Since there was some confusion about my last post, I figured I may as well clarify things the best I can.
Buffett is not suggesting that it is possible for you to provide 100% assurance against loses. It's all about calculated risks. However, there are some methods that can be used to help reduce the potential for loses (remember the all important principle of margin of safety?).
You've got to read between the lines here. It's really showing you Buffett's view when it comes to investing. Since I know a little more than the average person I'll tell you a few things about him:
- He's not into taking gambles. He likes to invest in companies that are solid and have a proven record of success -- not placing wagers on start-ups.
- He looks for situations where heads he wins, tails he wins too (yes, they exist). If that is not possible, then heads he wins, and tails he doesn't lose much.
- Buffett often remarks that his strategy involves significantly less risk than other methods of investing (and we can all see that it returns significantly more as well).
- Early in his investing career (there are 2 general phases: 1. partnerships, 2. Berkshire Hathaway -- that's a story for another time) he told his shareholders that he planned to achieve a long-term above average return that will likely be made up of 1. returns that approximately equal the average during prosperous periods, and 2. returns that are better than average during down markets (don't lose money!). This would work out to above average returns.
I could list more, but I just got home from an exam and I am tired. And you're probably all tired of this topic already! Have a good night everyone.
Showing posts with label Finance. Show all posts
Showing posts with label Finance. Show all posts
Friday, February 25, 2011
Thursday, February 24, 2011
Lessons from the Legends: Buffett on The Two Most Important Rules of Investing
Buffett has two very important rules when it comes to equity investing. Fortunately, they are easy enough for a monkey to understand and remember.
"Rule No. 1: Never lose money.
Rule No. 2: Never forget rule no. 1."
I would conclude by saying don't forget these 2 rules... but rule no. 2 already covers that.
"Rule No. 1: Never lose money.
Rule No. 2: Never forget rule no. 1."
I would conclude by saying don't forget these 2 rules... but rule no. 2 already covers that.
Wednesday, February 23, 2011
Lessons from the Legends: A Benjamin Graham Quote
In any value investors mind, it is a crime that I have not even mentioned Benjamin Graham yet. Why? Because he is the father of value investing! He is the guy who taught Warren Buffett in university and gave him the initial investing framework. He is a true legend of the practise.
Graham: “A stock doesn’t become a sound investment merely because it can be bought at close to its asset value. The investor should demand, in addition, a satisfactory ratio of earnings to price, a sufficiently strong financial position, and the prospect that its earnings will at least be maintained over the years”
You'll notice that this quote pretty much summarizes my last post. Don't worry, there will be a better profile on Ben Graham to come.
I'd also like to point out that EVERY investor I mention in this blog has a LONG record of beating the market. These guys are the real deal. Not the hot shot equity or forex trader who has 1 or 2 good years, but a poor long-term record.
Graham: “A stock doesn’t become a sound investment merely because it can be bought at close to its asset value. The investor should demand, in addition, a satisfactory ratio of earnings to price, a sufficiently strong financial position, and the prospect that its earnings will at least be maintained over the years”
You'll notice that this quote pretty much summarizes my last post. Don't worry, there will be a better profile on Ben Graham to come.
I'd also like to point out that EVERY investor I mention in this blog has a LONG record of beating the market. These guys are the real deal. Not the hot shot equity or forex trader who has 1 or 2 good years, but a poor long-term record.
Tuesday, February 22, 2011
Lessons from the Legends: Why Buffett Loves Investing in Insurance Companies (Part 3)
This is the third and final post of "Lessons from the Legends: Why Buffett Loves Investing in Insurance Companies" (find Part 1, & Part 2 here)
As I mentioned in "5 Steps to Successful Equity Investing" GEICO was a dear of Buffett's (if I remember correctly, it was one of his first investments as an analyst for Benjamin Graham). I also mentioned reinsurance. It's one of the most significant parts of Berkshire Hathaway, and he talks about it here!
Once again, I want to stress that the below are the wise words of Mr. Buffet, NOT mine. He can explain things far better than I could ever dream to.
