Invest Wisdom

This is the last in a four-part series on value investing. It follows a story I wrote for Money magazine in this month’s issue. Leading up to this post, I wrote about what value investing is, how to use a price-to-earnings ratio, and how to pick companies that will continue to grow earnings.

To finish off my series on value investing, I’m going to talk about a couple additional things value investors should do in this market that might not have been a focus in the past.

So did you understand how AIG made money? Be honest.

1) Buy businesses you can understand, and

2) Make sure the company doesn’t have a lot of debt that comes due soon.

Neither of these things are really “new”. Any value manager worth his salt should have done this before the credit crisis, but when earnings were rolling in and credit flowed freely, it might not have seemed urgent at the time.

Understand the business

You probably thought you knew how banks and insurance companies made money. But needless to say, most of the companies that are in deep trouble right now were the same ones that found “innovative” profit centers during the boom. AIG, for example, had plenty of vanilla insurance products that you’d recognize from its cheesy and now laughable commercials. But unfortunately for investors, it delved into credit default swaps, which basically bankrupted the company.

Before you invest in any company, pull their most recent annual and quarterly reports, which you can find in “Investor Relations” at the company’s websites, and read them front to back, including footnotes. If there’s anything that you don’t understand, research the topic until you do understand it or don’t invest at all.

AIG’s failure was spectacular, but mistakes can be made on a less dramatic scale. Warren Buffett famously avoids investing in most tech companies, not because he doesn’t think they have potential, but because he doesn’t understand how the companies work. He prefers investing in companies like Coca Cola and See’s Candies (which isn’t a public company), which make profits in very understandable ways. His companies’ profits can still go down, but at least that risk was known before the investment.

For me, personally, that means no investments in banks, insurance companies, and companies that rely on new technology. I do, on the other hand, know a lot about media properties and real estate companies, by virtue of the business I work in and the businesses I’ve covered in my career. (I also know enough to see that there aren’t many great investments in those areas). Your expertise is probably completely different.

Check a company’s debt structure

This is probably the most complicated thing I’ll talk about in this series, but it’s also one of the most important and is unique to this crisis.

Several years ago, companies had no trouble borrowing money. If they had bonds that matured (which means that they have to pay back the millions of dollars that they had initially borrowed), the companies could just roll over (i.e. refinance) that debt without a problem. But now, even companies with good credit history are having trouble refinancing large amounts of debt. If they are able to refinance, they’re having to pay very high interest rates.

That kind of a problem can bankrupt or seriously cripple an otherwise healthy company. And for that reason, make sure the company doesn’t have a bundle of debt coming due in the next three years. Hopefully, by 2012 or sooner the credit markets will have completely loosened up. But until then, take nothing for granted.

To make sure that a company isn’t about to face a refinancing problem, follow the steps detailed in my value investing story for Money in the last section. Again, this might not be a huge issue once the credit markets finish thawing, but right now, it most definitely is.

Well that’s it for now. Even in a few thousand words, this is really only a basic outline of some of the things value investing encompasses. If you don’t have the time or inclination to continue studying the subject, stick with an index fund or an actively managed fund that focuses on value stocks. (For a list of funds that Money magazine recommends, click here.)

Thanks again for reading.

- Joe Light

The Federal Reserve decided to leave the target interest rate between 0% and 0.25% today. Even before the Fed’s news, the market had soared, and it’s continued its climb upward since the Fed’s announcement. As of this writing, it’s up more than 2.5%.

I’ve always tried to be as candid in this blog as possible. While I did write that the stock market appears to be undervalued a couple months ago, I don’t understand why the stock market run up has been so dramatic. As the Fed’s statement today noted, the economic picture is still worsening, albeit at a slower pace.

Fed chairman Ben Bernanke

What really has me worried though is what happens once the economy does turn around. The stock market tumble has been marked by a flight to quality: risky assets, such as stocks, have been shunned in favor of ultrasafe assets. The ultrasafe asset of choice for the world’s investors has always been the U.S. Treasury bond.

