Friday, December 16, 2011

Ideas and business part i: Selfisness and making money is moral

So far I have written articles only relating to investing and business. But after continuously hearing about the morally bankrupt Occupy Wall Street protesters and the socialist rhetoric from the left on the news, I decided that I wanted to write a series of article about philosophy and ideas. Don’t get me wrong, these articles are still related to business as I believe the right ideas can help a person achieve success in business. The first article in the series will be about the morality of selfishness and profits, the second article will be about facing the facts of reality and how we can and should think for ourselves, and the third article will be about the freedom to achieve.

First off, let me just say that I do agree with the OWS protesters that cronyism is bad and that the banks shouldn’t have been bailed out. I, however, do not agree with the anti-capitalism stance of these degenerates as I believe that  capitalism is the only moral system, and that any other system is a system where the creators of wealth are chained up (through regulations) and forced to sacrifice themselves to others (wealth redistribution, taxing “the rich” to give to “the poor”). Capitalism also happens to be the system that lifted the most people out of poverty by giving them the freedom to rise on their own and make something of themselves.    

I disagree with how the OWS protesters are against property rights and, by extension, against freedom and individual rights. Men cannot be free if they do not have a right to their property and the right to make a profit. When you take away a man’s right to the fruits of his labor, you turn him into a slave. I disagree with how the OWS protestors are segregating people into either the 99% group or the 1% group. There’s no such thing as the 99% or the 1%, there’s only individuals. I disagree with how the OWS protesters are against success and achievement. Finally, I disagree with the method used by the protestors. First of all, if you want to get your ideas across, you use reason and debate about it, protest should be one of your last resorts. Secondly, while you do have the right to assembly, you have no right to intrude on other people’s properties. If those spoiled brats want to act like idiots as a collective, they are free to do so, as long as they do it on their own properties.

Before I go on any further, let me give credit where credit is due. The ideas that I’m going to talk about in this series of articles are ideas that I learned from the work of Ayn Rand and other voices of reason such as Yaron Brook, John Allison, and Leonard Peikoff. You can get podcasts and videos of their talks and lectures at this website here.

I’m an objectivist, in other words, I’m someone that brings reason into every aspect of my life. I believe that the ideas that I’m going to talk about are important to the businessman as well as to solving today’s biggest problems.

Side note: I’m a recent objectivist, so some of my previous articles may contain ideas and messages that are consistent with the garbage you would get from the liberal media. Just ignore those ideas and messages.

Being selfish and making money is moral

Selfishness, or acting in one’s own rational, long-term self-interest is a very good and moral thing. We have to act in our own self-interest to be successful; if an individual does not act enough in his self-interest, he dies. The same principle applies to business. If a company continuously sells its products at a loss, keeps too many employees on its payroll, and maintains loss making projects all in the name of self-sacrifice and the greater good of society, it will become uncompetitive and it will go bankrupt (or go to the government for a bailout).

A businessman of integrity and self-esteem is someone that pursues the rational, long-term interest of his business and doesn’t sacrifice his business for whatever reason. While that businessman might take care of his customers and employees, forge long-term commitments with suppliers, launch projects that help the poor, as well as implement other initiatives, that businessman never forgets that all those initiatives are just a means to a selfish end, and that end is to make money and to keep doing the work that he loves.    

There’s always this accusation that more innocent people will be exploited if businessmen started acting more selfishly. Nothing can be farther from the truth. You’re not acting in your rational self-interest when you exploit others; in fact, you’re being stupid when you exploit others. If you’re the kind of businessman that cuts corners and sells a lousy product, then you will lose a lot of customers, and that will translate to poor long-term profits or maybe even losses and bankruptcy. If you’re the kind of businessman that defrauds his customers and violates the terms of the contracts you have with your employees, then you’ll get sued or sent to jail.

A cheat or a fraud will not be able to take pride in his work or his life. He will never feel a sense of achievement and he will not have any self-respect. He will never attain happiness which is the end goal of any business or productive work. The cheat would have set out to fail. So, no, I don’t believe for a second that you’re being selfish or acting in your rational self-interest when you exploit others.       

Profits are a great thing. You’re a good person for making money, as it means that you’re leading a productive life and creating value that didn’t previously exist. It really pisses me off when people get angry because a certain businessman is worth $X billion or a certain company made $X billion last quarter. People (especially from the liberal left) will say stuff like corporations profit at the expense of its customers or employees, and that companies should be forced to “give back.” It’s just wrong on so many levels. First of all, an employee that feels exploited is always free to look for another job, and a customer that feels he’s not getting his money’s worth is free to take his business elsewhere.

In terms of the idea that businesses are morally obligated to give back to society, I argue that a company earned its wealth by means of voluntary trade with parties that freely decided it’s in their own interest to deal with the company. The businessman conceived of the idea for his business, assumed all the risks, and turned his idea into reality through careful planning, meticulous execution, passion, dedication, hard work, and perseverance. Every dollar that the businessman earns rightfully and morally belongs to him, and the idea that anyone else has a claim on part of the businessman’s profits can only be taken seriously in a morally bankrupt entitlement state where theft is legalized.

And while this is a secondary issue, businessmen do make the world a better place. They create jobs and improve our standard of living. Pharmaceutical and technology companies have increased our lifespan and made us much more productive, companies like Wal-Mart saves us money, and Coca-cola creates a product that brings enjoyment to millions of people every day. And that’s just the tip of the iceberg. Private businesses are responsible for much of the prosperity and wealth created in the world. And it is simply disgusting how deluded and ungrateful people can get when they demonize the businessman and say that companies exploit society, when the businessman is the one that’s responsible for making our lives so much better.   

I believe that a businessman should make decisions based entirely on the rational, long-term self-interest of the company (and by extension the businessman’s own self-interest) to make the company as productive as possible; this is a means to an end as a competitive company will allow the businessman to achieve the end goal of running a business: making a profit, both in the form of money and in the form of enjoyment and happiness that the businessman takes in the productive work involved in running the business. Businessmen should not feel guilty or apologize for making money, but should, in fact, take pride in their achievements, their ability to bring into this world value that didn’t previously exist. Finally, the businessman should know that his success is the result of his own virtues, and that every dollar he earned through voluntary trade morally belongs to him and to him alone.    

Thank you for reading, and may you always sustain good returns on your portfolio. Take Care.

Side note: I’m completely against cronyism, and I disagree with all forms of government bailouts or assistance. I don’t care if it’s Wall Street, the automakers, small businesses, farmers, green energy, or etc. Nobody should get help from the government; nobody should be allowed to steal (government does not create any wealth; the only way government can give someone monetary assistance is by taking from someone else). However, I’m not against tax breaks as I don’t consider tax breaks to be a form of government assistance. Taxes are a form of extortion; the government is merely giving back what they stole when it gives someone a tax break.

When I refer to businessmen in this article, I’m not talking about the dishonest businessman that got ahead through political connections and cutting corners. I’m talking about the men and women who made their fortunes through their own effort.

Friday, July 29, 2011

Asset allocation methods from the masters part III: Warren Buffett

In this last article of this 3 part series, I will be talking about the asset allocation method of the world’s greatest investor: Warren Buffett. If you haven’t checked out part 1 or part 2, please do so if you’re interested.