-------------------
GEICO’s Strategy: Foot-to-the-Floor
Another way to prosper in a commodity-type business is to be the low-cost operator. Among auto insurers operating on a broad scale, GEICO holds that cherished title. For NICO, as we have seen, an ebb-and-flow business model makes sense. But a company holding a low-cost advantage must pursue an unrelenting foot-to-the-floor strategy. And that’s just what we do at GEICO.
Originally, GEICO mailed its low-cost message to a limited audience of government employees. Later, it widened its horizons and shifted its marketing emphasis to the phone, working inquiries that came from broadcast and print advertising. And today the Internet is coming on strong. Between 1936 and 1975, GEICO grew from a standing start to a 4% market share, becoming the country’s fourth largest auto insurer. During most of this period, the company was superbly managed, achieving both excellent volume gains and high profits. It looked unstoppable. But after my friend and hero Lorimer Davidson retired as CEO in 1970, his successors soon made a huge mistake by underreserving for losses. This produced faulty cost information, which in turn produced inadequate pricing. By 1976, GEICO was on the brink of failure.
Jack Byrne then joined GEICO as CEO and, almost single-handedly, saved the company by heroic efforts that included major price increases. Though GEICO’s survival required these, policyholders fled the company, and by 1980 its market share had fallen to 1.8%. Subsequently, the company embarked on some unwise diversification moves. This shift of emphasis away from its extraordinary core business stunted GEICO’s growth, and by 1993 its market share had grown only fractionally, to 1.9%. Then Tony Nicely took charge. And what a difference that’s made: In 2005 GEICO will probably secure a 6% market share.
* * * * * * * * * * * *
General Reinsurance: Quality not Commodity
Reinsurance – insurance sold to other insurers who wish to lay off part of the risks they have assumed – should not be a commodity product. At bottom, any insurance policy is simply a promise, and as everyone knows, promises vary enormously in their quality.
At the primary insurance level, nevertheless, just who makes the promise is often of minor importance. In personal-lines insurance, for example, states levy assessments on solvent companies to pay the policyholders of companies that go broke. In the business-insurance field, the same arrangement applies to workers’ compensation policies. “Protected” policies of these types account for about 60% of the property-casualty industry’s volume. Prudently-run insurers are irritated by the need to subsidize poor or reckless management elsewhere, but that’s the way it is.
Other forms of business insurance at the primary level involve promises that carry greater risks for the insured. When Reliance Insurance and Home Insurance were run into the ground, for example, their promises proved to be worthless. Consequently, many holders of their business policies (other than those covering workers’ compensation) suffered painful losses.
The solvency risk in primary policies, however, pales in comparison to that lurking in reinsurance policies. When a reinsurer goes broke, staggering losses almost always strike the primary companies it has dealt with. This risk is far from minor: GEICO has suffered tens of millions in losses from its careless selection of reinsurers in the early 1980s.
Were a true mega-catastrophe to occur in the next decade or two – and that’s a real possibility – some reinsurers would not survive. The largest insured loss to date is the World Trade Center disaster, which cost the insurance industry an estimated $35 billion. Hurricane Andrew cost insurers about $15.5 billion in 1992 (though that loss would be far higher in today’s dollars). Both events rocked the insurance and reinsurance world. But a $100 billion event, or even a larger catastrophe, remains a possibility if either a particularly severe earthquake or hurricane hits just the wrong place. Four significant hurricanes struck Florida during 2004, causing an aggregate of $25 billion or so in insured losses. Two of these – Charley and Ivan – could have done at least three times the damage they did had they entered the U.S. not far from their actual landing points.
Many insurers regard a $100 billion industry loss as “unthinkable” and won’t even plan for it. But at Berkshire, we are fully prepared. Our share of the loss would probably be 3% to 5%, and earnings from our investments and other businesses would comfortably exceed that cost. When “the day after” arrives, Berkshire’s checks will clear.
Though the hurricanes hit us with a $1.25 billion loss, our reinsurance operations did well last year. At General Re, Joe Brandon has restored a long-admired culture of underwriting discipline that, for a time, had lost its way. The excellent results he realized in 2004 on current business, however, were offset by adverse developments from the years before he took the helm.
