Financial Reference

In the long run, markets are driven by fundamentals. In the short run, markets are driven by fear and greed.

The mere mention of emotion conjures up an image of an amateur. But, more often than not, it’s the professionals succumbing to fear. The fear of losing money, of losing clients, and of losing their jobs.

The professionals job is to try to outperform, but at the very least, to not lose clients. The job becomes “don’t make any huge bets that could make you underperform substantially.” This incentive and the emotionally baggage associated with thought of losing ones job for substantial underperformance leads to emotional decision making.

For example, in Fortune’s Investor’s Guide 2008, the experts wear their fear on their sleeve. One expert, Susan Byrne, is quoted saying, “Think in terms of being willing to lose opportunity instead of capital. Losing opportunity can be embarrassing, but losing capital is permanent.”

But, as any Economics 101 student will tell you, losses are losses whether they are due to a decline in market value or due to foregone profit. The only thing that rationally matters is what expected return for what risk. Trying to limit losses after the bubble has popped is more an emotional response than an analytical response. The professionals limiting their risk today are just compounding their mistake. It goes without saying, that when emotions drive decisions, the wrong decisions are often made.

Value investing is all about recognizing long-term value. It is more important to know timeless investing principles instead of short-term technical trends.

Therefore, much of what you need to know to be a value investor can be gleaned from books. Many of the important books on the list below were written well before current trends in the marketplace. However, the books are timely as when they were originally written.

One Up on Wall Street, Peter Lynch (Invest in what you know)

The Essays of Warren Buffett (Timeless Advice from the master himself; you can also access the entire letters to shareholders here)

Fooled By Randomness (more about risk, but a very good book)

The Warren Buffett Way (always good to learn more about the Man)

Common Stocks and Uncommon Profits (The original growth investment classic; growth is a component of the value equation)

You Can Be a Stock Market Genius (Horrible title, good book)

Value Investing from Graham to Buffett and Beyond (good intro to the basic idea of value investing)

Contrarian Investing Strategies (Data showing value investing works)

I hope you enjoy these books as much as I did when I first read them.

So you want to be a value investor? The first thing you should do is avoid short-term based thinking. This means avoiding the excitement of the markets daily fluctuations, emotional discussion board posts, and “research” based on technical analysis and short-term trends.

Value investors concentrate on the long-term, so it makes sense to use your time reading about long-term strategies. In addition to keeping up with industry news, I encourage you to learn about value investing by prioritizing your reading as follows:

1. Books
2. Magazines
3. Newspapers
4. Blogs/Websites
5. Analyst research

It may surprise you that I hold outside research in such low esteem. I do this for two reasons: (1) analyst expectations are usually baked into the share price and offer no unique information and (2) analysts are very concerned with the short-term view — value is only a component of the recommendation.

In the coming posts, I will recommend specific items within each category to read.

If you read financial news, it’s easy to compare markets to one another. All you need to do is compare price to earnings, price to cash flow, and price to book. Using these ratios, articles can be written determining the relative attractiveness of investing in different markets.

In fact the “Heard on the Street” column on Friday compares these ratios between Japan, the U.S, the U.K., and the world and comes to the conclusion that Japan is relatively cheap. While their conclusions may be correct, their analysis is overly simplistic.

I am not an expert by any means in international accounting or Japanese securities but what I do know was not even addressed in the article. First, international accounting differences affect the income statement, cash flow statement, and balance sheet. This will change the “normal” P/E, P/CF, and P/B ratios across countries.

Second, Japanese companies have significant cross ownership. This means that earnings and cash flow will likely be higher than reported, raising expected P/E and P/CF ratios. Any analyses should at least acknowledge the shortcomings inherent in ratio comparisons across industries, let alone countries.

Dell reported earnings yesterday afternoon and the stock promptly dropped 10% after hours. Obviously, investors did not like what they heard.

Dell reported earnings a penny shy of estimates and revenues that slightly beat forecast. With revenues higher and earnings lower, they obviously reported lower margins. Operating income, as a percent of revenue, declined quarter over quarter from 6.1% to 5.3%.

The cash conversion cycle, a measure of how quickly Dell is paid by their customers versus how quick they pay their suppliers dropped from 38 days to 35 days. In addition, management was not overly optimistic about the future, saying that they have seen some minor changes in purchasing by some financial firms, but overall, they have not seen a change in orders from the economic woes.

Despite all of these worrisome trends, the selling was overdone. As everyone knows, Dell has been pushing into the retail space. Selling through retail should reduce margins and hurt the cash conversion cycle. And management had a history of overpromising and stretching (sometimes illegally) to meet their guidance.

After the selling Dell had a market cap of $56 billion. They have $14.8 billion is cash and investments on their balance sheet. This leaves just over $40 billion in value attributable to the business. On the cash flow side, Dell reported free cash flow (after stripping out interest payments) of roughly $750-800 million last quarter. At this rate, Dell’s operations are selling for only 13 times cash flow.

This is extremely cheap given Dell’s huge return on capital. (Their return on capital has trended lower to 32%, in part due to a huge increase in cash on Dell’s balance sheet.)

Despite short term trends that may be negatively impacted by product mix, Dell is a huge value right now. Dell has ridiculous returns on capital and can be bought for only 13 times cash flow.

