Think of Your Stocks Like Real Estate

This past week, I was considering buying a home near my parents so that when I was back in area, I would have a place from which to work and live. With the real estate market falling to 2004 prices, on average, it seemed a good time to buy (value investing is not limited to stocks – it’s a business philosophy). Anyway, I made an opening offer roughly 10.6% below the list price, which was more than reasonable given the current economic environment, the fact that I don’t need a property per se, and my outlook for real estate values over the next five to ten years.

The owners of the property came back with their counteroffer, but refused to budge much. They had in mind a price that they thought appropriate for the property based upon their own analysis of the comparable sales in the neighborhood. They determined that based upon their own financial needs that they couldn’t afford to sell their asset for the price the market was currently indicating it was worth; indeed, they demanded the same appreciation that had been the rule for the past twenty years, not recognizing the new reality. That’s fine. That’s what I’ve been trying to teach you with the thousands of articles that have been published. Although I trust my own analysis (this is what I do for a living – valuing assets, buying them at attractive levels, and generating profit on those capital commitments), they had arrived at their own estimate of replacement value for the property. They will now either have to continue holding the real estate, wait for an offer that they think is more inline with their estimate of value, or be forced into a sale if they can’t hold out until the market recovers.

Now, here’s where most people make huge errors that cost them years, even decades, of wealth building effort. If they had owned a basket of stocks – say, shares of Wal-Mart, General Electric, Johnson & Johnson, and U.S. Bancorp – and they had experienced a drop of 10% or 20%, let alone the 50% drubbing many equities have taken over the past year, it’s unlikely that these same people would apply a rational disposition to their portfolio like they did their house. They wouldn’t research the valuation of comparable businesses to each of those they owned, estimate what they think their share of those businesses was, and then refuse to sell (or better yet, buy more while it was cheap) until it reflected a conservative estimate of intrinsic value.

Instead, it’s likely that they would be more likely to sell the further prices fell because they trusted their neighbor’s estimate of what their property is worth instead of their own, cold, dispassionate calculation. I wrote you a few weeks ago and told you that if you were selling your 401(k) assets, people like me were out there buying them in the midst of all the fear. In a few years, you would wonder why we had gotten substantially richer.

The bottom line: You must assess all of the assets in your life based on their estimated intrinsic value. There’s nothing more irrational than saying, “My accounts are down $10,000 or $100,000 or $500,000! What do I do?” If you are invested in a broad-based, low-cost index fund, falling prices are good for you in the long run. That’s because the dividend yield on your portfolio will increase, allowing you to purchase more shares with your reinvested earnings. Your regular contributions will also purchase more shares. This is the secret to building equity, which is the surefire way to building wealth.

Before You Open a Brokerage Account

Before you can begin investing, you must open a brokerage account (for those of you who don't know what this is, read the article "What is a Broker" in the Beginner's Corner). As an investor, choosing a broker is one of the most important decisions you'll have to make. Here are five things you want to look for before you open an account.

1. Full Service Broker vs. Discount Broker

There are two different types of brokers; traditional (also known as "full service") and discount. If you open decide to open an account with a traditional brokerage firm, you will work one-on-one with a personal stock broker. He or she will offer investment ideas, prepare reports about your portfolio, give you a run-down of how well your investments are doing, and generally be available with a single phone call or email to buy or sell stocks, bonds, mutual funds, or other investments for your account. In addition, traditional brokers offer a variety of different research sources to their customers. In exchange for this one-on-one service and guidance, you will be charged a significantly higher commission (we talk more about the price consideration below.) A few examples of this type of brokerage firm are A.G. Edwards, Morgan Stanley Dean Witter, and Merrill Lynch. (*Note: Merrill Lynch now offers both full service and discount brokerage accounts to customers.)

Discount brokers, on the other hand, are geared toward the do-it-yourself investor. Generally, they will not offer investment advice. They will simply execute orders once you've decided to buy or sell an investment. Instead of working with the same stock broker, you will do most of your trading online, or if you decide to call in your order, with the first available broker. Recently, discount firms have been offering research that is on par with those offered at the traditional brokerage firms. Some excellent examples of these types of brokers are E-Trade, Ameritrade, and TD Waterhouse, to name a few. In exchange for giving up personal contact with a regular broker, investors will be charged a significantly lower commission.

