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Tuesday, February 27, 2007

Book recommendation: The World is Flat by Thomas Friedman

On a recommendation from my father-in-law, I recently started Thomas Friedman's The World Is Flat. I'm really enjoying it.

Friedman's thesis is that the world has become "flat" within the last decade because of globalization and technology. He doesn't mean physically flat, he means the playing field has been flattened such that people can more easily compete with each other. Improved education, free trade, fiber optics, more open political systems have allowed people the world over to compete with each other for jobs, work, etc.

The good news is that around 1.3 billion people in China and 1.1 billion people in India are really benefiting from this. They will get paid more and have more interesting jobs. Their opportunity set in life has dramatically increased over the last decade. The majority of people outside of China and India will benefit, too, with cheaper products and more specialization.

The bad news is that some people in the United States and Europe are having a hard time competing with these new workers. Both blue and white collar jobs are getting transferred to those workers who have the most to offer at the lowest price.

I don't agree with everything Friedman has to say, but he makes some really great points and does a wonderful job of illustrating the changes occurring. I find it particularly interesting as an investor and as a soon to be father. If you're curious how the world economy may evolve going forward and what risks and rewards lie in wait, I highly recommend this book.

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, February 26, 2007

Process versus results

One of the hardest things to do when investing is to keep my focus on process instead of results.

Does that mean that results are unimportant? No. But, it does mean that an over-emphasis on short term results can prevent me from achieving truly unique investing performance.

I find that an analogy, here, helps me grasp this difference. I believe that being honest is necessary to achieving happiness. But, being honest at any particular time does not mean that happiness will instantaneously follow. Honesty is a virtue--like all others--that yields results over the fullness of time.

It seems that everyone has heard of an unscrupulous salesperson that has made a fortune while being less than honest. Such salespeople may do very well in the short term, but over the long term they're going to pay the price for treating others poorly. It may take decades for this price to be paid, but rest assured that it's always paid.

The same is true with investing. Those who focus on short term results seem to always be chasing the latest hot thing. They inevitably end up buying high and selling low because they are too focused on results and not enough on process.

Generating truly excellent investment results over the fullness of time requires an intense focus on process: the process of researching, analyzing, valuing, purchasing and selling partial ownership of businesses. Any focus on short term results that distracts an investor from this process will lead to sub par results. An intense focus on short term results will lead to disastrous decisions. Trust me, I've made them myself.

It's hard to focus on process at times. Sometime an investment's price will go down as business value goes up. Sometimes price will go up much faster than underlying value. Price is important, but it can distract you from underlying value.

The key is to have a process and discipline that you know will work, and to make sure you don't get distracted by short term results when you know long term results are what's important.

Even after 11 years of investing, I still find myself getting distracted by short term results. What do I do? I realize I'm letting it happen, then promptly and none too gently refocus myself back on the process. And, so far, that works.

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, February 23, 2007

Do what you love, love what you do

I believe one of the most important things in life is to find work that you love.

This may sound simple, but it isn't. Most people seem to get stuck in a rut of doing what they need to get by, instead of seizing the day and chasing their passion. It doesn't have to be that way.

In many ways I feel lucky to be pursuing my passion for a living, but I also remember the path that got me here.

Having gone through the Air Force Academy, I became a pilot at first. I didn't like that, so I got out of it. I started a masters degree in operations research, but it turned out that wasn't right for me, either. I started and finished an MBA program and liked that, but wasn't sure how to apply it. I got to manage people in the Air Force and did okay, but wasn't really thrilled about doing that for a living, either.

I took every career aptitude and interest survey I could find. I read and did all the exercises in What Color is Your Parachute. I talked to people in every career field I was interested in to find out what they did and didn't like about their field. I networked with people in hopes that at some point I could use such contacts to help me find a job.

I read about anything that interested me, from philosophy, to politics, to history, to psychology, to business, to investing. With investing, I really hit on something that jazzed me, and I read a ton more about it. I put myself to work learning everything I could about investing and applying it to my own money. Eventually, I realized I wanted to be an investor for a living, so I pursued the CFA designation to make myself more qualified.

