4LB Investments, LLC - Investment Research & Management

Principles of Investing

Interpretation of Value-Investing
This article’s purpose is to give the reader a succinct description of value-investing.
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Like most other disciplines, investing does not lend itself to a unique method. As such, I will discuss my thoughts on several different areas as well as provide an overview of my methods. This is by no means exhaustive; it simply serves as a quick way for you to determine if my philosophies fit your needs. Sophisticated investors may want to skip through some or all of this but I encourage everyone to at least get a feel for my thinking as it will be important in determining if I can assist in your wealth creation.

Subsets of theories and principles are used by different investment managers and the following are the ones I find most valuable. These are not my ideas but collectively represent those foremost in my mind as I go about my work. Some, few would argue with and others many. In fact, I even argue against a couple but only so you can better understand my thinking.

I have been most influenced by a school of investors begun by the late Benjamin Graham and continued by the likes of Warren Buffett, Charlie Munger, Bill Ruane, Walter Schloss, Charles Brandes and others. It is known as value investing, but like any other school of thought individuals interpret the principles and form their own theories. Likewise, I have tried to identify methods most likely to create results that outperform a benchmark such as the S&P 500.

Principle #1: Wealth Creation - The return you receive on your investment should at least keep your purchasing power consistent over time. The optimal result is to increase purchasing power over time.

Investing is simply the saving of capital for future use. An investor may not need capital in the present and choose to defer its use with the goal of elevating one's standard of living. An investor should expect capital to grow disproportionately to inflation in order to increase purchasing power.

The return on an investment is interest whether it is a cash payment such as a dividend or capital appreciation which is an increase in value of the asset itself. There are three basic possibilities…

2. An investor could buy a stock for $80, receive no dividend payments over a ten year period and sell it for $100. This is capital appreciation.

3. An investor could buy a bond for $900, receive annual interest payments of $20 over a ten year period at which time $1,000 is returned. This is a combination of the two previous examples.

The main issue concerns purchasing power. Purchasing power refers to the exchange value of an asset over time. If a dollar will buy a loaf of bread in 2000, but only three quarters of a loaf of bread in 2010 then its purchasing power has declined. The contrary also holds true.

The terms inflation and deflation refer to the purchasing power of assets over time. The real rate of return refers to this comparison. If the real rate of return is positive, an investor's purchasing power has increased over time. The contrary also holds true. The real rate of return is calculated by dividing the nominal rate of interest by the inflation rate. For example, in 2000 a loaf of bread costs $1.00. In 2001 the cost increases to $1.05 meaning that inflation was 5% over the previous year. If $1.00 was invested at 4% for one year in 2000, the investor lost purchasing power in 2001. His $1.04 would no longer buy a loaf of bread. If $1.00 was invested at 6% for one year in 2001, the investor gained purchasing power. His $1.06 would not only by a loaf of bread in 2001; he would have a penny left over.

Interest versus inflation determines one's performance. Interest, or the return on one's capital, has three main components…

2. The inflation premium is an additional amount added to the nominal rate in order to preserve purchasing power. If the first two figures are estimated accurately in the present, one will increase their purchasing power by delaying consumption.

3. The third and final element is the risk premium. Different asset classes hold dissimilar amounts of risk and hence the astute investor will demand a higher return on a riskier investment. I believe U.S. Government Treasuries are less risky than a Roberto Clemente baseball card so I will demand a higher rate of return on the baseball card.

A simple mathematical formula will make this clearer…

Nominal Rate of Interest = Risk Free Rate + Inflation Premium + Risk Premium

The trade off between risk and return deserves further mention. The basic theory is that assuming more risk will lead to higher returns. This should be fairly intuitive. If I have a one in ten chance of getting my capital back with the expected return versus a one hundred percent chance, my return should be ten times as high. Thus if I purchase ten risky investments versus one sure thing, I come out the same. Risk simply refers to the chance of getting an expected return.

If I can purchase an oil well for $1,000 and make $100 for the year at which time I get my $1,000 back, then I would make a 10% return. Assume the return is guaranteed (the chance is 100%). If I decide to gamble by wildcatting, then the game will change. Assuming each potential well has a 10% chance of a 1000% return and a 90% chance of a 0% return; this opportunity offers the same return as the previous example. On the nine dry holes, I lose all my money and on the well that comes in, I get my original investment back plus a $1,000 return for a total of $1,100.

Individuals need to access their risk tolerance. If you cannot sleep at night while owning biotech stocks then avoid them and buy something less risky. Many people have become wealthy by owning stocks like Coca-Cola!

