you think that is a common thing with most new investors?
Traub: I think we're seeing that happening right now. This is the time people should review their holdings, keep the stocks with the best potential, sell the losers (not those with the depressed prices but those whose revenues and earnings aren't capable of growing adequately), and buy others with better potential while they're selling cheap. Instead, people are selling out and running. As simple as it is to learn how to make the right decisions, read Take Stock to find out just how easy, there's no reason for investors to go through the same experience as I did when they can make those now and prosper.
JK: In the book you mention that it was fortunate you didn’t have access to your retirement accounts, or else you would have thrown those into a hot stock as well. Does this mean you think people should have a retirement account [such as a 401k or IRA] separate from their everyday portfolio?
Traub: I think that folks should do anything they can to legitimately and efficiently maximize their accumulation of funds so that they can regularly invest a fixed amount. Certainly programs that offer matching funds or corporate contributions accomplish both goals and add the benefit of tax deferment as well.
The thrust of my comment is really that folks shouldn't jump into any "hot stock" without knowing what they're doing. Had I known then what I now know, I'd have done a better job of picking the company and stayed with it even if the price went down, provided that the company's fundamentals remained as sound as they were when I picked it. I’d also have continued to invest on a regular basis for the next fifteen years.
You don't have to be a genius to make money in the market
THE LONG HAUL
...sell the losers (not those with the depressed prices but those whose revenues and earnings aren't capable of growing adequately...)
- Ellis Traub
Does a person have to be well educated to do well in the stock market?
Traub: Absolutely not! Using technamental analysis as described in Take Stock, a novice can know all they need to about the quality of a company as long as they can tell the difference between a straight and crooked line and the difference between one that slopes up, down, or not at all.
There are only ten terms that a person needs to know, all of them very intuitive. They can be applied to any company, whether it’s General Motors or Lucy's Lemonade stand.
JK: You talk about technamental investing quite often. What exactly is it?
Traub: "Technamental" investing refers to the technical analysis, charting and identifying significant patterns, of the fundamentals of a company rather than the meaningless meandering of the price and volume of a stock. The movement and trends in revenues, profits, earnings per share, and profit margins tell the investor a great deal about the character and quality of a company and are predictive of the stock's price over the long term.
JK: For readers who don’t know, what is the difference between fundamental analysis and technical analysis?
Traub: Simply stated, fundamental analysis looks at the company and its track record. Technical analysis seeks to find patterns in the movement of prices and volume that will forecast the future movement of the price. There are nearly a hundred different methods of technical analysis. It would seem to me that if any were successful, there'd be only one.
JK: What about those who have their money managed by professionals? Why should they learn about investment analysis?
Traub: The obvious reason is that they can do just as good a job for themselves by understanding the salient issues and save the fees that they would have paid the pro.
JK: Why do you think most people do not invest?
Traub: Number one, they're afraid that it's a gamble and they will lose. They don't know that there's an approach that, while boring and not exciting, lets them earn money with their money.
Secondly, they don't know just how simple it really is to do just that, and how little time and effort it takes to do it right.
Thirdly, many choose to spend all they earn rather than recognize that the time will come when they'd like to be free from the necessity to work but won't be able to do so because they haven't contributed the little it takes every month to make that dream a reality.
JK: In regards to diversification, how many companies do you think is too many?
Traub: More companies than you can comfortably keep track of is too many. With software tools, you can keep track of more than 10 or fifteen comfortably; but, hey, Warren Buffett doesn't hold more than 25 . . . why should I?
The Buy-from-a-Sucker-Sell-to-a-Sucker School of Investing & How to Double your Money in Five Years
HOW MANY STOCKS ARE TOO MANY?
More companies than you can comfortably keep track of is too many. Warren Buffett doesn't own more than 25, why should I?
- Ellis Traub
JK: In the book you talk about the BFS/STS school of speculation. What is it?
Traub: The “buy from a sucker, sell to a sucker” school of speculation I refer to in the book is that for anyone to make money through the purchase and subsequent resale of a stock without the actual value of that stock increasing, she must rely upon the ignorance of either the seller or the buyer or both. The odds are definitely against not being the sucker on either one or the other end of that transaction. It's another way of expressing the "Greater Fool Theory." "I may be a fool to buy this stock at this price; but I'll find another fool to buy it from me at a higher price." This is what fueled the recently exploded "bubble."