As I mentioned in "5 Steps to Successful Equity Investing" GEICO was a dear of Buffett's (if I remember correctly, it was one of his first investments as an analyst for Benjamin Graham). I also mentioned reinsurance. It's one of the most significant parts of Berkshire Hathaway, and he talks about it here!
Once again, I want to stress that the below are the wise words of Mr. Buffet, NOT mine. He can explain things far better than I could ever dream to.
-------------------
GEICO’s Strategy: Foot-to-the-Floor
Another way to prosper in a commodity-type business is to be the low-cost operator. Among auto insurers operating on a broad scale, GEICO holds that cherished title. For NICO, as we have seen, an ebb-and-flow business model makes sense. But a company holding a low-cost advantage must pursue an unrelenting foot-to-the-floor strategy. And that’s just what we do at GEICO.
Originally, GEICO mailed its low-cost message to a limited audience of government employees. Later, it widened its horizons and shifted its marketing emphasis to the phone, working inquiries that came from broadcast and print advertising. And today the Internet is coming on strong. Between 1936 and 1975, GEICO grew from a standing start to a 4% market share, becoming the country’s fourth largest auto insurer. During most of this period, the company was superbly managed, achieving both excellent volume gains and high profits. It looked unstoppable. But after my friend and hero Lorimer Davidson retired as CEO in 1970, his successors soon made a huge mistake by underreserving for losses. This produced faulty cost information, which in turn produced inadequate pricing. By 1976, GEICO was on the brink of failure.
Jack Byrne then joined GEICO as CEO and, almost single-handedly, saved the company by heroic efforts that included major price increases. Though GEICO’s survival required these, policyholders fled the company, and by 1980 its market share had fallen to 1.8%. Subsequently, the company embarked on some unwise diversification moves. This shift of emphasis away from its extraordinary core business stunted GEICO’s growth, and by 1993 its market share had grown only fractionally, to 1.9%. Then Tony Nicely took charge. And what a difference that’s made: In 2005 GEICO will probably secure a 6% market share.
* * * * * * * * * * * *
General Reinsurance: Quality not Commodity
Reinsurance – insurance sold to other insurers who wish to lay off part of the risks they have assumed – should not be a commodity product. At bottom, any insurance policy is simply a promise, and as everyone knows, promises vary enormously in their quality.
At the primary insurance level, nevertheless, just who makes the promise is often of minor importance. In personal-lines insurance, for example, states levy assessments on solvent companies to pay the policyholders of companies that go broke. In the business-insurance field, the same arrangement applies to workers’ compensation policies. “Protected” policies of these types account for about 60% of the property-casualty industry’s volume. Prudently-run insurers are irritated by the need to subsidize poor or reckless management elsewhere, but that’s the way it is.
Other forms of business insurance at the primary level involve promises that carry greater risks for the insured. When Reliance Insurance and Home Insurance were run into the ground, for example, their promises proved to be worthless. Consequently, many holders of their business policies (other than those covering workers’ compensation) suffered painful losses.
The solvency risk in primary policies, however, pales in comparison to that lurking in reinsurance policies. When a reinsurer goes broke, staggering losses almost always strike the primary companies it has dealt with. This risk is far from minor: GEICO has suffered tens of millions in losses from its careless selection of reinsurers in the early 1980s.
Were a true mega-catastrophe to occur in the next decade or two – and that’s a real possibility – some reinsurers would not survive. The largest insured loss to date is the World Trade Center disaster, which cost the insurance industry an estimated $35 billion. Hurricane Andrew cost insurers about $15.5 billion in 1992 (though that loss would be far higher in today’s dollars). Both events rocked the insurance and reinsurance world. But a $100 billion event, or even a larger catastrophe, remains a possibility if either a particularly severe earthquake or hurricane hits just the wrong place. Four significant hurricanes struck Florida during 2004, causing an aggregate of $25 billion or so in insured losses. Two of these – Charley and Ivan – could have done at least three times the damage they did had they entered the U.S. not far from their actual landing points.