So, billions of dollars that got pulled out of the stock market went into Treasuries, driving their prices down, and allowing the federal government to finance this bailout at extremely low rates. As long as people desperately want Treasury bonds, the government can continue to borrow money at only 1% to 3% interest.

But what happens when confidence in the market is restored, and that money comes streaming out of Treasury bonds and back into stocks? Sure, the picture looks good for the stock market, but what interest rate will the government have to offer to get people to keep buying Treasuries?

Take this quote from the Federal Reserve statement: “In addition, the Federal Reserve will buy up to $300 billion of Treasury securities by autumn.”

In other words, to keep interest rates low, the Federal Reserve is already buying Treasuries. This means that the federal government is already printing money.

Once people are willing to take risk again and less liable to buy Treasuries, how is the Federal Reserve going to be able to keep interest rates from getting out of control as tons of Treasury debt needs to be refinanced? A common answer is that the U.S. economy could grow its way out from under all that debt, but if nothing else, hasn’t the market proven itself to change its perception rapidly between euphoria and fear and back again? If so, do we have time for the market to grow the country out of debt?

It’s a classic catch-22. The government’s success in restoring confidence in the markets will also make it more expensive for them to borrow money. I don’t have the answers to any of those questions. It’s just one more fear of mine that will or won’t play out down the road.

- Joe Light

On Monday and Tuesday, I wrote about what value investing is and provided an introduction to the price-to-earnings ratio.

Today, I’m going to write about four things that value investors look for beyond a low P/E:

1) Wide economic moats

2) Strong brands

3) Consistent earnings, and

4) A margin of safety

Investors study economic moats, brands, and earnings consistency (and many aspects in addition to them) for the same reason: They want to make sure that the E (earnings) in the P/E ratio stays steady or grows after they buy the stock. In yesterday’s example, we looked at Wal-Mart, which had earnings per share of $3.43 in the last twelve months. That gave it a P/E of 14.5, which was below that of its industry and of the S&P 500.

But what if those earnings per share dropped sharply after you bought the stock? Let’s say they dropped by 30%, which doesn’t look that unreasonable in this economy. Instead of $3.43, Wal-Mart’s earnings would be about $2.40. A stock that you bought at a P/E of 14.5 would suddenly have a P/E of nearly 21. And more than likely, the stock price would drop as a result of that.

Studying the factors above helps investors predict whether or not there’s a chance those earnings will erode.

Wide economic moats

A wide economic moat is basically a high barrier of entry into the industry. A mom-and-pop hero sandwich shop, as I talked about a couple days ago, has a very small economic moat. Anyone could start their own hero shop next door and immediately cut into the original store’s business.

That makes its earnings extremely vulnerable. Even though that hero store owner might make $300,000 in one year. If someone started a store on the opposite corner and charged lower prices, he’d likely lose business and have to lower his own prices.

Wal-mart, which is a discount retailer on a massive scale, has a very wide economic moat. To offer the prices that Wal-Mart offers, a retailer would have to buy inventory in bulk, have a huge distribution system with razor-thin expenses, and rent about 100,000 square feet of retail space for each store. That’s not impossible, but it’s unlikely another retailer will enter the business. There is another major retailer that still survives in the space — Target. But Target is a known competitor whose impact on Wal-Mart’s earnings should already be reflected.

Company’s with wide economic moats tend to have low costs, high return on capital, and huge marketshare in their industries.

Now let’s take a look at a company like Research in Motion, the maker of the Blackberry. Research in Motion is basically in the communications business–its device lets you view emails on your cell phone and send them instantly between devices or to computers.

At one time, it might have looked like such a network was unique and had a wide economic moat. But now, pretty much every phone maker out there is putting out a “smart phone” designed to attack the very same business Blackberry has relied on. The iPhone has already been a major entrant into the scene. While Research in Motion’s earnings per share was $3.11 in the last twelve months, it seems unlikely that they can maintain that as the iPhone’s reach expands.

Strong brands

A couple months ago, PepsiCo redesigned many of the major logos of its brands. Some were a success, but there was one overwhelming failure: the redesign of Tropicana orange juice.