Safe investments include such securities as a U.S. Government bond or a bank CD. Very risky investments include start up capital for a bio-tech company or a lottery ticket. Keep these things in mind…

2. What will the future market demand be for the asset I hold

3. Will the supply of similar assets increase/decrease during the time I hold mine

Principle #2: Compounded Interest - Large sums of money are made when investors allow interest to compound. The avoidance of losses and deferral of taxes act to magnify this affect.

Another important principle is compounded interest. This simply means that as you achieve positive returns, the amount of the return, measured in dollars, grows each period. If you invest $100 at 10% per annum for three years then your return looks like this…

Each year your return is larger…$10, $11, $12.10. Over time the numbers are staggering. If I invest $1,000 at 10% per annum over 20 Years I will end up with $6,727.50. If my return drops to 8%, I will have only $4,661 or 30.72% less! If my return increases to 12%, I will have $9,646.30 or 43.4% more!

The real secret to compounding is to avoid losses. Consider the $1,000 invested for 20 years but with one twist. Instead of making 10% each year, our investor struggles in year two; he simply loses 5% instead of making 10%. Every other year he makes 10%. His total after 20 years is $5,810.11 versus $6727.50 or roughly 15.79% less! One bad year and over ten percent vanishes. This is one small example of the repercussions that will be felt from the market correction at the turn of the 21st century.

Capital gains taxes are a loss of capital and investors must overcome their effects. Selling profitable investments triggers a tax on one's gains. Current laws treat gains on investments held less than one year as ordinary income, which is taxed at the investor's current rate. Gains on investments held less than one year are taxed at one's ordinary income tax rate and gains on those held longer than one year are taxed at the 15% capital gains rate. One of my considerations in selling is whether the investment may decline more than the tax I will pay. If not, selling may not be the best option.

If an investor buys a $50 stock that returns 8% per annum for 20 years it will be worth $233.05. If, however, the investor sells after 10 years, pays capital gains taxes and reinvests the remaining capital a 9.75% compound return for the remaining 10 years will be required to reach $233.05! By selling the investor must continually make higher returns on the remaining capital in order to be in the same position. This simple example even excludes commissions which will require one to make even higher returns after selling and paying capital gains taxes.

Principle #3: Diversification - The more assets you hold in similar quantities, the less you will be hurt if one fails to perform up to expectations but only up to a point.

Diversification is great up to a point; however, diminishing returns eventually take affect. Pay close attention because this section depicts one of the ways I differ from most other investors. So as not to get too theoretical, let's take a simple example - the S&P 500. This is a stock index made up of the 500 most representative U.S. companies as determined by Standard & Poors. I use it as my benchmark or that by which I judge my performance. If I simply purchased the 500 stocks in the S&P 500 in amounts equal to those by which the index is calculated, I would make what is called a market return - I would do no better and no worse than the market. To attempt to do better than the market, I invest in stocks in different proportions to the index.

If I was sure (run from anybody that is) that General Electric was going to beat the index over a period of time, I could simply buy that one issue and accomplish my goal. The question is how many stocks make up an optimal portfolio that has limited risk and is more likely to outperform the benchmark. My belief is that about 20 assets, spread across 7 to 10 areas will accomplish full diversification. This is a bold statement and dangerous if not understood correctly so don't try it at home!

2. Consider the differences of the benchmark's components. Again using the S&P 500, one would not be able to buy 20 restaurant stocks and be considered to have fully diversified.

Large investors, namely mutual funds, are forced into a different game than that which I just described. Many mutual funds hold hundreds of stocks and make frequent trades in an attempt to beat their benchmarks. One reason is that mutual funds have huge amounts of money to invest and shy away from huge positions in few securities. Another is that the fund managers want to protect their reputations by at least following what the others are doing in this regard. Warren Buffett has brought this subject up at Berkshire Hathaway's annual meetings. His available capital has grown astronomically and his universe of potential investments has diminished. If fact, he has been forced to buy entire businesses that are not publicly traded.

Principle #4: Cash Flow - In ANY investment you must look at only four things in regard to returns. How much cash do I need to give up today? How much cash will I get back? When will I get cash back? What are the chances I will get the cash back as expected?

I use the word investment in the definition because emotional purchases should not be considered investments. That diamond ring or Porsche may bring unending happiness but not a positive cash return.

The majority of my day to day work involves this area. I analyze companies from a historical prospective to determine the quality of their cash flows and then make assumptions about the cash flows going forward. These future cash flows are discounted at my required rate of return and the value derived is called the intrinsic value. This value is compared to the current market price in order to determine if the issue is undervalued, overvalued, or fairly valued. I look for undervalued companies because I feel the market will eventually recognize the true value and raise the price proportionately. Think of this as buying a Mercedes S500 for $40,000 as opposed to $100,000.

