Newsletter June 28, 2006

InvestorsFriend Inc. Newsletter June 28, 2006

Warren Buffett Gives away billions…

There was big news this week that Warren Buffett would give away some $37 billion worth of Berkshire Hathaway shares in the largest such gift to charity in history. Actually he has only pledged to give the money (shares in Berkshire Hathaway) over a long period of time. Just 5% of the pledge will be given in 2006 and the number of shares to be given in each subsequent year declines by 5%, so technically it would take decades before the full amount of shares is handed out – although the remaining balance may be given upon Buffett’s death.

Warren Buffett still intends to be fully in charge of Berkshire Hathaway for the indefinite future and he expects Berkshire to continue to grow more valuable so that his eventual gift may be far greater than the current value of the pledged shares ($37 billion).

But I am more interested in how he managed to amass such an incredible fortune. He is said to be the second richest person in the world, after his long-time friend, Bill Gates.

I have read and studied quite a bit about Buffett and in 2003 went to Omaha to hear him speak at his annual meeting.

Buffett has often said that he was destined to become rich. I believe he knew at a very early age (15 to at most 20 years old) that he would be rich. He did not merely think so or hope so, he knew so.

How could he be so sure? He could be so sure because he knew that it was a mathematical certainty as long as he did certain things. He knew that if he saved and invested a significant portion of his wages (say 20%) then even with modest returns (say 10%) then over 30 or 40 years this would automatically compound up to a significant amount. (For example using today’s dollars, $20,000 per year compounded for 40 years at 10% builds up to almost $10 million.)

In addition, Buffett knew that it was a mathematical fact that if he could somehow make 20% or more annually, then his money would compound up to an extraordinary amount over his life time. $20,000 per year compounded at 20% builds up to $176 million in 40 years.

Buffett was confident that he could make high returns because he knew that in the stock market there is almost always at least a few companies selling at bargain prices. Buffett knew that if he could buy shares excellent money-making companies at significant discounts to their fair values then that would generate the high returns that would assure he would become rich. (Buffett calls this “buying dollar bills for 50 cents”).

The exciting part is, all of this math still works today. There are some under-valued companies. Finding them can lead to high returns. Modest amounts of savings yielding High returns over time compounds into huge amounts of wealth.

I think Warren Buffett’s story should provide value oriented investors with tons of confidence and tons of motivation.

Since the inception of this Site seven years ago our Stock Picks have out-performed with the Strong Buys returning an average 26% per year. That kind of return, if it can be sustained, leads inexorably to richness. Consider subscribing to our Stock Research and joining us as we travel a reliable path to richness.

Accepting More Volatility Might Improve Your Returns

If one of your stocks soars 100 to 200%, then you face a decision. Should you sell some of it or all of it to lock in profits? Or should you let your money ride perhaps on the assumption that it will continue to do well?

If you believe that the stock has become seriously over-valued then you would fear that it would soon fall back to a fair value and in that case it is an easy decision to sell some or all of the stock (particularly if held in a non-taxable account, where triggering capital gains is not a concern).

However if this winning stock still seems to be still reasonably priced based on its earnings and outlook, then the decision is more difficult. Such a stock can create higher volatility in a portfolio because it has become a larger percentage of the portfolio and because given that its price rose quickly, it could suffer a pull-back.

Investors holding such stocks may a have a great fear that if they keep the stock then it might fall and they will feel dumb for not selling it at a higher price when they had a chance.

On a number of occasions when I have sold to “take profits” I have regretted it when the stocks I sold ended up being up significantly in the next 1 to 3 years after I sold.

I have come to the conclusion that often I would be better off letting my winners ride. It will lead to more volatility in my portfolio but will also likely lead to significantly higher returns. This is particularly true in taxable accounts where taking profits leads to triggering tax payments.

Dow Jones Industrial Average – Cheaper but not Cheap

The Dow Jones Industrial Average (DJIA) has not risen as much as have the earnings of the DJIA companies in the past few years. The result is that the Price / Earnings (P/E) of the DJIA has declined over the past few years, from 27.1 at the end of 2001 to a current level of 17.5. A price of 17.5 times earnings seems a lot more attractive than a price of 27.1 times earnings. However while 17.5 times earnings is cheaper, it can be better described as a fair price than a cheap price. To see our updated analysis of whether or not the Dow Jones Industrial Average is attractively priced, see our updated article.

Warning Regarding Trading in U.S. Stocks

If you buy and sell U.S. stocks in a Canadian dollar RRSP or margin account then you may be paying a hefty charge that you are not aware of (because it is a hidden charge).

My own investments are almost entirely in “registered accounts” (RRSP, RESP). I have tended to invest less than 10% in U.S. stocks but lately have increased my U.S. exposure. (Not because I was looking for U.S. exposure, but rather it was because I discovered some U.S. stocks that I happened to like).

I was vaguely aware that when I bought U.S. stocks, I was paying some kind of commission to convert my Canadian dollars into U.S. dollars, and vice-a-versa when I sold. The commission is combined in with the exchange rate. For example if you buy $10,000 worth of an American stock, as of June 23my discount broker would charge $11,331. My broker makes an additional profit by charging an exchange rate that is higher than the “wholesale” exchange rate at which it can buy U.S. dollars, and certainly higher than the rate it will pay its clients for $U.S. dollars. But this extra profit is hidden in with the exchange rate.

Until recently I had not investigated the amount of this hidden commission. I have now discovered that my broker charges me 1.7% more for U.S. dollars compared to the amount at which it will buy U.S. dollars from me. The bottom line is that I have discovered that each time I buy a U.S. stock and then later sell it, the “round-trip” commission on the exchange rate is 1.7%.  With my broker it appears as if the same 1.7% applies for all amounts under $40,000 and beyond that the on-line system indicated that anything over $40,000 exceeded the allowable transfer limit.

An extra cost of 1.7% on a round trip trade of a U.S. stock (buy then sell later) is significant. In contrast the round-trip trading commission on $10,000 worth of U.S. stock is typically about $60/10,000 times 1.1331 = 0.7%. And of course the percentage trading commission goes down as you buy larger dollar amounts of stock. A trader who traded U.S. stocks in this manner and who turned over the portfolio twice in one year would lose 1.7% time 2 = 3.4% just in hidden exchange commissions. Losing 3.4% in a market where eking out a 10% return in a year can be difficult is a significant loss to consider.

Luckily there is a way to get mostly around this.

For non-registered accounts, simply open up a U.S. dollar account at your Canadian brokerage. You will pay a hidden commission of about half of 1.7% when you transfer money to the U.S. dollar account. But after that you can trade U.S stocks without constantly switching back and forth to Canadian dollars.

For registered accounts, I am told that government regulations prevent the brokers from allowing part of the registered account to remain in U.S. dollars. But at least some brokers allow a work-around. The investor puts cash into a U.S. money market account. Then when U.S. stock trades are made the investor can request the broker to “wash” the trade cash into or out of the U.S. money market account. Thus no currency transfer takes place and no hidden foreign exchange commission is paid. This is a good work-around. Interestingly for all the advice about getting into U.S. stocks I have never seen this little trick ever mentioned in the financial press.

Keep in mind that a big risk (or potential reward) of getting into U.S. stocks, is the risk that the Canadian dollar will continue to rise (or will fall).

However those who buy more than the very occasional U.S. stock should consider using a U.S. dollar account (for non-registered accounts) and a U.S. money market approach for registered accounts.


Previous editions of this newsletter can be accessed here.

Shawn Allen
InvestorsFriend Inc.

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