Warren Buffett’s investing strategy mainly centers on investing in good businesses (either in the form of private business as a majority or 100% owner or in the form of shares of stock as a part-owner) with durable competitive advantages and competent management at attractive or at least reasonable prices. Warren Buffett’s private companies (and certain of his stock holdings) generate lots of cash  for him to invest in more private companies and more stocks that either throws off lots of cash or have lots of opportunities to reinvest profits and grow.

Warren Buffett’s company Berkshire Hathaway also holds quite a lot of cash on its balance sheet to tide the company over rough times and to allow the company to seize attractive investment opportunities when they present themselves.

Side note: While it’s true that Buffett has also invested in assets other than stocks or private businesses, it’s through businesses that he created most of his wealth and the wealth of Berkshire Hathaway shareholders.

Here’s how an investor can allocate the assets in his portfolio like Warren Buffett:

Invest in shares of good companies you understand or start good businesses that generates lots of cash (car washes, caf├ęs, or whatever you understand and have enough capital to start). But what exactly is a good business? A good business first of all needs to generate strong profits for shareholders or it wouldn’t be considered a good business. I think Warren Buffett requires a company to generate at least 15% returns on equity before he considers investing in the company; a return on equity of at least 15% (the company should not have achieved this return by taking on too much debt) would be a good place to start when searching for companies for potential investment or when deciding on the feasibility of a business venture.

The reason why a company earns superior long-term profits is because it has a durable competitive advantage over its competitors. A competitive advantage can come in the form of a strong brand, an important patent, being the low-cost producer and etc. Buffett also looks for companies with honest and capable management. Investors looking to construct a portfolio the Warren Buffett way should look for companies with strong competitive advantages which allow those companies to earn superior profits and protects the profitability of those companies; investors should also look for companies that have good management as management are the stewards of the investors’ capital and they can help create great wealth for shareholders or destroy the company’s intrinsic value.

Buffett is also known for his patience and discipline in terms of investing in a company only when he believes it is undervalued or at least valued at a reasonable price. Never overpay for a stock, buying a good company at a great price is not a recipe for good returns.

Now we know the things Buffett looks for in a company, the companies we invest in can fulfill either 1 of these 2 roles: cash cows or future cash cows. The cash cows are usually shares of good companies that don’t have a lot of room to grow or don’t have any plans to expand but generate tons of cash that it pays out as dividends and buyback shares; in terms of a private business, a cash cow can be a very profitable ice-cream shop that you don’t plan to expand. Future cash cows are companies that generate lots of cash but reinvest most of that cash for future profits; it could be shares of a good young company with fast growth or a private ice-cream business that plans to reinvest most of the profits to open more ice-cream shops. The basic idea is for the investor to use the income he gets from the cash cows in his portfolio to invest in future cash cows or other cash cows (or more shares of the same cash cow companies held in the portfolio) to further increase the future cash flow generated by his portfolio.

If Warren Buffett can’t find any attractive investments, he is content to just build up cash to take advantage of attractive opportunities when they present themselves. So, if you can’t find any attractive opportunities, don’t throw good money after bad, build up cash and wait for good opportunities to show up.

This concludes the asset allocation method from the masters series, I hope you enjoyed it. 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.

This article is featured in the carnival of value investing, check it out for interesting investing articles!

Tuesday, July 26, 2011

Mistakes of omission are a bitch!

Warren Buffett once explained how some of his biggest mistakes were mistakes of omission which cost billions of dollars. This kind of mistakes doesn’t show up in the financial statements, but they can still be a real pain. In this article I will talk about some of my mistakes of omission and some of the things I learned to better avoid such mistakes in future. I hope that you would find this article useful.

A few days ago, I met up with an old friend and we started talking about my favorite topic, business. During the conversation, Prada’s IPO in Hong Kong came up and that reminded me of 2 fashion stocks (Coach and Tiffany’s) that I thought was pretty good before but didn’t do any further research and therefore didn’t invest in the stocks. Anyway, I checked the price of these 2 stocks when I reached home and they were up I think about 200% since when I first thought that those stocks could potentially make good investments at the prices they were trading then. I lost the opportunity to get invested in 2 good companies at attractive prices because I decided to sit on my ass instead of dive into the companies’ annual reports.

Now, it is only a mistake of omission if you can understand an investment opportunity and are in a position to capitalize on it.  So, it doesn’t count for me if I missed out on the next leader in cloud computing or a future biotechnology superstar as I don’t understand the businesses of those companies. I could understand the business of Coach and Tiffany’s and I was in a position to buy those stocks if my research confirmed that they were good businesses and good buys at the prices that they then traded at, but I did absolutely nothing, didn’t even bother to have a quick glance at the annual reports.

Here are some of the things I learned with regard to better avoiding mistakes of omission:

If you can understand something and it’s something you like to do and have time to do it, then don’t let potentially great opportunities pass you by. Do your research and if the facts tell you that the company is good and it is trading at an attractive price, then buy.

Don’t try and time the market and wait for a good company that’s already significantly undervalued to drop a few more percentage points. What difference does it make if you buy a stock at $15 instead of $16 when you believe that the stock’s intrinsic value is $60?      

Bet big. If the facts tell you that a stock is very attractive, don’t throw pocket change at it; bet an amount that’s significant enough for the investment to have a meaningful impact on your portfolio if your judgment to buy the stock turns out to be right.

Invest for the long-term; don’t sell a stock just because it went up by 30% or 100% or whatever, so long as the company isn’t terribly overvalued and the company is generating good profits, has honest and capable management, maintaining its competitive advantage and has a good balance sheet, then you’re ok and you don’t have to sell the stock. If you have invested in Berkshire Hathaway in its early years or Apple when it was trading at $10-$20 and sold those stocks when they doubled or even tripled, you would have missed out on their meteoric rise and the opportunity to become incredibly wealthy.

Similar to the point above, if you’ve missed out on investing in a great company and the stock when up by a lot but you believe it is still very attractive, don’t dismiss the company as it could still create a lot of value for its shareholders.  

Another mistake of omission is holding on to shares of a company that is producing lousy returns. I remember Warren Buffett once saying that Berkshire Hathaway could be worth twice what it’s worth today had he not invested in Berkshire Hathaway (originally it was a textile manufacturing company) and instead channel the funds elsewhere.

If you’re disciplined in your search for companies with good fundamentals and don’t overpay for stocks, then mistakes of commission should be few and far between. It’s the mistakes of omission that gets the prudent investor and those mistakes can be on a very large scale. True mistakes of omission aren’t as dangerous as mistakes of commission (these mistakes destroy your capital and can set you back for a very long time), but they can result in you missing out on a pile of money. Missing out on that one stock could be the difference between financial independence and great wealth; so be vigilant, and try not to make costly mistakes of omission.   

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.

Sunday, July 10, 2011

Constructing a passive income stock portfolio part 3

In part 3 of this 3 part series, I will be talking about earnings growth, dividend growth and management. Please check out part 1 and part 2 if you haven't already read them. Here's part III:

Earnings growth

The passive income investor needs to grow his income over time to keep up with inflation and maintain purchasing power. To do that, investors need to look for companies that they believe will keep growing earnings at a decent rate over the long-term. After all, the only way a company can keep raising its dividend is if it is able to keep growing its profits.