“When there’s blood on the streets, buy property.” - Baron de Rothschild

Every major bank is being hit with concerns over the debt they hold. Yesterday, Morgan Stanley reported a $3.7 billion hit to their fourth quarter earnings. Previously, Citigroup announced a $8-11 billion hit to their fourth quarter, after taking a hit in the third quarter.

While the fallout has been much higher than I anticipated, the recent sell-off has given everyone a great opportunity to buy.

Let’s look at Citigroup, for example. The big worry here is that Citigrup will need to raise capital or lower its dividend to increase its capital ratios. So what? Citigroup has many assets it can sell at less than firesale prices and who cares if they lower the dividend? It shouldn’t materially affect the long-term value of the company.

Even though the write-downs sound huge, Citigroup usually earns $5-6 billion per quarter after taxes. The two announced write-downs, after taxes, should only be equal to about 3 quarters of earnings for Citigroup.

After Citigroup takes the charges in the fourth quarter, the ship should start to right itself. In fact, analysts expect Citigroup to earn approximately $4.40 a share next year. This means you can buy this company, a company with an average ROE above 15% for a forward P/E of 7.6 (based on the price this morning of $33.41).

Citigroup looks cheap to me.

Disclosure: I own Citigroup. As always, perform your own research before making investment decisions.

In the last post, I said that I would much rather mistime than misvalue. This reminded me of an article I read recently.

Michael Sivy writes an article every month for Money magazine in which he updates his recommended portfolio (the “Sivy 70″). Considering he only has to update his portfolio once a month and give a paragraph or two explanation, it could very well be one of the easiest jobs in the world.

The one hard part of the job is that he opens his picks up for criticism. One of his recent actions had to be based on psychological/technical reasons rather than fundamental analysis. In his September 12, 2007 post
he replaced Dell with HP.

Obviously, before his post HP was on a tear and Dell had been slumping for years. Just as obviously, Dell has been en fuego after the article. See chart.

The problem with this pick is that it wasn’t just a mistiming. He replaced Dell after a long period of underperformance. If anything, Dell’s fundamentals had only improved. But it can be hard to keep the faith if the stock price is stagnant. If Sivy would have stuck with his original analysis and not, presumably, been influenced by relative performance he could have seen which stock offered the more compelling value.

Disclosure: As I have disclosed earlier — actually just a week after Sivy replaced Dell with HP — I have an interest in Dell. See earlier post arguing that Dell was in fact cheap even though it had a high raw P/E ratio.

I have never been good about timing the market. My recent posts, buy financial companies and sell UEC (Uranium Energy Corp) have not performed as expected so far. (It has only been a couple weeks so far.)

Financial companies have continued to feel pressure from the mortgage crisis prompting further selling. This has only made these companies cheaper. Before they were on sale; now, it’s closer to a liquidation sale. I will continue to invest in this area.

My recent recommendation to short UEC based on the fact that they have no revenues, are losing money hand over fist, and will likely continue this pattern for the next year or so, has also not performed as expected yet. The stock is slightly higher than where I sold it short.

Again, I am not changing my opinion. UEC’s board recently approved an increase in pay for the CEO, despite posting record losses over the last year. I still believe the company will continue to bleed red and will continue to reward executives — at the expense of shareholders — despite the lack of performance.

In the long run, we will see whether my current valuations are correct. In the meantime, I’ll continue to reflect on my uncanny ability to mistime the markets. Of course, in the end, I’d much rather mistime than misvalue.

This should be my last post regarding the book “Value Investing Today” by Charles Brandes. I think I’ve already given the book too much coverage, but I couldn’t pass up writing about this last screening variable.

According to Brandes, value investors should not invest in a company if the “earnings yield is less than twice current long-term (20 year) AAA bond yields.” (The earnings yield is simply earnings/price — the inverted P/E ratio.)

Presumably, if an investor pays more than two times current bond yields, he would be better off buying bonds. The rule, like many others, sets an arbitrary limit without justification.

Let’s take a look at what this rule means in the current market environment. As of today, 20-year AAA bonds are yielding 5.71%. Using Brandes’ math, we should only look for companies with an earnings yield of 11.42% or higher. Putting this into more familiar terms, we should only be investing in companies with a P/E ratio under 8.76!

This is, needless to say, hard to do.

This rule is ridiculously out of date. It reminds me of companies Graham and Dodd wrote about in “Security Analysis.” Companies that were reasonably profitable and could be bought for less than their liquid assets. These companies are harder to come by today.

A P/E ratio lower than 8.76 is almost always associated with operational difficulties or the end of an economic cycle. If you screen on such a low P/E ratio today, you will likely find many mortgage finance firms, some oil companies, and a few firms that recently reported unusually large non-operating gains.

If you want to find good long-term investments, you would be better of raising the P/E ratio of the screen and adding a return on equity/investment variable to weed out weak operators. While you will still have to sift through many dogs, you will raise your chances of investing in a good company.

This is one of the best times to be an investor if you can just get over the psychological inconvenience of recent losses.

The third quarter earnings season has been a disappointment to say the least. Banks are taking huge charges related to the real estate mess. Even financial companies that are not normally associated with banking, such as E*Trade Financial, have been hit hard by mortgage write-downs.

The cause of the mortgage write-downs is of course the collapse of the real estate bubble. The probability of default has increased across the board, but especially for more exotic, hard to value securities. Even large companies are struggling to value some of these securities — see, for example, Merrill Lynch’s recent restatement.