Commissions

Although the largest difference in between traditional and discount brokers is the cost of each transaction, differences in commission prices between two firms of the same kind can be tremendous. One discount broker may charge $30 per trade, whereas another may charge no more than $8. In some cases, the higher price means higher service, faster execution (i.e., your buy and sell orders are carried out in a shorter period of time), and more perks, but this is not always the case. That is why it is important to look around and compare brokerage firms before you open an account.

Minimum Opening Balance and Maintenance Fees

Each broker has a minimum opening balance requirement. Some are as low as $500, most are around $1,000, and several are higher. The general rule of thumb is you should have at least $1,000 when you go to open an account. Be careful though; some brokerage firms may have a low opening balance but will charge you a maintenance fee if your balance falls below a certain amount. Although the fee may be as little as five to fifteen dollars per quarter, it can significantly eat up your investment returns if you are just starting out (e.g., $60 per year in fees on $1,000 account balance is equal to 6% interest!)

Services, Perks, Research, and Investment Tools

No broker offers the exact same set of tools, research, and perks to their customers. Some will allow you to instantly log in to your account via the Internet and print out an analysis of your portfolio, view the balance of your account for the past six months, check your realized and unrealized gains, and view dividend records for the past few years. Others may be slim on features such as this, but offer amazing research that you can't get elsewhere. If execution time is important to you, check out the firm's policies. One online discount broker promises to execute your trade in 60 seconds or less, or you will not be charged a commission.
Lately, a lot of brokerages have begun offering Visa Check Cards which work exactly like a credit card. The difference is, the money you spend is taken directly out of your brokerage account. This way, you have the combined functionality of a checking / savings / money market account with a stocks / bonds investment account. It is tremendously convenient and can help simplify your finances. If you are looking for an all-in-one solution, an asset management account may be a more attractive alternative.

Online Availability - Interface and Ease Of Use

Before you open an account, you should fire up your favorite Internet browser and visit the web page of each of the brokerage firms you are considering. If you plan on doing a lot of your research or trading online, the feel of the site is going to be almost as important as the other benefits and services offered.

Understanding Intrinsic Value and Why Different Businesses Deserve Different Valuations

Readers of this site know that I’m an unabashed, dyed-in-the-wool value investor. Yet, a mistake many people tend to make is to associate this with only buying low price-to-earnings ratio stocks. While this approach has certainly generated above-average returns over long-periods of time (see Tweedy, Browne & Company’s publication What Has Worked in Investing), it is not the ideal situation.

Understanding Intrinsic Value and Why Different Businesses Deserve Different Valuations

At its core, the basic definition for the intrinsic value of every asset in the world is simple: It is all of the cash flows that will be generated by that asset discounted back to the present moment at an appropriate rate that factors in opportunity cost (typically measured against the risk-free U.S. Treasury) and inflation. Figuring out how to apply that to individual stocks can be extremely difficult depending upon the nature and economics of the particular business. As Benjamin Graham, the father of the security analysis industry, entreated his disciples, however, one need not know the exact weight of a man to know that he is fat or the exact age of a woman to know she is old. By focusing only on those opportunities that are clearly and squarely in your circle of competence and you know to be better than average, you have a much higher likelihood of experiences good, if not great, results over long periods of time.

All businesses are not created equal. An advertising firm that requires nothing more than pencils and desks is inherently a better business than a steel mill that, just to begin operating, requires tens of millions of dollar or more in startup capital investment. All else being equal, an advertising firm rightfully deserves a higher price to earnings multiple because in an inflationary environment, the owners (shareholders) aren’t going to have to keep shelling out cash for capital expenditures to maintain the property, plant, and equipment. This is also why intelligent investors must distinguish between the reported net income figure and true, “economic” profit, or “owner” earnings as Warren Buffett has called it. These figures represent the amount of cash that the owner could take out of the business and reinvest elsewhere or spend on diamonds, houses, planes, charitable donations, or gold-plated fine china.

In other words, it doesn’t matter what the reported net income is, but rather, how many hamburgers the owner can buy relative to his investment in the business. That’s why capital-intensive enterprises are typically anathema to long-term investors as they realize very little of their reported income will translate into tangible, liquid wealth because of a very, very important basic truth: Over the long-term, the rise in an investor’s net worth is limited to the return on equity generated by the underlying company. Anything else, such as relying on a bull market or that the next person in line will pay more for the company than you (the appropriately dubbed “greater fool” theory) is inherently speculative. I don’t know about you, but I don’t want to be in doubt about my ability to retire comfortably.