Tropicana's new design (left) and its old design.

Instead of the characteristic orange with a straw stuck inside, shoppers saw a slicker, toned down version that some people complained looked like a generic brand. The result? Tropicana orange juice sales plunged 20%. Needless to say, they’re returning to the old design.

A company with a strong brand has an emotional connection with the consumer. They look for the characteristic metallic red cans and cursive writing that signify a can of Coke or the slick white or silver designs that mark an Apple product. Brands develop overtime and can’t easily be replaced by a competitor.

Coke and Apple, as mentioned, are easy examples of companies with strong brands. They don’t necessarily have to have a well-recognized brand among the general populace. Cemex, while not the most well-known company among the general populace, is certainly known by construction companies that purchase their cement.

Young companies, of course, don’t have that brand recognition, which makes their business more vulnerable to competitors.

Strong normalized earnings

If you just look at the current P/E of a company, all you’re really getting is a snapshot of how the company performed at a moment in time. For mature companies, many investors like to look at something called “normalized” earnings rather than the earnings of the last year.

Earnings that are normalized are averaged over time. So instead of looking at a company’s 2008 earnings, you look at its average earnings for 2004 through 2008. By looking at a longer time period, you smooth out the peaks and valleys that companies might experience because of a temporary setback or economic cycles.

Take a look at Wal-Mart’s 10-year earnings track record. Over five years, its earnings has averaged $2.60 a year. Over the last ten years, it’s been $1.99. The 10-year average is much lower because Wal-Mart’s earnings grew pretty sharply over that period.

Divide Wal-Mart’s per share price of $48.47 by the normalized earnings, and you get a P/E of 18.6 for the five-year earnings and of 24.4 for the 10-year. To put it in terms of yield, paying $48.47 for a share of Wal-Mart right now would yield you about 5.4% if Wal-Mart’s earnings keep up with its 5-year track record.

The margin of safety

As you can see, all of the things listed above are very subjective. Does Coca Cola have a stronger brand than Pepsi? Is Wal-Mart really invulnerable to a start-up competitor or an expansion of Target? In other words, there’s a very good chance that at least one of your assumptions will be wrong.

The “margin of safety” is supposed to give you leeway in case your estimates are off. By definition, the margin of safety is the difference between the market price of a stock and the “intrinsic value” of a stock.

Let’s say you look a company such as Wal-Mart and decide that the company’s earnings consistency and wide economic moat make an investment in such a company about 5% riskier than the yield you could get in an ultrasafe CD. In other words, given what you know about Wal-Mart, you’re willing to put your money at risk for an additional 5% of return. What do you know? Wal-Mart’s P/E of 14.5, gives you a 7% yield exactly. So you buy the stock at its current price of $48.47.

But, as is likely the case, pretend one of your assumptions about Wal-Mart’s safety was wrong, and its earnings dropped by 10%. Now you only have a yield of 6.4%, below your target. You can’t just sell the company, as its stock price has probably fallen to reflect that.

Your purchase had no margin of safety, and just the slightest error caused it to be a bad investment.

Now let’s pretend Wal-Mart was selling for $40 per share, instead of $48.47. You would have been happy with a 7% yield in Wal-Mart, but at $40 per share, Wal-Mart is actually yielding 8.6% ($3.43/$40 * 100). Your estimate ends up being wrong, and earnings drop 10%. Even with the miscalculation, your yield is still 7.7%, which is well above your target. ($3.09/40 * 100). In fact, at the share price of $40, you could withstand an 18% drop in earnings without passing your target.

That, in a nutshell, is why value investors never want to pay what they calculate as the “fair value” of a stock. They want to pay a huge discount to that.

How big a margin of safety is big enough? As a general rule of thumb, the more uncertain you are about your estimate, the bigger a margin you want. I’d feel pretty confident in my earnings prediction for a company that’s earned exactly $1 per share per year for the last 10 years. Whereas I might not be as confident (and would want a bigger margin of safety) for a company whose earnings wavered between $1 per share and $5 per share in that time period, or for a company who makes a product that could easily being overtaken by the next hot item.