For example, if the intrinsic value of General Electric is $45 and it is selling for $30, I consider it undervalued by 50%. Let's say I use a ten year model with a required rate of return of 10%. This means I expect to receive a 10% compounded return if I pay $30 per share today, the additional $15 that I hope to realize will add to that return if it is recognized within the ten year period. This is an oversimplified example; in reality I assume growth to slow in future periods as companies mature thus reducing returns. The point is that buying stocks that do not reflect growth prospects is a way to achieve higher returns.

Discounted cash flow models are very sensitive to assumptions. A slight miscalculation in growth rates makes a big difference in intrinsic value. I attempt to be as accurate as possible on growth rates but will err to the conservative side. If a company looks attractive with conservative estimates built into the model, there is only additional upside to be expected!

Principle #5: Be a Selective Contrarian - The best time to buy a company is when the price has dropped below intrinsic value due to a sell off you determine is unwarranted.

A study by Fama and French determined stocks that had huge drops in price often outperformed the market in the ensuing two years. Contrarian investors realize this and buy ANY company that has had problems. Selective contrarians buy only those companies that they feel have the economics to recover.

It is not enough for me to simply buy any investment I feel trades below intrinsic value, I must feel that current valuations do not reflect long term fundamentals. Typically, I start tracking stocks I have analyzed and wait for some event to drive the price below intrinsic value. Short term thinkers flee the stock thus driving down price and hence creating a buying opportunity.

Principle #6: Efficient Markets - Many believe that at any given time the price one pays for an investment reflects all information disseminated to the public but this is wrong. Crowds of people tend towards extremes thus making future adjustments necessary.

The purpose of markets is to bring buyers and sellers together to affect transactions. This means that for every buyer a seller exists. Either they have different needs or contrary opinions. I have always believed that there are more different needs than contrary opinions. The Efficient Market Theory basically states that in total all the opinions of the buyers and sellers lumped together will approach an accurate estimate of fair value. For example, if I asked a group of people how much a loaf of bread is worth, the average answer will be the optimal market price.

The majority of today's investors look for a quick return. Mutual funds are notorious for trading in and out of stocks each trying to beat the others to the punch. I know because I worked for a fund company for as long as I could stand it! Because of the quest for short term results, investors understanding the long term economics of a company can take advantage of bad news affecting the short term. An example would be a company missing quarterly estimates but likely to perform well over a ten year period. Short term investors sell the stock thus driving down the price and hence creating an opportunity for long term thinkers.

Additionally, if all opinions in total approach the true value then there are sales/purchases both above and below this figure. Those who buy at prices below true value will reap better returns than those buying at higher prices. If one has a good idea of values then he or she can take advantage of swings in the market. One must discern between information that truly affects value and that which does not. Markets tend to over react in both directions to information that is impertinent to value. Simply look at the internet bubble during the turn of the century and ask yourself if those investments were trading on information solely linked to true value.

Principle #7: Self Evaluation -There are certain characteristics that successful investors have. Find someone else to manage your money if you do not possess them. Additionally, find someone else if you do not have the time to spend on proper analysis and don't want to index.

To be successful, you must either analyze investments yourself or find a source you trust. If you opt for external sources, make sure they are unbiased and up to date. Several analysts have landed in the hot seat for inflated opinions of companies. In most cases they did so to secure investment banking business for their firms. I can tell you from experience that proper analysis is very time consuming.

Self confidence is very important as well. You should select an investment and stick with it unless the company breaks down economically or intrinsic value is exceeded. Listening to the crowd can lead to sub par results because one will constantly doubt their decisions as naysayers emerge. On the contrary, you may make purchases for the wrong reasons as cocktail party hype leads you to unfounded decisions.

Realistic expectations going into investing will help immensely. Excess returns in a specific asset class will not continue forever, eventually they will trend with the economy. Historical returns can be sliced up in a number of ways, I do not include any due to this. Basically, I want to make about 10% per annum regardless of my asset allocation.

In real estate they say location, location, location; in investing I say patience, patience, patience. If short term fluctuations bother you, find someone else to manage your money, you will make bad decisions. Remember only sell if the economics of a company break down or intrinsic value is exceeded.

Principle #8: Bonds - Bonds are great at certain times and for certain investors but cannot be expected to create wealth as fast as other investment classes.