The result of this fundamental viewpoint is that two businesses might have identical earnings of $10 million, yet Company ABC may generate only $5 million and the other, Company XYZ, $20 million in “owner earnings”. Therefore, Company XYZ could have a price-to-earnings ratio four times higher than its competitor ABC yet still be trading at the same value.

The Importance of a Margin of Safety

The danger with this approach is that, if taken too far as human psychology is apt to do, is that any basis for rational valuation is quickly thrown out the window. Typically, if you are paying more than 15x earnings for a company, you need to seriously examine the underlying assumptions you have for its future profitable and intrinsic value. With that said, a wholesale rejection of shares over that price is not wise. A year ago, I remember reading a story detailing that in the 1990’s, the cheapest stock in retrospect was Dell Computers at 50x earnings. That’s right – had you bought it at that price, you would have absolutely crushed nearly every other investment because the underlying profits really did live up to Wall Street’s expectations, and then some! However, would you have been comfortable having your entire net worth invested in such a risky business if you didn’t understand the economics of the computer industry, the future drivers of demand, the commodity nature of the PC and the low-cost structure that gives Dell a superior advantage over competitors, and the distinct possibility that one fatal mistake could wipeout a huge portion of your net worth? Probably not.

The Ideal Compromise

The perfect situation is when you get an excellent business that generates copious amounts of cash with little or no capital investment on the part of the owners relative to the profits at a steep discount to intrinsic value, such as American Express during the Salad Oil scandal or Wells Fargo when it traded at 5x earnings during the real estate crash of the late 1980’s and early 1990’s. A nice test you can use is to close your eyes and try to imagine what a business will look like in ten years; do you think it will be bigger and more profitable? What about the profits – how will they be generated? What are the threats to the competitive landscape? An example that might help: Do you think Blockbuster will still be the dominant video rental franchise? Personally, it is my belief that the model of delivering plastic disks is entirely antiquated and as broadband becomes faster and faster, the content will eventually be streamed, rented, or purchased directly from the studios without any need for a middle man at all, allowing the creators of content to keep the entire capital. That would certainly cause me to require a much larger margin of safety before buying into an enterprise that faces such a very real technological obsolesce problem.

10 reasons to invest in gold coins

There are many reasons today in this global economy to invest in Gold. I’m not just talking gold stocks but actual physical gold coins, jewelry, ingots, & gold stocks. Since ancient times gold coins have been a accepted and valid form of currency. Gold in time will always increase in value due to devaluation of paper money. So a good way to improve your portfolio is to invest inn new and old gold coins. You can purchase them from pawn shops to online market places including EBay. Thus by keeping coins or gold investments with in your portfolio you can be assured that the value of your portfolio will increase over time. Look at the top Ten reasons to invest in gold today

Here is a list of the top 10 reasons to invest in gold coins:

1. Gold coins are a liquid investment. You can sell the metal to anyone and receive cash for it.

2. You are almost guaranteed a profit from having gold investments. The investment of gold coins increases in value. In February of 2004 gold was going for 400 an ounce. Just four short years later its trading in the 800-1000 dollar range per ounce. If your investment is in coins over time coins become scarce so investment will always increase.

3. There is a small comfort level in having coins or bullion in you portfolio. You can rest assured even if the economy is tough, you have a safer investment.

4. Certified gold coins, have limited mintages, governments only release small quantities of coins at one time to help increase the value of each individual coin

5. Coins are easily transportable either in a small bag or if selling them you are able to ship them worldwide for a lower cost.

6. Gold coins are simply stunning to look at. The greatest design is considered that of Augustus St. Gaudens who was commissioned by the American Mint to design the famous Double Eagle Coin from 1905-1907. In my opinion all the American coins are stunning, look for Indian Heads, Quarter Eagles; Eagles, and Double Eagles, coins are always a great investment.

7. Certified gold coins cannot be confiscated by any government agency just based on the premise that it needs them. “Should something like madoff happen they probably will take them away pending legal issues.”

8. Gold is also a legal asset to own where regular money is owned by the government and gold is the last legal asset to own in the world.

9. Gold coins are easily obtained easy to purchase and easy to sell. There are many places online and in your local markets to purchase and trade them.

