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Wednesday, December 26, 2007

2007 Year in Review

2007 was a very satisfactory year for me.

I generated significant market out-performance, and that came mostly by avoiding the things that did badly this year.

After waiting since 2004, this was finally the year when the mortgage bankers, mortgage insurers, bond insurers and other financial institutions reaped the consequences of their poor business practices. Although I did not short these investments, I was able to generate significant out-performance simply by avoiding the group.

Unfortunately, several of the Real Estate Investment Trusts (REITs) I invested in were also taken to the woodshed this year. In each case, I think the REITs I've chosen are the babies getting thrown out with the bathwater, and will almost certainly be market out-performers in the years to come.

I look forward eagerly to 2008 and beyond, when I think my out-performance will be generated not just by avoiding bad investments, but also because I've chosen great investments.

I believe 2008 will be another volatile year, as uncertainty about the economy and slowing corporate profits will lead to significant market moves both up and down. It should be a good year to be a bottom-up stock picker.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, December 21, 2007

Recession storm-clouds gathering

Although the latest GDP report showed the US economy grew at a blazing 4.9% in the 3rd quarter, the data looking forward is looking increasingly weak.

The Index of Leading Economic Indicators (LEI) has gone into negative territory. Our economy has gone into a recession every time the LEI has gone negative, except for once in the late 1960's.

The credit crunch, brought on by lax lending standards to subprime borrowers, is spreading to every credit market. Banks are taking HUGE write-offs, and being forced to make fewer loans as they rebuild their balance sheets.

The employment market looks to be rolling over. The four-week moving average of initial jobless claims has risen to 343,000, the highest since June 2004 (except for the spike due to Hurricane Katrina). In June 2004, it was on the way down after the 2001 recession. It's currently on the way up.

Retail sales are looking to be worse Christmas season since the last recession.

Volatility in the bond and stock market has risen dramatically.

Copper prices have been falling.

UPS and Fedex have announced disappointing results looking forward, and the Dow Jones Transportation Average has been diving.

Financial indexes have been tanking, and in a finance-based economy like ours, that's a bad sign.

The one big thing that hasn't confirmed all these dark clouds is the stock market. Either stock investors are more prescient and no recession will occur, or they are deluding themselves into believing things will be okay or the recession won't last long.

My guess is that most stock investors are being overly optimistic, and aren't looking at coming earnings shortfalls.

When companies begin to report earnings next January, I think investors will get an initial shock. Over time, more information will pour out that the economy is in a recession. By the time this evidence is conclusive, the economy will probably be recovering.

Most investors will be scared when they should be greedy. In other words, by the time investors are scared about a recession, stock prices will be low, and it will be a great time to invest.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, December 14, 2007

You can't get something for nothing

The market seems to be absolutely focused on the Fed.

Everyone seems to think the Fed has the power to make or break the economy, get lending moving again, support the dollar, etc.

The fact is, the Fed doesn't have that much power. If you don't believe me, go read John Hussman's article on the subject, or read any of his recent weekly commentaries that address the issue.

The thing that surprises me is how many people believe the Fed can take action with no seeming repercussions. As if the Fed could move interest rates, or lend money to banks without any adverse reaction.

The reality is that the Fed can only take action with consequences, just like the rest of us mortals.

When the Fed offers liquidity, they are printing money and creating inflation.

In the long run, the Fed doesn't matter much, although they do have a short term psychological impact on the market.

Even worse than that, the Fed's actions almost always come with some downside, and that long term impact can be profited from by smart investors.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, November 16, 2007

Concentrated money managers beat everyone else

Money managers who concentrate on a few well-researched ideas beat indexers and money managers who are closet indexers (those who mirror the index closely and try to tilt their portfolios in one direction or another).

Although I've long known this, it was nice to see this confirmed in a recent academic article.

The authors of the article created a unique measure for finding out how actively a money manager differs from an index.

Their research results indicated that money managers who differed significantly from an index in their holdings had a significantly higher chance of out-performing the index.

This may seem obvious to you, but many managers try to avoid risk by hugging an index. Such managers do this because they lack the skill to pick the best companies to invest in. Unfortunately, these managers still charge active management fees. Not surprisingly, their lack of conviction leads their investor to under-perform the index after fees.

This just goes to show what I always tell people: you should either index to match the market at minimum fees or find an investor who can beat the market after fees. Such managers are rare, but, if they can out-perform an index over the long term, they not only pay their fees, but lead their clients to reach significantly higher levels of wealth.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, November 09, 2007

Catching falling knives

One of the most difficult tasks in investing is to buy things as they go down. Psychologically, its no fun.

Hence, some investors refer to this as catching falling knives: you may do it right, but you may also get cut.

The payoff in investing can be huge. Buying companies that most people think will go bankrupt can be very profitable--if they don't go bankrupt. There's the rub, as Shakespeare put it.

How do you know the company in question won't go bankrupt? There are very smart people out there who know enough about certain businesses, bankruptcy, etc., who can pull this off. But it's not for the faint of heart any more than catching literal falling knives.

This question occured to me because a lot of very smart value investors are looking hard at mortgage and bond insurance companies (which I wrote about here and here).

Mortgage guarantee companies like Triad and Radian and bond insurers like Ambac and MBIA have been taken out to the woodshed recently, in terms of their stock prices. This seems justified considering they seem to insure a lot more than they could pay out.

Such investments were great as long as you assumed a housing recession or deep economic recession never hit. That doesn't seem like a very wise bet, now, nor did it beforehand.

The question is how will these investments do going forward? It seems hard to imagine the government will let the rating agencies downgrade their insurance ratings, for this would surely put them out of business and leave the financial markets in one heck of a mess (tons of investors have their money insured by these entities and would lead to a major dislocation).

But, do you want bet on that? That's the question. Will the government save these entities? Should their shareholders get off scott-free instead of bearing the risk they took? Will this encourage moral hazard (I can answer that last one--YES)?

Although I believe a ton of money could be made by investing in bond and mortgage insurers at these prices, I'm not expert enough to catch these falling knives. Do I know enough about the risks they've assumed and the capital they can use to support claims and the cozy relationship between rating agencies/the government/such insurers?