The trading mentality relies strictly upon luck and "winning" from another "loser" in order to be successful, where buying and selling at a fair multiple of earnings, when the earnings grows, requires no loser to participate.
JK: What is the rule of five?
Traub: How one expresses it depends upon his/her personality. For the pessimist, it says, "For every five stocks you buy, one will be a loser." For the optimist, which I am, it says, "For every five stocks you buy, four will be good, one of which will do even better than you expect."
JK: What percent growth is necessary to double your money every five years?
Traub: Just under 15 percent, compounded. It's feasible to find the well-managed companies whose earnings can grow at such a rate. And, since we can easily pick those above-average companies, a portfolio of such stocks should easily beat the indexes that contain both below average and above average companies.
JK: One of the most important questions a stockholder can ask is, How long will it take me to recover my initial investment? How would they answer this?
Traub: Most who diligently and conservatively invest as we suggest can actually double their money every five years, not just make their investment back. This requires that they reinvest what they make each year and invest regularly in high quality growth companies for the long term.
JK: Some investors are paying multiples of 50, 60, 80, and 100 for stocks. What is wrong with this?
Traub: You'd have to be Methuselah to be able to get back your investment, much less to double it! Personally, I wouldn't want to have to depend upon anyone paying more than 30 times earnings, at the most, for me to profit from an investment.
JK: You tend to look down on stocks that pay dividends some would argue that it is sometimes preferable for a corporation to pay out a portion of its earnings if it cannot continue to utilize capital at the growth rate it once did. This is especially true in realty trusts and industries such as tobacco, banking, etc. What are your thoughts?
Traub: The nature of efficient investing is such that the actual value of what we own must grow in order for us to maximize the growth of our investment. If we purchase a stock at a reasonable multiple of its company's earnings, and those earnings double, we can sell that stock at any time at the same fair multiple and enjoy the doubling of its price or value. Diluting the retained earnings with which revenue-producing assets can be acquired erodes the ability of the company to produce the kind of growth we're looking for.
Peter Lynch once made the point in an article in Worth magazine that retirees would be better off continuing to invest in growth with its potential return than to hedge and allocate assets to income investing. His rationale, and mine, is that one can make up for a lot of 6 percent years with a 12 or 15 percent return, even with some down years along the way. I believe that one should invest as if she expects to live forever. The return will justify it.
JK: What about those who are approaching or are already in, retirement age?
Traub: Again, my advice is to invest as though you will live forever. Your return will be better over the long haul and you can, at least financially, live forever.
JK: I like your point that not everyone has to have an MBA or CFA behind their name to make them a good investor. If that was the case, then stock brokers would be making their living through their investments instead of commissions.
Traub: Actually, if all stockbrokers were CFA's or MBA's, they'd probably be able to do that. Many are simply salesmen who sell what they're told to sell. The serious professionals typically don't do as well as the amateur can, but not because they're not educated or intelligent enough. Mostly it's because they are burdened by constraints that the amateur isn't; and this is because they have the responsibility for handling other people's money rather than their own. You can be freer than they. You don't have to worry about moving the whole market when you get out of a stock or into it. And you don't have a company policy that keeps you out of some of the more promising, though riskier, stocks. You also don't have to churn your portfolio just to look good to your peers.
JK: Peter Lynch seems to have influenced your investment strategies. In fact, I consider his "One Up on Wall Street" one of the best books ever written.
Traub: So do I. One of his most inspirational quotes came from the first paragraph of that book where he says, "...anyone using the customary three percent of his brain can pick stocks as well or better than the average Wall Street expert." I believe it and my book tells people how to do it.
What was the turning point where you became an advocate of value investing?
Traub: Basically, it was my discovery of NAIC. The logic was irrefutable and the simplicity elegant.
JK: You talk a lot about the NAIC. Many critics would argue that this book is a thinly veiled promotion for joining. How do you counter to that?
Traub: I disagree. It's not at all thinly veiled! NAIC saved my bacon and provide me with the philosophy that enabled me to turn my financial life around. I've just taken what they've taught me and added some minor changes to things that I think could be done a little better. But their basic methodology and approach to investing has been eminently successful for more than fifty years. Why wouldn't I praise it to the heavens, express my gratitude to its founders and volunteers who mentored me and recommend to those looking to maximize what I tell them in my book that great networking and continuing education opportunities are available by joining the organization?
