Financial Reference

Most people don’t want to put any effort into finances, but they want to see results. The bad news is: if you don’t apply yourself and you want to beat the market, you are probably going to lose. The good news is that with no effort, you can get very close to market returns using index funds and exchange traded funds (ETF).

It surprises how ordinary people think they can beat the market by following hot stocks, industries, or managers. But, the truth is, you have to put in a minimum of research to get market-beating returns (see High Returns With Little Effort).

For most people, this effort is just too boring. So, for all of you that don’t want to read annual reports and don’t want to learn the basics of valuation, do yourself a favor and don’t try to beat the market. If you bought tech stocks in the 90s and are currently buying real estate and energy stocks, if you have many different sector mutual funds, or if you have no idea what you are currently invested in, you have a problem.

The easiest way to solve this problem is to put your investments on autopilot. Using a simple strategy of buying and holding an index mutual fund or — even better — an ETF can give you close to market matching returns. They offer a market return less fund expenses — and the lower the expenses, the higher the return.

In fact, according to a recent Morningstar study, the fund expense ratio is the one piece of information that is predictive of future returns. Index funds and ETFs have lower fees than actively managed funds and so should have higher returns in the future.

If you do not want to do your own basic research, you should not take hot stock tips or speculate on hot managers or sectors; you should find a boring index EFT or mutual fund.

P.S. If you need help finding an ETF or mutual fund, you can start by checking out these ETFs: vti, ivv, spy; or these mutual funds: vfinx, fsmkx, fsemx, fsiix, fstmx, or fusex.

Don’t get me wrong — indexing is a great strategy. Indexing will beat active mutual funds any day of the week. But there are basic strategies to beat an index over the long-run — ways to enhance the return of a basic index by overweighting certain stocks.

In Contrarian Investment Strategies: The Next Generation, David Dremen shows that buying low P/E, low P/CF, low P/B, and low P/Div stocks outperforms the market index substantially.

The outperformance of the strategies over a market index vary, but any one of these strategies has outperformed the market over the long-run and there is no reason to believe that these strategies will not work in the future. The best strategy — the low P/E ratio strategy — has outperformed the market by an average of almost 4% over the study period. The worst strategy — a low P/Div ratio (or high yield) — still outperformed the market by almost 1% per year.

So, whether you are a mutual fund investor or select individual stocks, you should put a higher weighting in stocks that have a low P/E, low P/CF, low P/B, and low P/Div. Doing this will increase your odds of outperforming over the long-run. So forget all of the amazing growth stories and invest in a cheap, boring stock and laugh all the way to the bank.

With only a little more effort, you can increase your odds of beating your neighbors index fund. And, of course, trounce his actively managed fund as well.

It’s hard to escape the undeniable truth of often repeated truisms, such as you need to balance your portfolio between stocks and bonds. Even for very young long-term investors, financial advisors often recommend allocated some of your portfolio to bonds. Some, like this writer, even recommend owning commodoties to balance your portfolio.

However, this advice doesn’t make sense in the long-run. It’s true that year-to-year different asset classes will outperform, but over the long-run stocks have always outperformed. So, if you want to have more in your basket at the end of the day — and don’t care about short-term fluctuations — there is one asset class you should overweight: stocks. (An aside: commodities have been a horrible long-term investment and should be avoided — especially in times like today, when there is a speculative ferver surrounding them.)

We all know that over the long-run stocks return more than bonds. But few know that stocks are also less risky over the long-run.

The confusion stems from the fact that the risk of stocks varies widely depending on the holding period. While most measures of risk use standard of deviation of return over a one year period, the holding period for long-term investors is often much longer. Even if you are not Warren Buffett — who jests that his favorite holding period is forever — you probably hold you investments for much longer than one year.

In fact, if you are like me and plan to hold your investments at least 15 years, the risk of stocks is similar to slightly below the risk of fixed income investments. See The Future For Investors. In the land of no free lunches, this is a big free lunch for long-term investors.

The true risk (if you believe in CAPM), is the total risk of your portfolio over your holding period. However, the fact that the return is higher and the risk is lower for an asset class means more people should be allocating more of their portfolios to equities. Additionally, the models your financial advisors are using are probably wrong since they use a one-year standard deviation to measure risk and, therefore, overestimate the risk of stocks.

