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.