I worked for 8 years figuring out what I wanted to do for a living. I started two masters degrees and finished one. I talked to dozens of people about different career fields. I compared my talents, interests and tendencies to each career option I faced. I went down many paths before I discovered one that was right for me.

I made gobs of mistakes in this process. I'd been in two career fields that weren't right for me. I pursued education several times I didn't use. I spent a ton of time and money, I missed out on entertainment and social activities, I was repeatedly frustrated. But, it was all worth it.

Spinoza once said, "All things excellent are as difficult as they are rare." As my wife would put it, boy howdy.

Finding the right career was a long, arduous path, but waking up excited to work every day makes it so worth the effort.

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, February 21, 2007

Judging investor performance

One of the hardest things for investors to do is judge the performance of an investment manager.

Most financial periodicals emphasize quarterly, 1, 3 and 5 year records, but is that enough time to look at?

The problem is that there's a lot of noise present in investment returns. What do I mean by noise? Noise is what you hear in between AM radio stations, it's the static you see on TV channels where no content is broadcast. Investors need signal to make good decisions, so paying attention to noise can be a real problem.

Why is there so much noise in investment data? Part of the reason is that many "investors" are really speculators--buying and selling stocks at the drop of a hat instead of purchasing partial ownership of an underlying company. Those traders create noise because they aren't trading on fundamentals in most cases, they are trading based on chart patterns and intuition.

Another reason for noise is that a lot of estimates go into financial reporting. Companies must estimate how much of the credit they extend won't be paid, how much their inventory will be worth, how long their factory and equipment will last, how much they will have to pay into pension plans, etc. It can take years to see what these numbers really turn out to be. That's why so many companies must restate their financials over time.

A third reason is simply human psychology. People tend to over-emphasize recent data and under-emphasize old data. They tend to anchor themselves to a price they paid or a price they want to buy or sell at. They tend to follow the herd instead of gathering and analyzing relevant data. These psychological tendencies lead prices to trend too far in one direction and then the other.

That's only a few of the reasons, but you get the idea. Stock prices, in the short run, reflect a whole bunch of noise and very little signal. You have to look at the data over much longer periods of time to start to see signal. It's like trying to pick a good place to farm based on a weeks worth of rain and temperature data. A week just isn't a long enough period of time to look at--you need to look at YEARS worth of data.

How many years of investment performance do you need to distinguish signal from noise? It depends (I must sound like an economist). But, the absolute minimum you should use is 3 years, it's better to use 5 years, and even better still to use 10 years.

This may seem like a stiff test, especially when a manager has a limited record to observe. But, think of it like you would about picking a place to farm, too little data is just plain gambling, so wait until you have enough information before you act.

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.

Tuesday, February 20, 2007

Headlines frequently call the bottom

One of the amusing things I've learned as an investor is how the popular press almost always gets it wrong, especially when it comes to investing or the economy.

One popular magazine called the bottom with their headline about the death of equities in the early 1980's. Doing the opposite of what this headline seems to suggest--by investing in equities--would have been very profitable.

If you were awake during the late 1990's, you were inundated with headlines about the telecom, internet and technology companies that were going to grow forever. Once again, doing the opposite--by shorting telecom, technology or internet businesses, or investing in brick and mortar companies--was quite profitable.

More recently, the craze for flipping homes or condos as investments made headlines in the popular press during 2005 and early 2006. Want to guess how thats turning out?

Why does the popular press get it wrong? They don't tend to ferret out breaking news, they tend to report what is happening. In fact, they only tend to report such news once everyone already knows about it. In other words, they reflect popular sentiment more than anything else.

If everyone believes something is a great deal, they tend to buy it for themselves before they tell everyone how great it is. If everyone knows something is great, then price will already reflect that enthusiasm. If you wait for that enthusiasm to be obvious everywhere, then everyone will have already bought. And, when everyone has already bought, prices almost have to go down from there.