I don't. And not many do.

Perhaps that's why it might be best to leave catching falling knives to the experts.

As Warren Buffett put it, I don't try to find 7 foot fences to jump, I look for 1 foot fences to step over. Bond and mortgage insurers look like a 7 foot fence to me.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, October 26, 2007

Will the Fed cut rates?

The market certainly seems to think so.

Just look at interest rate futures and you'll see investors are expecting a 25 to 50 basis point cut in the Fed Funds Rate.

Or, more meaningfully, look at the gold market. Gold prices spiked to over $785 an ounce, today.

That's up 17% over the last month and 31% over the last year.

Why does the gold market indicate a cut in the Fed Funds Rate?

Because the Fed does not create growth--they do not possess some magical fairy dust that makes the economy run faster.

The Fed prints money to decrease interest rates. And, when the Fed prints money more quickly than the economy grows, they create inflation.

Gold prices are going up because gold investors believe the Fed will print money, also known as cutting the Fed Funds rate, thus creating inflation.

Gold is going up because investors are guessing the Fed will create inflation by cutting rates.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Monday, October 22, 2007

Comparing apples and oranges

What would you say if I told you the market was over-valued by 30%? Would you think I was full of it?

What if I told you that this over-valuation were based solely on market commentators comparing apples and oranges?

When someone says the market is fairly valued or over-valued, what do they mean by that? What standard are they comparing it to? This may seem like a pie-in-the-sky question, but it's very important.

Why? Because market commentators are frequently saying the market is fairly valued by comparing apples and oranges! And, the two are off by 30%.

You see, many say the S&P 500 is fairly valued because they are comparing the S&P 500's forecast, operating earnings to the S&P 500's actual, reporting earnings. But that's comparing apples and oranges.

This may seem like technical minutia, but it makes a big difference. In fact, operating earnings of the S&P 500 have been 20% higher than reported earnings over the last 5 years. And, forecast earnings for the S&P 500 have been 10% higher than actual earnings.

In other words, when commentators say that the S&P 500 is trading at its historical average, they are comparing apples (forecast, operating earnings) to oranges (actual, reported earnings). And, those apples are 30% overstated compared to the oranges.

Next time you hear someone say the market is fairly valued, ask them if they are comparing apples to oranges. Are they comparing forecast, operating earnings to the historical average of actual, reported earnings? If so, tell them to adjust their numbers and get back to you when their figures are fairly comparing apples to apples.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, October 19, 2007

Did credit market turmoil rattle equity markets...again?!

I watched with fascination as short term government interest rates plunged on Wednesday and Thursday. But, to my surprise, equity markets barely reacted.

Then along came Friday.

I don't think the anniversary of the 1987 stock market crash had a thing to do with it, but I do think interest rates had something to do with it--like they did in 1987.

When I see short term Treasuries surging in price and their yields plunging, that means that someone, somewhere is scared and they are running to the safest securities they can find--US Treasury securities of short duration.

Whenever this happens, like it did in August, it means risk is becoming more expensive. And, when that happens, equities will almost always dive.

Why did it take a couple of days to work out? I don't really know.

Perhaps the same people running to safety were hoping things would cool off, but they didn't. And when risk continued to be more expensive, then they started selling equities.

Perhaps some leveraged investors, like hedge funds, were squeezed by the people who lent them money as credit markets seized up again.

Who knows?

But, I do know you could see it coming, and it didn't surprise me (except that it took so long).

Its amazing to watch this because it shows how integrated financial markets are.

Anyone watching short rates plunge on Wednesday and Thursday had to scratch their head and wonder why equities weren't tanking. That is, until Friday--when they did.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Wednesday, October 17, 2007

My latest client letter is available

For those of you interested, my latest client letter just came out today.

In it, I discuss client account performance, my projections for the market over the next 6 years and my opinion on the economy, Part III of my assembling portfolios segment dealing with investment probabilities, an investment spotlight on Microsoft, a segment on why the subprime mortgage market impacted equity markets, and my section on admirable business people covering Benjamin Graham--the father of value investing.

If you get a chance to read it, please tell me what you think and what could be improved.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Monday, October 15, 2007

Does everyone believe the market will continue to climb from here?

Not John Hussman. Hussman makes his case in his latest Weekly Market Comment.

Although Hussman gets very close to attempting market timing, which I don't believe anyone can do successfully, he does make some very good points about why the market's returns from here may not be very exciting.

Luckily, we don't need to invest in the market per se, and it's possible to get significantly better returns in the right investments.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Wednesday, October 10, 2007

Stick to the fundamentals

Although I tend to write here about the economy and markets in general, I must admit such opinions affect my investment process very little.

I don't buy and sell based on what the market is doing or might do. I don't buy and sell based on my assessment of the overall economy.

I buy when I find businesses selling significantly below assessed value and sell when the businesses I've bought are selling significantly above assessed value.

I pay attention to secular trends, such as energy prices and the expansion of cable into phone and broadband Internet, but I don't use such trends as a starting point in my investment process.

I spend my days researching individual companies. I look for businesses with good economics--with sustainable competitive advantages. I look for businesses with great management, who are competent and rational, act as trustees for shareholders, and hold a significant stake in their company. Then, and only then, do I assess business value.

When the market is tanking or roaring ahead, it's important to keep this in mind.

The best way to succeed in investing is to buy good businesses below their assessed business value and sell only if price exceeds valuation. To do this, you must stick to the fundamentals--you must primarily focus on business economics, management and valuation.

When the market is diving, it may be an opportunity to buy, but only if prices go below assessed value. When the market is rising, it may be an opportunity to sell, but only if prices go above assessed value.

The focus is always on the business fundamentals primarily, and only secondarily on prices. What the market and economy are doing should take a distant, and almost completely unimportant, third.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Monday, October 08, 2007

If the US economy slows, will the world economy slow, too?

Many market watchers believe that even if the US economy slows (as it looks like its doing), the global economy will stay in the growth lane because emerging markets like China, India, Brazil and Russia will more than make up for US slowing.