Many insurers regard a $100 billion industry loss as “unthinkable” and won’t even plan for it. But at Berkshire, we are fully prepared. Our share of the loss would probably be 3% to 5%, and earnings from our investments and other businesses would comfortably exceed that cost. When “the day after” arrives, Berkshire’s checks will clear.
Though the hurricanes hit us with a $1.25 billion loss, our reinsurance operations did well last year. At General Re, Joe Brandon has restored a long-admired culture of underwriting discipline that, for a time, had lost its way. The excellent results he realized in 2004 on current business, however, were offset by adverse developments from the years before he took the helm.
Sunday, February 20, 2011
Lessons from the Legends: Why Buffett Loves Investing in Insurance Companies (Part 1)
I was going to write up this post myself, so I went online to confirm my facts. I found an article that explains it far better than I could, so why try to reinvent the wheel? I've gone through it and included only the most important snippets of information.
These snippets are taken from a post on the Insurance Journal, but they actually took the information from one of Berkshire Hathaway's annual shareholder letters.
ENJOY!!
--------------------------------------
Insurance has been Berkshire’s core operating business since it purchased National Indemnity, a commercial auto and general liability insurer, in 1967. Insurance has supplied the “fountain of funds” Buffett uses to buy other businesses and securities. Among Berkshire’s other insurance holdings today are GEICO, a direct provider of auto insurance, and General Reinsurance.
The Power of Float
The source of our insurance funds is “float,” which is money that doesn’t belong to us but that we temporarily hold. Most of our float arises because (1) premiums are paid upfront though the service we provide – insurance protection – is delivered over a period that usually covers a year and; (2) loss events that occur today do not always result in our immediately paying claims, because it sometimes takes many years for losses to be reported (asbestos losses would be an example), negotiated and settled. The $20 million of float that came with our 1967 purchase (National Indemnity- NICO) has now increased – both by way of internal growth and acquisitions – to $46.1 billion.
Float is wonderful – if it doesn’t come at a high price. Its cost is determined by underwriting results, meaning how the expenses and losses we will ultimately pay compare with the premiums we have received. When an underwriting profit is achieved – as has been the case at Berkshire in about half of the 38 years we have been in the insurance business – float is better than free. In such years, we are actually paid for holding other people’s money. For most insurers, however, life has been far more difficult: In aggregate, the property-casualty industry almost invariably operates at an underwriting loss. When that loss is large, float becomes expensive, sometimes devastatingly so.
These snippets are taken from a post on the Insurance Journal, but they actually took the information from one of Berkshire Hathaway's annual shareholder letters.
ENJOY!!
--------------------------------------
Insurance has been Berkshire’s core operating business since it purchased National Indemnity, a commercial auto and general liability insurer, in 1967. Insurance has supplied the “fountain of funds” Buffett uses to buy other businesses and securities. Among Berkshire’s other insurance holdings today are GEICO, a direct provider of auto insurance, and General Reinsurance.
The Power of Float
The source of our insurance funds is “float,” which is money that doesn’t belong to us but that we temporarily hold. Most of our float arises because (1) premiums are paid upfront though the service we provide – insurance protection – is delivered over a period that usually covers a year and; (2) loss events that occur today do not always result in our immediately paying claims, because it sometimes takes many years for losses to be reported (asbestos losses would be an example), negotiated and settled. The $20 million of float that came with our 1967 purchase (National Indemnity- NICO) has now increased – both by way of internal growth and acquisitions – to $46.1 billion.
Float is wonderful – if it doesn’t come at a high price. Its cost is determined by underwriting results, meaning how the expenses and losses we will ultimately pay compare with the premiums we have received. When an underwriting profit is achieved – as has been the case at Berkshire in about half of the 38 years we have been in the insurance business – float is better than free. In such years, we are actually paid for holding other people’s money. For most insurers, however, life has been far more difficult: In aggregate, the property-casualty industry almost invariably operates at an underwriting loss. When that loss is large, float becomes expensive, sometimes devastatingly so.
