Friday, December 31, 2010

Thinking about the long-term and as part-owners the Warren Buffett way

I remember reading in The Essays of Warren Buffett about how investors can really benefit by building portfolios based on the idea of accumulating stocks that they believe will result in their portfolios generating the best possible long-term look-through earnings.  Buffett says this will force investors to think about the long-term business prospects of the companies behind the stocks in their portfolios and not the short-term prospects of the stock market.

Look-through earnings reflect in the operating income of a company both its share of the earnings paid out as dividends and its share of the operating earnings retained by the companies it has a below 20% stake in. GAAP or generally accepted accounting principles only let a company take into account the dividends it receives from the companies it owns less than 20% of, but not its share of the earnings retained by those companies, which is being reinvested for its economic benefit. You can read more about look-through earnings in this article I wrote here

Here's the formula for calculating look-through earnings: the company's operating profit + the company’s share of the operating earnings retained by the companies it has a below 20% stake in – the extra taxes it would have to pay if those retained earnings were all paid out as dividends. To calculate the look-through earnings of your investment portfolio, simply total the look-through earnings belonging to each of your holdings.

After all, the best way to invest is to buy small pieces of great companies and hold on to those shares for the long-term. And if we don’t have this mentality of making long-term commitments to businesses, but think of investing in stocks as simply buying pieces of paper that we hope to sell to someone else for a higher price because of reasons not related to the underlying businesses, then we’re gambling, and gamblers never win in the long-term.

If you don’t focus on the long-term and on becoming a part owner in your investing approach, then it becomes very unlikely that you will ever find stocks that will  make you incredibly wealthy, stocks like the modern day versions of young Berkshire Hathaway and McDonald’s that can multiply your investments in them by many, many times.  

Thank you for reading, and may you always sustain good returns on your portfolio. Take care and have a very happy new year!    

Thursday, December 30, 2010

Start/buy a private business or buy some stocks?

Investing in a stock and investing to start up a private business are more or less the same things, as they both are in essence businesses with the only difference being that when you invest in a stock you are buying a small portion of a business, and when you start your own business you own the whole thing (for simplicity’s sake, we’ll assume that there are no partners). As with any other choice between 2 investments, you should pick the option which you believe will generate the highest long-term risk-adjusted returns.

And while stocks and private businesses are in essence the same things, there are some differences that can have an impact on their risks and the returns that they produce. In this article, I will be talking about some of the advantages of owning a business outright, as well as some of the advantages of owning a small fraction of a business.   

Control over hiring and firing decisions

If you have your own company, you will have control over hiring and firing decisions. You will be able to take your time and really select to join your organization good, honest, hardworking people who are good culture fits and who are passionate about what your company is trying to do.You can also fire managers or employees that might be destroying shareholder (you) value.

Getting the right people on board and firing the people that hold a company back is a main ingredient in creating a great company that generates really excellent long-term profits.

If you owned shares of a public-listed company, however, it can be very difficult or almost impossible for you to remove a management team that is more interested in their perks and bonuses than in creating value for shareholders. Sure, you can vote against the re-election of board members and maybe voice your displeasure at the annual general meeting, but unless you are very rich and own a huge amount of shares in the company, or if you and a lot of other shareholders team up together, you probably won’t be able to change very much.

I don’t know the exact number, but I believe that quite a number of public-listed companies have damaged their competitive advantage and their long-term profitability by hiring people that are dishonest or people that might not necessarily fit in well in their organizations. How many times have you shopped at a retail outlet that had really lousy customer service and you vowed never to shop with that company again? What about management teams that took on excessive risks only to see shareholder value destroyed when their bets didn’t pay off?

While you might have control over firing and hiring decisions in your own business, some publicly traded companies have really great hiring processes, superb cultures, and effective training programs. These companies select the right people and help them grow in a way that is mutually beneficial for both the employees and their businesses. Because of their reputation of hiring only really good people and having in place really good training programs, these companies are also able to attract really talented people to apply for jobs with them. Unlike those companies that are experiencing deteriorating competitive advantages and profitability due to them having sub-standard employees working for them, the employees at these companies  drive profitability and keep their companies relevant and ahead of the competition.   

Your newly started company might also find it difficult to attract talented people, as it might not have a reputation as a good place to work at yet. It might also take a long time to develop a great culture and put in place excellent training programs (and many companies, both private and public-listed, fail to achieve these things); these things have to be in place for your employees to grow, remain relevant, and create great value for your company.   