So, if you are a long-term investor, do yourself a favor and allocate more of your portfolio to stocks and less to bonds and commodities.

Good and Bad Debt & Margin Debt
There is good debt and bad debt. Even the IRS agrees: mortgage, business, and student debt are deductible, while credit card, personal lines of credit, and margin debt are not. (An aside: there is an option to offset investment income against margin interest, but then the character of all your investment gains changes to income — i.e. long-term capital gains and dividends will lose their special tax status and be taxed at your marginal rate.) I suppose there are reasonable reasons to favor one type of debt over another — the government wants to encourage home ownership, entrepreneurship, and education but not speculation or excessive spending.

There are good and bad debt — but the analysis is not as easy as saying one type of debt is “bad” and another is “good”. Mortgage debt is in not necessarily a good type of debt — many people take on too much debt and do not appreciate the risk of newer mortgage products. For example, Option ARMs — a mortgage with a teaser rate that allows people to buy more than they can afford — have a lot of built-in interest rate risk.

On the opposite end of the spectrum, credit card or margin debt is not necessarily bad debt. You can use either to leverage your investments. For example, some fixed rate credit cards are offered way below my current estimated cost of capital of roughly 6-8%. If I can borrow at a fixed rate below my cost of capital, I am adding long-term value.

With margin borrowing (or variable rate credit cards) you are also taking on interest rate risk and if interest rates increase, the value of your investment can decrease at the same time your borrowing costs increase. Still, especially with margin borrowing, you can significantly leverage your investments and increase value to your portfolio.

The most important problems people encounter when they use margin are: they over-leverage, they leverage the wrong investments, and they don’t manage their cash flows. The first, and most common, problem is that people leverage their portfolio to the hilt so that even a small an adverse price movement can mean liquidating part of your portfolio.

The normal person who uses margin is a risk-taker, the same sort of person who wants to invest in the next big thing. But, if you invest in more conservative run companies, with large dividend payments and low P/E ratios, you should not have as much price risk in your portfolio and will reduce your chance of a margin call.

It also helps your chances if you have positive cash flow to devote to your portfolio when the inevitable price declines come. If you are adding cash to your portfolio, there will have to be a much bigger decline in value before you need to liquidate.

I have learned most of these lessons the hard way. Now, I currently use a reasonable level of margin on more conservative investments and make sure that I have positive cash flow to devote to my portfolio when the value of my portfolio decreases. This does not guarantee that I will not have a margin call down the road, but it definitely decreases my chances while still increasing my returns.

Although most people’s goal is to become debt-free, debt can be a powerful way to increase your returns. As long as you are responsible in managing your risk, margin debt and other “bad” debt can be a good way to leverage yourself and create long-term value. However, if you are not responsible managing your risk, taking out any debt — even to purchase a home — can be disastrous.

(Disclaimer: I am not a tax advisor, so do not rely on statements contained herein — consult a tax advisor before filing. I try to be as accurate as possible but there are no guarantees.)

A collection of my favorite stories of the week:

Thou shalt not pay too much for oil: nothing like a right-wing religious zealot suggesting murder is the cure for high oil prices. Link

A great blog by a UCLA professor of the Vioxx trial and the jury system in general. Link.

This needs no introduction. Link

Have a great weekend!

Right now you can get an amazing 4.18% yield to maturity on 10-yr treasuries! Or, if you want to take on some more risk, you can earn 5.04% before fees investing in the DJ Corporate Bond Index. At that rate you may be able to outpace inflation by 1-2%. OK, maybe there are better options out there.

For example, the following stocks have yields that rival the total return of the T-notes. (And, if you are a long-term investor, you have significant up-side potential.)

Citigroup 4%
Bank of America 4.6%
ING 4.5%
Merck 5.4%
UST 5.2%

(Disclosure: I currently own ING and UST and might be in the market in the near future for some of the others.)

Most of the companies above have headline-grabbing risk factors and have less than spectacular near-term prospects. Citigroup’s executive office has been depleted; BAC is integrating a couple very large mergers; ING is particularly susceptible to a flattening yield curve and reserving in their Asian insurance operations; MRK has significant litigation risks; and UST always has litigation risk and is losing market share. (In addition, the banks listed have general industry risks in that associated with under-reserving for loan losses, risks associated with a slowdown in the housing market, and risks associated with a flattening yield curve.) Although these risks are real, they are still great companies with good long-term prospects, with yields close to a 10-yr T-note.