A look at historical information and the global yield curve seems to contradict this. William Hester, CFA of Hussman Funds wrote a great article addressing this subject.

The global yield curve is a way of looking at the yield offered by government bonds around the world at different maturities. By comparing short to long term bond yields, one accesses one of the most reliable predictors of economic growth.

You see, when short term rates are equal to or higher than long rates, this almost always signals economic slowing and, usually, a recession. When short rates are equal to long rates, that's referred to as a flat yield curve. When short rates are higher than long rates, that's called an inverted yield curve.

Using global bond yields, as Hester does, a flat or inverted yield curve usually precedes a recession by a year or two. As he shows, the global yield curve turned flat last July, perhaps signaling that global earnings growth may slow, too.

Although the yield curve is not a fool-proof method of determining future economic growth, it's been reliable enough that it shouldn't be ignored, either.

Although it looks like the world economy is currently humming right along and will easily weather the US slowdown, the yield curve is telling a different story.

As Hester suggest, this has historically been a bad time to be in industrial, consumer discretionary or energy stocks, and a good time to be in materials and consumer staple stocks.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Thursday, October 04, 2007

The Fed's interest rate cut hurts the prudent

For those who think the Fed's recent interest rate cut is an unmitigated good, read Allan Sloan's recent Fortune article titled, "Heads I Win, Tails I Get Bailed Out; The reckless are getting relief from Bernanke. How does that work?"

I've blogged in the past about the moral hazard implicit in the Fed cutting rates. I believe the Fed's large rate cut encourages imprudent risk taking.

But, I didn't highlight how the rate cut hurts the prudent, and Allan Sloan does a great job of that. As Sloan puts it, the "recent interest rate cut has done a lot of harm to those of us who've managed our finances prudently."

The Fed cut rates to calm market turbulence, and this was directed to helping the "players in the biggest trouble," those "who'd taken the biggest fliers in junk mortgages, ultra-risky leveraged buyouts, and other financial esoterica that proved to be malignant."

But, this rate cut not only helped the imprudent, it hurt the prudent. It hurt "those of us who keep score in dollars and didn't need to be bailed out" because we are now "less wealthy than we were in terms of anything other than our home currency."

Why? Because the rate cut "contributed heavily to the dollar's recent sharp drop in the currency markets...and to the price spike in hard assets like gold, silver, copper, and oil." In other words, prudent people's wealth, in terms of dollars, is worth less relative to the things we want to buy with dollars.

Added to this, the rate cut caused long term and fixed mortgage rates up. Once again, this benefits the imprudent who gambled on floating rate loans and punishes the prudent who may be seeking fixed rate loans at what are now higher rates.

Those investors who stayed away from toxic waste and invested prudently are also being punished because the Fed's bailout is helping toxic waste investors to the relative detriment of those who avoided subprime mortgage risks of all sorts (whether bonds, CDO's, stocks, swaps, etc.).

Finally, the prudent get to bail out the imprudent in that our tax dollars will be used to bail out subprime borrowers, subprime lenders (like Countrywide), subprime investors, and the investment banks and rating agencies who should have known that subprime investments were junk.

As Sloan puts it, the Fed's bailout allows the imprudent to play "heads I win, tails I get bailed out" whereas prudent investors get stuck with depreciated wealth, higher fixed rate loans, worse relative investment performance, and a higher tax burden.

If you've been imprudent over the last several years, you probably think the Fed's rate cut is wonderful. But, for those of us who were prudent enough to avoid bad risks, the Fed's rate cut is bad news.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Wednesday, October 03, 2007

Thank you Wall Street Journal for calling the bottom on Wal-Mart

Let me say at the get-go that both I and my clients own shares in Wal-Mart, so I'm anything but unbiased on this subject.

I've blogged in the past about how frequently the popular press reflects popular sentiment instead of reporting news that can be used to make good investment decisions. Well, here's another example.

Today, a Wall Street Journal article by Gary McWilliams may have called the bottom on Wal-Mart. The article is titled, "Wal-Mart Era Wanes Amid Big Shifts in Retail; Rivals Find Strategies To Defeat Low Prices; World Has Changed."

My point here is not to dispute the article's facts or conclusions, but to highlight that stock prices are a reflection of popular sentiment. By the time "news" hits the front page of the popular press, stock prices almost certainly already reflect that "news." I believe this to be the case here, too.

You see, everyone knows that Wal-Mart same store sales are low.

Everyone knows that Wal-Mart is perceived to treat its workers unfairly.

Everyone knows that competitors like Target, Whole Foods, Kroger, etc. have been growing more quickly than Wal-Mart.

Everyone knows that Wal-Mart's suppliers like Pepsi, Proctor and Gamble, etc. are tired of being squeezed by Wal-Mart's ever-present desire to wring costs out of the system.

Everyone knows that Wal-Mart pulled out of Korea and Germany and is struggling in Japan.

Everyone knows that Wal-Mart's store expansion has cannibalized older store sales.

Everyone knows that Tesco is entering the US market and will probably compete fiercely with Wal-Mart.

I don't think the article reports on a single piece of information that hasn't already been frequently and widely reported in other places.

In other words, the article isn't news, it's simply the reflection of what everybody already knows. And, all of this supposedly bad news had already been priced into the stock.

When articles like this, summarizing what everybody already knows, hits the front page of the popular press, calling for the end of whatever or the ultimate dominance of whatever, it's almost always a sign that things are about to reverse.

And, I believe this to be the case here, too.

The time to sell a company is not when the popular press reports that its era has passed. By then, it's too late. You should probably be buying.

The time to buy a company is not when the popular press reports that it has become completely dominant. By then, it's too late and you should probably be selling.

No, when the popular press decisively concludes that the end of a company's era has arrived, it's almost certainly the time to buy.

And, I'll bet that in a few years I'll be writing a blog saying that I've sold Wal-Mart because the popular press is reporting that Wal-Mart is back at the top of its game again.

Thank you popular press for making the timing of my purchases and sales easier.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Monday, October 01, 2007

Contrary to popular belief, firms that pay return on capital to investors are better investments than those that reinvest capital back into the business

A recent paper by James Montier brilliantly highlighted this issue.