The fact that the liabilities are hard to value is creating uncertainty and apprehension in the financial arena as no one knows who is going to be hit next. Consequently, everyone with any exposure is on sale. If you are able to ignore headlines, and hold a security for the long term, start allocating more capital to financial companies. You almost can’t go wrong buying any large bank or investment bank in the current environment.

This post continues a discussion of the screening criteria in Brandes’ book “Value Investing Today.” His third screeening criteria (I’ll get to the second in a later post) is that tangible book value is above share price.

This criteria is old-school Graham and Dodd. Not even hard-core value investors like Warren Buffett follow this criteria anymore.

There are a couple reasons for this transition. First, companies selling for less than book are harder to find today — not impossible — but harder. Second, most of the companies selling for less than book today either have some losses coming or have an overstated book value. Third, and most importantly, companies selling below book value are likely to have lower returns on capital.

In other words, screening based on book value can find companies selling at a great price, but it also likely to find mediocre companies. Companies selling below book value are likely to be companies with low returns on capital.

One of the major reasons for this is that great companies often have large intangible assets in their brand names. For example, you will likely never see the classic Buffett investment Coke selling anywhere near book since most of the value of the company is intangible.

Paraphrasing Buffett, I would rather own a great company at a good price, than a good company at a great price.

Finally, I found a short: Uranium Energy Corp (UEC). UEC owns some land is currently doing surveys to find uranium deposits. While uranium has a great future, this fact is already reflected in the high valuations of nuclear power-related companies.

UEC has a market cap of $140 million. But they have no revenues and lose about $5 million per quarter.

They support their operation by diluting current shareholders. And will continue to dilute current shareholders as there are no revenues imminent.

If they have a large uranium find, they might survive for the long-term. More likely, they will be lucky to survive they way they dilute the value of the company to support management.

But don’t take my word for it. In their own words, as filed with the S.E.C.:

“WE HAVE A HISTORY OF OPERATING LOSSES AND THERE CAN BE NO ASSURANCES WE WILL BE PROFITABLE IN THE FUTURE.

We have a history of operating losses, expect to continue to incur losses, and may never be profitable, and we must be considered to be in the exploration stage. Further, we have been dependent on sales of our equity securities and debt financing to meet our cash requirements. We have incurred losses totaling approximately $16,969,779 from May 16, 2003 (inception) to December 31, 2006. As of December 31, 2006, we had an accumulated deficit of $16,969,779 and had incurred losses of approximately $14,818,318 during the fiscal year ended December 31, 2006. Further, we do not expect positive cash flow from operations in the near term. There is no assurance that actual cash requirements will not exceed our estimates. In particular, additional capital may be required in the event that: (i) the costs to acquire additional uranium exploration claims are more than we currently anticipate; (ii) exploration and or future potential mining costs for additional claims increase beyond our expectations; or (iii) we encounter greater costs associated with general and administrative expenses or offering costs.”

But don’t worry about the management. They have sweet contracts. In the same SEC filing, you can see that the CEO is paying himself a generous salary ($510,000 including bonus and options) for a company with revenues of $0.

Unless they stumble across a huge uranium find, the company is worth far less than the $140 million. This is especially true when you consider how well the management will compensate themselves if they happen to get lucky.

Disclosure: As you may have guessed, I am short the stock. As always, perform your own research before making investment decisions as even good investors can be wrong much of the time.

I was just reading “Value Investing Today,” a book by the Forbes 400 member, Charles Brandes and I had a couple thoughts. I realize it’s way too early (5:15) to be up, let alone reading and having thoughts, but here they are.

In the book, he details a list of characteristics by which an aspiring value investor should screen. Although he does say that one or more of the criteria can be waived in certain circumstances, I take issue with some of the criteria he uses. Of course, I’m not the billionaire, so you’ll have to make your own judgment.

One of the criterion he uses is that the company should not have any losses for the last past 5 years. The problem with that is that there are many circumstances in which you would want to buy something with recent one-time losses. In fact many of my best performers have fit this criterion.

For example, I invested in both BLX and AES back in 2003. BLX is a Latin American bank that had just written off a large portion of its loans due to the Argentinian financial crisis. AES is an international power company that wrote off a large portion of its assets during some volatile times when some of its hedges broke.

The reason both of these companies survived was (1) losses due to write-downs are usually short-lived, (2) both companies were producing positive cash flow from operations before, during, and after their respective crises.

If you are looking at companies with recent losses make sure that the losses are probably short term and the company is still producing positive cash flow from operations. Or, of course, you could listen to someone who invested his way on to the Forbes 400.

While stock markets overall are reaching new highs, the past quarter has been eventful. The beginning of the end for the real estate bubble is leading to a general credit slowdown across all parts of the economy. While passive long-term investors can still sleep easy at night, the current environment is turning into a disaster for some well-paid finance geeks.

First, the mortgage debt used to finance the real estate bubble also financed many financial alchemists. The companies that originate mortgages aggregate a large number of mortgages together (or sell them to another company that aggregates them) and sells them into a company whose sole purpose is to hold the debt.

Once these mortgages are aggregated, the cash flows are very predictable, assuming there is no shock to the system. The problem right now is that there has been a couple shocks: a decline in the price of housing coupled with a huge rise in the use of exotic mortgages. The current crisis is having a huge effect on the mortgage issuers, aggregators, and trading desks, mostly effecting banks, investment banks, and hedge funds.