Reader Questions
SPENDING YOUR WEALTH AWAY
Many people choose to spend all they earn rather than recognize that the time will come when they'd like to be free from the necessity to work; but won't be able to do so because they haven't contributed the little it takes every month to make that dream a reality...
- Ellis Traub
Question: What does it mean when stocks are held in a street name?
- Caroline Douglas
Traub: It simply means that stockbroker through which you purchased the stock has actual possession of the stock certificates that make you a shareholder and that they hold them for you. You still have the opportunity to vote those shares; but you don't have the certificates to show for it.
Question: What do you think you would be doing today if you hadn’t dropped out of Harvard during the Korean War?
- Amanda S.
Traub: Goodness knows! I certainly wouldn't have been a pilot.
Question: Why do you think the P/E Ratio is important for investors to consider?
- Michael Wells
Traub: The foundation of long-term investing is the notion that the company's earnings drives the price of a share of its stock. The higher the earnings, the higher the price. The PE is an expression of the price of the stock, expressed as a multiple of those earnings. And it's important to consider that relationship when considering the value issues (the stock's price). You can tell a great deal about that price by considering the PE. If the stock is selling at a very low PE (lower than it typically has sold for), it's a signal that suggests that you need to find out what the current investors know that you don't that makes them unwilling to pay as high a price has they have before. If it's higher than average, it's best to wait until the price comes down before you spring for it.
JK: Related to that; what is the PEG ratio and do you think it is an important factor in considering an investment?
Traub: Where the PE ratio is a measure of investor confidence -- by that I mean that the greater the investor's confidence that the company can produce strong earnings into the future, the higher the price she will pay -- the PEG ratio is kind of the second derivative of that confidence. The actual ratio is the Price divided by projected earnings growth; and, the higher the growth
rate of earnings, the greater the investor confidence.
It's most often used to suggest a limitation on the estimated future PE of a company. Many will limit their PE forecast to a PEG ratio of 1.5 or one and a half times the projected earnings growth. If earnings are projected to grow at 15 percent, then a PEG of 1.5 would suggest that the highest reasonable PE would be 22.5 percent or one and a half times the growth the moment rate.
Question: Is reinvesting your earnings really important?
- E. Rogers
Traub: It sure is. It spells the difference between being able to double your money in five years and not being able to. The "magic of compounding" is what enables you to achieve a 15 percent appreciation in your portfolio. If you were to take out your earnings each year, assuming 15 percent growth, you'd achieve only 15 percent growth each year on your original amount which equals a dollar seventy-five for every dollar invested over a five year period. If, however, you leave your earnings in, then the five-year result would be about 2.01 for every dollar, since the additional 15 percent would grow at 15 percent each year as well.
Copyright © 2001 Joshua Kennon
http://beginnersinvest.about.com
http://beginnersinvest.about.com/library/weekly/nellist.htm
with Joshua Kennon
One on One: Ellis Traub
If you want to take your first walk down Wall Street, Ellis Traub will be happy to show you the way
Ellis Traub
One on one
With four sons about to enter college, Ellis Traub lost everything. Today, he's a widely respected author, Chairman of the NAIC, and CEO of Investware. Learn how you can avoid the same mistakes he did - and save your pocketbook a lot of trouble.
PROFILE
Name: Ellis Traub
Occupation: Author and CEO
Location: Davie, FL
Education: Harvard, Left School to Fight in the Korean War
There are only ten terms that a person needs to know, all of them very intuitive. They can be applied to any company, whether it's General Motors or Lucy's Lemonade stand.".
-Ellis Traub
A Random Walk Down Wall Street: Ellis' Story
JK: You were an airline pilot for thirty-one years. What made you get involved in finance and investing?
Traub: I got involved in finance and investing out of necessity. I made some serious investment mistakes when I had four sons to send to college and lost nearly everything I had. That experience frightened me out of the market for a decade and a half. When I retired from the airline, I needed to take care of my pension and failed again. Fortunately, I stumbled onto the National Association of Investors Corporation (NAIC), a non-profit organization whose mission is to educate amateur investors to be successful. NAIC turned my financial life around.