The bust in the housing market and home loans seems to be making the news a lot lately. But, I'm not sure it's hit page one of a popular weekly magazine, yet, so perhaps it's not quite time to act on this one.

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, February 19, 2007

General Motors + Chrysler = ???

The recent buzz is that GM may be thinking about buying Chrysler. I'm not certain this is a good plan.

I don't think either GM or Chrysler have problems that can really be solved by additional scale. In fact, one could easily argue that they both have too much scale right now, not too little. They both need tremendous downsizing to target narrower markets and to alter their cost structure to be able to make profitably the few things they can do well.

So what benefit will accrue if they combine? Will they have greater bargaining power to deal with the UAW? Perhaps, but couldn't gaining the upper hand on their unionized workers possbily lead to additional product quality problems? If their problems are scale, products and costs, will tackling costs alone really help?

Will their combined engineering and design teams suddenly be able to make higher quality cars that people really want? Would the combined company be capable of streamlining their supply chains, further integrating their suppliers and buyers? I doubt it. In fact, a larger, more bureaucratic company with at least two, probably many more, dissimilar cultures will find it even more difficult to solve such problems.

Although I think GM looks like a statistically cheap investment right now, I think its problems are too big to solve this way. I have no reason to believe that Daimler Benz wants to sell Chrysler because they believe its their crown jewel, and the fact that Daimler's stock price took off on the rumor seems to indicate many investors agree. So, GM is thinking about buying the red-headed step-child from a better company that couldn't fix its operations, in hopes that they can both right Chrysler's and their own operations in a heroic effort. Wow, that sounds silly.

Both GM and Chrysler need to scale back operations, vastly improve the quality of their vehicles, and produce niche designs that they can sell at a profit, while also dealing with their legacy cost structure that needs immediate overhauling. Can they really work on this problem together and hope to succeed, or should they get their own house in order first before combining with others?

I really don't know the answer, but I do know what bet I'm NOT making.

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.

Sunday, February 18, 2007

"I made my fortune by selling too early"

Baron Rothschild once said, "I made my fortune by selling too early." What did he mean by that?

Some "investors" think they can buy an investment as it bottoms and then sell right before it tops. I call such "investors," speculators. There is too much speculative movement in price to precisely time tops and bottoms.

But, because so many speculators pursue this ideal, they tend to laugh at those who sell too early. Hence, Rothschild's quote is in response to them.

Investors like Rothschild spend time figuring out what an investment is worth. Only then do they try to buy low and sell high. With the reference point of worth, or value, they can try to buy things below value and sell them above value. Not surprisingly, speculative stock movements lead them to buy before a stock bottoms and sell before it tops. In buying investments below value and selling them above value, though, they make fortunes over the fullness of time.

In other words, Rothschild has the last laugh. Speculators make fun of him for selling too early. But, his ability to sell too early is the reason why he keeps his gains, while the speculators end up holding investments on the way down. Using the rational reference of value, Rothschild buys low and sells high (and too early in most cases), while speculators frequently buy high and sell low trying to time tops and bottoms.

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, February 16, 2007

Does it really matter if it's the year of the pig?

Believe it or not, there were several articles in the financial news today emphasizing that we are about to enter a new Chinese new year--the year of the pig--on Feb 18th.

These articles described how many in Asia are using this sign of the times to make investment decisions. Apparently, the geomancers--people who divine the future by reading stars, numbers and energy flows--are telling people to stay away from stocks and bonds and to consider buying real estate and paper-related businesses.

This may be a good year for real estate and paper-related businesses, and it may be a bad year for stocks and bonds, but I don't think the stars or numbers or energy flows have anything to do with it.

If you think that such methods are a good way to make investment decisions, please consider the long term records of those who have made good investing decisions, and notice that there isn't a single geomancer among them.