Saturday, February 19, 2011
5 Steps to Successful Equity Investing
I'm still trying to introduce the ideas behind value investing, so these 6 steps are very general. In future posts I will go into more detail on each and every step, so don't worry.
Big picture first, then details. Remember, in the most basic sense we are trying to by anything something that is worth $1 for $0.66. It can be stocks, corporate debt, etc. This list is mostly directed at stocks (equities), but some tweaking can help with other securities.
Enough blabbing, onto the list:
Step 1: Identify Potential/Create a List of Potentially Undervalued Stocks
- Look at ‘daily/weekly low’ lists in Wall Street Journal, Investor’s Business Daily, Financial Times, other newspapers, internet sources such as Barron’s.
- Financially distressed/bankrupt securities (note, this takes more extensive knowledge)
- Other special situations such as spin-offs (what's a spin-off?)
Step 2: Evaluate the Balance Sheet/Foundation (look for red flags)
- The balance sheet shows the financial position/solvency of a company
- Gives an idea of actual worth, how much it owes, and what resources it has going forward
- Basically the same form filled in for a loan
- Make sure it’s not overburdened with debt
- Make sure has enough capital to stay in business during bad times
Step 3: Evaluating Earnings Power/Prospects (lifeblood of company)
- Use “normal”/adjusted earnings for all these calculations – not simply last years net income
- Adjusted means you remove non cash items (e.g. depreciation), non-recurring/extraordinary items (e.g. large one time write-off), etc
- When we say adjusted earnings, we basically mean free cash flow (money that is available to shareholders basically)
Step 4: Come Up With Questions to Understand Competitive Position & Growth Prospects
- I'm going to do a detailed post on this soon, so for now I'll leave it at that
Step 5: Step 5: Get Info Through the “Scuttlebutt” Method (from Phil Fisher)
- "Scuttlebutt" is basically Fisher's way for saying you need to ask important questions to customers, suppliers, employees (& ex-employees), management, competitors, and anyone else who understands the company/industry and may have insights
- One of Fisher’s favourite questions for top executives: "What do you consider to be the most important long-range problem facing your company?"
Upcoming posts:
"Why Buffett Loves Investing in Insurance Companies" (everything from auto insurance (GEICO was a dear of his) to MASSIVE reinsurance (reinsurance = insurance that is purchased by an insurance company (insurer) from another insurance company (re-insurer)) deals)
AND
"Understanding Student Loans and a Basic Analysis of Various Debt Instruments Available to You" (I see too many students on campus with a student loan of more than $100,000! The worst part is they don't know the details of that debt ... if ignorance is bliss, then bliss is expensive!)
Big picture first, then details. Remember, in the most basic sense we are trying to by anything something that is worth $1 for $0.66. It can be stocks, corporate debt, etc. This list is mostly directed at stocks (equities), but some tweaking can help with other securities.
Enough blabbing, onto the list:
Step 1: Identify Potential/Create a List of Potentially Undervalued Stocks
- Look at ‘daily/weekly low’ lists in Wall Street Journal, Investor’s Business Daily, Financial Times, other newspapers, internet sources such as Barron’s.
- Financially distressed/bankrupt securities (note, this takes more extensive knowledge)
- Other special situations such as spin-offs (what's a spin-off?)
Step 2: Evaluate the Balance Sheet/Foundation (look for red flags)
- The balance sheet shows the financial position/solvency of a company
- Gives an idea of actual worth, how much it owes, and what resources it has going forward
- Basically the same form filled in for a loan
- Make sure it’s not overburdened with debt
- Make sure has enough capital to stay in business during bad times
Step 3: Evaluating Earnings Power/Prospects (lifeblood of company)
- Use “normal”/adjusted earnings for all these calculations – not simply last years net income
- Adjusted means you remove non cash items (e.g. depreciation), non-recurring/extraordinary items (e.g. large one time write-off), etc
- When we say adjusted earnings, we basically mean free cash flow (money that is available to shareholders basically)
Step 4: Come Up With Questions to Understand Competitive Position & Growth Prospects
- I'm going to do a detailed post on this soon, so for now I'll leave it at that
Step 5: Step 5: Get Info Through the “Scuttlebutt” Method (from Phil Fisher)
- "Scuttlebutt" is basically Fisher's way for saying you need to ask important questions to customers, suppliers, employees (& ex-employees), management, competitors, and anyone else who understands the company/industry and may have insights
- One of Fisher’s favourite questions for top executives: "What do you consider to be the most important long-range problem facing your company?"