I was inspired to learn and teach their methods and wrote a software program (to simplify calculations) that ultimately became the organization’s official stock analysis software. From that time forward, I've been dedicated to helping others avoid the same mistakes I made and encouraging them to find out how simple it is to invest successfully in common stocks.
JK: Your first experience with investing is something that a lot of my readers can identify with. One of your mistakes was investing on margin; could you tell us exactly what happened?
Traub: During the 1972 presidential campaign, I met a young fellow who was a broker for a major stockbrokerage firm. Concerned that I wouldn’t have enough to send the kids through school, I asked what I might do to beef up my savings. He recommended that I invest my savings in a hot stock and hold it until two weeks before the election at which time I should sell it for a huge profit. His justification was that the incumbents would continue to pump up the economy prior to the election.
I didn't have a clue and took his advice, selecting the stock that had the biggest daily gain the previous day for my "hot stock."
Needless to say, that was a bad strategy and, when half of Wall Street lost their proverbial shirts, I went along with them, not only having invested all my savings but margining as much as I could and borrowing all I could on my signature. When the dust cleared, I had a house, a car, the debt on them, and fortunately a good job flying airplanes.
JK: Very early on in the book you mention the other mistakes you made as a new investor. Everyday, people write in and they are doing the same things you mention - would you mind repeating them here?
Traub: Those mistakes largely stemmed from my mistaken belief that investing was above and beyond my ability, and the lack of basic investment knowledge.
I didn't start early enough to invest regularly and intelligently. I sought, listened to, and took the advice of someone that wasn't really qualified to offer counsel. I invested without understanding what a share of stock was and what I should expect of it. I sold it without understanding the proper reasons for selling a stock. And I stayed out of the market during my most productive years, losing the best opportunity to make money through long-term stock ownership.
JK: Your first experience with the stock market scared you away for more than fifteen years. Do you think that is a common thing with most new investors?
Traub: I think we're seeing that happening right now. This is the time people should review their holdings, keep the stocks with the best potential, sell the losers (not those with the depressed prices but those whose revenues and earnings aren't capable of growing adequately), and buy others with better potential while they're selling cheap. Instead, people are selling out and running. As simple as it is to learn how to make the right decisions, read Take Stock to find out just how easy, there's no reason for investors to go through the same experience as I did when they can make those now and prosper.
JK: In the book you mention that it was fortunate you didn’t have access to your retirement accounts, or else you would have thrown those into a hot stock as well. Does this mean you think people should have a retirement account [such as a 401k or IRA] separate from their everyday portfolio?
Traub: I think that folks should do anything they can to legitimately and efficiently maximize their accumulation of funds so that they can regularly invest a fixed amount. Certainly programs that offer matching funds or corporate contributions accomplish both goals and add the benefit of tax deferment as well.
The thrust of my comment is really that folks shouldn't jump into any "hot stock" without knowing what they're doing. Had I known then what I now know, I'd have done a better job of picking the company and stayed with it even if the price went down, provided that the company's fundamentals remained as sound as they were when I picked it. I’d also have continued to invest on a regular basis for the next fifteen years.
You don't have to be a genius to make money in the market
THE LONG HAUL
...sell the losers (not those with the depressed prices but those whose revenues and earnings aren't capable of growing adequately...)
- Ellis Traub
Does a person have to be well educated to do well in the stock market?
Traub: Absolutely not! Using technamental analysis as described in Take Stock, a novice can know all they need to about the quality of a company as long as they can tell the difference between a straight and crooked line and the difference between one that slopes up, down, or not at all.
There are only ten terms that a person needs to know, all of them very intuitive. They can be applied to any company, whether it’s General Motors or Lucy's Lemonade stand.
JK: You talk about technamental investing quite often. What exactly is it?
Traub: "Technamental" investing refers to the technical analysis, charting and identifying significant patterns, of the fundamentals of a company rather than the meaningless meandering of the price and volume of a stock. The movement and trends in revenues, profits, earnings per share, and profit margins tell the investor a great deal about the character and quality of a company and are predictive of the stock's price over the long term.
JK: For readers who don’t know, what is the difference between fundamental analysis and technical analysis?