Second, the mortgage crises has led to a general credit/liquidity crisis. It is harder for less than ideal debtors to finance their companies. It’s not that creditors are now being stingy — it’s just that debtors were used to easy money. It’s similar to the problems in housing — companies were able to get financing, even when they couldn’t afford it.

Now that markets are returning to sanity, many of deals struck before the bubble burst are now being renegotiated or scuttled. The main effect of this will be to decrease the leverage used by private equity firms to take firms private, decreasing the potential returns and number of deals completed. This will be partially offset by an increase in strategic mergers — or companies buying rivals, suppliers, and users.

In the final tally, this quarter’s events were substantial for certain segments of the economy but could hardly be felt by a conservative investor with a conventional mortgage. While it remains to be seen how much the real estate and liquidity crises will reverberate throughout the economy, my own feeling is that the damage will be largely contained in select corners of the financial markets and, of course, to homeowners with exotic mortgages.

Despite the constant use of the word crisis the quarter, most long-term investors may not remember this quarter in a year.

Hedge funds offer a service. A most valuable service to be sure. Generally speaking, they offer the opportunity to profit in all types of markets. The idea is to profit, even when everyone else isn’t.

And it all worked…until, of course, it didn’t. Apparently, “all types of markets” doesn’t include the exact time a hedge is useful — when everyone else is hurting.

In fact, their excuse is that all of the other hedge funds are being forced to liquidate the same securities they hold in their portfolios. Their performance is not their fault — the problem is that everyone else has the same securities as them.

So what happens when they have good performance? Did they just front run other hedge funds?

In addition, if all of the funds hold the same securities, what are investors paying for? Is it really worth it to pay 2-and-20 for a common strategy?

“When you do not know a thing, to allow that you do not know it — this is knowledge” –Confucious

One of the biggest enemies investors face, is overconfidence. It doesn’t seem to matter whether the investor is professional or novice, one of the hardest things to admit is that you don’t know something.

Nearly all investors are confident in the direction of the economy, interest rates, stock markets, and even individual securities. Surprisingly, the returns of these overly confident investors often lag the comparable indexes.

So, what went wrong? After all, given their level of confidence, wouldn’t you expect them at least to earn a return equal to their benchmark?

The problem most investors face is not their knowledge or lack thereof, but their overconfidence. Investors that “know” exactly what is going to happen trade too much, trying to take advantage of their superior “knowledge.”

If investors would just admit to their lack of knowledge, they would be better off by sticking to their core competencies.

For example, my core competency is being able to perform a reasonable valuation of individual companies. I can not predict where the economy is heading, where the price of securities are going in the short term, where interest rates are heading, or what the next big thing is. So I don’t pretend to know what is happening in these domains.

As an investor, it helps to figure out what your core competency is and exploit that. Effort spent satisfying your ego by researching areas in which you don’t add value, is pointless. Knowing what you are able to do is something every investor should spend time figuring out.

With all the volatility in the market, it’s good to remember the parable of Mr. Market. Created by the father of value investing, Benjamin Graham, Mr. Market is a reminder of how we should act in turbulent times.

As the story goes, Mr. Market is a very accommodating partner who, every day, shows up and offers a price at which he will purchase your interest in the partnership and sell you his interest in the partnership.

However, Mr. Market is a very emotional person who changes his appraisal of the company based on his mood. In a good mood, he will offer an extremely high price; in a bad mood, he will offer you his shares for a pittance.

How would you transact with Mr. Market? Would you sell to him when he offers too high a price and buy when he offers too low a price? Or would you, like so many market commentators, fall under his spell — letting your own emotions rise and fall with Mr. Market’s bipolar tendencies?

The easiest way to take advantage of Mr. Market is to figure out how much you think something is worth and compare it to Mr. Market’s price. If there is a large difference, buy or sell.

This was one of those weeks financial writers love. They finally have something easy to write.

In case you actually had something important to do, and didn’t hear about the huge losses this week in the market, I will recap the week for you. The market (i.e. the Dow Jones Industrial Average) started the week at 13,850 and ended at 13,250, a 4.5% slide.

Or better yet, here is a graph.

According to the press, the decrease was due to a tightening credit market and mixed earnings reports. Tightening credit markets are evidenced by a more sane LBO financing market. Mixed earnings reports means good earnings, “but we have to blame something for the decline, and it is earnings season…”

The reaction to this type of week is typical. Finally financial writers can write about something important. Something that many average investors are thinking about. “Is this the beginning of the end of this bull market? How should I prepare for the coming bear?”

Well, to be honest, your strategy shouldn’t change.

You mean nothing should change, even after on of the worst weeks in the market? Yes. Because nothing has changed: the bonds that are now considered risky we always risky. The investments that were good buyout candidates (due to good cash generation and low debt) are still good companies to own.

The market, though it’s down 4.5% in the last week is still about the same level it was in May. The market as whole, particularly large caps, offer many opportunities for investment.

This last week was a huge week only in the sense that it will create more attractive investments.

I am bombarded daily with emails promising that if I pay them a monthly fee, I will be able to retire early. Usually, they are offering their unparalleled ability to select stocks. The most common litterers in my inbox are The Motley Fool and, more recently, Investopedia.com.

The most common sales tactic involves a statement like: “This strategy has returned x% over the last y years. Don’t miss out!” Their logic always seems to prey on those who don’t want to fall behind their neighbors. If other people are making this money, I better make it as well. I can’t be left behind.

