Newsletter August 3, 2003
INVESTORSFRIEND INC. NEWSLETTER, AUGUST 3, 2003
Warren Buffett (The Worlds Most Successful Investor – by far)
In 1973 Warren Buffett bought a significant chunk of the Washington Post Company for $10.6 million. He paid an average $22.75 per share. The shares had fallen from a recent $38.00. They bottomed out at about $18.00. Since then he has not bought or sold any shares in the company. At the end of 2002 that $10.6 million investment was worth a staggering $1,275 million. Over about 29 years that is a compounded gain of 18% per year and that does not count the millions in dividends he has received.
This is truly remarkable, $10.6 million turned into $1.3 billion and millions in dividends collected as well. It’s also remarkable that it took “only” an 18% annual return to do that.
Some would say he got lucky. But he was smart enough not only to buy, but he never sold a share. How many of us would have had the confidence to hang on as the share price rose over 119 fold (and counting)? Also he has had numerous other success stories. His success did not come from just few brilliant moves. He does limit his stock investments to a small number of companies. But there have been more than enough examples to prove that his methods are based on skill and intelligence, and not luck. Therefore I believe that investors would be fools not to study his methods and learn from them.
I believe that I understand Warren Buffett’s methods far better than most people and that I can convey that understanding to you and also apply that to my stock picks which are available on a paid subscription basis.
Buffett has laid out his investment rules many times, for example in his 1978 letter to shareholders he said that he only buys businesses, in whole or as shares when he can find “(1) businesses that we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) priced very attractively.” He also said, “We try to avoid buying a little of this or that when we are only lukewarm about the business or its price. When we are convinced as to attractiveness, we believe in buying worthwhile amounts”.
Buffett believes that the market occasionally becomes extremely irrational. To avoid following an irrational crowd, Buffett believes that investors must think analytically and attempt to quantify the value of stocks before they purchase. In a November 10, 2001 article in Fortune he said “If you quantify, you won’t necessarily rise to brilliance, but neither will you sink into craziness”.
I’m happy to say that since the beginning, this Web Site has been dedicated to quantification and rational thinking.
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How to Invest In Stocks
Going back to basics there are three main theories of investing in stocks.
Theory 1 says the market is highly efficient. Each stock is worth exactly the price you must pay for it. Thousands of analysts have already figured out where each stock price should be. When news comes out the price reacts so fast you have no chance to benefit from the news. Winners and losers cannot be predicted through any means, it is impossible. If this is true, the best you can do is invest in index funds and exchange traded funds to get diversification and keep your trading and money management fees to a minimum. Academics mostly believe that this theory is reasonably close to correct. However, virtually the entire financial community of mutual funds, investment newsletters and legions of investment commentators believe that is is false and that there are in fact many opportunities to beat the market averages.
Theory 2 states that stocks are priced largely on the basis of human emotions. In this view stocks are similar to collector plates, they go up in price when they are popular, and they go down when they are unpopular. In this theory you look at graphs of the price tend and the volumes traded and try to guess where the market is going. You look at momentum and resistance levels. You look for seasonal effects and many other trends. Short-term traders tend to believe in this theory. In this view there is little point in looking at company earnings or fundamentals, your time is better spent analyzing trends.
Theory 3 assumes that some stocks are over-priced and some are under-priced based on fundamentals and that it is possible to identify them. Cruder versions of this simply invest in lower P/E ratio stocks. Sophisticated versions of this require the investor to make an independent calculation of the value of a stock, usually based on its earnings growth forecast, and to compare that intrinsic value to the price at which the stock can be bought in the market.
I believe that Theory 1 has some merit, there is a lot to be said for investing in index funds and avoiding the time, effort and cost of selecting individual stocks or paying a manager to do it. It is a mathematical certainty that this method will beat the average actively-managed stock portfolio over time, due to the cost advantage. (Some equity managers will beat the market, some will under perform, the average will match it, but after costs the average manager will under-perform the index, it’s that simple).