Of course, if you don’t want to take the small risk of investing in these companies, enjoy your 4.18% and I will enjoy the dividends and capital appreciation for years to come.

One of the first things most financial planners will tell you is that you need about 6 months of cash on hand for emergencies. But, if you have discipline, there is no need for you to keep cash on hand. In fact you would be better off not following their advice.

For example, my wife and I spend about $3-3.5K per month. In order to have 6 months of expenses on hand we would need to have $20K of cash on hand.

Let’s assume that we could earn 4% in a money market account (currently above the best rates at Bankrate.com) and an average of 8% in the stock market (below the historical average of 10%). In the first year we would accumulate an average of $800 more investing in the stock market than in a money market account.

Due to the magic of compounding the difference is much larger the longer the strategy is followed. For example, the annual difference in the 5th year would be $1241 and $2060 in the 10th year.

Even though the differences in percentage return seem small, over a long period of time, the effect on your net worth can be substantial. In 20 years, the initial $20K investment would be worth $44K if you were to invest it in a money market account versus approximately $93K if you were to invest it in the stock market.

However, if you know that you do not have the self-control to keep lines of credit available for emergencies, then you should not follow this strategy!

In the past, I have recommended this strategy to friends but they have decided to keep extra cash on hand. I think the thought of having cash is too comforting and the thought of debt too frightening for most to consider using this strategy. But this is a long term strategy that has been very rewarding for us and could be very rewarding for you.

Additionally, the same strategy has been advocated by Jonathan Clements, a columnist for the Wall Street Journal, in his book, 25 Myths You’ve Got to Avoid - If You Want to Manage Your Money Right:

So how will I pay for my emergency? If I put my mind to it, I figure I can get my hands on a fair amount of money fairly quickly by tapping credit cards, the equity in my home and the money in my company’s retirement-savings plan. I will borrow money to pay for the emergency and then pay off the debt either out of my paycheck or by selling stocks after the market recovers. Borrowing money is clearly costly. But over the long haul, the superior returns from stocks should more than compensate for any short-term borrowing costs.

How would you describe your investment style? The first way people usually describe their style is value vs. growth. But what does this distinction really mean?

Growth investors, as the name implies, invest in companies with great growth prospects that usually sell at a premium to the market P/E or P/B (Price/Earnings and Price/Book). They invest in companies like: Nextel, UnitedHealth Group, Tyco, AES, InterActiveCorp, Amazon.com, J.P. Morgan Chase, Google, and Aetna. (Disclosure: I own shares of AES as of this writing.)

Value investors, on the other hand, traditionally invest in companies with low P/E and P/B. They invest in companies with lesser growth prospects that sell at a lower price relative to current cash flows.

However, these distinctions are not as clear cut as people would have you think. For example, the companies mentioned above as growth companies are the top nine holdings in Legg Mason Value Trust –– arguably the most successful value fund in history. Is the fund mislabeled? Or are the labels “value” and “growth” misleading? I argue that that latter is correct.

The descriptions “value” and “growth” are overused and confusing. P/E, P/B, and Div yield are of little use in defining real value. Value is the present value of future cash flows, and as such, growth is an intrical part of the value equation. (Mathematically speaking, assuming constant growth, Value = CF/(discount rate-growth). So the higher the growth rate, the higher the value of the security.)

“Most analysts feel that they must choose between two approaches customarily thought to be in opposition: ‘value’ and ‘growth.’ Indeed, many investment professionals see any mixing of the two as a form of intellectual cross-dressing. We view that as fuzzy thinking…Growth is always a component in the calculation of value, constituting a variables whose importance can range from negligible to enormous and whose impact can be negative as well as positive.” (Warren Buffett, Berkshire Hathaway annual report, 1992)

Despite the constant conversation otherwise, value and growth are not opposites, but are very positively correlated. Intelligent “value” investors see the value in growth. And intelligent “growth” investors see the value in a reasonable valuation. So the next time someone asks whether you are a value a growth investor, you can do what I do, and give them a very confused look and stumble through a lengthy explanation.