The reason they do so is they want us to analyze these “investment” opportunities with fear and greed rather than intellect. Fear and greed lead to speculation — the search for short term trading profits. While speculation may work for some, it usually ends with disappointment.

However, if we think of investing as capital allocation instead of as the search for profits, we are far less likely to fall for the speculation-pushers. Investing as capital allocation means that we look for the best long term options for our dollars. It is more akin to acting like the CFO of a corporation, trying to allocate capital to the highest return investments, rather than acting like a gun-slinging Wall-Streeter.

An investor allocating capital looks at the projected returns the company will likely earn on capital and the current valuation. Short-term considerations, such as next quarters earnings or technical indicators are only distractions.

Thinking like a capital allocator, rather than trying to predict future prices has helped me earn great returns for my investors and I hope it will work for you as well.

Recently, even after a large increase in international stock and commodity prices, a strange thing is happening: people are being encouraged to buy more. Even people who believe the sector is “fairly valued” (read “over-valued”) are buying more because of the diversification benefits of these investments.

It is usually the case when one asset class has a large run-up in price, the asset class should be re-examined and possibly partially sold. This is due to a couple factors. First, it might be sold because the asset class is more over-valued relative to other asset classes. Second, it might be partially sold to rebalance the portfolio.

But after the run-up in the prices of international stocks and commodities, Americans still don’t have enough invested in these assets, according to some analysts. While I agree with the basic sentiment — there are diversification benefits of investing in these asset classes — I believe that much of this diversification benefit is going to be overblown for the following two reasons.

First, international stocks and domestic stocks are becoming more correlated and are more correlated in times of panic. It makes sense that the correlation is increasing: (1) our economies are becoming more integrated in an increasingly globalized world and (2) domestic companies own significant foreign assets. Also, historically the time at which diversification is most useful — when markets are in crisis — have seen higher correlation (and hence lower benefits).

Second, I believe investors are buying these assets for the wrong reasons and so are more likely to sell than if they were buying for the diversification benefits. While investors and planners claim they are increasing their allocations due to the benefits of diversification, I believe the most important reasons for the increased allocation are recent performance and, possibly, a belief in a weak dollar and higher inflation. Investors have always had the opportunity to increase ther exposure to these assets but have only chosen to very recently.

Investors who buy for the diversification benefit are more likely to stick around, even when markets decrease. Investors who buy in order to increase returns are speculating and will be more likely to sell when these markets naturally fluctuate. While, overall, investors should increase their allocation to foreign assets, the motivation of the investor is more important than the actual allocation in determining performance.

When we sell an investment, we feel the pain of a loss or the joy of a gain (offset in part by the tax bill). It is at this point that we know if our investment was “successful”, or so goes the common wisdom. We “lock in” our gains and either admit we failed or take pride in our obvious skill.

However, an investor doesn’t create value when he sells; he creates value when he buys. An investor creates value by buying investments whose current value is greater than the current market price. There are very few things the investor has control over but if, over time, he buys undervalued assets, he should be successful. One of the things he does not control is the future price.

So, by definition, if he does not control price, the success of the investment can not fully depend on the future price. It’s hard to think this way. Over time, someone who makes intelligent decisions should reap the rewards, but he will not be successful in every investment he makes. So, a long-term successful track record is indicative of success while individual picks are not. A successful long-term track record indicates that the investor probably has enough ability to put the odds in his favor and create value.

“The art of being wise is the art of knowing what to overlook” – William James

Even for long-term investors, it’s hard to ignore the short-turn fluctuations of the market. I do something I don’t recommend — I put the stocks we own on our “My Yahoo” home page. So every day(actually, every couple of minutes), my wife and I can see how our day was financially.

The short-term changes in stock market value is just noise. Noise that distracts from accumulating investment knowledge.

In the future, I’m going to try to keep price information as far away from myself as possible. I recommend you do the same.

How much should you expect any one of your investments to return? If you’re investing in highly-rated bonds and expect to hold the bonds to maturity, the answer is easy: you should get the yield to maturity minus a small amount for the small probability of default.

However, what if you are trying to forecast the returns of stock? The analysis becomes much more complicated and is often misunderstood — even by experienced market commentators. Even, Michael Sivy, in the April 2006 issue of Money magazine (p. 78), gets the analysis wrong. He claims that since certain stocks are projected to have earning growth above 10% per year for 5 years and currently pay dividends above 1%, investors should expect average returns above 11%.

The problem with this analysis is that it assumes the future outlook of the company is the same as the current outlook. There is an embedded assumption in Sivy’s analysis that the P/E multiple is not going to contract (or expand). If the outlook becomes less favorable for these companies (i.e. the projected growth rate drops below 10%), the P/E ratio will probably contract and reduce the actual returns.

(On a side note, 10% growth is an optimistic assumption. The market as a whole can only grow as fast as GDP. GDP growth has averaged 3-4%, so 10% growth is 3 times the growth of the market as a whole. While 10% doesn’t seem like a crazily optimistic assumption, be careful of overly-optimistic growth projections — they can throw your whole analysis off.)

The shortcut used by Sivy to arrive at a projected ruturn is often used by laypeople to justify overpaying for growth stocks. The calculation that should be used is to value the company using a discounted cash flow analysis (whether it’s discounted dividends, free cash flow, etc.) to arrive at a current value for the company and it’s shares. You can then calculate a value for the company at any date in the future using the same assumptions you used in your initial calculation.