The value of a bond is straight forward to calculate, simply discount the cash flows at current interest rates. Sound familiar, it should, that is how to calculate the value of all investments. One of the big differences with bonds is that in most cases future cash flows are known. They are written into the agreement between lender and borrower. As interest rates change, bond values change.

The main concept is as interest rates increase, bond values decrease. The contrary holds true. A second concept is that interest rates vary depending on the time period involved. A graphical depiction is called the yield curve. Bond investors are constantly trying to determine the future of interest rates in order to identify opportunities. This is very difficult to do and my recommendation is to buy bonds if you want to diversify or like the income prospects. Don't try to trade bonds in the short term.

One of the reasons most bonds under perform other investment classes is that they offer less risk. Remember that less risk equals lower yields and vice versa. If you buy a bond based on that days interest rates and hold it to maturity, you will make a known return. This is how I recommend you enter the bond market. One additional idea to consider is that if interest rates drop substantially leading to a large gain, you may want to sell your bond and realize the higher return. Make sure you have other investments in mind before doing this.

A final note on bonds, their low returns have historically been around that of inflation thus leading to a real return close to zero. In buying bonds, you are simply saving your money for the future not trying to increase your purchasing power. As one ages, they may opt to put more of their assets into bonds as they will have more income on which to live. Capital appreciation becomes less important.

Principle #9: Mutual Funds - the vast majority of mutual funds are unexciting as their pitfalls outweigh their upside.

I am not a big believer in most mutual funds for several reasons. I have worked in and around that segment of the industry and came out of the experience less enamored than ever. Keep one thought in mind as you read this, about 70% of all mutual funds under perform their benchmarks in any given year. Additionally, those outperforming in one year tend to under perform in the future making the number of funds that boast continued out performance very few in number.

Mutual fund managers tend to move around as better opportunities emerge and they must leave their records with the fund. This means if Bill Miller leaves his post managing the Legg Mason Value Fund, he cannot take his stellar record with him. If you look at mutual funds, consider the manager and look into his track record elsewhere. This can eliminate many unpleasant surprises.

Mutual funds tend to have high turnover rates. This means managers buy and sell investments frequently. A 100% turnover means that the entire value of the portfolio has been bought or sold over a one year period. For example, if the fund was worth $6 billion on January 1st, then $6 billion dollars of trades occurred during the year. Buying and selling triggers tax consequences that are passed on to the investor. I know of several people who have received nasty surprises relating to capital gains taxes due at inopportune times. Consider the turnover rates.

Mutual funds tend to hold a large number of securities, most in excess of 100. The sheer number of holdings makes it hard to outperform the benchmarks. Remember holding more than 20 securities has diminishing returns i.e. the more you hold the more likely you are to achieve the market return.

Some mutual fund managers have little or no money tied up in their own funds. They are simply playing with other people's money. This shows me no confidence on the part of a manager. Let me know if you can figure out how to get it, but knowing what percentage of the managers net worth is tied up in the fund is invaluable.

Fees are another consideration. Some funds charge a load or upfront fee when you invest. If the load is 5% than $5 out of every $100 disappears immediately thus putting you in the hole to begin with. Exit fees are another consideration and are basically penalties for moving your money elsewhere. (Probably due to the inept performance of the manager in the first place!)

Principle #10: Indexing - Buying either a traded security or mutual fund linked to an index is a great way to go for many people.

When I have small accounts, I tend to index. Buying several securities in order to diversify leads to high commissions which have to be overcome to receive good returns. When these accounts grow large enough, I switch management styles. By indexing I will be market neutral which has not been a bad choice over time.

Who should index? Those who do not feel the market can be outperformed over time, those that cannot devote the proper time to analysis or those who cannot find a manager they trust.

In conclusion, I hope this brief essay helps you understand some basics of investing. My investment style is to try to take advantage of discrepancies between intrinsic value and market prices. Most would consider me a value investor and history has shown this school of thought to produce the best results. Started by Benjamin Graham, value investing has been practiced by none other than Warren Buffett as well as several other legends.

My specialty is to manage individual's stock portfolios along the lines I have discussed. Some clients choose to have me manage the entire equity portion of their assets and others give me a portion. There is no right or wrong way to allocate your assets. It comes down to personal preference. Pundits come up with all sorts of formulas to determine how to allocate assets and I feel they come dangerously close to group think. I personally know people who have allocated the vast majority of their assets to unique classes such as real estate or stocks. I believe this to be the best way to accumulate wealth IF you develop extensive knowledge in a particular area. I would certainly not try to invest in futures with my limited knowledge; I would seek the advice of someone else.