I personally won’t aim to just keep up with inflation, but to beat it by a significant margin. I would look for companies that I believe can at least grow earnings at 6-7% over the long-term.

Dividend growth and management

For the dividend investor, rising profits isn’t enough. Management must be committed to raising the dividend. Investors should look back to the past to see if the company had been paying steadily rising dividends over the past 10 years or more. The company should also have raised its dividend at a rate that’s higher than the rate of inflation. 

When I say that the company should have steadily increased its dividend at a rate greater than inflation, I don’t mean that the dividend has to increase every year at a rate greater than inflation. There might be some years where the company didn't raise the dividend or only slightly raised the dividend, but I think that’s normal. What matters is that over the long-term, the increase in the dividend has outpaced inflation. Looking back over a 10 year period, I would take the average dividends paid in the starting 3 years of the period and compare it to the average dividends paid in the latest 3 years. If the average dividends paid in the latest 3 years is acceptably higher (what you find acceptable is up to you, but the dividend should have at least risen at the same pace as inflation) than the dividends paid in the starting 3 years of the period, then I would think that management is doing ok in terms of raising the dividend.     

If I were to invest for passive income, the security of my sources of income would be one of the things I would rank as most important. For a stock to be reliable in producing good returns and paying out generous dividends to shareholders, the business or stable of businesses behind the stock needs to have good fundamentals, and management needs to be competent and committed to enhancing shareholder value. A management team that’s committed to their role as stewards of shareholders’ money will do things like buyback shares when they’re undervalued, increase the dividend when there’s no other better use of capital, avoid taking on excessive risks, maintain ample liquidity and financial strength, face the brutal facts of reality and adapt accordingly,  and etc.

I wrote an article about some of the things I look at when judging the performance of a company’s management team. You can check it out here if you’re interested.


At the end of the day, dividend paying stocks are still stocks. And apart from certain things that the dividend investor has to pay attention to (dividend yield, dividend payout ratio, and etc.), passive income investors should focus on the same things that any other investor would normally focus on when picking stocks. Things like balance sheet strength, whether the company has good liquidity, competitive advantage, returns on equity, revenue and profit growth, how competent management is, and whether or not the stock is trading at a reasonable price.

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

Constructing a passive income stock portfolio part 2

In part 1 of this series, I talked about the dividend yield and Warren Buffett's owners' earnings. In this article, I will be talking about the importance of competitive advantages, the nature of the business and the way a company deploys capital. You can check out part 1 and part 3 if you're interested. Here's part II:

Competitive advantage and the nature of the business

To ensure that the income or dividends we receive from the stocks in our portfolio are stable, we need to invest in companies that have a competitive advantage and sell products or services that have relatively stable demand, both in good times or bad.

If a company doesn’t have a competitive edge which makes the customer choose its products over the products of its competitors, then the company’s profits are at risk from other firms that decide to compete with the company and take its market share, this will lead to falling profits, which will in turn lead to the company slashing the dividend. That’s why it’s crucial that the company has a competitive advantage to protect its profits. Apple for example has a very strong brand and has a huge apps store which gives their IPhones and IPads an edge over the offerings of their competitors. Wal-Mart is very good at keeping costs low and passing on the savings to customers, this makes it hard for Wal-Mart’s competitors to compete with it on price. 

The type of business the company is in can also be a good gauge of whether or not the company’s profits (and therefore dividends) will be stable. For example: The earnings of a beer company or a tobacco company with a strong brand shouldn’t experience a significant drop in profits during a recession. While I don’t think that it’s conventional, some of the people I met seem to think that the rental income from real estate is without a doubt more stable than dividends from stocks. I understand that some real estate really do produce stable income for their owners, but I would rather invest in a venerable consumer products company with a portfolio of strong brands than in an apartment located in an area where there are a lot of vacant apartment units and where rent can fall anytime.

How the company deploys capital

The best kind of business is a business that throws off lots of cash and needs very little capital to expand, in other words, a business that earns superior returns on capital. These cash cows are in the best position to payout generous dividends to their shareholders. One of the best examples of a great company generating absolutely huge piles of cash for its owners is See’s Candy. Warren Buffett’s company Berkshire Hathaway bought See’s Candy for $25 million in 1972. From 1972 to 2007, See’s Candy has generated $1.35 billion in pre-tax profit for Berkshire Hathaway. Of the $1.35 billion in pre-tax profits, only $32 million needed to be reinvested in the business (you can read more in Berkshire Hathaway’s 2007 letter to shareholders). This is the kind of cash a great business throws off to its shareholders. That’s why investors should look for companies that are able to generate good returns on equity without taking on excessive debt.  

Unfortunately, there are not many businesses that both earn high returns on capital, trades at a reasonable price, and has a healthy dividend yield (a healthy dividend yield is not necessary for an investor looking to maximize wealth and not secure passive income, but it is an obvious necessity for the dividend investor, which makes his or her search even harder).While definitely not as impressive as the great companies, companies that earn above average returns on capital are acceptable candidates for a passive income portfolio.

Constructing a passive income stock portfolio part 1

There are many reasons for wanting passive income. A married couple may want passive income so they can go buy something nice for themselves every now and then, a retiree may need passive income to meet his day to day expenses, and an investor may want passive income to deploy into cash generating assets.

Passive income can be generated from real estate properties, a portfolio of bonds, a portfolio of stocks, private businesses and etc. In this 3 part series, I will be talking about the things that an investor should look out for when building a portfolio of stocks for the purpose of generating stable dividend income. In part 1 of the series, I will be talking about the dividend yield as well as something Warren Buffet calls owners' earnings and how that applies to dividend investing. Please also check out part 2 and part 3 (The articles in this series can be read in any order). Here's part I:

Dividend yield and owners' earnings

We first need to start by finding stocks that have healthy dividend yields. We also need to make sure that the dividend is sustainable in the sense that the dividend yield wasn’t inflated by the company paying out a special dividend that isn’t likely to recur, and the dividends paid out as a percentage of owner earnings is manageable.

If the company paid a very high dividend in the previous year because it received a lot of money from selling its assets, profited from its foreign exchange contracts, delivered an extraordinarily large order that’s not likely to recur anytime soon, or because of any other event that has nothing to do with the company’s normal earnings power, then there’s the risk that the dividend will not be sustainable, and investors who bought the stock for its dividend might find that the income they receive from the stock is much less than what they expected.    

Warren Buffett came up with the concept of “owners’ earnings.” Owners’ earnings is the cash that the shareholders or owners can take out from a business without affecting the current profitability and competitive position of the business. I believe that measuring the dividends paid out as a percentage of owners’ earnings can give you a much better gauge as to the sustainability of the dividend than measuring the dividends paid out as a percentage of net profit. This is the case as owner earnings take into account the capital expenditure as well as any additional capital that the company has to put up to maintain current profitability and its current competitive position (a lack of capital expenditure will lead to the company’s profitability being impaired, which will lead to dividends being cut as there are less profits to pay out dividends). Net profit might not be a reliable measure of the amount of cash a company can return to shareholders without damaging the earnings power of the business.

