In this guide we will lay out the basics of why you want to invest your money based on the value that you get from your investment and why an approach like Warren Buffet’s almost always outperform in the long run. We will talk about value investing in the broad sense as well as the traps you want to avoid. We will not get too deep into technicalities like return on equity and working capital although we will briefly mention them. We will especially talk about how you as an investor can manage your money for the better and how you can build your nest egg – slowly.
(Note: If you would like to know more about the financials of Tesla Motors please read this article.)
To invest your money is both easy and hard at the same time. If you just want to invest somewhere you can do that with the click of a button, but if you want to invest wisely it’s a little bit harder. To invest wisely you have to go through the financial statements that are found in the quarterly or annual reports of the companies that you are interested in. When that is done, you need a framework for telling if the stock is worth buying or not.
When we first started investing many years ago and then sold our holdings at a profit, we thought that we ruled the world. There was nothing stopping us from making a killing in the stock market. We bought shares like there was no tomorrow. The only question that was relevant to us was how much money we could possibly deploy for our next speculation.
But then something happened. The market fell.
When it did there was no bottom to our losses. Everything that we had gained during the previous years was now lost and then some.
Wise from our experiences we laid out another strategy, one that was based on value instead of spectacular growth. One where a steady cash flow was more important than spikes in earnings.
This is why we write this guide. To prevent others from making our mistakes and to teach them how to be prudent with their hard earned money. This is especially true if you like sleeping well at night without any financial worries.
We caution you to take a more prudent approach with your cash and do your due diligence before you buy or sell any security. Never buy securities without asking for advice from a qualified adviser. You should always ask yourself if the investment decision you are about to make is justified by the fundamentals. If it is then go ahead, if it’s not then wait until it is.
There are many examples of occasions where the market has been severely wrong. We see them almost every day. These occasions ultimately create good buying and selling points for every shrewd investor out there. But you have to remember being patient.
Here we are going to talk about allocating your portfolio. What proportion of stocks to bonds you should keep and how to deal with the urge to speculate.
There is nothing giving you more thrill than seeing the ball fall at the right number when you’re at roulette table at the casino. This feeling of exhilaration is very strong and also very addictive. But it deceives you. The next time you will not be that lucky and when looking at it objectively, you have the odds stacked against you. After all, that is how the casinos around the world are making their money, by making sure that they will win more times than they will lose.
The same is true for investing. You can see a speculative stock go up two or three times in price over a short period of time. But to believe that you are consistently able to time the market so that you always buy low and sell high is just unrealistic. Sure you may be able to have a few quick wins, but they will almost invariably be accompanied with losses that exceed your gains.
You therefore have to have a system in place that prevents you from speculating. Keep a proportion of your portfolio – the smaller the better – aside for your speculation, but never mix money you gain from speculation with money for investment. What we suggest is keeping a proportion of 10 per cent or less aside for speculation. That way you can participate in the excitement, but you will never let it overtake your life.
Furthermore, there is a misconception out in the public that says that investing is like betting in the casino. We would like take a different view. Where betting is ultimately dependent on luck, the same cannot be said about investment. Investing is about putting money to work and getting a reasonable reward in return.
The safer this return is the better.
Regarding portfolio allocation it depends on the where in the market we are. In normal times the prices of bonds are the opposite of the prices of stocks. Therefore you should try to keep an equal balance between the two.
However, at times the prices of stocks are depressed while the prices of bonds are high. In such a situation it makes sense to increase the stock proportion in your portfolio. We suggest that you never exceed 90 per cent stocks when they are undervalued and that you don’t exceed 90 per cent bonds when stocks are overvalued. That way you will keep an even balance in your portfolio at all times.
Ultimately it depends on how high corporate- and treasury bond yields are compared to the average yield on stocks. As we write this interest rates are chillingly low. In fact they are so low that treasury bonds do not correspond to our of a good investment. Instead you have to look into the world of investment grade corporate bonds. These are rated by rating agencies according to how likely they are to continue paying out their return. An investment grade bond has at least a rating of BBB.
Here we will discuss what to do when the market plummets and the need to resist any urge to sell good investments just because the market has been going down. Similarly, we will also discuss the psychological urge to buy more stock when prices have been going up.
When the market goes up it is very easy to buy more securities in the hope that they will continue to go up. That may very well happen for a while. But then reality sets in and the security that you bought for dear money will sense gravity and eventually fall to the ground.
The lesson learned over and over again is that there is always a fair price of the securities that you buy. This means that it is wrong to look at a rising price in the market as a vindication of having made the correct decisions regarding a security. If anything, a rising price signify that what you are about to buy has become more expensive and that you will get less value out of it in the long run.