Many investors use multi-stage models (in which the growth assumption decreases over time) to reflect (1) that the near-future is more certain than the distant future and (2) eventually growth companies lose their growth potential and increase their earnings at the rate of GDP. If you assume a multi-stage model, the P/E will contract over time and your returns will be lower than simply adding the growth rate to the dividend rate.

Don’t fall for lazy solution Sivy falls for; go through the calculations (or at the very least reduce P/E expectations and return expectations) to arrive at a better forecast of your return.

Investing would be easier if we weren’t always fighting against ourselves. We have natural tendencies that work against our own self-interest. We are not rational. We often make decisions based on emotion rather than based on a calculated cost-benefit analysis. (What follows is from The Psychology of Investing by John Nofsinger – required reading for the Level III CFA exam.)

First, we are overconfident in our abilities. For example, Garrison Keillor describes a fictitious place in Minnesota, Lake Wobegon, as a place where all the women are strong, all the men are good-looking, and all the children are above average. Additionally, when people describe their driving, they are invariably above average. Obviously, something has to give, not everyone can be above average. Not everyone can beat the markets, since everyone together is the market.

Overconfidence can lead to large investing mistakes. It can lead to large miscalculations in the amount of risk being taken. For example, the hedge fund Long Term Capital Management had the best and brightest designing it’s trading strategies (including two Nobel Laureates). But due to past successes, the partners developed an overconfidence that lead them to overleverage and pursue trades outside of their expertise. A couple warning signs that you are suffering from overconfidence is if you are trading too much or you are buying investments you don’t fully understand because you are either venturing into new territory or neglecting to do basic research.

Second, we tend to sell our “winners” too fast and hold our “losers” too long. The price at which a security is purchased should not affect the decision to sell. (The only exception is for tax purposes which is an incentive to sell losers and hold winners.) When you sell a loser, you admit to yourself that you failed, that you were wrong. When you sell a winner, you were right, and that feels good. Of course, the reason for buying or selling a security should be your estimate of the intrinsic value of the company and its shares.

Third, the past price movements of stocks affect the way we feel about stocks. If you bought a stock and made a lot of money, you are more likely to seek riskier investments since you are now playing with “house money.” So, if your investments in tech stocks went up the 90s you would be more likely to invest more of your money in risky tech ventures. If you recently lost money, you would be more likely to accept less risk. Often, the right move is the exact opposite: it’s better to be more aggressive after a market decline and less aggressive after a market advance.

Also, people want to at least break even. If you find yourself waiting to sell a stock because you want to break even, it is probably a good idea to sell. Or if you find yourself looking at past quotations or the original purchase price, try to keep that information out of your mind and redo an analysis of the company. What matters is not the return on any individual investment but the return on your whole portfolio. To that end you should track your long-term returns. That way, will be forced to face your real returns and won’t be fooled by the returns you remember. If your returns significantly trail the market over the long-run, it would be a good idea to either form a different investment strategy or, better yet, invest passively.

Fourth, we don’t account for things the right way. We create mental accounts for certain activities. For example, some people will maintain a large cash balance and credit card debt. It would be more economical to pay off the credit card debt and then use the credit cards in case of emergency. Another example is that people will not be averse to taking a large, risky mortgage but will never take out a margin loan or credit card loan – even if the margin loan or credit card loan is cheaper and less risky. The reason is we have a tendency to categorize and summarize rather than analyze.

Fifth, we are not able to look at a portfolio holistically. We are able to see the risk of individual investments but are not able to see how the individual investments fit into our portfolios. For example, equities are widely considered to be more risky than bonds. However, a portfolio of all bonds is probably riskier than a mix of stocks and bonds. This is because bonds and stocks often move in different directions. Instead of thinking of an individual security as risky or not, try to figure out how the risks associated with the investment fits into your overall portfolio.

Sixth, we often identify a good company as a good investment and a bad company as a bad investment. This is often not right. The real question is whether the value of the company is greater than the market value of the company. If the company is great, but everyone knows it is great, the price will reflect public knowledge and the shares may not be a good investment. For example, Google is a great company with great prospects but everyone already knows this and the stock is priced to reflect many years of uninterrupted growth. At its current price of $425.80, the stock is probably not undervalued. In fact, people often bid up the stock of great companies too much. This can be seen by noticing that stocks with low P/Es outperform high P/E stocks. Even though a company can be good, its stock is not necessarily good.

Seventh, we are much more likely to buy investments with which we are familiar. We are more likely to buy shares in local companies, especially our own company. We are also more likely to buy domestic rather than foreign companies. We do so because things that are familiar feel less risky. But concentrating our investments creates more risk. This is especially true when we invest in the stocks of the companies for which we work. Just ask anyone who worked for Enron, Global Crossing, Qwest, or any number of tech firms that shined and then fizzled. Buying stocks with which we are familiar gives us a warm, comfy feeling but can actually increase the risk we take.

When investing, we are our own biggest enemy. We are not built to make rational decisions but use mental shortcuts to arrive at decisions that are correct enough to serve us in the real world. But in the financial world our mental shortcuts can get us into serious trouble. We need to be aware of our psychological shortcomings so we can avoid making decisions based on psychological factors instead of real analysis.

In an era of low returns, alternative assets start to look better and better to the average investor as they get frustrated with low returns. This is why a lot of hedge funds are seeing huge inflows of cash. But at least hedge funds are only marketed to rich, wealthy investors. Right?