To measure the amount of dividends paid to shareholders as a percentage of owner earnings, we first need to calculate the owners’ earnings. Here’s how I calculate owner’s earnings: Net profit (I try and take out one-time gains or losses) + depreciation and amortization +/- certain      non-cash items - average capital expenditure needed to maintain current profitability and competitive advantage - increase in working capital (if there is).

After we get the owners’ earnings figure, we just divide the dividends the company paid by the company’s owners’ earnings. This is similar to the dividend payout ratio only that we replaced net income with owners’ earnings. We should look for companies that don’t pay out too high a percentage of owners’ earnings as dividends as this might put the dividend in risk in the event that the company has to invest more money in the business, and if the company choose to forgo investing in the business to maintain the dividend, then it will be worse as the company will be killing itself in the long-run.

Wednesday, June 29, 2011

Asset allocation methods from the masters part II: Benjamin Graham

In the first article of this 3 part series, I talked about an asset allocation method suggested by Peter Lynch which advocated that the investor have his portfolio consist of as high a stock component as he can tolerate. This is the case as a portfolio of stocks generally outperforms a portfolio of bonds or a portfolio of part stocks and part bonds over the long-term.

In this article, I will be talking about an asset allocation method suggested by the father of value investing, Benjamin Graham.

Benjamin Graham once suggested an asset allocation method where an investor would put 50 percent of the money in his or her portfolio in bonds while the other 50% of his or her portfolio would consist of stocks. The investor can then tweak the portfolio up to 75-25 stocks or 75-25 bond, depending on whichever asset class the investor thinks is attractive enough to commit more money to.

This asset allocation method is good for emotional investors who might panic when the price of stocks fall and might make some decisions that they could potentially regret. With at least 25% of the portfolio allocated to bonds at any one time, the investor might not get so emotionally affected even when stocks do take a tumble. This is the case as even if the value of the stock component of his portfolio falls, the investor would still receive interest income from the bond component of his portfolio which should help in keeping the investor’s emotions stable during the bear market.

Here are some other investing principles from Benjamin Graham:

Benjamin Graham came up with the margin of safety concept which advocated buying stocks at a significant discount to intrinsic value. This would give investors at least some protection against any impairment in the businesses behind the stocks that the investor bought for his portfolio. Benjamin Graham also advocated that investors do not invest in stocks trading above 1.5 times book value or stocks trading at a P/E ratio of above 15. Investors can buy stocks with a P/E ratio higher than 15 provided that the stock is trading below 1.5 times book value and vice versa. However, the sum of the P/E ratio multiplied by the price to book value ratio shouldn’t exceed 22.5.

Note: Benjamin Graham suggested calculating the earnings for the P/E ratio by averaging out earnings over 3 years. This should help in giving the investor a more accurate picture of the company’s financial performance.

I can’t remember the exact amount of EPS growth Benjamin Graham suggested that a stock should have for the long term, but investors should only invest in stocks that have grown EPS at a decent rate in the past and which they believe can keep growing EPS at decent rates in the long-term future so as to keep ahead of inflation. I personally would require a long-term growth rate of at least 6-7% (the minimum rate of growth that you should require is of course up to you).

I’m not 100% sure, but I think that the Benjamin Graham investing principles and asset allocation method I talked about in this article are meant for investors which Ben Graham called ‘defensive investors’ or investors that are not very experienced and don’t have much time to devote to investing. But even if you’re an experienced investor, there’s no harm in knowing these investing principles.

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.

This article is featured in the carnival of value investing, check it out for interesting investing articles! 

Saturday, June 25, 2011

Surviving inflation part 2: Treasury inflation protected securities

In the first article of this series I talked about why I believe investing in stocks of good companies is the best way to protect yourself from inflation. But unless stock prices are really attractive (and even then I believe investors should still maintain ample liquidity), investors should probably have a certain percentage of their portfolio invested in cash and other short-term liquid assets such as CDs and treasury bills.

While it’s prudent to hold some cash in your portfolio, the value of your cash holdings can get significantly eroded in periods of high inflation. As a way to give their cash holdings and portfolios better protection against inflation, investors can consider substituting some of their cash and cash equivalents with treasury inflation protected securities or TIPS.

TIPS pay a fixed rate of interest that’s based on the TIPS’s principal that rises with inflation. The consumer price index determines the increase in the TIPS principal.

Here’s an example: Let’s say you bought a TIPS at auction with a $1,000 face value that pays a fixed coupon of 2% on the TIPS’s principal. The consumer price index is at 10% for the first six months which will cause the treasury inflation protected security’s principal to rise by 5% or $50 when it’s adjusted at the end of the first six months (The principal only increased by $50 or 5% instead of the CPI’s 10% because the principal is adjusted on a semi-annual basis not on an annual basis). And because the coupon payments are based on the principal of the TIPS which have been adjusted to $1050, the investor would get a $10.50 coupon at the end of the first 6 months (again, the investor only received 1% in interest or half of the TIP’s 2% annual fixed interest rate as the coupon was a semi-annual coupon).

It is important to note that the TIPS’s principal can also decline with deflation. This will cause interest payments to decline as interest is fixed to the principal of the TIPS. TIPS do, however, protect the investor’s principal in the sense that the investor will receive at maturity either the adjusted principal or the face value of the TIPS, whichever is greater. This will only work if you buy TIPS at auction or on the secondary market when they’re trading at or below face value.

It is also important to note that in the US, investors are taxed on the interest payments of the TIPS as well as any increases in the principal even if the TIPS did not mature, and regardless of whether or not they sold the TIPS. That’s why it’s important to hold TIPS in tax-advantaged retirement accounts.

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.

Thursday, June 23, 2011

Surviving inflation part 1: Stocks

No matter how you cut it, inflation is a bad thing for your investments. Be that as it may, there are some investments that would be less affected by inflation than others. In this 2 part article series, I’ll be talking about 2 asset classes that can provide us with significant protection against inflation; stocks and treasury inflation protected securities or TIPS.

Businesses, whether it’s private businesses or stocks, have been and will continue to be the greatest generators of wealth over the long-term. Some would say that stocks are a good hedge against inflation as a company can raise prices to maintain profits in real terms. But that isn’t completely true as lousy companies might find it difficult to raise prices. In other words, stocks can be good hedges against inflation, but only stocks of good companies.

But shouldn’t we be investing only in good companies, regardless of whether or not there’s high inflation? Yes, we absolutely should. That’s why I’m always puzzled when people start panicking when there’s inflation and look to some guy on TV to tell them where to invest. If you invest in good companies at a reasonable price and hold on to those stocks for the long-term, you should do fine.

Here are a few characteristics we should look out for when identifying good companies that are resistant to inflation:

Good returns on capital

Good companies generate attractive returns on capital (hence the reason why they’re good). A company that’s asset-light and earns good returns on capital will be more resistant to inflation than one that’s asset-intensive and earns poor returns on capital. This is the case as in times of inflation, the company with a lower return on capital has to tie up more money in things like inventory and accounts receivable than a company that earns high returns on capital to stay even in terms of real profits.