I have a bit of respect for Theory 2 involving trend analysis. But I personally have no use for it. I would not invest in collector plates and I will not invest in stocks as if they were collector plates. I have no reason to think I could gain an advantage in playing this game. I tend to be methodical in my thinking processes and not lighting fast. Therefore, I bring nothing to the table that is useful for this method. For all the people who follow these trend methods I don’t know of any famous billionaires from the group.
When it comes to theory 3, fundamental analysis, I bring a wealth of education and common business sense to the table. I am confident that I can do a better job at understanding accounting, finance and business than the vast majority of the investing population. I believe I have a strong competitive advantage in this area. Furthermore, I know that the second richest person in the word, Warren Buffett, got there strictly by practicing this style of investing. Many other have amassed many millions in this fashion. Also people like Warren Buffett and Benjamin Graham have shared their secrets on how to apply this style of investing. As long as only a small percentage of investors really practice this method properly, we have only to copy the masters to be successful.
For me, the choice is easy, I follow the fundamental investing method. I have no use at all for momentum and trend type strategies. In applying fundamental analysis I am increasingly learning that I don’t have to look at all types of companies. Many companies are simply too unpredictable for this method. I increasingly focus on companies with steady track records an that are easier to predict. For more information on how I pick stocks, refer my articles on picking stocks on fundamentals.
Taking Advantage of Stock Market Ninnies
When you think about it, the only way one person can out-perform the stock market average is for someone else to under-perform it. In fact, after taking account of management fees and trading costs, the average investor mathematically will under-perform the stock market index by at least 2%.
We can all ride the index up or down together, but for each person that beats the index, someone else must lose.
To beat the average, you need someone else to under-perform by at least 2% so you can beat the index after costs.
I hate to take advantage of anyone but in a way we should thank heavens for all the “ninnies” in the market.
Ninnies include the great masses of investors who have no clue what they are doing and yet are making their own investment choices. Ninnies also include a lot of professionals who invest in ways that are simply not rational.
Ninnies are all around us, these include the people who are putting 5 and 10% of their wages into video lottery machines and lottery tickets when the same amount invested conservatively could assure them of financial security eventually. Ninnies are once again investing in tech stocks with no earnings. They have no clue what these companies do, but they are convinced the price will go up. I mean, did the vast majority of them really understand what products Nortel actually made? 99% of Nortel investors would be very hard pressed to give a coherent and accurate explanation of what exactly Nortel produces, and who its customers are.
I believe that in general, the Ninnies tend to be willing to pay too much for the future potential of big gains. They essentially put a lottery ticket premium on a lot of unproven companies. Meanwhile they tend to fail to see the true value in boring companies that do nothing but grow at 15% per year in a steady fashion. More rational investors can take advantage of this by buying the boring cash generators at good prices.
I’m insulting a lot of people here and I should admit that at times I have been guilty myself. I bought some Nortel on the way down, against my better judgment. For the most part I have reformed myself and tried to exercise the self-discipline not to be a Ninny. I try hard to make my investment decisions only after rational analysis. I urge you to do the same. Buying Nortel recently at under $2.00 may have been a rational decision – if the analysis was done, buying it at over $100.00 clearly was not. Even a very rough rational analysis at that time proved it was over-priced.
I would count virtually all day-traders as Ninnies. Sure some of them might win, just as someone has to win the lottery. But in general I don’t believe that either buying lottery tickets or being a day trader are winning strategies.
If you have been guilty of being a stock market ninny (and who hasn’t at least at times?) you can’t look back, but you can resolve to stop thinking about the market as if it were a casino and start thinking more rationally and quantitatively and start paying more attention to the better sources of knowledge, including this Web Site.
I summary, I feel sorry for the Ninnies but it is their existence that allows me to think that we can continue to beat the market averages. We should have a national Ninny day to thank them. Long Live the Ninnies!