While technically true, there is a new breed of “fund” being agressively marketed to middle-class individual investors. A recent New York Times article entitled “Have I Got a Fund for You,” describes one such fund, Superfund. They are currently trying to air a commericial advertising their “fund”.

Hedge funds, by their very nature, can not advertise; they can not have more than a small number of non-qualified investors. The Superfund is not organized as a hedge fund but as a “managed futures funds that are publicly registered partnerships.” This way they can bypass the regulations that protect small investors.

I might think that they are just trying to provide a service to a previously unserviced population. But once I saw their fee structure, I realized that it was much closer to to a fleecing than a service. According to the NY Times: “Superfund is guaranteed at least 8.75 percent in brokerage and management fees, and can take up to a 25 percent cut of any profits after expenses in any month when a fund reaches a new high.” The horror! The horror! (sp?)

Hedge funds have a problem. It’s a problem I would love to have — to much money and not enough good investment ideas. We’ll at least I’ld love to have the first problem. The problem is that too many people are looking for yield in a low yield environment. To find yield, people are taking on too much risk — both interest rate risk and default risk. (I.e. people are not getting paid enough to lengthen the duration of their portfolio or to invest in the bonds of riskier companies.) Even Greenspan has commented on this problem.

In the search of higher cash returns, more people have entrusted their savings to hedge funds. Hedge funds, generally speaking, try to produce alpha or excess return. They employ a variety of strategies to reach this goal. Many of them trade often, use leverage, and try to create yield for their investors.

But the biggest mark of a hedge fund is the compensation structure. Hedge funds charge 2% of assets and 20% of profits. Of course, they don’t pay 20% of losses. (They will generously stop charging 20% of profits until they recoup previous losses.) The idea is to give the managers a large incentive to perform. The effect is often much different.

If a manager of a regular corporation had the option of betting $1mm on a fair flip of a coin, there is no way he would take the gamble. But, if a hedge fund came across the same gamble, he would be incented to take it. If he was successful, he would have an extra $200K in comp. If not, he would still get 2% of assets.

If you think this scenario is too academic, check this Reuters article out. Hedge funds have been investing in “cat” bonds for while. Cat bonds are bonds whose payments are correlated with catastrophe losses. They allow reinsures to spread the risks of their losses and give a higher yield to investors willing to accept more risk. After Katrina, I thought some of these hedge funds would realize that they didn’t appreciate the risks.

But the opposite has occurred. Hedge funds are now setting up captive reinsurance companies and trying to compete with established reinsurance companies. Good luck. They don’t have the expertise or relationships to compete. They will drive prices down, will make our insurance more affordable (thank you), and hopefully hurt their investors. Reinsurance is based upon long-term contracts and relationships; insurance companies (especially well-financed ones) do not want to change their reinsurer often. The hedge funds will have to compete on price (and probably charge significantly less) to get customers.

This begs the question: why don’t the hedge funds just invest in established reinsurance companies? The answer is 2 and 20. There is a small probability of a major event. If it occurs, they don’t have to pay — and may even liquidate and restart so they don’t have to make up their losses. If it doesn’t occur, they get 20% of a much larger gain. If they, instead, invested in reinsurance companies they would be at the mercy of the market to value their investments. It’s easy money for the managers even though there is a much better alternative for investors.

The better question is: why would investors in hedge funds pay 2 and 20 for reinsurance exposure?

The last two days I have opened the Wall Street Journal (my main source of news, besides the Daily Show…) Greenspan has been in the first section. He was on the front page yesterday warning of consumer’s reliance on housing loans to support their spending habits. Today he was on the second page warning that investors are not appreciating risks to the economy.

I know that when Greenspan speaks, the press and investors listen. But the warnings he provided over the last few days are not new. We all know that people have been taking money out of their homes — just listen to the radio ads or look at new mortgage businesses being formed. And, when people have money, they usually find a way to consume more, rather than save. We also know that there is “froth” (to say the least) in the housing market so consumers will not be able to tap increases in home equity in the future.

Also, we know that investors are doing anything to look for more yield. The risk spread between junk and treasuries is absurdly low. The yield spread between short and long-term bonds is also extremely low — i.e. the yield curve is flat. The flat yield curve has previously been referred to by Greenspan as a “conundrum.” And we can all see the low price being paid for taking on extra risk by looking at bond mutual fund yields.

There is no new information in these articles. Well, maybe a little — the risks be more obvious than we previously thought. But, if they are so obvious, when will the market take notice? Do we remember how the “irratonal exuberance” warning ended?

We have a very large exposure in Property & Causualty insurance and reinsurance stocks. Needless to say, the last few days have not been kind.

In times like these, when your portfolio begins free-fall, I always remember a quote from one of the best investors of all time, Peter Lynch, “I’ve always said, the key organ here isn’t the brain, it’s the stomach. When things start to decline - there are bad headlines in the papers and on television - will you have the stomach for the market volatility and the broad-based pessimism that tends to come with it?”

I’m not going to pretend that losses don’t affect me, but I’ve learned to keep my finger off the trigger. The worst thing to do is to take risk but then sell as soon as the market turns against you. I’m still optimistic about the long-term prospects of the companies we own but days like today, test my confidence to the fullest.

The Fed increased the target for the federal funds rate to 3.75% today. The Fed’s statement included: “Higher energy and other costs have the potential to add to inflation pressures.”