For example: Suppose both company A and company B earns $1 million. But company A only needs to put up $5 million to earn the $1 million (high return business) while company B has to put up $20 million to earn $1 million (low return business). Now, let’s say that inflation has caused prices to double, and while both companies managed to increase prices at the same pace as inflation, both of the companies also had to put up two times as much capital just to stay even in terms of real profits. While inflation has hurt both companies, company A only needed to put up an extra $5 million in capital while company B had to put up an extra $20 million in capital.

It's hard to tell the exact return on capital a company enjoys as the company might be holding on to a lot of excess cash and etc. But generally, if a company consistently earn good returns on equity and good returns on assets without having to reinvest a lot of cash in the business to maintain profitability, then that would most likely be a company that can employ capital at good returns.

Pricing power

When trying to find good companies, it’s always useful to start out by looking for companies with strong brands that differentiate their offerings from that of their competitors and give them pricing power. But how do we know which company has a strong brand and which don’t? Doesn’t every CEO say that their company has a strong brand and pricing power? To answer this question, we need to look at the gross profit margin of the company and compare it to the gross profit margin of its competitors. If the gross profit margin is significantly higher, then the company has pricing power as customers are willing to pay more for the company’s products than for the products of the company’s competitors.

Here’s an example: There are 2 burger stands, both sells 100 burgers a day and the cost of the ingredients to make 1 burger (let’s just say $5) is the same for both burger stands. But if burger stand A has pricing power and is able to sell its burgers for $7 while burger stand B is only able to sell its burgers for $6, burger stand A will earn higher revenue than burger stand B ($700 for A and only $600 for B). And because both burger stand A and B have the same cost of ingredients at $500, but burger stand A has pricing power, burger stand A will earn a higher gross profit and have a higher gross margin than burger stand B. That’s why it’s important to look at the gross profit margin of a company in comparison to its competitors to determine if the company has pricing power.

Note: When I talk about using the gross profit margin to give us an idea of a company’s pricing power, I'm mainly talking about companies that sell physical goods. This method might not apply to certain industries or companies. There might also be more accurate methods to measure pricing power. But nevertheless, I think comparing the gross profit margin of a goods selling/producing company to that of its competitors is a good way to get a general idea of the company’s pricing power.

Operating profit margin

Good companies manage their costs well and should have higher operating profit margin than their competitors. By earning a higher profit margin relative to their competitors, good companies are able to weather inflation better than their competitors in the sense that they can better absorb cost increases (increases in raw material prices, increases in employees’ wages, and etc) than their competitors. They can wait a longer time before increasing the prices of their products and win market share from their competitors who have to pass on the costs to customers earlier or operate at a loss.

I believe the best way for investors to fight inflation is to do what they should always be doing regardless of what’s happening with the economy or how high inflation is going to get, that is to just invest in stocks of good quality companies at reasonable prices and hold those stocks for the long-term. Inflation might even cause stock prices to fall giving the savvy investor attractive buying opportunities.

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

Saturday, February 26, 2011

The best investors KISS and understands

I think it was Peter Lynch that once said something along the lines of “if you can’t explain to a child the reasons why you want to buy a certain stock or make a certain investment, then you should probably rethink the decision to make that investment.” And I think that it was Warren buffet that said something like “if you can’t make a decision to invest in 5 minutes, you can’t make a decision in 6 months.

These 2 values of keeping things simple and understanding any investments that you commit yourself to are, in my opinion, an essential part of any great investor. After all, there are not many things that you need to look at when determining whether or not an asset would make for a good investment; there are crucial things to look at such as competitive advantage, price, return on equity, and a few other things when evaluating the investment appeal of a company’s stock, but there aren’t many of these crucial things. By keeping things simple, ignoring the noise, and looking out for the things that matter, we can make much better investment decisions.

It is through understanding that you can tell within minutes the reasons why an investment has the potential to produce good returns. If you can’t tell within a few minutes if a company would make for a good investment, then you don’t understand the company, and if you don’t understand something, you shouldn’t invest (gamble) in it.  By knowing which companies have the potential to do well, and which don’t, we can also save a lot of time by researching only the companies that have good prospects. The returns we enjoy would very probably also improve, as we are now only valuing assets that we understand and that have potential to produce attractive returns for us.

By keeping things simple and understanding what we’re doing, we will not only be able to explain to kids the reasons why we make an investment or decide, in a matter of minutes, if an investment is worthwhile researching, but more importantly, our returns could improve significantly, and our risks will be reduced.

So, understand what you're doing and always remember to tell yourself to keep it simple stupid (KISS). There is so much more value in kissing your girlfriend/boyfriend whom you love and understand than a meaningless kiss in a one night stand; the same concept applies to investing.

Thank you for reading, and may you always sustain good returns on your portfolio. Take care.

Monday, February 21, 2011

The employee saga part 1: Hiring the right people

You're only as good as the people you hire. –Ray Kroc

It is important to find and hire people that you believe are honest, passionate about what your company is setting out to achieve, believes in and have the desire to provide customers with great service, and can fit in well with your company’s culture. If you can get the right people on board, the other stuff will start falling into place. I remember reading in Jim Collins’ book “From Good to Great” about how some companies that became really great focused first on hiring good employees, then only on which direction to take the company.

The right people are driven, self-disciplined, take pride in their work and in serving customers, like to step up and make decisions, and conduct themselves with integrity. Employees with these qualities don’t need to be constantly monitored, can be empowered to make decisions and use their judgment in their work, and can be trusted to really perform for your company. It is after all your employees that make your business run, take care of your customers, and create value for your company. They are the ones that are in the best position to make decisions, and it is through their skills, talents, and efforts that real value is unlocked in your business.

Management’s job is to hire these good people, train them and help them grow, create and maintain a culture where they can thrive, cut out bureaucracy, put in place a relevant compensation system, as well as do other things to ensure that  employees are able to perform at a very high level  and drive superior returns for their company.       

To select the right people for our companies, we need to have in place a thorough and well-designed hiring process. It’s important to involve our employees in the hiring process, as they would be in a good position to identify people that would do well in your company. 

According to the book “The New Gold Standard,” The Ritz-Carlton really takes the time to select good people to come work for them and become a part of their family. And because The Ritz-Carlton invested so much time and effort in selecting their employees, the people that do get selected to join the company feel a sense of pride and believe that the company thinks that they are really good and expects a lot out of them, this will drive them to live up to the standards that are expected of them.

Back to the point I made earlier about finding and hiring people that you believe have integrity, are passionate about what your company is doing, and fit in well with your company’s culture. It isn’t enough if your potential employees are smart and have the relevant skills but lack any one of those qualities. If your employees aren’t passionate about what your company is doing, they won’t give it their all for your company.  If your employees can’t be trusted to conduct themselves with integrity, you can’t empower them to take the initiative and make decisions.

Tony Hsieh, the CEO of Zappos once said that “your culture is your brand.” And if you hire people that don’t fit in well with your culture, you are destroying your brand. Imagine that a company has a culture that is very customer oriented, but it starts hiring people that might not necessarily be customer oriented. When that company’s customers come into contact with these people, they will get disappointed with the service and tell their friends about their experience with that company; over time, this can lead to significant impairment of that company’s brand. By hiring people that don’t fit in your company’s culture, not only will these people not thrive in your company, they might damage the culture and bring down your other employees that were doing well in your company.  