Pension Plan Woes
I have mentioned before that we you should expect to hear a whole lot more about pension plan troubles. The only way to solve the shortfalls is for money to go into the plans.
As an example, the Alberta Public Service Pension plan just announced HUGE increases in contributions for employees and the government as employer.
An actuarial valuation found that the plan was 21% under-funded. This required a stunning 31% increase in average contributions effective September 1, 2003. Average contributions for the government and the employee each rise from 5.06% to 6.61%. This is an increase of 1.55% of salary.
This is pretty huge when you consider that the government would certainly balk at an additional 1.55% increase in wages – on-top of the normal annual increases. This increase also removes a total of 3.1% of wages for a huge group of employees from the consumer and government spending economy and transfers it to pension investment accounts. That can’t be good for the Alberta economy.
Existing pensioners are pretty much unaffected except that plans to bump up their cost of living allowances to 70% of Alberta CPI are scrapped and they will only use the promised minimum of 60% of CPI. Also a plan to increase the minimum pay-out time, on early death, from 5 years to 10 years is scrapped.
You can expect to hear lots more of the same, pension contributions rising 30% will probably be common, and this will hit the bottom line of many companies quite hard. And it should be treated as a permanent change. As an investor my suggestion is to be cautious with companies that have big legacy pension plans. If the company is very strong, it may not be a big deal. But in the case of weaker industries like Airlines and Auto manufacturing, I would not touch one of the old-line companies with their legions of pensioners who need to be “fed” no matter what the stock market does.
For more information see my detailed article on pension plan woes. Part of the reason for the increase in the deficit in the Alberta Public Service Pension Plan was a decrease in the “discount rate” to reflect lower interest rates and a decrease in assumed returns, just as predicted in my article.
Foreign Exchange Losses
Predictably, many companies with sales outside of Canada are showing lower earnings in 2002 due to the higher Canadian dollar. This should be treated as a permanent change, the Canadian dollar is not likely going to retreat to the low 60s anytime soon. The companies may be able to continue to grow earnings from here, but they start off from a new lower base, that is just the way it is.
I have to laugh when callers to investment shows ask if the foreign exchange can be hedged. They are really saying, can you make the problem go away? Sadly the company usually answered by saying that yes they are doing some hedges and implying that they are indeed making the problem go away. Well, unless they bough hedges back when the dollar was low and bought about 10 years worth, it is too late to hedge. When they hedge now, all they can do now is lock in today’s higher dollar and typically only for a year at most. That prevents the problem from getting worse for a year. It also prevents the problem from getting better if the dollar falls. It really does little. The higher Canadian dollar is now a fact of life that has to be dealt with. Generally it means that Canadian companies that have expenses mostly in Canadian dollars and sales mostly in other currencies are simply less competitive and less profitable than they were previously. There are probably lots of benefits to a higher dollar but for some companies the impact is negative and hedging cannot solve the problem in the long-term.
A lot of Canadian companies have investments outside of Canada. This is creating some interesting accounting problems due to the exchange rate change. If a company has debt outside of Canada that debt is now a lower burden. Accounting rules allow the company to bring into earnings a gain associated with the lower value of the foreign debt. This is not consistent with the usual practice of smoothing these types of gains into earnings over a period of years.
In contrast if a company has a fixed asset outside of Canada, it has lost money on that investment when the dollar rises. But the losses are being smoothed into income by placing them in a separate category of shareholders equity and not showing the loss on the income statement. Some companies get to claim an immediate gain on their debts while the loss on their foreign asset is “hidden” away on the balance sheet. This is inconsistent. Probably both should go to the balance sheet and be smoothed into earnings. Certainly, the treatment should be consistent.
This is arcane stuff, but it just illustrates that net income is not always a figure to be trusted. That is why I always look at one-time gains and losses and why I always include a section on quality of earnings in all my reports.