Newsletter January 19, 2014

InvestorsFriend Inc. Newsletter January 19, 2014

Getting Started in Investing

Some of you reading this are seasoned investors. But at some point everyone was a beginner. The following are links to two articles that address how to get started in investing and how to get started investing in individual stocks (as opposed to mutual funds).

How to get started in investing

How to get started in investing in individual stocks (as opposed to mutual funds)

How Much Money Will You Accumulate Through Investing?

It depends on just three factors:

1. How Much you invest (and later withdraw) either initially, monthly or yearly

2. The average annual return that is earned on each dollar invested

3. The time that each dollar is left invested

Of these, the last, the time invested will often be, by far, the most important factor. Consider that $10,000 invested at 7% for 20 years will grow to $38,697. But $10,000 invested for 40 years (twice the time) at the same 7% return will grow to $149,745. By leaving the money invested twice as long, the accumulated amount is not merely twice as high, instead it is 3.9 times higher.

The average annual return earned is very important as well.

$10,000 invested at 8% for 40 years grows to $217,245. That’s 45% more than the result from a 7% return! And if you could somehow find a way to get double digit returns over a period of decades the wealth than can be generated is truly staggering. If you could squeak out an extra 1% by, for example, lowering your investment management fees, the extra wealth generated is quite stunning over 30 or 40 years.

If you are interested in accumulating a significant amount through investing (and especially if you are just getting started) you will need to try to maximize all three factors. It will help if you are younger, if you have more discretionary dollars to invest and if you are willing to leave the money grow for a very long time.

At this point, you cannot change your age, and you cannot change how much you invested (or withdrew) in the past, nor your past returns,  but you can still exercise considerable influence over each of the three factors listed above from this point forward.

It’s really all up to you. That, for better or for worse, is how the world works.

Compartmentalized Thinking

One thing that can be dangerous in investing is a human tendency toward compartmentalized thinking.

Consider the following two examples:

1. You own three stocks and each gains 10%, for an overall portfolio return of 10%.

2. You own three stocks, two of them rise 20% and the third loses 10%. Your overall portfolio return is the same 10%.

Many people seem to feel better about the first scenario, the loss in the second scenario bothers people even though the portfolio return was the same.

If you hold a stock and sell it and reinvest in another stock that rises 40%, and the first stock rises 30% after you sell it you may be bothered by this. Most will feel that they “missed” out on the 30% gain and they forget that the money was used to make an even bigger gain. In our minds we tend to somehow think we should have gotten both the 40% and the 30%.

When a companies outlook changes to the negative and we lose money on a stock we are often reluctant to accept the loss and move on to better investments. We often feel that we should hang on hoping that the stock will recover. In reality it is true that you don’t have to make back the money in the same place you lost it. But somehow our compartmentalized thinking habits seem to think we do need to get the money back from the losing stock.

The Meaning of Buffett’s Rule number 1: “Don’t Lose Money”.

I understand that Buffett has said that rule number 1 is “Don’t lose Money” and that his rule number 2 is “Don’t forget rule number 1”.

This advice can easily be seriously misinterpreted. When Buffett says “Don’t Lose Money”, he is certainly not suggesting that you should never buy a stock that could decline in price. That would mean you could never buy any stock.

Buffett does not consider the stock market (especially in the short term) to be the arbitrator of the “true” value of stocks.

What Buffett is referring to is don’t invest in a company that is at all likely to suffer a permanent decline in value. Stock market fluctuations are not of much concern to Buffett as long as the underlying value of a company continues to increase over the years as it retains part of its earnings and reinvests those and grows over the years.

My understanding is that Buffett would agree that preservation of capital is a good thing, he just measures it far differently than most other people.

When investors insist on never risking a decline in the market value of their investments they are usually making a serious mistake — unless they plan to spend the capital fairly quickly and are unable to ride through any temporary dips.

How Buffett Measures His Returns

Warren Buffett has had the vast majority of his vast wealth in a single stock, Berkshire Hathaway for about 45 years. I saw him state on television that over these many years there have been four occasions on which Berkshire’s stock value has declined by at least 50% from a prior high. I know there were huge declines in the stock in 2008 / 2009, also around the year 2000 and back in the early to mid 70’s.

I am sure he did not enjoy these price declines and felt badly for his investors. But basically these things don’t bother him much.

He has said from the very outset of his investing career that what really matters is the intrinsic value of his companies, not the market value. This is increasingly true in his case because when he buys a business outright (Berkshire makes an acquisition) he buys for keeps. I don’t think he has ever sold a subsidiary of Berkshire after buying it. He has had to close a (very) few down but he never sells. It’s part of his strategy that when you sell him a business he promises that Berkshire will never ever sort of strip it and sell it off for parts or sell it to another owner just to make a fast gain. When it comes to Buffett’s larger investments in stocks (Coke, American Express, IBM, Proctor and Gamble etc.) he is not in the habit of selling shares just because they spike up in price. He can buy on dips but he really can’t sell on rallies. Can you imagine what would happen if it was reported that he was selling even a tiny fraction of his Coke or American Express shares? The stocks would likely tank.

That is not to say that he can never sell shares. He does reduce his position in some companies from time to time. In earlier years this was much more frequent. Today he can do that with smaller positions especially partly because he now has two portfolio managers that handle part of his investments and with smaller positions the market would not know if it was him selling or his two portfolio managers.

In any case by desire and in part by necessity, Buffett tends to buy for keeps. Because he intends to keep investments indefinitely, he concerns himself with the profits from the businesses and not the price he could get if he sold. Even in the case of stocks, if the earnings per share grow at a strong rate over the years then the stock price will eventually reflect that notwithstanding its shorter term meanderings.

When it comes to Berkshire he annually makes a rough estimate of its intrinsic value per share (which figure he keeps to himself) and his goal is to increase that intrinsic value per share over the years. He relies on the increase in book value per share as an imperfect and understated proxy for intrinsic value and the growth in book value per share is dutifully reported to shareholders each year. As of the end of 2012 book value per share had risen by 587,000% or 5,870 fold since Buffett took control of Berkshire Hathaway in 1965.

Buffett’s goal is not to push Berkshire’s share price higher, as such. His goal is to continue to increase the intrinsic or true value per share of Berkshire and he is confident that the stock price will reflect such growth in the long term.

Meanwhile most investors are left to obsess about movements in share prices rather than focus on gains in the intrinsic values of our shares. In part, this is because the vast majority of investors have no ability to estimate changes in intrinsic value or to recognize if the current share price is above or below that intrinsic value.

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END

Shawn Allen, President
InvestorsFriend Inc.

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