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, February 15, 2007

Retirement withdrawal planning can be very complex

I read a fascinating article recently about retirement withdrawal planning in the November/December 2006 issue of the Financial Analysts Journal (Withdrawal Location with Progressive Tax Rates, Stephen M. Horan, CFA). Let me warn you, the Financial Analysts Journal is not light reading. However, the issues of the article and some of it's conclusions are important to consider.

Planning withdrawals in retirement can be complex because it's possible to have so many different kinds of retirement accounts to withdraw from: Roth IRA, traditional IRA, taxable accounts, etc. Which account you withdraw from and when can have huge implications on your standard of living and the length of time your money may last.

The reason is simple, each type of account is taxed differently when you withdraw the money. Roth accounts have no tax consequences at withdrawal. Tax deferred accounts (like traditional IRAs, 401(k)s, Thrift Savings Plans, etc.) are taxed at income tax rates, where the tax increases as you withdraw more money. Taxable accounts are currently taxed at a maximum of 15% for capital gains and dividends or at your marginal income tax rate for interest or non-qualified dividends (dividends that haven't been taxed at the corporate level like Real Estate Investment Trusts and Business Development Companies).

Which account you withdraw from may have significant tax consequences, and withdrawing from different accounts at different times could also significantly impact the amount of money you can pull from your retirement accounts and the length of time your money lasts. Added to this, tax deferred accounts like traditional IRAs require mandatory withdrawals, even further increasing the difficulty of figuring out how to withdraw your money.

The article mentioned above attempts to find the optimal strategy for withdrawing money. To simplify the problem, the author only looks at Roth and traditional IRAs to find the best strategy. He starts with the simple strategy of withdrawing from the traditional IRA for income needs first, and then withdrawing from the Roth IRA once the traditional runs out. Then, he tries the reverse strategy, Roth first then traditional. It turns out withdrawing from the traditional first leads to significantly higher withdrawal levels and longer lasting withdrawals.

He also tests mixes of withdrawals from Roth and traditional IRAs. What he finds is that withdrawing up to the 15% tax bracket level from the traditional and then pulling from the Roth next to meet spending needs is the optimal strategy. Of course, this depends on how much money you have saved, too. And it doesn't include taxable accounts, or pension distributions, or social security, etc.

I hope you're getting the picture: this is complex stuff. The article's math is very complicated, and as soon as tax rates change, his conclusions need to be retested. This is one difficult problem to solve, and it can have huge impacts on how much money you live off in retirement and the amount of time your money will last.

I hope some genius designs a computer program that will solve this problem for people. You know, just plug in the amount you have from each source and what you're getting from a pension and social security, and it tells you to pull out X dollars from A account, etc., so you optimize your income and its longevity. But, in the meantime, this will be one difficult problem to solve.

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, February 14, 2007

One of the best ways to find investment ideas

Over the years, I've found that one of the best ways to find great new investment ideas is to look at what other great managers, with excellent long term records, are buying.

Every manager with over $100 million under management has to file something called a form 13f with the Securities and Exchange Commission (SEC) at least 45 days after the close of the quarter. Every mid February, May, August and October you can find out what the portfolios of the best money managers in the country look like. In fact, by comparing their most recent 13f to the previous quarter's 13f, you can figure out exactly what they are buying, selling and holding.

This provides a great tool for generating additional investment ideas to look in to. And, these filers even include hedge funds managers, so if you know who they are, you can see what they've done with their portfolios every quarter, too.

I've worked pretty hard to generate my list of managers that I look at every quarter, so I'm not willing to share it. But, I can tell you that researching managers with great long term track records is a great place to start.

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.

Tuesday, February 13, 2007

Great article by Ed Easterling in John Mauldin's Outside the Box

I just read a great article by Ed Easterling in John Mauldin's weekly Outside the Box newsletter.

The article is about the safe withdrawal rate retirees should use in deciding how much of their savings to spend each year without running out of money. This is a crucial topic for everyone because we will all be retired at some point and need to know how much money we can spend and not run out.