Upcoming posts:
"Why Buffett Loves Investing in Insurance Companies" (everything from auto insurance (GEICO was a dear of his) to MASSIVE reinsurance (reinsurance = insurance that is purchased by an insurance company (insurer) from another insurance company (re-insurer)) deals)
AND
"Understanding Student Loans and a Basic Analysis of Various Debt Instruments Available to You" (I see too many students on campus with a student loan of more than $100,000! The worst part is they don't know the details of that debt ... if ignorance is bliss, then bliss is expensive!)
Friday, February 18, 2011
Lessons from the Legends: Joel Greenblatt
This guy has an incredible strategy. It's so easy an elementary school aged child could follow it successfully.
It's based on two basic ideas. You want to invest in:
1. Good companies
2. Cheap companies
How does he measure this? How "good" a company is, is measured by its . A companies return on capital employed measures how good it is, while its price-earnings (PE) ratio (how much you pay per dollar of (adjusted) earnings) measures how cheap it is.
With this basic information he:
1. Takes a list of companies (list size depends on how small of a market cap you are willing to invest in (market cap = share price * # of shares outstanding))
2. Ranks each stock from 1 to n (with 1 being best, 2 being 2nd best, etc) on its return on capital employed and then again on its PE ratio.
3. Combine the two ranks for each company
4. Invest in the top ranking (combined ranks) 20-30 companies
5. Repeat each year
This is the simple method, a more advanced analyst can add some slightly more complicated steps. However, his data shows incredible returns when using this simple strategy.
Check out this video of him talking about his approach:
It's based on two basic ideas. You want to invest in:
1. Good companies
2. Cheap companies
How does he measure this? How "good" a company is, is measured by its . A companies return on capital employed measures how good it is, while its price-earnings (PE) ratio (how much you pay per dollar of (adjusted) earnings) measures how cheap it is.
With this basic information he:
1. Takes a list of companies (list size depends on how small of a market cap you are willing to invest in (market cap = share price * # of shares outstanding))
2. Ranks each stock from 1 to n (with 1 being best, 2 being 2nd best, etc) on its return on capital employed and then again on its PE ratio.
3. Combine the two ranks for each company
4. Invest in the top ranking (combined ranks) 20-30 companies
5. Repeat each year
This is the simple method, a more advanced analyst can add some slightly more complicated steps. However, his data shows incredible returns when using this simple strategy.
Check out this video of him talking about his approach:
Tuesday, February 15, 2011
Lessons from the Legends: Charlie Munger
In my mind, Charlie Munger is likely the second smartest investor in the world. He is the man that really brought a qualitative side of analysis into Warren Buffett's previously pure quantitative mindset.
He gives some simple but valuable insights in this video. You owe it to your future self and family to watch it!!
As he outlines, their approach to finding value is as simple as 4 steps:
Invest only in businesses:
1. You are capable of understanding
2. With intrinsic characteristics that give it a durable competitive advantage
3. With management in place who have a lot of integrity and talent
4. At a price that makes sense & gives margin of safety
He gives some simple but valuable insights in this video. You owe it to your future self and family to watch it!!
As he outlines, their approach to finding value is as simple as 4 steps:
Invest only in businesses:
1. You are capable of understanding
2. With intrinsic characteristics that give it a durable competitive advantage
3. With management in place who have a lot of integrity and talent
4. At a price that makes sense & gives margin of safety
Monday, February 14, 2011
Finally, an intro to Value Investing
I've been talking about long term investing and, more specifically, value investing. I suppose I should probably explain what the hell it is.