In the same way, a falling price signify a cheaper security and gives you the opportunity to buy more of the stock than before. The only reason to buy or sell any security is if the fundamentals of that security have changed. If they have then, by all means, go ahead and buy or sell. If the fundamental situation does not change then you are better off holding onto your securities.
The financial media is to blame for much of the hype that has surrounded the stock market in recent years. Often media don’t reflect that investing in essence is a rather boring activity. This is especially true when we are talking about value stocks.
The average investor would actually be better off had the securities in his or her portfolio been unquoted. That way he or she would be sure not to fall into the mass hunt that has proliferated in the financial media. The media often portray the business of investing as a kind of safari where it is all about killing big animals.
The true business of investing is very different. It is not a question about winning against the pros, it is about beating yourself in your own game. If you take a long term view and buy stock at a regular basis and reinvest your dividends in a disciplined manner, you are almost certain to succeed.
That is not to say that you should forget about the ups and downs of the stock market all together. If you see that your stock plummets, you need to sit down and harshly once again check the fundamentals. Are the steady earnings constant or are they slipping? Has the company taken on more debt? Does it finance its dividends with borrowed money? If it does then the market is right and you have to sell, but if it isn’t then you should take advantage of the low prices and buy more stock.
This is why we recommend holding on to your stocks for at least 5 years. That way with the dividends reinvested you should see a real accretion of your wealth during this period.
To sum this up: the more the market falls, the more value you will get out of your securities. Do not fall into the trap of selling just because everybody else is selling.
Here we will discuss the merits of mutual funds and index funds and how they can help the lay investor to grow his/her wealth.
One of the most common ways of investing is to leave the hassle of finding investment-worthy stocks to others. There were more than nine thousand different mutual funds in the US alone in 2014. As an aggregate they are almost perfect, but only just. Their biggest drawback is that they charge a hefty fee for the sake of looking after your money. You can pay anywhere from 0.25 percent all the way up 1.5 percent depending on what type of mutual fund it is.
This brings us to another aspect of stock picking which is that past performance almost never is a good guide for future rewards. A mutual fund may start out small, but inevitably, as the fund grows in size, it will attract more money. When the fund attracts more money it has a set of bad decisions to make:
Thus, there simply are no good options for the money managers who manage big accounts. So what they tend to do is that they indulge in the process of “herding” which means that most mutual funds buy the same kinds of stocks and at similar proportions as everyone else.
Another thing that may affect the long-term performance of the fund is that a top stock picking manager may be recruited to a competing fund. Good managers with good track records are almost always sought after, which is another reason that these are paid so well.
For the lay investor there is another possibility which is to buy an index fund. The upside to these is that management fees are low – it is not very complicated to buy equal amounts of the S&P 500, for instance. Another positive is that the fund will always follow the index – no worse or no better – which is good because it is fiendishly difficult to beat the index over time. Another plus is that you will always receive the aggregate dividend yield that the index pays. For somebody who is not very interested in stocks this is an almost ideal solution.
The downside is of course that they are boring. You will be able to look at the performance of the index to tell yourself how much money you have made recently. There will be no excitement when a stock finally takes off and you see that its price increases by the day. Likewise you will probably not see your stocks go down too much in value either. If you just want to participate in the stock market without doing the extra work it takes to analyze individual stocks, this may be the solution for you. As we shall see, the work of a financial analyst is very different.
In this chapter we will look into what determines the value of a security. How the operational cash flow, the assets on the balance sheet and the debt ultimately decides what kind of return you will get from your security.
If you have ever seen an annual report you will see that it contains a lot of information. If it’s a retail company you will likely find sales volumes in different regions of the company, if it’s a mining company there are many pages about reserves and resources and if it is a technology company there are probably discussions about their recent technological advances.
But what we are interested in as investors are the financial statements. You will see that they are divided into three parts:
The income statement is about how much money the company has made in the period (1) and how much money it has paid in taxes (2). When you subtract (2) from (1) you end up with the Earnings that the company has made in the period.
This Earnings number is then divided by the total number of shares to find the Earnings per share during the reporting period.
When you then look at the current price of the stock and divide it with the Earnings per share, you will get the price to earnings ratio or the P/E ratio. If you on the other hand are using last year’s P/E number you are in effect calculating the trailing P/E ratio and similarly if you are using an estimate of analysts expectations of next year’s earnings, you are determining the forward P/E ratio.
What this all boils down to is that it tells you something about about how much profits a share in the company will buy. A common share in a company is nothing but a stake in the profits.
