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.