Traub: Simply stated, fundamental analysis looks at the company and its track record. Technical analysis seeks to find patterns in the movement of prices and volume that will forecast the future movement of the price. There are nearly a hundred different methods of technical analysis. It would seem to me that if any were successful, there'd be only one.
JK: What about those who have their money managed by professionals? Why should they learn about investment analysis?
Traub: The obvious reason is that they can do just as good a job for themselves by understanding the salient issues and save the fees that they would have paid the pro.
JK: Why do you think most people do not invest?
Traub: Number one, they're afraid that it's a gamble and they will lose. They don't know that there's an approach that, while boring and not exciting, lets them earn money with their money.
Secondly, they don't know just how simple it really is to do just that, and how little time and effort it takes to do it right.
Thirdly, many choose to spend all they earn rather than recognize that the time will come when they'd like to be free from the necessity to work but won't be able to do so because they haven't contributed the little it takes every month to make that dream a reality.
JK: In regards to diversification, how many companies do you think is too many?
Traub: More companies than you can comfortably keep track of is too many. With software tools, you can keep track of more than 10 or fifteen comfortably; but, hey, Warren Buffett doesn't hold more than 25 . . . why should I?
The Buy-from-a-Sucker-Sell-to-a-Sucker School of Investing & How to Double your Money in Five Years
HOW MANY STOCKS ARE TOO MANY?
More companies than you can comfortably keep track of is too many. Warren Buffett doesn't own more than 25, why should I?
- Ellis Traub
JK: In the book you talk about the BFS/STS school of speculation. What is it?
Traub: The “buy from a sucker, sell to a sucker” school of speculation I refer to in the book is that for anyone to make money through the purchase and subsequent resale of a stock without the actual value of that stock increasing, she must rely upon the ignorance of either the seller or the buyer or both. The odds are definitely against not being the sucker on either one or the other end of that transaction. It's another way of expressing the "Greater Fool Theory." "I may be a fool to buy this stock at this price; but I'll find another fool to buy it from me at a higher price." This is what fueled the recently exploded "bubble."
The trading mentality relies strictly upon luck and "winning" from another "loser" in order to be successful, where buying and selling at a fair multiple of earnings, when the earnings grows, requires no loser to participate.
JK: What is the rule of five?
Traub: How one expresses it depends upon his/her personality. For the pessimist, it says, "For every five stocks you buy, one will be a loser." For the optimist, which I am, it says, "For every five stocks you buy, four will be good, one of which will do even better than you expect."
JK: What percent growth is necessary to double your money every five years?
Traub: Just under 15 percent, compounded. It's feasible to find the well-managed companies whose earnings can grow at such a rate. And, since we can easily pick those above-average companies, a portfolio of such stocks should easily beat the indexes that contain both below average and above average companies.
JK: One of the most important questions a stockholder can ask is, How long will it take me to recover my initial investment? How would they answer this?
Traub: Most who diligently and conservatively invest as we suggest can actually double their money every five years, not just make their investment back. This requires that they reinvest what they make each year and invest regularly in high quality growth companies for the long term.
JK: Some investors are paying multiples of 50, 60, 80, and 100 for stocks. What is wrong with this?
Traub: You'd have to be Methuselah to be able to get back your investment, much less to double it! Personally, I wouldn't want to have to depend upon anyone paying more than 30 times earnings, at the most, for me to profit from an investment.
JK: You tend to look down on stocks that pay dividends some would argue that it is sometimes preferable for a corporation to pay out a portion of its earnings if it cannot continue to utilize capital at the growth rate it once did. This is especially true in realty trusts and industries such as tobacco, banking, etc. What are your thoughts?
Traub: The nature of efficient investing is such that the actual value of what we own must grow in order for us to maximize the growth of our investment. If we purchase a stock at a reasonable multiple of its company's earnings, and those earnings double, we can sell that stock at any time at the same fair multiple and enjoy the doubling of its price or value. Diluting the retained earnings with which revenue-producing assets can be acquired erodes the ability of the company to produce the kind of growth we're looking for.