Value investing is a style of investing that uses fundamental analysis, which means basing your investment decisions on what is really happening with the business in question. This is in contrast to a technical analysis approach which looks at the (arbitrary) short term movements in a stocks price and tries to predict/profit from which way it will move next. In the short term, a stocks price movement absolutely does NOT always reflect the true nature of the business .. so why is it useful to us? It isn't. When a stock's price goes from $10 to $5 in a single day, it is almost always the case that the business itself did not have it's value cut in half within a single day. So why does the stock price get cut in half? Because the short-term market price is crazy!
The only way the price of a stock is useful to us is in comparing the true value you are getting in that business (slightly more advanced topic which I will cover later) relative to the price you can buy it for.
There are two principles to value investing:
1. Intrinsic value (this is the "true value of the business" that I alluded to above)
2. Margin of safety (you don't want to pay $1 for $1 worth of value)
You need to assess a companies intrinsic value and then purchase the stock IF you can buy it at a price that is less than or equal to about 2/3's of that intrinsic value. Believe it or not there are plenty of companies that you can purchase like this.. that is, you can buy $1 of value for only $0.66.
My next post will involve a more detailed (and coherent!) explanation of the margin of safety principle. For now I'll leave you with this interesting fact: Seth Klarman wrote a book entitled 'Margin of Safety,' but only published a limited number of copies. Value investors today are paying more than $500 for a copy of the book on eBay, Amazon, etc!! They must see A LOT of value in it to pay $500+ for it.
Value investing is a style of investing that uses fundamental analysis, which means basing your investment decisions on what is really happening with the business in question. This is in contrast to a technical analysis approach which looks at the (arbitrary) short term movements in a stocks price and tries to predict/profit from which way it will move next. In the short term, a stocks price movement absolutely does NOT always reflect the true nature of the business .. so why is it useful to us? It isn't. When a stock's price goes from $10 to $5 in a single day, it is almost always the case that the business itself did not have it's value cut in half within a single day. So why does the stock price get cut in half? Because the short-term market price is crazy!
The only way the price of a stock is useful to us is in comparing the true value you are getting in that business (slightly more advanced topic which I will cover later) relative to the price you can buy it for.
There are two principles to value investing:
1. Intrinsic value (this is the "true value of the business" that I alluded to above)
2. Margin of safety (you don't want to pay $1 for $1 worth of value)
You need to assess a companies intrinsic value and then purchase the stock IF you can buy it at a price that is less than or equal to about 2/3's of that intrinsic value. Believe it or not there are plenty of companies that you can purchase like this.. that is, you can buy $1 of value for only $0.66.
My next post will involve a more detailed (and coherent!) explanation of the margin of safety principle. For now I'll leave you with this interesting fact: Seth Klarman wrote a book entitled 'Margin of Safety,' but only published a limited number of copies. Value investors today are paying more than $500 for a copy of the book on eBay, Amazon, etc!! They must see A LOT of value in it to pay $500+ for it.
Sunday, February 13, 2011
Tax advantages of long term investing
I'd like to discuss the beauty that is called capital gains tax (it's beautiful relative to regular taxes anyway). What's so great about it? Well you are only taxed on HALF of your capital gains.
The basic math:
$1000 income from working (say 30% tax rate) = $300 tax bill ($1000*30%)
$1000 from capital gains (same 30% tax rate) = $150 tax bill ((1/2)*$1000*30%)
When you're investing for the long term, the majority of your wealth creation comes from capital gains. As a result you get to enjoy the very advantageous capital gains tax. Since it's long term you also don't pay the tax for a few years either. Deferred taxes at an advantageous rate? I'll take 3!
Check out this video showing the legendary Warren Buffett (he's probably my hero with Wolverine or something coming in a close second) talking about how he pays a lower % tax rate than his receptionist:
(I'm sort of technically challenged so I can't quite figure out how to insert a YouTube video here .. if anyone wants to let me know in a comment that would be greatly appreciated!!)
EDIT: You guys rock! Thanks for the help getting this video posted!!