Control over capital allocation decisions

Being the owner of a private business, you get decide exactly how to allocate your company’s capital. How you deploy your capital today will determine the kind of returns you get in the future. I can only imagine the number of sub-optimal decisions regarding the deployment of capital that have been made by management teams of public-listed companies. These sub-optimal decisions range from buying back shares when they are overvalued, not investing enough in their divisions that can generate good returns on investment, investing in divisions that generate poor returns on investment, holding on to too much cash for too long and letting inflation eat into shareholders’ wealth, and etc.

There will always be managers that are absolutely horrible at allocating capital, but there are also managers that are really excellent capital allocators, and their decisions on how capital should be deployed can very well make their shareholders very rich. It is also a fact that not all private business owners are good capital allocators themselves, and they can very well end up destroying a lot of value.    

Competitive advantage

There are some really great companies with really have great competitive advantages which you can buy shares in. These competitive advantages will help protect those companies from the threat of competition, put those companies in a better position during economic downturns, and allow those companies to grow at a healthy rate and reap greater profits than the average company in their industries. All this can translate to lower risks and higher long-term returns for you if you are a shareholder of those companies.  

When you start a new business or buy a private business, that business might not have a significant competitive advantage or even any competitive advantage at all. It can take many years to develop a durable competitive advantage, and I don’t think many companies succeed in doing that.

But if you believe that you have a great concept or can create a business that can serve a certain market segment better than other competitors in that market, then you can build on this concept and develop competitive advantages that can sustain and grow your company for the long-term.

While I believe that the best returns and lowest risks come from investing companies with very good competitive advantages or starting companies and developing durable competitive advantages for those businesses, the fact is that there are a lot of companies, both publicly traded and private, that don’t have a significant competitive advantage but are still profitable and still can grow (although the long-term growth and profits will never be as impressive as those companies with important competitive advantages).

So, it might be ok to invest in mediocre companies when they are trading at a very steep discount to intrinsic value (as long as you sell once they approach 2/3 of their intrinsic value, and probably even before that  depending on your tolerance for risk) and to start mediocre businesses that might not have much growth prospects but can generate a reasonable amount of cash to justify the investment to get them up and running.    
Price

This applies more to buying stocks vs. buying a private business than buying stocks vs. starting a business, but investors can sometimes find stocks trading at such a steep discount that the companies behind those stocks have market caps that are only a fraction of the price that they would fetch if they were private companies being bought in a negotiated transaction. 

The lower the price paid, the lower the risks, and the higher the returns; if you buy a business for $20,000 that you estimated is worth $100,000, there’s a lot of room for a mistake to be made in your estimations or for the business’ profitability to be impaired before you start losing money on your investment (not paper losses but losses in the sense that intrinsic value falls below the price you paid for the stock). There might not be much of a margin of safety if you buy a private business at full price.


If you have any questions, or if there's anything that you would like to share, please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio. Take care and have a very happy new year!

Thursday, December 23, 2010

Do your portfolio really need exposure to international equities?

Everybody’s mother wants to participate in the growth of emerging markets. And considering that the  average stock should only grow about as fast as the GDP growth in its country, a strong case can be made for having significant exposure to international stocks.

But before making a decision of whether or not to invest in stocks from a particular country, we need to  look at whether or not the country observes the rule of law, and also look at the political condition of that country to determine if the country is a stable place to invest our money. I don’t think I would ever invest in a country run by dictators (even if stocks in that country are trading at a P/E ratio of 2) who could seize the assets of the private sector whenever they feel like it. We should also take the time to look at inflation, budget deficit, national debt, and some other macroeconomic factors just to make sure things won't go out of control anytime soon.  

Foreign stocks and domestic stocks are in essence stocks. And like any other stock, the price you pay plays a huge part in whether or not your investment will turn out to be a success. Yes, we have to pay more for a company with a good long-term growth rate, but if we pay too much, then the company needs to keep growing without any hiccups for a very long time before its intrinsic value catches up to the price we paid for it. Usually things don’t always go so smoothly, and there usually will be hiccups which can cause the price of the stock to crash back down to reality leaving the investors who paid too much with significant paper losses for what could be a very long time. 

One of the main reasons for investing internationally is to get better returns, and the price we pay plays a very significant role in the kind of returns we get. So, by paying too much for a foreign stock, we are defeating one of the main purposes of investing in foreign stocks. I will pick a domestic stock with decent growth and solid fundamentals trading at a discount to intrinsic value over an overpriced foreign stock any day.