10. Gold coins are fun to collect, so collect them first and foremost for the enjoyment.

There are three categories of financial capital that are important for you to know when analyzing your business or a potential investment. They each have their own benefits and characteristics.
Equity Capital

Otherwise known as “net worth” or “book value”, this figure represents assets minus liabilities. There are some businesses that are funded entirely with equity capital (cash written by the shareholders or owners into the company that have no offsetting liabilities.) Although it is the favored form for most people because you cannot go bankrupt, it can be extraordinarily expensive and require massive amounts of work to grow your enterprise. Microsoft is an example of such an operation because it generates high enough returns to justify a pure equity capital structure.

Debt Capital

This type of capital is infused into a business with the understanding that it must be paid back at a predetermined future date. In the meantime, the owner of the capital (typically a bank, bondholders, or a wealthy individual), agree to accept interest in exchange for you using their money. Think of interest expense as the cost of “renting” the capital to expand your business; it is often known as the cost of capital. For many young businesses, debt can be the easiest way to expand because it is relatively easy to access and is understood by the average American worker thanks to widespread home ownership and the community-based nature of banks. The profits for the owners is the difference between the return on capital and the cost of capital; for example, if you borrow $100,000 and pay 10% interest yet earn 15% after taxes, the profit of 5%, or $5,000, would not have existed without the debt capital infused into the business.
Specialty Capital

This is the gold standard. There are a few sources of capital that have almost no economic cost and can take the limits off of growth. They include things such as a negative cash conversion cycle (vendor financing), insurance float, etc.

· Negative Cash Conversion (Vendor Financing) Imagine you own a retail store. To expand your business, you need $1 million in capital to open a new location. Most of this is the result of needing to go out, buy your inventory, and stock your shelves with merchandise. You wait and hope that one day customers come in and pay you. In the meantime, you have capital (either debt or equity capital) tied up in the business in the form of inventory.

Now, imagine if you could get your customers to pay you before you had to pay for your merchandise. This would allow you to carry far more merchandise than your capitalization structure would otherwise allow. AutoZone is a great example; it has convinced its vendors to put their products on its shelves and retain ownership until the moment that a customer walks up to the front of one of AutoZone’s stores and pays for the goods. At that precise second, the vendor sells it to AutoZone which in turn sells it to the customer.

This allows them to expand far more rapidly and return more money to the owners of the business in the form of share repurchases (cash dividends would also be an option) because they don’t have to tie up hundreds of millions of dollars in inventory. In the meantime, the increased cash in the business as a result of more favorable vendor terms and / or getting your customers to pay you sooner allows you to generate more income than your equity or debt alone would permit. Typically, vendor financing can be measured in part by looking at the percentage of inventories to accounts payable (the higher the percentage, the better), and analyzing the cash conversion cycle; the more days “negative”, the better. Dell Computer was famous for its nearly two or three week negative cash conversion cycle which allowed it to grow from a college dorm room to the largest computer company in the world with little or no debt in less than a single generation.

· FloatInsurance companies that collect money and can generate income by investing the funds before paying it them out in the future in the form of policyholder payouts when a car is damaged, or replacing a home when destroyed in a tornado, are in a very good place. As Buffett describes it, float is money that a company holds but does not own. It has all of the benefits of debt but none of the drawbacks; the most important consideration is the cost of capital – that is, how much money it costs the owners of a business to generate float. In exceptional cases, the cost can actually be negative; that is, you are paid to invest other people’s money plus you get to keep the income from the investments. Other businesses can develop forms of float but it can be very difficult.

Sweat Equity

There is also a form of capital known as sweat equity which is when an owner bootstraps operations by putting in long hours at a low rate of pay per hour making up for the lack of capital necessary to hire sufficient employees to do the job well and let them work an ordinarily forty hour workweek. Although it is largely intangible and does not count as financial capital, it can be estimated as the cost of payroll saved as a result of excess hours worked by the owners. The hope is that the business will grow fast enough to compensate the owner for the low-pay, long-hour sweat equity infused into the enterprise.

Are You Gambling or Investing?