For example, a recent McKinsey paper showed that corporate executives know 17% of their invested capital went toward underperforming investments that should have been terminated and 16% of their investments were a mistake to have financed in the first place.

Many corporate managements do a terrible job of investing corporate capital.

When asked how accurately such executives could forecast corporate investments, 70% of managers said they were too optimistic about the time to complete a project, 50% said they were too optimistic about the impact an investment would have, and 40% were too optimistic about the costs involved.

It's not surprising that management is overly optimistic about their pet projects.

Even worse, 40% of managers admitted that they "hide, restrict, or misrepresent information" when submitting capital investment proposals, and 50% of subordinates working on such capital investment projects said it was important to avoid contradicting superiors.

No wonder most companies are bad capital allocators--managers are rarely honest with themselves about their pet projects, and they discourage dissent when discussing potential results.

In other words, companies that retain capital instead of paying dividends or buying back stock and debt tend to be worse investments than those that tend to pay out return on capital to shareholders. Here's the proof:

A study by Anderson and Garcia-Feijoo showed that low capital expenditure companies outperformed high capital expenditure companies by up to 10% per year.

The companies that returned capital to shareholders beat the companies that pumped capital back into the business.

Another way to look at it was highlighted in a study by Cooper, Gulen and Schill, who showed that companies with low asset growth, in terms of cash, property, plant, equipment, etc. returned as much as 20% per year more than companies with high asset growth.

I think these findings are counter-intuitive to what most investors believe, and certainly to what many professional investors think, too.

It's a rare company that can allocate capital effectively, and the proof is clear that companies, on average, that retain capital for investing aren't necessarily good investments. It's important to realize, too, that not all companies are bad capital allocators.

This is why I pay so much attention to return on incremental capital invested when I research businesses to invest in.

I stay away from any company that rewards management for retaining capital, especially when management has a bad track record of effectively reinvesting those dollars.

But, I love to see a management that wisely returns capital to investors when they don't have opportunities and have great track records for adding value when capital is retained.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Saturday, September 29, 2007

In investing, beware the halo effect

People frequently--and incorrectly--attribute wonderful characteristics to something that has succeeded. Just because something has succeeded does not necessarily mean it's specifc attributes are also excellent.

This issue is succinctly highlighted in the third part of Michael Mauboussin's Legg Mason article.

The "halo effect is the human proclivity to make specific inferences based on general impressions." This was first noted over 80 years ago by psychologist Edward Thorndike and was recently described in detail in Phil Rosenzweig's book, The Halo Effect.

What Thorndike found by studying military officer reviews was that superiors tended to attribute overwhelmingly positive specific attributes to subordinate officers who they had good overall impressions of. In other words, they assigned impossibly high ratings to their intelligence, physique, leadership, etc. based on their high overall opinion.

This tendency can be particularly dangerous in picking investments. Those who attribute outstanding specific characteristics to Apple or Google simply because they have done well in the past and everyone seems to love them may be in for a rude surprise if they invest in these companies at current prices.

The same can be true on the downside as well. People tend to assume that companies whose stock has performed poorly or whose profitability has lagged have universally negative specific characteristics. This is unlikely to always be the case.

The halo effect partly explains why popular stocks tend to under-perform and unpopular stocks tend to out-perform.

People tend to assume that popular stocks have great specific attributes, reflecting popularity more than excellence. When an inevitable blemish appears, the stock tanks because it was priced for perfection

In reverse, people tend to assume that unpopular stocks have universally negative attributes. When it turns out the business isn't as bad as everyone believed, the stock takes off because it was priced for bankruptcy.

In selecting investments, it's very important to gain a clear view. Popularity is no way to judge an investment. Look critically at every investment opportunity, no matter how much people love it. And, companies that everyone things are doing poorly may be a great place to invest because good characteristics may have been overlooked.

To avoid the halo effect, look for disconfirming evidence--evidence that conflicts with the popular view. Work hard to understand both the good and bad characteristics of an investment. This will help you rationally assess its prospects, and almost certainly lead to better investment results.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Wednesday, September 26, 2007

"If only I had..."

The psychology of regret can be very useful in investing.

A recent article by Michael Mauboussin, of Legg Mason, points this out beautifully.

You see, psychologists refer to the tendency to consider what would have happened if you had taken a different action as counterfactual thinking. This way of thinking can work to your benefit, but it can also create traps.

One example of a trap is called inaction inertia. Inaction inertia occurs when you initially fail to take advantage of an investment opportunity, say buying Microsoft in 1996, and subsequently pass over the same opportunity in the future, say buying Microsoft in 1997, because its price has run up from where it was in 1996.

If an investment opportunity is good right now, you should buy regardless of the price you could have gotten if you'd acted earlier. I learned this the hard way with Leucadia in 2002, 2003 and 2004 when I didn't purchase because the price had gone up, but then finally got it right in 2005.

A benefit of the psychology of regret results from learning about errors of action versus errors of inaction. You see, some regret is good because it encourages future changes in behavior.

Most of us tend to focus on short term regrets related to action. Like, I wish I hadn't eaten that whole platter of brownies.

But, it can be equally beneficial to also focus on regrets related to inaction. Warren Buffett is famous for bemoaning the investments he didn't make more than the investment he did make. He knows his greatest investment errors were sins of omission rather than commission.

If you consider both the investments you've made as well as the investments you haven't made, you can learn from your mistakes and become a better investor.

One of the biggest psychological traps investors fall into is due to their psychological immune system. This system exists to help bad situations seem better, but they can lead to big investing mistakes.

"First, we tend to explain away situations in a way that makes us feel better." Like, someone who gets turned down for a job and tells themselves they didn't want it anyway. This kind of thinking leads to investing errors that aren't learned from. Don't explain away errors dismissively, try to understand what went wrong.

"Next, we seek facts that support our views and disavow or dismiss factors that don't back us up. This is known as the confirmation bias." If you read every article that says that Google or Apple is the greatest investment ever, but fail to read the articles critical of those companies, you probably won't make good investment decisions. Look for evidence that your investment ideas may be flawed.