Peter Lynch once made the point in an article in Worth magazine that retirees would be better off continuing to invest in growth with its potential return than to hedge and allocate assets to income investing. His rationale, and mine, is that one can make up for a lot of 6 percent years with a 12 or 15 percent return, even with some down years along the way. I believe that one should invest as if she expects to live forever. The return will justify it.
JK: What about those who are approaching or are already in, retirement age?
Traub: Again, my advice is to invest as though you will live forever. Your return will be better over the long haul and you can, at least financially, live forever.
JK: I like your point that not everyone has to have an MBA or CFA behind their name to make them a good investor. If that was the case, then stock brokers would be making their living through their investments instead of commissions.
Traub: Actually, if all stockbrokers were CFA's or MBA's, they'd probably be able to do that. Many are simply salesmen who sell what they're told to sell. The serious professionals typically don't do as well as the amateur can, but not because they're not educated or intelligent enough. Mostly it's because they are burdened by constraints that the amateur isn't; and this is because they have the responsibility for handling other people's money rather than their own. You can be freer than they. You don't have to worry about moving the whole market when you get out of a stock or into it. And you don't have a company policy that keeps you out of some of the more promising, though riskier, stocks. You also don't have to churn your portfolio just to look good to your peers.
JK: Peter Lynch seems to have influenced your investment strategies. In fact, I consider his "One Up on Wall Street" one of the best books ever written.
Traub: So do I. One of his most inspirational quotes came from the first paragraph of that book where he says, "...anyone using the customary three percent of his brain can pick stocks as well or better than the average Wall Street expert." I believe it and my book tells people how to do it.
What was the turning point where you became an advocate of value investing?
Traub: Basically, it was my discovery of NAIC. The logic was irrefutable and the simplicity elegant.
JK: You talk a lot about the NAIC. Many critics would argue that this book is a thinly veiled promotion for joining. How do you counter to that?
Traub: I disagree. It's not at all thinly veiled! NAIC saved my bacon and provide me with the philosophy that enabled me to turn my financial life around. I've just taken what they've taught me and added some minor changes to things that I think could be done a little better. But their basic methodology and approach to investing has been eminently successful for more than fifty years. Why wouldn't I praise it to the heavens, express my gratitude to its founders and volunteers who mentored me and recommend to those looking to maximize what I tell them in my book that great networking and continuing education opportunities are available by joining the organization?
Reader Questions
SPENDING YOUR WEALTH AWAY
Many people choose to spend all they earn rather than recognize that the time will come when they'd like to be free from the necessity to work; but won't be able to do so because they haven't contributed the little it takes every month to make that dream a reality...
- Ellis Traub
Question: What does it mean when stocks are held in a street name?
- Caroline Douglas
Traub: It simply means that stockbroker through which you purchased the stock has actual possession of the stock certificates that make you a shareholder and that they hold them for you. You still have the opportunity to vote those shares; but you don't have the certificates to show for it.
Question: What do you think you would be doing today if you hadn’t dropped out of Harvard during the Korean War?
- Amanda S.
Traub: Goodness knows! I certainly wouldn't have been a pilot.
Question: Why do you think the P/E Ratio is important for investors to consider?
- Michael Wells
Traub: The foundation of long-term investing is the notion that the company's earnings drives the price of a share of its stock. The higher the earnings, the higher the price. The PE is an expression of the price of the stock, expressed as a multiple of those earnings. And it's important to consider that relationship when considering the value issues (the stock's price). You can tell a great deal about that price by considering the PE. If the stock is selling at a very low PE (lower than it typically has sold for), it's a signal that suggests that you need to find out what the current investors know that you don't that makes them unwilling to pay as high a price has they have before. If it's higher than average, it's best to wait until the price comes down before you spring for it.
JK: Related to that; what is the PEG ratio and do you think it is an important factor in considering an investment?
Traub: Where the PE ratio is a measure of investor confidence -- by that I mean that the greater the investor's confidence that the company can produce strong earnings into the future, the higher the price she will pay -- the PEG ratio is kind of the second derivative of that confidence. The actual ratio is the Price divided by projected earnings growth; and, the higher the growth
rate of earnings, the greater the investor confidence.
It's most often used to suggest a limitation on the estimated future PE of a company. Many will limit their PE forecast to a PEG ratio of 1.5 or one and a half times the projected earnings growth. If earnings are projected to grow at 15 percent, then a PEG of 1.5 would suggest that the highest reasonable PE would be 22.5 percent or one and a half times the growth the moment rate.