There are also companies based in the US that do a significant amount of business outside the US, but might not trade at a premium, as they are not based in a “hot” country. If you invest in these companies at sensible prices, you could potentially enjoy better returns than the average US stock due to the companies you invested in having higher growth rates from their international business units. You also could potentially earn much better returns than if you were to invest in overvalued foreign stocks which could very well produce dismal returns or even heavy losses.

Even if a company only has operations in the US, doesn’t necessarily mean it’s a bad thing. The US is still the largest economy in the world, and it’s a huge market for any company to expand and grow healthily in (especially for small-cap and medium-cap companies which might only have operations in a few states or maybe even a city).

While it’s always foolish to bet against the US, the fact is that it’s prudent to try and diversify your portfolio to have some international exposure. Emerging markets will probably continue to be the big story for a long time to come, and while emerging market stocks can be overvalued at times, there are also times when fast growing, good quality emerging market stocks trade at a discount or trade at a fair price (just remember that a company really needs to have excellent fundamentals for you not to need a margin of safety when investing in it), and this kind of opportunities if acted upon can potentially result in really spectacular returns for investors.

I personally believe that the best way to go about things is to, of course, invest in equities that you believe will produce good risk-adjusted returns regardless of where those companies are based, but also try to pick up  some domestic stocks with international exposure and good quality emerging market stocks when the opportunities present themselves.
  
Another strategy to get international exposure that I like and might consider using in the future is to allocate a certain amount of money every month or so to dollar-cost average into a few country ETFs or maybe even just one country ETF if you really like equities in that country. I talked about why I like ETFs to get exposure to foreign stocks in this article here. I would just like to say that it might be wise to avoid countries which stocks might be too overvalued as the risks can be too great even with dollar-cost averaging.       

If you have any questions, or have anything that you would like to share, please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio. Take care and have a great holiday!

Wednesday, December 15, 2010

How value investors think about risk

Quite a number of people will tell you that investing in stocks is very risky, and that you can lose a lot of money by buying stocks. A significant number of these people think stocks are risky simply because they can drop in price.
While it is true that there are a number of risks in investing in stocks, short-term market fluctuations is definitely not one of them (This assumes that you know what you’re doing, invest for the long-term, and apply sound investing principles. And if you don’t have these things in your approach to investing, you shouldn’t be buying stocks anyway.)

When you invest in stocks, you are investing in small pieces of companies. And because of that, a lot of the risks you face are generally related to whether or not those stocks or companies you have invested in will remain financially stable and continue to be profitable and grow profits at a healthy rate. Some of the other risks that investors face are paying too much, dilution of their holdings, and etc. In this article, I will be talking about some of the risks that value investors look at when investing in stocks.

Side note: Investors should avoid picking individual stocks if he or she doesn’t know how to value them. This doesn’t mean that investors who can’t value stocks can’t get invested in stocks. You can still get exposure to stocks through dollar cost averaging into a low-cost index fund or a good mutual fund.    

Financial strength

The better the financial position of a company, the less likely it will go bankrupt, restructure, or do things that will destroy significant shareholder value, and the lower the risk of you losing a huge part or even all of the money you invested in that company (when I talk about losing money, I don’t mean paper losses, but permanent impairment to the profitability of the company). True, just because a company is financially stable doesn’t mean you won’t lose money investing in it. But if you don’t get the basics right, you will always be exposed to significant risk, and a strong financial position is the foundation of a company that’s unlikely to wipe out their shareholders anytime soon. 

Here are some of the things I look at when deciding whether or not a company is financially stable:

The company’s operating cash flow need to be able to comfortably fund its interest payments and capital expenditures.

The company shouldn’t have too much debt, and should have enough cash on its balance sheet to keep operations running (even in severe downturns) without taking on significant debt, diluting existing shareholders and issuing new shares, restructuring, or etc.  

Growth

In his “Conservative Investors Sleep Well” writing, Philip A. Fisher wrote, “It has already been pointed out that in this rapidly changing world companies cannot stand still. They must either get better or worse, improve or go downhill. The true investment objective of growth is not just to make gains but to avoid loss.”

The main reason investors put their money into stocks is to beat inflation and end up with more money (in real terms) in the future. If the earnings and revenue of the stocks you invest in don’t grow or grow at a very slow pace, you will face the risk of inflation eroding the value of your investments. To reduce this risk of losing our money slowly to inflation (or even quickly if inflation really spikes), we have to invest in stocks that we believe will consistently grow both profits and revenue at a faster pace than inflation.