Mention the stock market or investments and some families or organizations will react with loathing and disgust, likely drawing parallels between a trip to Vegas and a call to a broker. A good deal of this is due to the cultural aftermath of the Great Depression and the simultaneous drop in the financial markets as a result from the excess of the 1920’s. Yet, the primary reason for this attitude is a complete lack of understanding regarding accounting, finance, economics, and basic compounding. Yet, this attitude isn’t entirely irrational. Gasoline, for example, can be extraordinarily helpful if you are trying to power a tractor that will provide food to thousands of people. But in the hands of rash, uninformed people, you could end up with horrific physical damage and even the loss of life. Without an understanding of what exactly a stock is, outside of an indexing strategy, the market can be a very dangerous place. (For information on what stocks are and how they are created.

How do you know if you are gambling or investing? Here are a few simple tests to give you a clue.

1. Do you have a clear reason for investing in a particular stock or security, or are you just going on your “gut”?

In every case, you should be able to write out a short, simple explanation that makes sense to the average high school student as to why you are purchasing a specific investment. It should lay bare your expectations and they should be reasonable.

Here’s an example. Say you were interested in acquiring shares of U.S. Bank for your IRA. You might write something like this, “As of the market close on Sunday, July 1, 2007, the stock traded at $32.95 per share, or a price-to-earnings ratio of 12.66 as a result of $2.60 earnings per share. Taking 1 divided by the p/e ratio of 12.66, we get .0789, or 7.89%. This figure is known as the earnings yield. When compared to the long-term yield on the risk-free U.S. Treasury bonds of 5.22%, this amounts to a 2.67% higher rate for the stock. This is supposed to compensate me for inflation and the risk of investing in a stock. In and of itself, this is insufficient. However, management has vowed to return 80% of earnings to shareholders each year and expects to maintain growth in earnings per share of 10%. In other words, I am buying an ‘equity bond’, to borrow a phrase from Warren Buffett, that currently yield 7.89%, which will grow earnings per share of no more than 10% for the next few years (and probably top out at 3% thereafter.) In the meantime, the 4.8% dividend yield can be used to acquire more shares and, because they are held in an IRA, will not have taxes assessed against them. Compared to the S&P 500, this appears to offer an attractive value. I’m not particularly concerned about competition as the bank has an enormous base of branches throughout communities in the Midwest and beyond. With metrics that are typically the highest in the big banking field – return on assets, return on equity, and a stellar efficiency ratio – it appears management is clearly doing right by owners. It’s unlikely I’ll have a lollapalooza bonanza on an investment like this, but it does offer a conservative way to compound my capital in a manner that appears to be above average compared to the broader index if left alone in an account with instructions that all dividends be reinvested.

2. Are you hoping to profit from a move in share price over the short-term, or from the long-term performance of the business?

If you ultimately expect to earn your profits in the market because a stock is going to go up as investors find it more fashionable, rather than an improvement in the long-term performance of the underlying business, you are gambling. One of the stupidest reasons to buy a stock is because you believe one of the company’s products or services is going to be a huge hit. That alone could be a reason if you believed it would result in underlying profits increasing on a per-share basis.

When you bank on someone else paying a higher price (the so-called “greater fool” theory), rather than selecting a demonstrably superior business, you are putting your financial well being in jeopardy.

3. Do you utilize leverage to amplify your return?

Margin debt is dangerous because it’s so easy to access. If you approach a traditional bank, you’re going to have to complete a myriad of paperwork, prove you have the cash flow to repay the loan, post collateral in the event you are unable to meet your obligation, go through a background check, and a whole lot more. With a brokerage firm, you may have $100,000 in assets in an account and instantly be able to borrow another $100,000, effectively leveraging your funds on a 2-1 basis. The problem, of course, comes if stocks fall – which they are often prone to do. In this example, a 20% drop would result in $40,000 of losses for you on your $100,000 equity, bringing your net account equity balance to $60,000.

With results like that, you may be right in the long-run, but, as the Wall Street expression goes, you’ll be explaining it to someone in the poor house. You must play your hand in a way that no matter what happens in the financial markets, you and your family will still have enough chips to participate in the recovery when it comes. We’re big fans of another Buffett assertion, “Don’t risk what you have and need for what you don’t have and don’t need.” It just doesn’t make sense to put yourself in a position where being wrong can cost you your standard of living.
If you are determined to put as much capital to work for you as possible, focus your energy on generating more cash in your professional life either by working more hours, starting a side business, cutting expenses, etc. It may take you a bit longer to get to your ultimate goal. But it will still be a much shorter journey than if you are completely or partially wiped out as a result of borrowing against your securities.