Question: Is reinvesting your earnings really important?
- E. Rogers
Traub: It sure is. It spells the difference between being able to double your money in five years and not being able to. The "magic of compounding" is what enables you to achieve a 15 percent appreciation in your portfolio. If you were to take out your earnings each year, assuming 15 percent growth, you'd achieve only 15 percent growth each year on your original amount which equals a dollar seventy-five for every dollar invested over a five year period. If, however, you leave your earnings in, then the five-year result would be about 2.01 for every dollar, since the additional 15 percent would grow at 15 percent each year as well.
Copyright © 2001 Joshua Kennon
http://beginnersinvest.about.com
http://beginnersinvest.about.com/library/weekly/nellist.htm
Value Investing: Bargains With Caveats
Value Investing: Bargains With Caveats
Focusing on a Company’s Intrinsic Value
by Virginia B. Morris
BetterInvesting methodology relies on studying a company’s revenues, earnings and other fundamentals in a search for quality growth companies whose stocks are selling at reasonable prices. Another type of fundamental investing seeks so-called value stocks.
Investors in value stocks typically look for bargains in the stock market that will allow to them to capitalize on the most basic of all investment dictums: Buy low and sell high. But this isn’t as easy as it sounds, despite the fact that Warren Buffett — perhaps the world’s most famous current practitioner of this approach — has amassed a financial empire through value investing.
The initial challenge in becoming an effective value investor is to recognize that many other investors, including those with deep pockets such as managers of mutual funds and pension funds, are also seeking substantial returns using this same strategy. These professional investors aren’t looking at today’s performance stars or at the long-term winners often considered the backbone of an investment portfolio. Rather, they’re trying to find the wallflowers nobody is asking to dance because they’re perceived as unattractive, ungraceful or just plain dull.
Once they’ve been discovered, however, these investments draw a great deal of attention and are wallflowers no more. The potential they offered as bargains disappears, and value investors begin the search again.
Companies that might fall into this category include well-known retailers that have been overshadowed by the competition, respected manufacturers that haven’t substantially updated their products in a generation and even financial services companies that have been buffeted by miscalculating the market.
Picking Through the Bargains
As a value investor, you need a long-term perspective and the conviction to wait out short-term downturns. This doesn’t mean, however, that value investing is always a buy-and-hold strategy. Instead, some value investors establish a target when they buy, and they sell off a portion—perhaps 50 percent — of each holding when its price has increased by a set percentage. This approach not only protects profits that have been realized but also frees up cash for new opportunities.
As with any investment strategy, the key challenge for value investors is to find appropriate investments. The place to start is by assembling a list of undervalued securities. Undervalued stocks, by definition, have price-earnings and price-to-book-value ratios that are lower than average as well as dividend yields that are higher than average as compared with comparable companies in their industry.
These are typically companies most investors aren’t buying and may be actively selling. Investors may be reacting logically to recent negative news about the company. Or they may be behaving inexplicably: Remember that emotions, including irrational ones, often play a significant role in the decisions investors make.
After you identify several candidates, you’ll need to narrow the field. One way to begin is to take a closer look at each company: Do you understand its business, and does the information you have about it tell a clear story? Do the long-term prospects seem promising, perhaps because the company has competitive advantages? Has the company been making money consistently over the long term, or are the financial results erratic?
You must also develop a set of criteria and a methodology that will help you determine a corporation’s intrinsic value, or what it’s really worth regardless of its current stock price. This approach is essential because value investing isn’t about buying cheap. It’s about paying a low cost for something of potentially long-term value.
Sticking With the Fundamentals
The fundamental information you’ll want to focus on in evaluating companies as value investments includes profit margins, the number of consecutive years a company has been profitable, patterns of revenues and earnings, and dividend payouts to see whether they’ve been consistent, steadily increasing or fluctuating considerably. And it’s always important to look at a company’s level of debt, particularly relative to its assets: Are they in balance, or does the level of debt seem burdensome?
Other fundamentals you might want to evaluate include a company’s current assets in relation to its total liabilities, or what’s known as the current ratio, and the company’s discounted cash flow — the estimated present value of cash it expects to receive in the future.