There is a problem with P/E ratio however and that is that the number does not take into account the earnings over time. To do that we have to calculate an average over the past years’ earnings and adjust for inflation. Then we can use this average number just as we did when we calculated the real P/E-ratio. This is called Cyclically Adjusted Price to Earnings (CAPE) ratio and was introduced by the economist Robert Shiller in his book Irrational Exuberance from 2000.
The balance sheet is where the company is stating all its belongings and debts. The belongings are called Assets and are further divided into Current- and Non-current assets where the current assets are assets that can be sold over the next 12 months and the non-current assets cannot. On the one hand you have the assets (a) and on another you have the liabilities (b). Then you subtract the liabilities from the assets to end up with the Shareholder’s equity which is precisely defined as the Total assets minus the Total liabilities.
Then we prefer to divide the short-term liabilities, the long-term liabilities and the total liabilities with the shareholders equity to figure out if the debt is sustainable or not. If it is not then the company runs the risk of seeing the debt eat in to their earnings due to amortization. This will of course create a vicious circle.
When is the debt too much?
The debt levels vary significantly across different sectors. Some types of businesses are very capital intense and therefore highly leveraged (or running on borrowed money). Other businesses don’t need so much money, but can rather start to churn out money with a laptop computer from home. So it’s difficult to make a definitive statement about much debt is too much. For a mining company or a shipping company which are very capital intensive may see debt levels (i.e. total liabilities to shareholders’ equity) of more that two whereas a startup tech company may have very low debt levels.
The cash flow statement is where the cash that has goes in and goes out of the company during the reporting period is reported. The statement is divided into three different categories. These are usually divided into cash flow from Operational activities, Investment activities and Financing activities. The free cash flow is the money that the company can use for discretionary purposes, i.e. paying out dividends to shareholders.
The free cash-flow is defined by subtracting Investment in plants and equipment (CAPEX) under Investment activities from the Operational cash flow. The formula looks like this:
Another thing that is important is how much the company pays out in dividends, i.e. the dividend yield. You want to look for companies that pay a good dividend, but also has a history of increasing that dividend over time. Most companies that are doing well in this respect also has good cash flow coverage of their dividend. It makes sense, otherwise they would not be able to sustain their dividends.
A warning here is in place. Just because the company has a high dividend does not mean that the dividend is safe. For instance, the major oil companies nowadays almost exclusively has a high dividend yield, but that is more a reflection of the risk that you are running when investing in those companies. One way to check this is to make sure that the dividend is fully covered by the free cash flow.
The lower the P/E-ratio and the higher the dividend yield is, the more value you will get out of your investment. In mature companies this may be difficult, but in the small-cap space finding so-called “double-sevens” is most definitely feasible. A “double-seven” is a a company with a P/E ratio of 7 as well as a dividend yield of 7. The trouble here is that the cash flow is not as stable for a small-cap stock and may vary a little bit more than for more bigger companies, but anyway they are worth looking into.
We also want to mention the Return on equity or the ROE. The ROE is defined as the companies’ net income over the period divided by the shareholders’ equity. This is a measure of how much profit the company makes per dollar of shareholder investment. For a good profitable business an ROE of at least 17 percent should be sought after.
The last thing that we want to mention is the net net working capital. The net net working capital has been popularized by legendary investor Benjamin Graham who figured out a good way of valuing stocks in the stock market. The method involves taking the Working capital (current assets less current liabilities) and then subtracting any additional debt.
We can then divide the net working capital with the total number of shares to end up with a number for the intrinsic value of the shares. In the 1920’s and 30’s these numbers were at times surprisingly close to the quoted value and extraordinary bargains could be found. In today’s stock market these extreme values are seldom found because, let’s face it, a stock that is priced for its net working capital is priced for liquidation. In today’s market liquidations are rare and the costs associated are huge. They also take a long time to unwind.
The upside of this is of course that if you buy a stock that is priced by its Net Working Capital you are protected by their assets value (like plants and buildings) which effectively puts a floor beneath the price.
To conclude we would like to emphasize that what matters is the consecutiveness of the earnings in relation to their price. We would therefore propose the following list when we select a stock:
This chapter will contain a few real life examples of what we are teaching. We will in particular look at some of the stocks that we picked out in our small-cap screen at the end of last year.
We will compare two small-cap stocks that trade on the New York Stock Echange: “The Buckle” (BKE), an apparel company and “Cummins Inc.”, a company that manufactures natural gas engines.
What we did here was that we used data from the annual reports, Yahoo and Morningstar to come up with this:
What is clear from the data is that the earnings are pretty constant over the three years. They are decreasing slightly, but not so much that it justifies the stock to go from 53.39 USD in December of 2014 to 24 USD on this Friday the third of October. That is a good sign.