It is ironic that some, if not most, of the same people that avoid stocks because they think that stocks are too risky expose themselves to a much higher risk of losing money in real terms to inflation by having too much of their assets in cash or even very low yield bonds (cash are incredibly lousy long-term investments, and I don’t think you will do very well lending money to IBM at 1%).       

Competitive advantage

Investors can reduce their risk by investing in companies that have a competitive advantage over their competitors, as these companies’ competitive advantages will, to a certain extent (this depends on the significance of the competitive advantage), protect their current profitability and give them the opportunity to grow healthily and profitably.   

There are quite a few different types of competitive advantages. Here are a few of them: Having a strong brand, being the low-cost producer, having a near monopoly over a certain market, and etc.

Management

One of the main purposes of a company’s management team is to minimize the risk of shareholders losing money (as I said earlier, when I say losing money, I don’t mean losing money in terms of paper losses, but losing money in terms of impairment of the long-term profitability of the company) and create good value for shareholders by making sure the company stays financially stable, grows profits and revenues at a healthy rate, constantly increases its competitive advantage, reinvest its profits at a good rate of return or pay out dividends if it can’t, and etc. Needless to say, bad management equals high risk of losing money. That’s why we need to invest in companies headed by good management teams if we want to reduce our risk.

I wrote this article here about some of the things we should look at when evaluating the quality of management. It’s a good sign if management does what it says, is honest with shareholders, own, in relation to their annual compensation, a significant amount of shares in the company, and consistently achieve a good return on equity for shareholders.  

Price

It’s always important to utilize Benjamin Graham’s margin of safety concept when investing,and generally only buy a stock when it is trading at a significant discount to your estimation of intrinsic value. The lower the price you pay for the stock in relation to its intrinsic value, the larger your margin of safety and the lower your risk.

Just think about it this way:

If you pay too much for a company’s stock, the company has to keep producing fantastic results for maybe even a long time (I think most companies will eventually disappoint), and if it doesn’t, reality will catch up to the stock and its price will plummet.

But if you buy a company’s stock for cheap, the company can perform poorly and you still might get away with your principal intact. This is the case as the price you paid for the stock might reflect that of a company that’s of a much lesser value than what the company’s current intrinsic value is. So, even if the intrinsic value of the company significantly declines, the company’s declined intrinsic value per share might still be somewhere around the price you paid for each share of the company’s stock.

Circle of competence

Risk comes from not knowing what you're doing. –Quote from Warren Buffett

How you value a company should also be affected by the industry the company is in. Example: same-store-sales are important for retailers, while cost of funds and a strong deposit base is important for banks.

It can be very dangerous to invest in companies from an industry that you do not understand, as you might buy a stock that you think is cheap and has great fundamentals, only to find out later that because you didn’t take into account something significant during your evaluation of the stock, you actually overpaid for the stock and/or the fundamentals are actually quite lousy.

It really isn’t important to have a large circle of competence, as you can make a lot of money by simply having a very good understanding of a few or maybe even one industry, and investing in good companies (when they trade at attractive prices, of course)  in those industries or industry. As long as you invest in companies you understand, the risk of losing money is significantly reduced.

This circle of competence concept also applies to investing. If you don’t know how to value companies, you should regularly invest your money in a low-cost index fund or a good mutual fund instead of picking individual stocks.


If you have any questions, or have anything that you would like to share, please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio. Take care.

Tuesday, December 7, 2010

Asset Allocation methods from the masters Part 1: Peter Lynch

I recently watched an episode of the Suze Orman show where someone with about $2 million in net worth asked Suze if she could afford to retire soon, and Suze actually gave that person a pretty low grade (it was a C- I think). The problem was that lady had a significant portion of her assets in undeveloped land that doesn’t generate any income for her.

Side note: I’m recalling what I saw on the Suze Orman show strictly from memory, and my account of what happened might not be 100% accurate. But you get the point I’m trying to make.

After watching that episode, I really started to appreciate how much asset allocation mattered. Sure, saving money is good. But knowing where to invest your money or how to allocate your assets is crucial to building significant wealth.

In part 1 of this 3 part series, I will be looking into the asset allocation method suggested by Peter Lynch. I will be talking about the asset allocation method suggested by Benjamin Graham in part 2 of this series, and in part 3, I will be talking about an asset allocation method inspired by Warren Buffett.