"We also exhibit hindsight bias. Once an event has passed, we tend to believe we had better knowledge of the outcome before the event than we actually did." How many people insist they knew an investment would do well but failed to act. Did they really know it beforehand, or are they just convincing themselves they knew after the fact? Write down your thinking beforehand and you'll find out what you really thought instead of what you hazily remember you thought.

"Finally, when we make a prediction or take an action that doesn't work out, we believe we were almost right--the close-call counterfactual." If I had a dime for every investment I almost made and went up, I'd have a lot more money than I do. Once again, write down what you think beforehand, then you can check to see whether your close-call wasn't just a rationalization after the fact.

To avoid making mistakes with the psychology of regret, "be aware of how the mind works and the suboptimal behaviors that may ensue." If an investment is good, make it regardless of the price you could have paid if you'd invested earlier. Be sure to consider your inaction as well as your actions. There may be a lot to learn from what you didn't do.

Also, "be careful not to kid yourself." Don't just explain away situations in a way that makes you feel better. Look for disconfirming as well as confirming evidence. Write down what you think will happen beforehand so you can check whether you are suffering from hindsight bias or the close-call counterfactual.

Understanding the psychology of regret just may make you a significantly better investor. It sure has helped me.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Monday, September 24, 2007

When do we reach our financial decision making peak?

Financial sophistication peaks in our early 50's. Younger adults and older adults borrow at higher interest rates and pay more fees than middle-aged adults.

These conclusions come from a fascinating paper I read recently.

The authors hypothesized that financial sophistication would depend on a combination of analytic ability and experiential knowledge.

Their research on cognitive aging implied that analytic ability follows a declining concave trajectory after age 20. Our brains function as well as they will in our early 20's, then degrade from there.

The authors also hypothesized that experiential knowledge follows an increasing concave trajectory due to diminishing returns. The older we get, the more experience we have. The more experience we have, the better decisions we can make. But, each unit of experience does not provide the same benefit as the unit before. Hence the diminishing returns. Our experience helps us make better decisions, but each bit of experience benefits us less and less over time.

When adding together the effect of cognitive decline and experience with diminishing returns, we end up reaching our peak at some point and then our abilities decline over time.

The same thing can be seen in other pursuits. Baseball players peak in their late 20's. Mathematicians, theoretical physicists and lyric poets peak around age 30. Chess players peak in their mid 30's. Autocratic rulers peak in their early 40's. Authors peak around 50.

The authors validated their hypothesis by showing that younger and older financial decision makers pay too much in interest and fees. Sure enough, those in their early 50's pay the least in interest in fees, seemingly validating the cognitive decline/experience with diminishing returns thesis.

Here's an interesting question: what age person should you want to work with to help you make financial and investing decisions? Would you want to chose someone in their mid 50's, whose cognitive abilities are declining and whose experience doesn't make up for this decline? I don't think so.

You'd probably want someone on the upswing, someone whose cognitive abilities may be declining, but who has enough experience to make up for that decline. Perhaps you'd want to pick someone who would reach their sweet spot of optimal decision making in the future, who still had the best benefits of aging and experience ahead of them.

Okay, this is a shameless, self-promoting plug. I'm in my late 30's and will become a better investor over the next 15 years. Doesn't that sound like the right target, instead of someone with so much experience they're in decline? If you're going to work with someone for 30 years to reach your goals, wouldn't you prefer someone on the upswing instead of the downswing. I sure would.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, September 21, 2007

Social influence plays a big part in outcomes

The success or failure of a venture can be greatly influenced by the early reactions of people.

This statement may seem obvious to you, but a recent academic study recently showed just how important initial reactions can be on success or failure.

I read about the study in Michael Mauboussin's recent Legg Mason article. Three Columbia University sociology researchers set up a website where people could download music. 20% of the people who went to the website were provided with no information about what others had downloaded. Another 8 groups (10% each) were formed which could see download rankings.

The study showed that top songs tended to finish in the top, and bottom songs tended to finish at the bottom regardless of whether download rankings were available. But, the vast majority of songs in the middle were ranked very differently depending on whether people could see download frequency.

In fact, the study showed that once 1/3 of the participants had downloaded songs, the next 2/3 of people followed their lead. This lead to very different outcomes between the 8 groups who could see download frequency.

In other words, the intrinsic quality of songs was trumped by the cumulative advantage of social influence for the vast majority of songs. Songs downloaded frequently by a group were then downloaded more frequently by others, creating cumulative advantage.

This may seem obvious when you think about Betamax versus VHS digital video tapes, or Apple versus Microsoft Windows, or, more recently, iPod versus any other MP3 player.

The same is undoubtedly true for picking investments. In the short term, people pile into the same investments that everyone else is talking about, regardless of the intrinsic value of the underlying business.

Luckily, the market has the benefit of quarterly and annual earnings reports, which force stock prices to track with underlying value over the fullness of time.

This doesn't mean that stock prices are always right--quite the opposite.

Don't judge an investment by what it's stock does over the short term if you're a long term investor. Otherwise, you may suffer from the social influence of following the crowd.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Wednesday, September 19, 2007

401k investing

Many investors are just plain baffled about how to invest their money. They don't know where or how to invest to reach a comfortable retirement.

One of the best investment vehicles out there, if it's available through your employer, is the 401k plan.

Traditional 401k plans allow for pre-tax contributions that grow tax-deferred until retirement (when withdrawals are taxed as ordinary income). Roth 401k plans allow for after-tax contributions that grow tax-deferred and are not taxed on withdrawal (they also provide more flexible withdrawals and better estate planning options).

Many employers match employee contributions. This is like getting a raise in salary, yet less than 66% of all employees eligible participate in such plans.

If a 401k plan is available to you, you should almost certainly be contributing to it.

The earlier you start saving, the sooner you don't have to work for other people or the bigger your retirement will be. Start saving NOW!

Before you invest, you should learn a few things about the plan available from your employer. You'll want to know your employer's policy on matching contributions, the vesting schedule for contributing, and the plan's maximum contributions.