If we then calculate the cyclical P/E ratio we see that the averaged earnings over the last three years puts cyclically adjusted price-to-earnings ratio (CAPE) at 7.32. We see that the dividend yield is OK and we have a good free cash flow to pay for the dividends.
In all, when we are analyzing the stock we conclude that the market has weighed too much importance to the decreased earnings in 2015. The prudent thing would therefore be to buy more of the stock rather than selling. Therefore our recommendation for this stock is BUY.
If we then look at Cummins Inc. instead we see this:
What we see here is that the earnings are increasing over the years, but are they increasing too much? We see that the price has gone from 89 USD to 128 USD over the last year while the earnings have increased from 3.70 USD per share to 4.5 USD per share. The increased earnings do not reflect such an explosive increase in the price and the cyclical P/E ratio is much higher today than at the beginning of the year.
Taken altogether we do not recommend buying this share at this point. It is simply too expensive. If you already own it, by all means keep it, and reinvest your dividends so that you will receive a higher dividend next time. Another possibility would be to take some profits so that you can invest in other companies. In the small-cap space there are plenty of stocks with sufficiently low P/E ratios at all times. Therefore, if you look at a sufficiently low P/E ratio and a good dividend yield, you will always be able to find good investment options in this field.
In this guide we have been trying lay out the basics of value investing. We have been trying to answer the questions of what a good investment is, what constitutes value in an investment and how to deal with your non-discretionary spending whilst investing them in the market.
Value investing is not something that will make you rich quickly, but rather a technique for the turtles. The power of it comes from the “compound interest” that you will experience when you reinvest your dividends in the same stock. If you have bought shares in a good value company with a steady earnings, you will see that your wealth increases exponentially with time.
To the questions of what to buy and when to buy we have given real life examples which makes it easier for you to follow along.
How come Warren Buffett is such a fantastic investor?
To answer that question we first need to look into what Warren Buffett has actually done.
He studied at Columbia University under the legendary Benjamin Graham where he learned the fundamentals of value investing.
What a value investor does is that he or she is looking for securities which prices are below its intrinsic worth.
What matters is the price. Buffett knows that if he can buy a well-run company for pennies on the dollar, sooner or later the market will appreciate its error and see the price of the security rise.
That is value investing and that was exactly what he did in the early days of his investing career.
For instance he bought a 5% stake in in American Express in the mid-1960’s for $13 million dollars.
There are of course a few metrics that he looks at when investing in a company:
Good luck with your investments. If you want to look at value metrics of small-cap stocks you can look here.
First of all congratulations. You have achieved something most of us just dream of and cannot achieve in a lifetime. Because both stocks or real estate are assets with fluctuating values your money is not guaranteed but needs to be invested. And wisely so.
Now is the time to do some serious soul searching. What is your long term goal with your money? Do you want to preserve its value long-term or make a decent return? It may sound as a trivial question, but it actually holds a little bit more substance than first anticipated.
At first it may be a good idea to read some books on what you want to do with your money. Even if blogs like this may give you a short description, we cannot do your due diligence. You have to do that yourself.
If you come up with an answer where you want to preserve the value of your capital you should invest in tangible assets, like precious metals, farmland or fine art.
The reason for this is the current regime of central banks where quantitative easing is slowly diluting the value of money. One of the facets of precious metals is its “moneyness” and the reason people buy it is that it preserves buying power over the long haul.
The fundamental reason the gold price got higher in the period between 2008 and 2011 was the negative real interest rates. The negative real interest rates is defined as the differential between the nominal interest rate and the inflation rate. In other words, it is the interest rate that businesses and people are experiencing at any given time. During the three years between 2008 and 2011 the real interest rate was negative which drove prices higher.
The trouble with gold is that its value fluctuates wildly and that when its price in dollars goes up, it soon blows out of proportion. For instance, in 2011 when gold had its last peak at over 1900 $, it had gone up from 1100 $ a year earlier. The hype around it made it very expensive very fast. Similarly, it fell from 1900 $ to 1150 $ over two years. These wild gyrations are attributed to the size of the gold market. If you compare it to the size of the bond market, it is minuscule.
In this sense farmland is a better investment since it also is a tangible asset that preserves its value. Over the past few years farmland has increased in value of an average 8 per cent a year.
My own preference when it comes to investments in tangible fixed assets is fine art. For instance, if you had invested 100$ in a work of art by the French artist François Boucher in 2001, it would be worth 197 $ by now. Similar gains can be seen with other artists.
It is however important to stress that this strategy of preservation only makes sense if you believe that “money” as we know will be diluted and eventually die at some point in the future. It does not make sense to preserve value like this if you believe that the central banks are doing the right thing .