Here’s the asset allocation method suggested by Peter Lynch:

In his book “Beating the Street,” Peter Lynch talked about how stocks will outperform bonds over time, and that if an investor wants to increase the value of his or her portfolio, that investor better have part of his or her portfolio invested in stocks.

Peter Lynch suggested that investors increase the stock component of their portfolios to as much as they can tolerate, as unlike bonds, stocks can appreciate in value and increase the dividends they payout to investors. He even included data in his book showing the results of $10,000 invested for 20 years in all bonds, split 50/50 between bonds and stocks, and 100% in stocks (In the 3 scenarios, it was assumed that bonds paid 7% interest and stocks had a dividend yield of 3% and appreciated at 8% a year. True stocks might not return that much anymore, but I believe stocks will still easily outperform bonds over the long-term, especially if companies like IBM can borrow money at 1% interest).

A 100% bonds portfolio would return $14,000 in interest income and the original principal of $10,000.

A 50/50 split between bonds and stocks would return $10,422 in interest income, $6,864 in dividends and a portfolio worth $21,911.

100% invested in stocks would result in $13,729 in dividends and a portfolio worth $46,610.

Another scenario in the book showed that even if you need income, stocks still make for a much better investment than bonds (The scenario assumes a 3% dividend yield and an annual 8% in capital gains). Here’s the scenario:

If an investor had $100,000 to invest and needs $7, 000 in income, the investor can just put all of the $100,000 in stocks, even if stocks only have a 3% dividend yield. This is the case as the investor can just sell some shares to supplement his or her income until the dividends reach his or her income target ($7,000 in this case).

So, the investor would get $3,000 in dividend income at the end of the first year, and have to sell $4,000 worth of stock to get $7,000 in income. But if the investor’s stocks appreciated at 8%, he or she would have a portfolio worth $104,000 after selling the $4,000 worth of stock.

At the end of the second year, the investor’s dividend income would have increased to $3,120. This would result in the investor only having to sell $3,880 worth of stocks. The investor’s portfolio should, according to my calculation, be worth $108,440.

Every year, the investor’s dividend income rises, and he or she will need to sell less stock (eventually not needing to sell stock at all). The investor’s original investment would also have grown every year. At the end of 20 years, the $100,000 would have turned into $349,140, and the investor would have had income of $146,820. A 100% bonds portfolio that pays a 7% interest would only return $140,000 in interest income and the original principal of $100,000.


Peter Lynch pointed out that even if investors know that stocks are much better than bonds, stocks don’t appreciate in a straight line, and not all investors can keep their emotions stable and ride out the corrections of the market or sometimes even sell some of their shares at depressed prices to supplement their income. That’s why I think he recommends investors to hold in their portfolios as much stock as they can tolerate instead of have a 100% stock portfolio.

I personally am almost fully invested in stocks, as I believe that businesses will continue to be the greatest creators of wealth, and investing in stocks is one way to get invested in businesses. The other way is, obviously, through setting up your own private companies, but that might not be for everyone (I have plans to set up a holding company sometime in the next few years, but until then, stocks will probably be the only asset class I’ll invest in).

In my next article for this 3 part series, I will be talking about an asset allocation method suggested by Benjamin Graham. So, check back soon if you’re interested.

Before I go, please allow me to be true to my “captain obvious” nature and list down some “very obvious” points related to this asset allocation series. Here are the “very obvious” points:

We should all have a 6-8 month emergency fund in case something unexpected happens and we need cash (this emergency fund should not be thought of as part of your investment portfolio, and should generally be established before you start investing).

It’s ok if you don’t understand how to value stocks or companies. You still can get exposure to stocks by investing in a low-cost index fund or a good mutual fund.

Sometimes stocks can be drastically overvalued, and it might not be such a good idea to buy stocks for your portfolio during those times. It might, however, be a good idea to build up cash when you can’t find attractive opportunities, so that you have some cash to put to work when you do find investment opportunities that you believe are attractive.

You should only invest money that you won’t need for a very long time to come.

You don’t need to follow the asset allocation method in this article or the asset allocation methods I plan to talk about in the future articles of this “asset allocation” series of articles. Just make sure that you understand what you’re investing in (whether it’s stocks, real estate, commodities, or etc).

Common sense and rational thinking should always prevail.


If you have any questions, or have anything that you would like to share, please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio. Take care.

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