A Word of Caution
When it comes to value investing, there’s also one caveat to keep in mind: The same factors that make a stock a probable candidate for a value investor can also be the signs of imminent meltdown. That’s why it always pays to do your homework. It can protect you from companies whose business is smoke and mirrors while helping you identify firms whose stock is undervalued and worth considering for your portfolio.
Virginia B. Morris is the Editorial Director for Lightbulb Press.
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/0208abpublic.htm
Focusing on a Company’s Intrinsic Value
by Virginia B. Morris
BetterInvesting methodology relies on studying a company’s revenues, earnings and other fundamentals in a search for quality growth companies whose stocks are selling at reasonable prices. Another type of fundamental investing seeks so-called value stocks.
Investors in value stocks typically look for bargains in the stock market that will allow to them to capitalize on the most basic of all investment dictums: Buy low and sell high. But this isn’t as easy as it sounds, despite the fact that Warren Buffett — perhaps the world’s most famous current practitioner of this approach — has amassed a financial empire through value investing.
The initial challenge in becoming an effective value investor is to recognize that many other investors, including those with deep pockets such as managers of mutual funds and pension funds, are also seeking substantial returns using this same strategy. These professional investors aren’t looking at today’s performance stars or at the long-term winners often considered the backbone of an investment portfolio. Rather, they’re trying to find the wallflowers nobody is asking to dance because they’re perceived as unattractive, ungraceful or just plain dull.
Once they’ve been discovered, however, these investments draw a great deal of attention and are wallflowers no more. The potential they offered as bargains disappears, and value investors begin the search again.
Companies that might fall into this category include well-known retailers that have been overshadowed by the competition, respected manufacturers that haven’t substantially updated their products in a generation and even financial services companies that have been buffeted by miscalculating the market.
Picking Through the Bargains
As a value investor, you need a long-term perspective and the conviction to wait out short-term downturns. This doesn’t mean, however, that value investing is always a buy-and-hold strategy. Instead, some value investors establish a target when they buy, and they sell off a portion—perhaps 50 percent — of each holding when its price has increased by a set percentage. This approach not only protects profits that have been realized but also frees up cash for new opportunities.
As with any investment strategy, the key challenge for value investors is to find appropriate investments. The place to start is by assembling a list of undervalued securities. Undervalued stocks, by definition, have price-earnings and price-to-book-value ratios that are lower than average as well as dividend yields that are higher than average as compared with comparable companies in their industry.
These are typically companies most investors aren’t buying and may be actively selling. Investors may be reacting logically to recent negative news about the company. Or they may be behaving inexplicably: Remember that emotions, including irrational ones, often play a significant role in the decisions investors make.
After you identify several candidates, you’ll need to narrow the field. One way to begin is to take a closer look at each company: Do you understand its business, and does the information you have about it tell a clear story? Do the long-term prospects seem promising, perhaps because the company has competitive advantages? Has the company been making money consistently over the long term, or are the financial results erratic?
You must also develop a set of criteria and a methodology that will help you determine a corporation’s intrinsic value, or what it’s really worth regardless of its current stock price. This approach is essential because value investing isn’t about buying cheap. It’s about paying a low cost for something of potentially long-term value.
Sticking With the Fundamentals
The fundamental information you’ll want to focus on in evaluating companies as value investments includes profit margins, the number of consecutive years a company has been profitable, patterns of revenues and earnings, and dividend payouts to see whether they’ve been consistent, steadily increasing or fluctuating considerably. And it’s always important to look at a company’s level of debt, particularly relative to its assets: Are they in balance, or does the level of debt seem burdensome?
Other fundamentals you might want to evaluate include a company’s current assets in relation to its total liabilities, or what’s known as the current ratio, and the company’s discounted cash flow — the estimated present value of cash it expects to receive in the future.
A Word of Caution
When it comes to value investing, there’s also one caveat to keep in mind: The same factors that make a stock a probable candidate for a value investor can also be the signs of imminent meltdown. That’s why it always pays to do your homework. It can protect you from companies whose business is smoke and mirrors while helping you identify firms whose stock is undervalued and worth considering for your portfolio.
Virginia B. Morris is the Editorial Director for Lightbulb Press.
http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/0208abpublic.htm
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