We need to think about efficiency when hiring, not only because we can cut costs by needing less people than our competitors to do the exact same jobs that they do, but also because we wouldn’t need to layoff so many people when things get tough, this in turn would result in your employees feeling more secure about their jobs and being more loyal to your company.

We need to have the patience to carefully select our future employees and not just hire anyone because we are short-staffed or something. We also need to fire bad employees as they might demotivate and drag down the good employees that want to work hard.

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.

Saturday, February 12, 2011

Long-term greedy

Being long-term greedy is a philosophy popularized by Gus Levy, former senior partner of one of the most successful financial institutions of all time, Goldman Sachs. It’s just so profitable to be long-term greedy that I can’t for the life of me understand why any company or investor would do things that only have short-term benefits in favor of positioning themselves for the long-term.

A lot of speculators would buy a stock with the hopes of selling that stock with the next quarter or two at a profit.  Not only are these short-term greedy decisions not as profitable as investing for the long-term, it’s gambling and not investing to buy a stock for the short-term and for reasons unrelated to the fundamentals of the business; things might not happen exactly the way the speculator or some idiot on TV that the speculator listened to predicted, and the stock might plunge in value because it missed earnings estimates by 2 cents, or gross margins are down 1%, or some other short-term reasons. Even if you were to invest based on fundamentals, a stock can be irrational in the short-term and its price might not reflect its intrinsic value.

If they’re lucky and their bets pay off, speculators can sometimes make money, just like how a gambler might sometimes win at roulette. But most of the time, those short-term gains pale in comparison to the gains (potentially amounting to many times the original investment of the investor)  that an investor can get if he or she simply invested in great companies at reasonable prices for the long haul. Warren Buffett didn’t try and time the market; he just invested in great companies and let those great companies create value for him over many, many years.

Companies and entrepreneurs can also benefit tremendously from being long-term greedy. Spending a little bit extra to surprise customers or to make up for any problems the customer might have encountered can result in the customer having a good experience and becoming a customer for life, continuing to invest in a downturn when assets are cheap can result in good future profits (I remember reading somewhere that Panera Bread opened some of its most profitable stores during the recent recession), and helping out the communities it operates in because a company cannot thrive when society is suffering (to me, helping others is simply the right thing to do, but being socially responsible do come with long-term benefits) are some of the ways for a company to take a long-term approach.

At the end of the day, investors should look for companies that are long-term greedy, and entrepreneurs should focus on being greedy for the long-term when running their companies, as the companies that are long-term greedy are the ones that create the most value for their shareholders.

Short-term greedy companies have many disadvantages, not only are they less well-positioned for the future, they can also destroy a lot of value for their shareholders. Take the financial crisis for example, the banks could have been in much better shape had they not made out so many loans to people who were buying houses that they couldn't afford. But the banks were only thinking about all the profits they could earn(and the bonuses they could pocket)  by making out those loans, and not thinking about how sustainable those profits really were. A lot of those loans eventually went bad, and many banks either went under or saw their stock plunge in value.

While I'm not saying that the financial crisis could have been prevented if the banks were more disciplined in their lending, I'm pretty sure that shareholders wouldn't have suffered so much if the banks weren't so focused on the short-term. Further evidence of the value of long-term greed: when all was said and done, it was the banks that were long-term greedy and kept their heads in the madness that not only survived, but took advantage of the crisis and acquired assets on the cheap and set themselves up to create good long-term value for shareholders.

Thank you for reading, and may you always sustain good returns on your portfolio. Take care.

Saturday, February 5, 2011

The pride of ownership

It's always awesome to think about the stocks you own as representing part-ownership in businesses as opposed to pieces of paper that move up and down in price everyday. I get a mental boost every time I see someone wearing a pair of jeans that's made by a company I own stock in and think to myself how I got a small part of the profit (a very minuscule part to be exact) from the sale of that pair of jeans.

When I'm on a bus on the way back to my hometown, and I pass by a plantation belonging to a conglomerate that I'm a part-owner of, I'll imagine all the palm oil being harvested there and how that company, a company I own a tiny piece of, is responsible for employing thousands of people. I would look around at all the happy people at one of the best shopping malls in the country, a shopping mall I'm a shareholder of.

By thinking about stocks as real businesses that earn profits, employ people, make products, and create value for customers, we will not only be able to shrug of the need to take part in speculation, but we will also be able to make better investment decisions as well. When we think like business owners, we start looking at things like competitive advantages, returns on equity, sustainable growth, what are reasonable prices to pay for shares in businesses, and etc; these are the things that we should think about if we want to find investment opportunities that have the potential to deliver really spectacular returns.

It's also just plain awesome to drive around and see restaurants, office buildings, petrol stations, or whatever businesses that you're a part-owner of and get a cut of the profits from. It's like you're watching over your business empire (even if it might be a very small empire). That to me is the pride of ownership.

Thank you for reading, and may you always sustain good returns on your portfolio. Take care.

Wednesday, January 26, 2011

IPOs are for shmucks

While it might seem exciting to get in on the action of a hot IPO or two, it might not make good business sense to do so. When a company has an initial public offering, chances are that the company insiders have made sure that the shares being sold to the public are fully priced (or maybe even overpriced).

Sure, the company insiders might claim that investors are getting a good deal, but think about it, the better the deal that the public gets, the worse the deal for the company insiders.If you owned 100% of a great business, would you sell part of it to someone else at a discount? No way. In fact, you would demand a premium for the stake you're selling. The insiders of a company that has plans to have an initial public offering are in the exact same position.

The best, most successful way to invest is to buy good companies at prices that afford you a healthy margin of safety (the margin of safety concept states that an investor should only invest in a stock if it is trading significantly below intrinsic value. The margin of safety concept was popularized by Benjamin Graham). When investing in stocks through IPOs, it isn't likely that investors will have a margin of safety as those stocks will likely be fully priced or even overpriced at the time. Without a margin of safety, investors will be taking on more risks,and if investors overpaid for a stock, they could experience significant losses for quite a long time.    

People might tell you that taking part in IPOs is an easy way to make money and point to some stocks that have went up over 100 percent or even a few hundred percent in the first few days after their IPOs. Just remember that while a stock can surge after its IPO, the stock's price could also fall after its IPO; taking part in an IPO in the hopes to sell the stock at a profit the day it starts trading is gambling not investing.

The title of this article proclaiming that IPOs are for shmucks is, of course, an overstatement. Just be really careful and thoroughly do your research if you plan to take part in an IPO, and ask yourself this question: If the company insiders who know their company better than most, if not all outsiders decide to sell stock in the company, would they really price the stock for the public's benefit (low price), or price the stock for their own benefit (as high a price as possible).

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.

Monday, January 24, 2011

Only in a perfect world will I invest in gold

You could take all the gold that's ever been mined, and it would fill a cube 67 feet in each direction. For what that's worth at current gold prices, you could buy all -- not some -- all of the farmland in the United States. Plus, you could buy 10 Exxon Mobils, plus have $1 trillion of walking-around money. Or you could have a big cube of metal. Which would you take? Which is going to produce more value? –Warren Buffett

Gold has done really well over the past decade, and the gold bugs believe that the price of gold will keep on climbing. But unless the world becomes perfect and we can all walk on sunshine, I don’t think I’ll be investing in the precious metal. In this article, I will be talking about the reasons why I stay away from gold.