Who wouldn’t have loved to buy Google’s IPO in the $80s? (It currently trades for $280.) There are countless examples of IPOs that in hindsight would have made us rich. If only I could have foreseen the huge returns offered in Dell, Microsoft, or Cisco and avoided the countless IPOs that have floundered, I could have made a killing.

But I can’t foresee which companies will be successful. And I imagine you have the same problem. (Of course, in hindsight, it seems obvious and next time –of course, next time — we will pick the right ones.)

In the meantime, I am going to play the odds — and the odds are that IPOs will not perform well over the long-term.

First, IPOs have not performed well in the past. The relative performance of IPOs verses a small stock index (it’s closest comparison group) is abysmal. According to study in The Future For Investors by Jeremy J. Siegel, in 29 out of the 33 years a portfolio built of IPOs underperformed a small stock index portfolio. And in the four years when the IPOs outperformed, it did so by a small margin. In addition, the IPO portfolios had significantly higher standard deviation of return (the most popular measure of risk). The statistics cross a wide range of IPO markets so it is not one period that is driving the results.

On a side note, the IPO markets of the late 90s showed the worst returns. This coincides with when most of us were hearing about IPOs daily and were most likely to “invest” in them.

Second, IPOs occur because of two main reasons — investors want out or the company needs more capital than it can raise in the private markets. Both of these are usually signs of trouble. The original investors know more than we do about the company — and they want out! They want out because they believe that — even after paying the substantial underwriting costs — they can get more than fair value from the buyers of the IPO.

If these companies cannot raise the capital they need from private purchasers, it means that the smart money is not biting and it may be an indication that the company is going to need to continue to raise capital in the future. Of course, companies that burn through capital do not create value for shareholders. For example, Seigel showed that capital expenditures/sales are negatively correlated with shareholder returns. ibid.

So, despite all the headlines about Google’s, Microsoft’s, Dell’s, and Cisco’s phenomenal results, you haven’t missed the party if you have stayed on the sidelines for all of these IPOs. You would, in all likelihood, be ahead of your neighbors who participated because as Benjamin Graham stated in his seminal work, The Intelligent Investor, “Most new issues are sold under ‘favorable market conditions’ — which means favorable for the seller and less favorable for the buyer.”

I am starting this blog to offer a forum for discussing long-term strategies for managing our personal finances. Most people fall into two categories about managing their money: either they are confused and do not want to learn about finance or they are overly active managers. Both can be very dangerous!

It is a huge mistake to not learn the basics of managing money. Even if someone else is managing your money (be it a spouse, investment advisor, or broker) it is extremely beneficial to know the basics so you can make sure you are getting value from your advisor.

Probably more dangerous are the over-confident traders that put their family’s future at risk betting on the next new thing — whether that be China, India, Google, Taser, Netflix, etc. It’s not that the trends don’t exist but that the story of the growth inebriates to the point of forgetting about valuation.

I hope that this blog helps people avoid some common pitfalls in managing their finances — pitfalls that are often encouraged by people’s regular sources. Most people get their news — be it investing or other — from regular media outlets and trusted advisors. However, most of our traditional sources for financial information are fraught with problems:

1) Our investment advisors or brokers are often compensated based on how much revenue they bring in to the firm (i.e. how much they can raise your expenses). Not only is their comp based on revenues but as their revenue increases, the percent of the revenue they receive can increase — further exacerbating their adverse interest. (For more, see Edward P. Mahaffy, Brokers in Sheep’s Clothing, Barron’s 8/22/2005; subscription required)

2) Even if we just leave our spouse in charge of the finances, often our spouses can make errors that will effect our well being.

3) Even supposedly impartial articles by reputable news sources are not intended to be unbiased — they are intended to sell the publication. Who would tune in to see someone talk about long-term prospects of a company? What would they talk about tomorrow? There is a natural bias toward short-term trading and telling stories of huge growth potential, rather than talking about valuation. Although valuation may seem dull and uninteresting, and rarely fits into a 30-second sound bite, it is the foundation for understanding your personal finances.

4) Both traditional media and brokers/advisors want to complicate the facts so you believe you can’t understand finance without their expertise.

5) Many brokers/advisors have very little knowledge of finance as they are usually little more than salespeople.

With all these biased sources of information, it’s no surprise that many people avoid finance or don’t understand how to create long-term value for their portfolio. Hopefully, this blog will help us avoid common pitfalls and help us all create long-term value.