The hardest part about investing in a 401k--after clearly understanding you should--is picking the right investment(s). Most plans offer anywhere from 25 to 900 choices. Almost all investors are overwhelmed by such choices.

Unlike most advisors, I don't necessarily believe that investors should go crazy diversifying their money to the 4 corners of the investment world. There are better and worse investing opportunities, and any good investment advisor will know the difference between the two.

Don't necessarily go for target date funds, either. Their allure seems wonderful because someone else does the thinking for you, but their high fees and necessarily mediocre performance may not meet your personal desires or your investment needs.

Finally, I would advise you not to invest in your company's stock through such a plan. Your pay check is already dependent on the company, so you probably don't want your retirement nest-egg to be in the same spot. The folks at Enron, Worldcom and Arthur Anderson found out the hard way what a big mistake that can be.

If you need any help making these decisions, I'd be happy to help. Just give me a call at 719-761-3148.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.
Your returns depend on the CEOs you invest with

Not surprisingly, what's happening in a CEO's life impacts the performance of their company and it's stock price. A September 5th article in the Wall Street Journal by Mark Maremont highlighted this fact, recently.

Several studies have shown that a death in a CEO's family negatively impact the company's stock price. The death of a child resulted in an average loss of 20%. The death of a spouse led to a 15% slip in price. Amusingly enough, the death of a mother-in-law led to a 7% rise in stock price.

Other studies showed that the stocks of companies run by CEOs who buy or build megamansions sharply under-performed the market. This hardly seems surprising to me, but it's good to see the statistical backing.

Another study showed that narcissistic executives, those who tended to take all the credit for what their companies accomplished, tended to take greater risks that led to bigger swings in company profitability.

Although I've never done a statistical study of these issues, I've always looked hard at the leaders of the companies I invest in. Not only does this result in better investment results, on average, but it also allows me, and my clients, to sleep better.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Monday, September 10, 2007

Bad reasons not to save

Jonathan Clements, who writes for the Wall Street Journal, had a somwhat amusing article on September 9th.

His title was, "Six Bad Reasons Not to Save for Retirement." I couldn't agree more.

Bad reason #1: I still have plenty of time.

Say you start saving for retirement as a diligent 25 year old. Your goal is to have $1 million by retirement, which you plan to start at 65 years old. You'd need to save around $846 a month for 40 years.

If you wait until 35, you'd have to save 70% more a month, or $1,441 per month for 30 years. If you wait until you're 45, you'd have to save 322% more a month, or $2,726 per month for 20 years. If you wait until 55, you'd have to save 803% more a month, or $6,791 per month for 10 years.

It pays to start as early as possible. The longer you wait, the more painful reaching retirement will be.

If you think you'll earn more money as you age and have more money to save later, you're right on the first issue but wrong on the second, because I almost guarantee you're expenses will go up faster than your income as you age.

Start saving as soon as you can, as much as you can, and you'll reach a bigger retirement with a lot less stress and strain.

Bad reason #2: My house is worth a bundle.

See my previous post on this subject. Counting your home as a retirement asset usually doesn't work out.

Bad reason #3: My investments are doing great.

They may be doing well, now, but what matters is how they do over the full length of your retirement years.

For those who retired in the late 1990's with enough money, the sell-off during 2000-2003 slammed them right back into working again. It's not enough to have a lot of money at the peak.

A retirement plan should be set up with a margin of safety, not merely "enough money to get by as long as everything goes well."

The best way to get there is to save continuously into your retirement plan (which should be based on reasonable assumptions).

Bad reason #4: I'll receive a fat inheritance.

Very few people, after inheritance taxes, will receive enough money to retire on, perhaps 1.6% as Clements suggests.

If you are part of that 1.6%, congratulations.

If not, get to saving.

Bad reason #5: I have a pension.

41% of households currently have a defined-benefit pension plan, whereas 62% of workers expect to receive a pension.

If you actually have a pension and are not part of the 21% of "land-of-fantasy" types who expect a magical pension to appear in the future, be sure it will cover your actual expenses in retirement.

Also, keep in mind that, because of recent accounting pronouncements and the expense of defined-benefit plans for companies, many defined pension plans are going the way of the dodo.

If you don't have a pension or are part of the 21% who are clicking your heels for the future-fantasy-pension, get to saving.

Bad reason #6: I'll work in retirement.

This is actually not a bad idea.

I love my job and don't plan to stop working until I'm unable to work, so I can sympathise with this argument.

But, many people don't want to or can't work into their 70's and 80's.

Planning to work into your 60's makes sense, but assuming you'll be capable of working into your 70's and 80's is gambling where the odds are against you.

Plan to work if you can and want to, but have enough money saved in case you just plain can't.

Saving for retirement is like paying for insurance. You may never make a claim or need as much money as you've saved, but that doesn't mean you don't want to make regular payments so you are safe and secure in your old age.

Save for retirement as soon as you can, as much as you can, and as regularly as you can. You'll sleep better and have greater peace of mind.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Is the Fed cutting interest rates really a good thing?

It seems like market participants have been wishing, hoping and praying that the Fed will cut interest rates for over a year now. Unfortunately, this may not be a good sign for the market, but a clear signal of worse things to come.

You see, the Fed cuts interest rates not because things are going great, but because they are seeing clear signals the economy is headed for rough waters.

In fact, the stock market has historically dropped around 40% during an average recession, so the Fed cutting interest rates may not be a signal market participants should be cheering about.

Two weeks ago, John Hussman had a brief section on this subject in his weekly Market Comment. He posted a couple of graphs showing how the S&P 500 did during Fed rates cuts that led up to the 2000-2001 and 1981-1982 recessions.

From 2000-2001, the Fed cut interest rates from 6.5% to 1.25%, and yet the S&P 500 tanked around 41.1% over that same period.

From 1981-1982, the Fed cut rates from 20% down to 11%, and yet the S&P 500 tanked around 21.5%.

The Fed cutting interest rates is not a cure-all that makes the market go up. The market does sometime do well because of rate cuts, but not every time.