The difference between between buying something tangible and investing in a return-yielding stock or bond is called “compound interest.” This does not take place if you invest in tangible assets. What “compound interest” means is that if you have an interest rate of 10 per cent and you reinvest those 10 per cent each year, you will be building on your capital much faster than if you did not reinvest the surplus. The longer your investment period is, the higher the return.
In real terms this means reinvesting your dividend each month or each quarter or whatever the dividend period is. If you just stick to reinvesting your dividends in a disciplined manner your money will soon grow much bigger than any doubling or tripling of prices that you occasionally see in the stock market.
If you do not believe central bank policy being a problem then you want to shun precious metals and fine art and invest in good cash generating stocks instead. I would take a look at small-cap stocks in your own country with good cash flows, dividends and interesting business ideas.
The idea may sound like a dangerous approach, but is less so once you know the companies that you invest in a little better.
It does not really matter where in the cycle we are – what matters is how these stocks are valued at any particular time. Try to go for stocks with a positive free cash flow (the free cash flow is calculated by taking the operational cash flow and subtracting the CAPEX spending which is found under investing activities in the cash flow statement.) The free cash flow is the amount of money that the company has available for paying out dividends. If the company is not generating a free cash flow it has to borrow the money.
Another thing to look for is a low price to earnings ratio and a high dividend yield. Ideally, for a good investment, the P/E should be around 7, but a higher number may be acceptable. It depends on the business. When it comes to the dividend, of course the higher the better.
The next thing is of course to reinvest your dividends in the same stocks and see your capital grow, slowly. The key will always be to be patient. In the short-term there is no guarantee of financial gains at all and anything might happen, but if you have chosen good value eventually the market will reward you.
In today’s post we have been looking at a (presumably) young man or woman who has inherited a fortune. Allegedly his or hers fortune is an 8-figure dollar inheritance which apparently is invested in stocks and bonds. The person then asks how he/she should invest his/her money.
We have divided our answer in two. One which is based on tangible fixed assets if you don’t believe in the current central bank policy and another if you do.
Our suggestion would therefore be based on your current thinking. Remember that it is not a question of prudence – we are always prudent.
If you believe in the current central bank policy we would invest 10 per cent of our portfolio into tangible fixed assets and the rest in small-cap stocks. That way you are hedging against a really bad outcome whilst at the same time earning a more than decent return on your money.
If on the other hand you don’t believe in the central banks you can increase those 10 per cent into tangible fixed assets to 25 or even 40 per cent.
Absolutely. To invest successfully you need to manage risk, not avoid it. Warren Buffett has understood every aspect of this and made a lot of money executing the idea.
By focusing on good companies with steady cash flows and high return on equity, he has been able to increase his wealth even at the worst of times.
This is in sharp contrast to resource investing where a mediocre year may be followed by an excellent year – all depending on commodity prices.
The question then becomes “How did Warren Buffett manage the risk?”
Some of his holdings may have seen exceptionally big in respect to his whole portfolio at times, and you would be forgiven to believe that he was putting all his money at risk. But then you realize that he wasn’t gambling at all.
He could at all times liquidate his holdings in American Express, Coca-Cola or Wells Fargo and at least get what he paid for them back. In this sense it has been clear that Buffet has been taking very little financial risk.
The environment in which he made his money was every bit as uncertain as the one that we have today. Yet, he was able to steer clear and make a lot of money.
Today there is rapid credit growth, quantitative easing by the central banks and a potential bubble in China to worry about. When Warren Buffett started investing in the sixties and seventies, the worries were different but no less severe.
You often hear things like “Financial markets don’t like uncertainty”, but that is only half-right. Financial markets may not like uncertainty, but good investors thrive.
That all sounds very good, but what is the best thing that I can do with my money?
When you read this you may think that it is only to invest in a few good stocks and you’re ready to go off and settle on the beach, but it also takes a lot of psychological strength to be able to go with just a few stocks like Warren Buffet has done.
The strategy that we recommend is to diversify your portfolio in order to spread the risk.
If you don’t consider yourself to be a Master of investing who turn all that he touches into gold, to diversify your holdings would seem to be the most prudent strategy.
Today we have been talking about the success of Warren Buffett and how he has managed to make a lot of money even when times were rough.
He did so not by investing in the fastest growing companies, but in companies that had the safest cash flows.
We have also talked about diversifying your portfolio if you haven’t identified stocks with good cash flows at the exact good time point to invest.
The reason why we recommend you to do this is that it spreads the risk that you run from owning just a few companies.
Published on the 1’st of September 2016