Tomorrow, I’m going to talk a little bit about other ways investors try to value companies and about what’s changed about value investing since Graham and Dodd articulated the process. If you got to the end of this post, congratulations! You’ve read nearly four times more about value investing than I was able to detail in my recent Money article. And really, we’ve only brushed the surface.

Thanks for reading.

- Joe Light

Hello attendees of the Carnival of Personal Finance at Weakonomics! Thanks for checking out my blog. The post below was the second in a four part series on value investing. The series started here, and continued here and here.

I really appreciate that you’ve come to check the series out. Subscribe here if you like what you see. And remember to check out today’s post which highlights five things investors should remember from Berkshire Hathaway’s annual shareholder meeting (the company Warren Buffett runs).

——

Yesterday, I wrote about the foundation of value investing and what value investors strive to do.

Today, I’m going to give a quick summary of value investors’ most popular tool, the Price-to-Earnings (i.e. P/E) ratio.

The P/E ratio is probably the most widely used measure of a stock’s value out there. I’d argue it’s also the most understood. I’ve read about investing strategies that rely on nothing but the P/E ratio to choose stocks. That doesn’t make sense, and I’ll do my best to explain why.

Calculating a price-to-earnings ratio is easy. You take the company’s current stock price and divide it by its earnings per share. Both of those can be found as popular websites, such as Yahoo! Finance, but most of the time, those same websites will simply give the P/E to you, already calculated.

The number that’s used for the earnings per share can vary between services. Most of the time, the default is to use the earnings from the trailing twelve months (TTM). But sometimes you’ll see a P/E based on estimated earnings for the forward 12 months or for the current fiscal year. All three of these kinds of P/Es are important. A service such as Morningstar will give you all three P/Es.

In effect, the P/E tells you what your money will yield, similar to the yield calculated for the hero sandwich shop in yesterday’s post. Except the ratio is inverted. To get the earnings yield, you divide the earnings per share by the price. The P/E is just the opposite.

Rather than take two mythical companies as we did yesterday, let’s look at an actual stock — Wal-Mart (WMT).

Go to the Morningstar page for Wal-Mart, click on “Valuation Ratios”, and you’ll get this page.

Wal-Mart’s price-to-earnings ratio, using trailing twelve month earnings, is 14.5. The retailing industry has a P/E of 15.8, and the market as a whole (represented by the S&P 500) has a P/E of 15.5.

I just threw a whole lot of numbers out there, but the basic premise is pretty easy. All else being equal, you want a company whose P/E is lower than that of its peers and that of the market. Wal-Mart’s stock meets both criteria.

If you look at Wal-Mart’s P/E based on estimated earnings (Click on the “Forward Valuation” tab), you’ll see a forward P/E of 12.5. This is even lower than its current P/E and means that analysts predict the stock’s earnings will go up this year.

——

Easy buy, right?

Well, the problem is the “all else being equal” part. Analysts regularly underestimate and overestimate earnings. What’s more, the P/E ratio doesn’t take into account any assets or debt that company has.

Take two companies. One has a P/E of 14, $100 million in cash on its balance sheet, and no debt. The other has a P/E of 14, $50 million in cash, and $400 million in debt. If you looked just at the P/E ratio, those companies would look equal. But take a look at the company’s balance sheet (where the assets and debts are recorded) and you’ll see a big difference.

Some investors try to take this discrepancy into account by subtracting cash from the share price or adding debt to the share price to calculate the true cost (known as “enterprise value”) of the company.

If you look at Wal-mart, for example, you’ll see that the company has $52.9 billion in “current” or liquid assets and $102.3 billion in total liabilities. (To find that, click on “Financial Statements” > “10-year balance sheet”) So its net liabilities are $49.4 billion. Divide that by the number of shares of Wal-Mart (about 3.9 billion) and you get net debt per share of about $12.61.

So while a share of Wal-Mart costs about $48.40, you’re actually taking on an extra $12.61 of debt, bringing the total per share price to $61.02.