So, if you've been betting on the Fed cutting interest rates in hopes of making a killing in the stock market, you may want to consider buying short term bonds instead--they will much more likely benefit.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, September 07, 2007

If a shoe falls in the woods, and no one is around to hear it, does it make a sound?

In an earlier post, I brought up what could knock down credit markets. One issue was the availability of credit, which has been the subject of much pain and anguish, recently. The other two issues were interest rates and employment.

In the news today, the employment report for the month of August looked dreadful. For the first time in 4 years (when we were stumbling out of the last recession), payrolls tracked by the Labor Department shrank instead of climbing.

Could this be the result of financial service firms laying off workers in an attempt to adapt to current credit conditions? Could these laid off workers then have trouble making their home payments, thus promoting the negative spiral of home price declines, credit defaults, financial market troubles, and more layoffs?

I certainly think so. In fact, I believe this is the beginning of the other shoe dropping. I also believe the Fed will react as it always does, by lowering interest rates in an attempt to "jump-start" the economy.

This will, in time, lead to higher interest rates on longer dated bonds as foreigners demand higher rates to compensate for the dropping dollar. The dollar will drop further as more and more market participants realize the Fed will lower interest rates by printing more dollars (in other words, creating inflation).

How bad will this get? I don't know, but lower employment and higher interest rates will make current housing problems look tame by comparison.

It's a good time to avoid companies with lots of debt. It's a good time to avoid investments related to the housing market or its financing (although a bit late).

More importantly, it's a good time to be invested in securities that will benefit from this fallout. It's a good time to have some cash that can be invested as the market goes down.

If inflation is a concern, it's a good time to consider investing in tangible things (other than real estate) that are hedges against inflation. It's not a bad time to consider foreign investments that may be hedges against inflation, too.

It's also a great time to consider those companies that will fair best as we emerge from our credit market problems and into another growth up cycle.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Wednesday, September 05, 2007

Do you include the value of your home as a retirement asset?

An excellent article in the Wall Street Journal on September 2nd, by Glenn Ruffenach, echoed what I've been telling people for years: you may not want to count your house as a retirement asset.

As the article states, many people have been thinking of their home as an investment asset they can cash in when they retire. The thinking goes like this, "If my budget gets tight in retirement, the equity in my home will serve as a safety net."

In fact, a study by Bell Investment Advisors in California "found that 68% of surveyed 60-year-olds count their personal residence as a retirement asset. And of that 68%, one in four say their home represents half or more of their retirement savings."

The problem is that home prices are falling nationwide, the decline is accelerating, and it's particularly bad in the same places where real estate prices climbed the most, like California, Florida, Nevada, and Washington, D.C.

As the article states, "If the value of your home falls...there's less equity to help finance your retirement."

There are two problems with thinking of your home as an investment asset.

The first is that most people are unwilling to give up their lifestyle to cash out their home and move into a smaller place.

The second problem is that higher interest rates, which are not unlikely in the future, could make house prices fall even further and dramatically decrease the payout of doing a reverse mortgage (having the bank provide you with monthly payments as they acquire the equity in a home).

Counting your home as a retirement asset may not be prudent. It turns out that few people can turn the value of their home into cash flows during retirement.

If you count your home in your net worth or as a retirement asset, you may want to reconsider.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Monday, September 03, 2007

"The typical small investor has no idea what his or her performance has been"

This distressing quote comes from an article I read in the September edition of Financial Advisor magazine.

A study by Markus Glaser and Martin Weber of the University of Mannheim came to this conclusion after surveying 215 retail investors to find out what they thought about their investment results versus how they had actually done.

Their study showed that investors with bad results thought they were doing just fine, and that there was almost no relationship between how investors actually performed and how they believed they had done. They also discovered most investors weren't as successful as they thought.

Although the authors focused on cognitive biases that caused this result, my mind turned, instead, to other questions.

If investors don't know how they're doing, is that their fault, or the fault of their advisors?

If investors think they are doing okay when they're not, how would they know they should switch advisors?

If investors work with advisors who aren't serving their best interests, do they know they can get better results by working with an advisor with fiduciary responsibility?

It's troubling that so few have saved enough for retirement. It's more troubling to realize they may not know this. To me, it's most troubling that the people who should be helping investors reach their goals are frequently using an investor's ignorance to keep them in the dark.

After all, who gets an education in the math of investing such that they understand investing results? Who gets an education in the costs of investing and the compensation schemes of financial service providers? How can people make good decisions if their financial advisors benefit at their expense?

Many investors are getting bad advice because they work with salespeople who are likeable. Such salespeople are trained to be likeable because financial service firms know most people can't judge performance and tend to choose based on gut feel.

I believe this is the real cause of the problem Glaser and Weber discovered. The solution is to work with professionals. Professionals are experts in their field based on extensive education, training and experience. They tend to have ethical guidelines and join associations that enforce those ethical standards.

If you want a great doctor, pick a doctor with great education, training and experience. If you want a great accountant or lawyer, look for the same thing.

If you want to pick a great investment advisor, look for education, training and experience--not likeability.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Friday, August 31, 2007

Moral Hazard

Today, the Federal Reserve and President of the United States offered a life raft to the mortgage market.

It sounds like this will come in the form of additional liquidity for lenders from the Federal Reserve, and loan guarantees and loan restructuring for borrowers through various government departments.

Although this may seem like much needed help for "victims" of the market, to me it looks like a dangerous incentive to take more risk--also known as moral hazard.

You see, borrowers who shouldn't have gotten money were lent money. Many were speculators hoping home prices would keep going up. Others were ignorant of the loans they signed because they didn't bother to read the paperwork.

Should borrowers be bailed out who shouldn't have borrowed? Suppose I go out and buy a large screen TV with my credit card. Suppose I can't make the payments because I didn't realize the interest rate I would pay. Should taxpayers bail me out because I'm ignorant of the contract I signed? If they do, what would I learn? Not to take the risk?

Even worse, lenders knew about their borrower's credit histories and ability to pay. Lenders also knew they would pass such loans off to Wall Street investment banks who would sell such bad loans to ignorant investors.