I can’t value the damn thing

The main reason why I don’t want to have anything to do with gold is the fact that I simply can’t value it (maybe some other people can or think they can, but I can’t). Unlike shares in a company that generates profits and pay dividends, or bonds that pay interest, gold just sits there doing nothing. And because gold doesn’t actually earn any money, there isn’t any cash flow for me to discount back to the present to arrive at a value.

If I can’t value something, how would I know whether or not I’m getting an attractive or at least a fair deal? Take stocks for example, if I know the value of a company, I can buy the stock if it’s undervalued, and be completely ok if the price of the stock fell, so long as its fundamentals remain intact, as it’s creating real value for me by giving me income or reinvesting profits for my benefit.

With gold, I can’t tell how much of the price reflects real value, and how much represents speculative greed. I could buy gold one day, only to watch its price fall significantly over a few months, and be stuck with paper losses for years (it isn’t too hard to imagine, as gold did crash before) while my gold holdings just sit there doing absolutely nothing. I am well aware that the price of Gold could keep on climbing, but I would rather invest in an asset that creates real value for me than invest in something that people might value highly and demand more of, but doesn’t create any real value.

While a case can be made for using the cost of production of the commodity or the inflation-adjusted price of the commodity to help us value that commodity, gold isn’t exactly like any other commodity in the sense that a lot of the demand for gold comes from investors while most of the other commodities are used mainly for industrial or commercial purposes. The problem comes when these aspiring King Solomon gold bugs find out that gold isn’t all that it’s cranked up to be, and start dumping the precious metal in favor of other asset classes that actually generate profits or income.

I know the fed is printing money, I know that all the stimulus could very well lead to high inflation in the future, and I know all these things could cause gold to soar. But I personally think that it’s gambling to buy gold in the hopes that its price will rise because we will experience high inflation or a significant decline in the dollar. In my book, investors can only hope for returns when the assets they invest in actually returns to them cash or reinvest the investors’ share of the profits for the investors’ economic benefit.

A sometimes volatile store of value

People say that gold is a store of value, and over the long-term, that appears to be true. The thing is that gold can get overvalued, and like any other asset that has gotten too far ahead of itself; the price of gold will probably come crashing down (assuming of course that gold is overvalued, I wouldn’t know if it is, as I can’t value the damn thing).

If we live in a perfect world where there isn’t any risk of gold having any volatile price swings, then yes, I will consider replacing my cash  holdings with gold, as gold holds its value and cash don’t. But because there is the risk that the price of gold can decline, I can’t use gold as a currency or as a proxy for cash, as I don’t want to be in a situation where an attractive investment opportunity presents itself, and I have to sell my gold holdings at a significant loss or take a pass on that opportunity.

If I wanted to preserve my wealth, then maybe I can consider gold as a long-term investment. But why aim to only preserve my wealth, when I can just dollar cost average in a low-cost index fund, and very probably get a decent growth in my wealth over the long-term?

Historically, gold produced pretty lousy returns while businesses (both stocks and private businesses) have been the greatest generators of wealth. This makes sense as gold just sits around and do nothing while businesses pay out dividends and reinvest profits so that they can generate even more income for their shareholders in the future.  

I’m of course not telling you to avoid gold too, just letting you in on why I personally think gold makes for a bad investment. But maybe I’m missing something here; maybe gold can really be a good investment. If you think I’ve missed out on something in my evaluation of gold as an investment, or if you have any questions, please feel free to comment.

Thank you for reading, and may you always sustain good returns on your portfolio. Take care.     

Monday, January 17, 2011

When you should sell your stocks

We always hear people talk about selling a stock because it went up from $20 to $22, revenue missed expectations by 2%, the company has no plans to go into the tablet computer business, or something else that makes absolutely no sense to a value investor. But what exactly are the reasons for an investor to sell a stock? When should we sell?

If you buy, at a reasonable price, shares in a company that has excellent fundamentals, then the right time to sell should almost always be never. There can, however, be situations where an investment like that should be sold immediately, as well as situations where selling such an investment can be considered. In this article, I will be talking about the situations where a stock investment should be sold immediately.

When the economics of the business gets significantly impaired

It’s the economics of the business that will drive its growth, protect its profits from being competed away, and allow it to earn good returns on equity or shareholders’ money. When there is significant deterioration to the fundamentals, the company’s long-term profitability will be at risk, and shareholders should sell the stock immediately, regardless of whether or not the stock’s price is below what they originally paid for it.

When the company’s long-term profitability gets impaired, it might not be able to generate decent enough returns to justify holding its stock. The economics of the business might also continue to deteriorate, which might in turn cause the price of the stock to keep falling.

The combination of earning poor returns on equity and the risk that the stock will continue its downward spiral in both fundamentals and price makes it a bad idea to hold on to such a stock in the hopes of at least breaking even, especially when you can use the proceeds of the sale to invest in a business with good economics  and which has a much better chance of not only helping you recoup your losses from the previous investment, but might even put you very far ahead.  

Very obvious side note: You should also immediately sell a stock if you find out that the economics of the business behind the stock is significantly worse than what you originally thought it was.  

When management shows itself to be incompetent

Management is trusted with the responsibility of safeguarding shareholders’ money or capital, and intelligently allocating capital so that shareholders can enjoy good long-term returns (or at least as good as it can get after taking into account the economics of the business). No one is perfect, and mistakes will be made every now and then. But when too many mistakes are made, a lot of shareholder value can be destroyed.

Here a few things that an incompetent or greedy management team would do:

Make pricey acquisitions or put shareholders’ capital to work at poor returns.

Issue shares when the stock is undervalued.

Buyback shares when the company’s stock is overvalued.

Take on too much risk (taking on too much debt, getting involved with a lot of complex derivatives, and etc).

Pay themselves huge bonuses that don’t reflect business performance directly created from management’s own talent and efforts.  

If you believe that management isn’t doing a good job at safeguarding your money, is more interested in their welfare than your welfare, and make decisions that destroy shareholder value. And you believe that the mistakes aren’t just one-time things, but are mistakes that are likely to occur. Then you should sell the stock immediately. Even if each mistake doesn’t do much damage to shareholder value on its own, the mistakes will add over time, and you will wake up one day to find that the intrinsic value of the company has dropped significantly.

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.  

Monday, January 10, 2011

Facebook: Love the product, don’t really love the stock

By the time this article gets published, it would probably be the 10,735th article written on how Facebook is now valued at $50 billion. While I love using Facebook, I personally would stay away from the stock, as I believe that it’s overvalued, and it could have more than its fair share of growth already priced in.

According to this article here, Facebook made around $2 billion in revenue, and around $400 million in profits in 2010. That could put Facebook at a P/E ratio of more than a 100, and a price to revenue ratio of about 25, very expensive indeed. I am aware that Facebook has more than 500 million users, and could very well have a lot of room to grow revenue and profits, but paying too much for growth is no recipe for investment success, and can in fact cause significant paper losses that could cause you to miss out on years of compounding returns.