Take $61.02 and divide by Wal-Mart’s per share earnings ($3.43) and you get an enterprise value/earnings ratio of 17.8. Doesn’t look as good now, right?

——

That’s just one of many reasons why a P/E is too blunt an instrument to use by itself in valuing companies. 17.8 seems like a high ratio, but Wal-Mart gets a premium for being a market leader in its industry and for having strong growth prospects in a recession. Unlike those of a company whose earnings are dropping (like an automaker), Wal-Mart’s earnings will probably grow over time. Investors know that. So they’re willing to pay a higher P/E for Wal-Mart.

In addition to looking at the P/E of companies in the traditional way, I’d recommend thinking of the P/E in an absolute sense. A company with a P/E of 10, for example, is giving you about a 10% yield for your money. That’s compared to guaranteed 2% to 4% yields in ultrasafe investments like CDs or money market accounts. When you see the 10% yield, tell yourself, “I could guarantee myself a 2% yield if I just stuck my money in a bank account. How confident am I that the company will be able to maintain or improve its earnings? And does the extra 8% yield pay for that additional risk?” If the answer is “very confident”, then the 10% yield is a very good deal.

A P/E of 10 in a company like Wal-Mart looks much better than a P/E of 10 in a company like GM. That’s what value investors mean when they say they look for companies with stable earnings, wide economic moats, and strong brands. What they’re really saying is just that they look for companies where they’re confident the earnings won’t erode.

Unfortunately, that kind of judgment is qualitative, not quantitative, and it separates brilliant investors like Warren Buffett from the also-rans.

You don’t have to be as adept as Buffett to find bargain companies. Most of the “secret” is simply to build in a margin of safety in case your estimates are off by a small (or sometimes wide) margin. I’ll address those qualitative measures in tomorrow’s post.

Thanks for reading.

- Joe Light

If you’re coming from the Carnival of Financial Planning, welcome, and thanks for stopping by. If you like what you see here, remember to subscribe!

——

Yesterday, the market dropped 1%. Most media outlets assigned the drop to fears that swine flu could cause a worldwide pandemic.

I’ll admit that I was first skeptical of the idea that investors would react that way to a disease that’s only infected 50 people and killed no one in the U.S. (as of last night). Tamiflu, which has been found to be an effective treatment, is already stockpiled. (And if it’s resistant to Tamiflu, stockpiles of other drugs are available.

Now don’t get me wrong. It sounds like this flu has the potential to be a big deal. I feel sorry for those who have suffered from it or died, and I know that I’m suffering from a bit of “boy who cried wolf” fatigue, after the bird flu and SARS false alarms. But swine flu causing the market to fall?

Well, before I went into a huff about how the markets and the media always blow a small problem out of proportion, I did a little research. Last year, the World Bank estimated that a massive pandemic, such as the Spanish flu in the early part of the 20th century would cause world GDP to drop by 4.8%. A “moderate” pandemic, such as the 1957 Asian flu which killed 14 million people, would hurt GDP by 2%. A mild flu pandemic, such as the one starting in Hong Kong in 1968, would hurt GDP by less than a percentage point.

The big question, of course, is how bad will this one be? And how much would the market suffer as a result of that?

A popular method of measuring world stock market values is to take a country’s total market capitalization (that is, the total value of all companies in the country) and divide it by the country’s gross domestic product.

Right now, the market cap of the S&P 500 is $7.5 trillion. The U.S.’s GDP in the fourth quarter of 2008 was $14.2 trillion. That gives us a ratio of about .53 .

The World Bank’s estimate was for world GDP, but let’s assume a potential pandemic affected the U.S. proportionally. The U.S.’s GDP is already expected to fall this year for other reasons, but let’s just measure what the swine flu’s impact alone would be.

In the event of a major pandemic, where U.S. GDP dropped by 4.8%, U.S. GDP would drop to $13.5 trillion. Keeping the .53 ratio, the S&P’s market cap would drop to about $7.2 trillion, which is a 4.5% 4.8% drop in the S&P 500’s value.

For a moderate pandemic, where GDP drops by 2%, you’d expect a 1.7% 2% market drop.