Access the article here: http://www.investorsinsight.com/otb_va.aspx?EditionID=469

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.

The problem with deep value investing

If you've read much about investing, you may have heard that value investing beats growth investing over the long run. Numerous studies have shown this in detail. Basically, buying low price to fundamental stocks beats buying high-flying, glamour stocks. But, that's not the whole story.

I was reminded of this, recently, when I was reading David Swensen's book, Pioneering Portfolio Management. Swensen has been managing Yale's endowment for almost two decades and has been generating great returns, so what he has to say should be taken quite seriously.

Swensen warns against just being a deep value investor. What he says is that deep value investing does great until the proverbial 100 year flood comes along. At that time, low price to fundamental stocks get crushed because they tend to be lower-quality, fundamentally riskier businesses.

Deep value investing works like this: poorly performing companies have very poorly performing stocks. People who buy these stocks at super-depressed prices (deep value investors) get great returns as long as the 100 year flood doesn't hit. In other words, they get great returns for bearing the risk of a flood as long as this isn't the year a flood comes. This makes value investors' records look extraordinary--until the flood.

When the flood hits, such portfolios get wiped out! Jeremy Grantham's (of GMO) research on how these investments did during the Great Depression is revealing. From 1929 to 1933, high price to book stocks (higher-quality, growth-oriented stocks) declined 84.3%. In contrast, low price to book stocks (lower-quality, value-oriented stocks) declined 93%. This may not sound like a big difference because they both did terribly, but an 84.3% loss requires 640% growth to get back to break-even whereas a 93% loss requires 1,430% growth to get back to break-even. Put differently, that's a 9.7% annualized return for 20 years for the growth stocks versus a 14.2% return for 20 years for value stocks! When the flood comes, you don't want to be in deep value stocks.

Does this mean that value-investing isn't the way to go? Not at all. It just means that buying something simply because it is statistically cheap doesn't mean it will do well in all situations. Just because it has done well doesn't mean that it will continue to do well. Unless 100 year floods are a thing of the past or you can predict them with great accuarcy, you probably want to make sure your portfolio isn't filled with deep value stocks.

When evaluating investment managers, this method of investing issue becomes critically important. Looking at someone's 10 or even 20 year record isn't enough. You have to know more about the process they use. If Investor A has earned 18% returns by investing in deep value stocks, and Investor B has earned 15% returns by buying good companies below fair value, you may actually want to go with Investor B. That is, unless you know how to predict 100 year floods...

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, February 12, 2007

A great source for stock research

I'd like to make a quick pitch for a new book I bought this weekend: Morningstar Stocks 500.

First off, I do not follow this guide brainlessly. I find it to be a great way to look at potential investments. It doesn't cover every investment (only 500, hence the name). Their valuation method is not flawless, but neither is mine. Some of their recommendations and analyses are weak, but overall it's not too bad.

So, why do I like it? I think it's a great verification source. I like to use it to scan valuations of companies and to read their take on each business and management. Even when I disagree with them, it's pretty easy to understand why their take is what it is.

I also think their approach is spot on. First, they look at the economics of a business, its moat. Second, they look at management, what kind of stewards are they for shareholders. Third, they look at valuation, how much is a business worth. This is the same basic approach I use, too, and so I like to read others who take that same approach.

How should this tool be used? Personally, I use it after I've already done an evaluation of a potential investment. After I've learned about the business, its competitive advantages, its management, its financial reporting, and formed a thorough opinion of all these things myself, I like to look at Morningstar's take on the business and compare it to mine. Either I get a warm fuzzy because they did things similarly to me, or I can see how they evaluated things differently and I can question my position.

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.
Welcome to my blog

At long last, I've decided to start my own blog. In it, I hope to talk about things of interest to me and, hopefully, to you, too. This may cover investing, personal finance, personal news, various rants, or whatever I feel like talking about. I also plan to provide links to other information that I find out there, be it interesting books, articles, websites, whatever!

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.