People who say that Facebook is a growth company and that its current high price shouldn’t worry you don’t know what they are talking about. Forsaking value investing principles just because a company is growing very fast is never a good idea, and can in fact be a very costly idea. As Warren Buffett said, value investing and growth investing are joined to the hip, and that growth is a component in the calculation of value.

Facebook might do some really amazing things in the future, but I don’t know what those amazing things are yet. I also don’t know if Facebook can consistently execute to the point that its $50 billion price tag is justified. Just look back to the dot-com bubble, everyone thought that tech companies would do amazing things, and investors paid irrationally high prices for tech companies only to see a lot of those companies turn out to be very lousy businesses.

True, some tech companies like Google and Microsoft turned out to be great companies, but I’m not smart enough to tell if Facebook could turn out to be a great enough company that you can buy its stock today when it’s valued at $50 billion and still earn good returns.  To the people that think they can accurately tell that Facebook will become an obscenely profitable cash cow that can rival the lights of the great companies in terms of creating value for shareholders, I wish you the best of luck!

Since Facebook is a rapidly growing company, it will probably issue more shares (I keep hearing and/or reading about how Facebook might have an IPO in 2012), and that could result in existing shareholders facing significant dilution to their holdings, effectively requiring the company to perform even better to justify its current price tag.

I’m not saying Facebook won’t go up in value, it very well could (either because it really creates shareholder value or because of more speculative fever), I just personally feel that it’s a gamble and not an investment to buy shares in Facebook at its current price. I admit that I hardly have any information on the company, and I could be missing out on something that justifies its $50 billion valuation. But the something that I might have missed really has to be huge though and be on par with something like being able to turn lead into gold or water into Johnnie Walker Blue Label.

I really hope that the people who bought or want to buy Facebook’s stock on the shadow market are given enough information to properly calculate the company’s intrinsic value. Thank you for reading, and may you always sustain good returns on your portfolio. Take care.

While this article mainly talks about Facebook and its stock, my hope is that it can be used to help at least some of you form sort of a mental template to think rationally about any "hot stock."  

Saturday, January 8, 2011

Guest Post: Loan - A Part of Debt

The following is a guest post contributed by Neo Anderson. Enjoy!

Loan is an arrangement of money in which lender gives money to a borrower for some purpose, and then the borrower agrees to repay the money along with some interest. Loan can be paid in regular installments. In this process of loan lender have <a href="">benefit of earning</a> an extra amount on the loan. While in case of legal loan which is based on some contracts is under some restrictions and obligations which the borrower has to follow. Loan can be available for House, Education, Car, Two-wheeler loan, Personal loan and Trade loan. In Education loan repayment starts when the person starts earning.

There are three types of loan including Secured loan, unsecured loan and Demand loan.

Secured loan are those loan which are granted to the company or an individual on the basis of some assets which acts as a collateral security. This collateral security acts on the safer side as non - payment of loan, this security will go to the borrower under certain terms and condition.

Subsized loan is also a part of secured loan in which you will not gain interest unless you began to pay the amount. On the other side there is Unsubsized loan is one in which interest is started as soon as the distribution of loan takes place. This proves to be disadvantage because as compared to sub sized loan the lender has to start paying the amount immediately weather he has paid money or not well in sub sized loan when he collects the amount he can pay and began to give interest.

Unsecured loan is the second part of loan which is borrowed without any secured assests.This loan can be easily available from the financial market under terms and conditions. Unsecured loan includes credit card debts, bank overdraft, and personal loan. The interest rate will be depending on the borrower and lender which may or may not regulated under the law. This type of loan contains risk because wheather the lender will pay the amount or not.

Demand loan is the third part of loan which is for a short period less than 180 days, this type of loan contains interest at a floating rate which can be varied at a prime date and they didn’t contain fixed date of repayment.

Contributed By: Neo Anderson

Friday, January 7, 2011

Characteristics of a good business according to Buffett

From reading stuff that Warren Buffett wrote, as well as stuff that other people wrote about Buffett, I think I learned a few things about what makes a good business. The characteristics of a good business are: Able to deploy a lot of incremental capital at good rates of return, throws off lots of cash and do not need to reinvest much of its cash flow to maintain current profitability, and have a wide economic moat. In this article, I will be talking about those 3 characteristics of a good business.

Putting incremental capital to work at good returns

A good business is able to deploy a lot of incremental capital at an above average rate of return for a long time. If a business is able to do that, it will in effect be helping its shareholders compound their money at a good rate of return (the surest path to great wealth) and saving them the trouble of having to invest the extra dividends they would have received if the company didn’t reinvest in its operations (the average investor would, obviously, find it very difficult to achieve results that are similar to a company that can reinvest earnings at above average returns).

To see if a company has been able to earn good returns on incremental capital, I look at the increase in equity and the increase in net profit over a period of time (the timeframe that you use is, of course, up to you, but it should give you a long-term picture). I then divide the increase in net profit by the increase in equity to find the return on incremental capital.

Throws off lots of cash  

A good business shouldn’t need to continually invest a lot of cash just to maintain current profitability, that’s just a recipe for lousy returns. Warren Buffett said on a CNBC interview that his company would be worth $200 billion more had he not bought Berkshire Hathaway and got into the textile business, but bought a good insurance company instead.

Investors should find companies that generate lots of cash, and that don’t need to reinvest a lot of its cash flow at low returns or watch their profits deteriorate, but can instead use the cash to do things like pay out dividends, buy back shares, expand its operations, make acquisitions, and other value creating activities.

The really great businesses earn really great returns, and don’t need much incremental capital to grow their earnings. But because these companies can grow with very little incremental capital, they can’t, for an extended period of time, keep reinvesting a significant amount of its earnings back into their business at the high rates of return they are accustomed to.

If you can get invested in them when they still have a lot of room to grow, then you could potentially have bought a golden ticket to great wealth (assuming that you bought the stock at a sensible price and management is hones and able). But if you can’t, this kind of businesses can still make for very good investments, as you will be able to use the cash that they pay out as dividends to invest in other similar cash cows or even businesses that might not be as attractive, but are still very good in the sense that while they need to invest significantly more money than the great companies to grow, they still earn good returns on equity and can reinvest earnings at above average returns (remember the first characteristic of a good business that we talked about in this article).

To see if a business is able to generate good amounts of cash for their shareholders, and not simply cash that the company has to reinvest in its operations at low returns or face the prospects of declining profitability, I look at the company’s return on assets. But instead of measuring net income against total assets, I divide what Warren Buffett calls “owner earnings” by total assets to get the return on assets figure. Unlike operating cash flow that only takes into account the cash received from operations but not the cash that must be reinvested to maintain the business’ competitive advantage and profitability, owner earnings take into account the capital expenditures necessary to maintain current operations.

The asset-light, great businesses will generate excellent owner earnings in relation to assets, and the lousy, asset-intensive businesses will, of course, generate poor owner earnings in relation to assets.           

Economic moat

A durable competitive advantage is what sets apart the good and great companies from the mediocre and downright lousy companies. A significant competitive advantage allows a company to earn better than average profits or maybe even excellent profits, and protects the company’s profits from competitors that want to get a piece of the action. A strong brand, being the low-cost producer, patents, and having a near monopoly over a certain market are some sources of competitive advantage.

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.