The basic math:
$1000 income from working (say 30% tax rate) = $300 tax bill ($1000*30%)
$1000 from capital gains (same 30% tax rate) = $150 tax bill ((1/2)*$1000*30%)
When you're investing for the long term, the majority of your wealth creation comes from capital gains. As a result you get to enjoy the very advantageous capital gains tax. Since it's long term you also don't pay the tax for a few years either. Deferred taxes at an advantageous rate? I'll take 3!
Check out this video showing the legendary Warren Buffett (he's probably my hero with Wolverine or something coming in a close second) talking about how he pays a lower % tax rate than his receptionist:
(I'm sort of technically challenged so I can't quite figure out how to insert a YouTube video here .. if anyone wants to let me know in a comment that would be greatly appreciated!!)
EDIT: You guys rock! Thanks for the help getting this video posted!!
Saturday, February 12, 2011
Net Income for Which Purpose?
I'd like to make a brief post to point out an important difference between income for accounting purposes and income for tax purposes. In 99.99% of cases there is a difference between the income that companies report to their shareholders and the income they report for tax purposes.
Some of these differences are permanent while others are temporary. This means that at some point in the future, temporary difference will reverse while permanent differences will never reverse.
I'll outline a common example for each to clear things up a bit.
Temporary difference:
The amount of depreciation that a company claims in any given year is almost certain to be different under tax and accounting approaches. For tax purposes, a company may use a declining balance method at a prescribed rate depending on the type of asset (e.g. business vehicles are assigned to Class 10 and decline at 30% per year). On the other hand, under the generally accepted accounting principles (GAAP) which are used for accounting purposes, a company is likely to use a straight line amortization schedule (i.e. the depreciation reported on an asset is basically a set amount over its economic useful life).
The result of this is that in early years an asset is going to depreciated faster for tax purposes, which means that it will reverse in later years when the depreciation for accounting purposes will be higher. This leads to future income tax liabilities or assets to be reported on the balance sheet!
Permanent difference:
Meals & entertainment. Under GAAP, these expenses are fully deducted from income. For tax purposes, only 50% of these expenses can be deducted from income. The idea is that you can deduct the cost of entertaining clients (1/2 the bill), but cannot deduct your own meal (the other 1/2 of the bill)!
Some of these differences are permanent while others are temporary. This means that at some point in the future, temporary difference will reverse while permanent differences will never reverse.
I'll outline a common example for each to clear things up a bit.
Temporary difference:
The amount of depreciation that a company claims in any given year is almost certain to be different under tax and accounting approaches. For tax purposes, a company may use a declining balance method at a prescribed rate depending on the type of asset (e.g. business vehicles are assigned to Class 10 and decline at 30% per year). On the other hand, under the generally accepted accounting principles (GAAP) which are used for accounting purposes, a company is likely to use a straight line amortization schedule (i.e. the depreciation reported on an asset is basically a set amount over its economic useful life).
The result of this is that in early years an asset is going to depreciated faster for tax purposes, which means that it will reverse in later years when the depreciation for accounting purposes will be higher. This leads to future income tax liabilities or assets to be reported on the balance sheet!
Permanent difference:
Meals & entertainment. Under GAAP, these expenses are fully deducted from income. For tax purposes, only 50% of these expenses can be deducted from income. The idea is that you can deduct the cost of entertaining clients (1/2 the bill), but cannot deduct your own meal (the other 1/2 of the bill)!
Wednesday, February 9, 2011
Basic Finance Definitions
Before we get into the thick of finance, it would probably be helpful for me to define a few basic financial terms.
Money markets are financial markets where short-term debt securities (sometimes called money market instruments) are bought and sold. For example, a
Capital markets are financial markets where long-term debt and equity securities are bought and sold.
These can be either primary or secondary markets.
A primary market is where debt and equity securities are FIRST created. So when a corporation first sells it’s stock through an IPO (initial public offering), it is called a transaction within a primary market.
When that equity is then sold to someone else, it is done so in a secondary market. For example, the New York Stock Exchange would be considered a secondary market.
In order for a firms stock to actually be listed (stocks being traded) on an exchange, the firm must meet specific minimum criteria. Different exchanges, of course, have different criteria; some points of concern though are minimums in net tangible assets, pre-tax earnings, outstanding share market value, and more.
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