Should the mortgage originators, Wall Street banks and lazy investors be bailed out for making bad loans? Suppose I lend someone money at a 20% rate because they can't get a loan elsewhere. Suppose they can't make payments at some point. Should the taxpayer bail me out for making a bad loan? What would I learn? Not to make loans to people who can't pay?

The Fed and President are offering to bail out borrowers and lenders with other people's money. Those other people are U.S. taxpayers. You will pay in the form of inflation due to the Fed printing money and higher tax rates or higher government debt due to the executive branch bailing out "victims" of bad lending.

The real problem with this scheme, as any study of history will tell you, is moral hazard. If someone learns they can take risk at another's expense, then they're incentivized to take that risk over and over again.

If you let a teenager borrow your car and they get in an accident, what do they learn if you prevent them from living with the consequences? Why would that be any different with adult borrowers and lenders in the U.S. economy?

Just look at the people rebuilding their huge houses in Alabama that were wiped out by hurricane Katrina. They know they don't have to pay for insurance because the government will bail them out, so they are quite happy to rebuild because they know they won't bear the expense of the risk they're taking.

So, when you see spiking inflation over the next several years and higher tax rates or increased federal debt to pay for all the bailouts the government is offering, keep in mind that you're getting to bail out speculators in real estate, people with bad credit histories, banks who pass their loans off to Wall Street, Wall Street investment banks that don't need the help, and investors who don't bother researching what exactly they are buying.

And, when such teenagers take this risk over and over again, and you get to bail them out each time, remember that there is a name for this phenomenon--moral hazard.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Wednesday, August 29, 2007

My evolving investment approach

It's interesting to note how my investment research process has changed over the years.

From the time I first read about value investing in 1995 up until 1998, my focus was almost exclusively on the numbers. Basically, I picked investments based on my assessment of the value of each business with a much lower emphasis on other factors (management, economics, product life cycles, etc.). I crunched the numbers and bought if something looked remarkably cheap.

From 1998 until 2001, my focus began to include a more thorough analysis of business economics. Here, my aim was to gain an in-depth understanding of the competitive advantages of each business and to what degree they were sustainable. This effort was much more qualitative than quantitative.

In 2001, I started to include a much more thorough analysis of management, too. For this, I looked at management's tenure, their competence in the field, their compensation structure, their ownership of the business, the way that they talked to shareholders, etc. This, too, was a more qualitative effort.

What I've found is that you can never stop learning in this field (or in any other for that matter). Every year, I bring new elements into my analysis. Every year, I read books or articles that lead me to dig deeper into certain aspects of each business.

Although my general approach has remained the same--I look to buy underlying businesses, not stocks, and I try to buy them significantly below their assessed value--I continue to add more and more layers of analysis and experience on top.

I keep very good records of the investments I've looked at over time, both the ones I invest in and the ones I don't. This has allowed me to review my past decisions and prevent sins of both omission (not investing) and commission (investing when I shouldn't have) going forward.

I love my job, and I love learning more and more each year such that I can improve my expertise and, more importantly, my results going forward. And, as Charlie Munger and Warren Buffett have amply demonstrated, that's a great way to build wealth and enjoy life.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Monday, August 27, 2007


On becoming a father

Last Wednesday, I became a dad. My daughter, Vivian Lacy Rivers, was born at 8:55 am. She was 8 pounds 11.6 ounces and 21 inches long. I have a new found respect for my wife (and I respected the heck out of her before).

Now that's a life changing event.

I feel a tremendous sense of responsibility to help this little being. My wife and I have been reading about child rearing and preparing for it for well over a year and a half.

My wife was trained as a chemist and I was trained as an engineer, and we're both avid schedule makers and precise planners. You can guess what the first week has looked and felt like to us. Pure chaos.

We're adjusting, though, and we both feel more purpose and humility than ever before. I can't wait to be a guide for her discovering life, and I'm sure I'll be growing right with her because I have so much to learn, too.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Monday, August 20, 2007

Monday's articles

I read several enjoyable articles today that put the market's current situation in context.

The first is by John Hussman of Hussman funds. In it, he takes the Fed Model to task. The Fed Model says that the stock market's earning yield can be compared to the yield on 10 year US Treasury bonds. As he clearly shows, this model looks great from 1980 to 1998, but would have given terrible investing advice from 1948 to 1980 and from 1998 until now. Does that sound like a good guide to investing--a method that worked during only 30.5% of post WWII stock market history?

He also takes to task the current practice of saying the stock market is reasonably priced by looking at forward price to earnings ratios and comparing that to historical trailing price to earnings ratios. Not only is this comparing apples and oranges by comparing projections and history, but it also ignores that profit margins are at all time highs and will almost certainly come down over time. As usual, his analysis brings a broader historical context to the situation.

The second is by Edward Chancellor (author of Devil Take the Hindmost: A History of Financial Speculation) and appeared in the Washington Post. His title is, "Look out. This crunch is serious." In it, he argues that comparing current market problems to the short term problems of 1987 and 1998 may not be valid. His warning is that credit splurges have turned into major market problems in the past, and this one may look more like 1929 when everything is said and done.

The third article, in the Financial Times, is by Gillian Tett. In it, Tett argues that bond insurers, like MBIA and Ambac, may be in for serious trouble because they've insured so many structured financial products that contained bad credits. As he suggests, it's very hard to know what these bond insurers have backed, so holding on to them as investments may prove foolhardy if it turns out they must actually support the insurance they've underwritten.

The last is by Bill Gross, of PIMCO, and appeared in Fortune. Gross compares current market turmoil to playing Where's Waldo. Everyone seems to know a lot of bad credits are "out there," but no one seems sure who is exposed to such fallout and by how much. Problems keep turning up in unexpected places, like German and French bank's books. These problems were created by financial wizards on Wall Street who believed they could turn lead into gold, and, unbelievably, some people actually believed them!

In my opinion, it will take a long time to fully understand the severity of the current situation. This may turn out to look like 1987 or 1998, but it could also be much worse. For those who believe that credit excess always ends badly, it's a great time to play defense and bet on those who can benefit from debt implosions.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.