The market tanked. Everything on my “My Yahoo” page went from green to red in a moment.

High energy costs and increases in materials costs (most likely due to high energy prices) are causing the Fed to raise their target rate. And all of these factors are weighing on the market. But, I would argue, the risks are overblown.

The story goes: high energy prices slow down the economy but high energy prices also increase the price of goods and inflationary pressures. Soon, people start having nightmares of 1970s stagflation.

The Fed, by raising its target rate, said that the risks of inflation outweigh the risks of stagnation; or, alternatively, that it’s going to keep the same playbook despite the risks of stagnation due to the Hurricane. (I wonder: would we be concerned about stagnation instead of inflation if the Fed had not raised rates?)

High energy prices are being double-counted. They are leading to lower growth assumptions and higher discount rates (through a higher inflation assumption). So, if we buy stocks now we have a large upside if energy prices decline. Not a bad position given that energy prices should come down.

Based on recent articles I’ve read, the cost of producing a barrel of oil is somewhere between $25-35. From Econ 101, if the cost of production is less than the price, there should be more entrants, forcing the price down.

I have no clue how long it is going to take to be back in equilibrium — where the cost of production is equal to the price — but when it does, I bet the price will be lower than the $66 it’s trading at right now. And when oil prices go down, growth should increase, inflationary pressures should ease, and stocks should do well.

Of course, the worst could happen — our oil wells could run dry, new technology could not be developed to tap new fields, and new technology could not be developed to reduce our dependence on oil. But I wouldn’t bet on it.

An aside: I’m not good at economic forecasts and my timing is usually horrible, but I have done well over the long-run. Also, I don’t recommend trying to predict the direction of commodity prices but rules are made to be broken…

Back in 1938, John Burr Williams codified the fundamental principle of value investing: the value of a stock is the present value of its future dividends. It seems obvious, but underlying this statement is some very powerful, yet often forgotten, advice.

We forget at our our own peril. “From 1871 to 2003, 97 percent of the total after-inflation accumulation from stock comes from reinvesting dividends. Only 3 percent comes from capital gains.” (The Future For Investors) (By the way, if you are looking for a great introduction to investing, read this book!)

Not only have dividends been the driving force behind the real returns of the market as a whole, but the returns of individual stocks are driven by their yield. Jeremy Siegel sorted the stocks comprising the S&P 500 every year by dividend yield. He found, “in strictly increasing order, the portfolios with higher dividend yields offered investors higher returns.” (Ibid.)

David Dremen found similar results looking at the 1500 largest companies from 1970-1996. (Contrarian Investment Strategies: The Next Generation) He found that higher yielding stocks produced higher returns.

In addition, both authors found that “high yielding stocks also provide you with the best protection in a bear market.” (Ibid.) So, stocks with high dividends return more and offer better downside-protection. (So much for “tinstaafl”.)

There is one small difference between the findings of the two studies, however. The Siegel study found that the highest yielding quintile produced the highest return while the Dremen study found the highest yielding quintile produced the second highest return (to the second highest yielding quintile). I’m guessing it’s just because there is still enough variance left in the data to get different results with slightly different methodologies and data sets.

Either way, I am going to continue buying stocks with large dividends. And I am not going to worry whether a dividend is too high — just whether the company can support it in the future. For a reasonable dividend strategy — I agree with most of what he has to say except that I don’t worry as much about a high payout ratio (dividends/earnings) — see this blog).

But there is one big question left unanswered: why do dividends predict higher returns? From a strictly mathematical viewpoint, they should reduce the value of the company because they increase the tax burden.

I can think of three reasons why dividends increase value: (1) Dividends encourage managers to make better investments with the cash they have — i.e. they don’t have cash to burn on bad investments; (2) management will only give out large dividend payments if they are very confident about the future; and (3) a company can not pay dividends if it does not have cash earnings (without diluting shareholders).

Interestingly enough, there are people who argue that an increased payout ratio (dividends/earnings) is an indicator of higher future growth. (See, e.g., this month’s SmartMoney, p. 56.) I’m not yet convinced this is true because there is a very strong mathematical reason for the opposite to occur: the growth rate is = (1-Payout Ratio)*ROE. The mathematical relationship between the payout ratio is the exact opposite as what they are claiming!

In any case, there is very little doubt that buying high dividend paying stocks is good for your financial health. And I personally invest in high dividend paying stocks — I own no REITs, trusts, or bonds but have a yield of nearly 4%. (Of course, I think the companies I own have other good attributes as well. I don’t invest solely based on one factor.) Even if the market goes sidewise for some time, I will still get close to a t-bond return. And, if history is any guide, I should outperform the market over the long-run.

The reason a fund complex launches a new fund is to try to attract more assets. I’m okay with that. But sometimes a fund complex takes it too far. Take, for example, the new Van Kampen IPOX 30 Index Portfolio.

IPOX allows the investor access to recent large IPOs. But there are significant problems with the fund — drawbacks that make the fund uninvestible. The fund charges up to a 4.95% sales load!

There is no secondary market for the shares. The company states that they are creating one and that you can deal the shares back to the company.

In addition, despite their claims that their strategy will produce market beating returns, I have significant doubts because (1) IPOs have traditionally underperformed (see Buying IPOs Is a Loser’s Game) and (2) according to a recent Morningstar study, high expenses mean low returns.

If you want the excitement of IPOs feel free to play around with this fund but if instead, you would like to increase your net worth, I would stay away.