For a mild pandemic, where GDP drops 0.7%, you’d expect a 0.36% 0.7% drop.

The market’s drop of 1% yesterday (if it wasn’t paying attention to anything else, which is unlikely), factored in a pandemic somewhere between the mild 1968 Hong Kong flu and the moderate 1957 Asian flu, if you believe the World Bank’s numbers.

Now for my disclaimer: There are so many assumptions I just made that it’s difficult to list them all. The market cap to GDP ratio might not remain consistent in the event of a GDP drop, since investors tend to look past short-term setbacks. In other words, while GDP would drop 4.8% in the event of a major flu, would there also be a huge rebound once the flu passed? Does the current economy’s fragility make it more susceptible to a setback by the flu? And so on.

I do hope, however, that this helps put the crisis in perspective.

Come back later for my second post in my series on value investing.

Update: I now realize that I did a bunch of calculations that really just explained something very simple: the market cap should fall in proportion to the GDP’s fall. And a 1% drop in the market, would seem to project a 1% drop in GDP, which is somewhere between the mild and moderate flu pandemic scenarios. Not sure why actually sticking all those numbers in a calculator came up with slightly different numbers. It probably has something to do with rounding and dealing with trillions of dollars.

- Joe Light

As far as I can tell, I’ve finally completed the process of moving Invest Wisdom to its own domain. You can now find the blog at www.investwisdomblog.com, so please update your bookmarks and links if you have them!

All traffic going to the original wordpress.com site should automatically forward to this site. I’ve also updated Feedburner. So those subscribed to Feedburner’s feed should receive the blog just as they always have. Those of you subscribing some other way can find the feed at www.investwisdomblog.com/feed .

Please let me know if anything seems messed up, and I’ll get right to work on it. You can contact me at joelight at gmail dot com.

Thanks again.

- Joe Light

If you’re coming from the Money Maniac blog carnival, welcome! The story below was the first in a series on value investing that continued over the next few days. Thanks for visiting and please subscribe if you like what you see.

—-

A story of mine from the May issue on value stock investing just hit the website a couple days ago. While I’m happy with the final product, it’s a classic example of why I started this blog. For space issues, editors and I cut the story down to 650 words or so. But as you can imagine, value investing is just a tad more complicated than that.

Over the next four days I’m going to give a primer on value investing. I’m also hoping to have my regular news-based posts for readers who know this stuff already.

Here’s what’s coming up:

Today: Where value investing comes from. What is a value investor?

Tomorrow: What is a P/E ratio and how is it used properly?

Wednesday: Understanding a company’s business. How to make sure a company’s earnings don’t disappear after you buy it. Building in a “margin of safety”.

Thursday: What’s different about value investing today? Other measures of “value” in a company.

Security Analysis by Benjamin Graham and David Dodd

I hope you find it informative.

———

The invention of “value investing”

You might not be sure of the definition of value investing, but you probably do know its greatest living proponent, Warren Buffett. If you spoke to Buffett, he’d actually point to his mentor, Benjamin Graham, as the greatest value investor of all time.

Graham, and co-author David Dodd, literally wrote the book on value investing—- Security Analysis. In the preface of book’s latest edition, modern value investor Seth Klarman aptly summarized their philosophy this way:

Value investing, today as in the era of Graham and Dodd, is the practice of purchasing securities or assets for less than they are worth—-the proverbial dollar for 50 cents. Investing in bargain-priced securities provides a “margin of safety”—-room for error, imprecision, bad luck, or the vicissitudes of the economy and stock market. While some might mistakenly consider value investing a mechanical tool for identifying bargains, it is actually a comprehensive investment philosophy that emphasizes the need to perform in-depth fundamental analysis, pursue long-term investment results, limit risk, and resist crowd psychology.

Whereas speculators hope that their purchases gain rapidly in value, Klarman says, value investors strive to avoid losing money.

You see, Graham and Dodd wrote the first edition of the book in 1934, after seeing the most dramatic stock bubble in history followed by the most dramatic bust. Their book was meant as a way of sorting through the thousands of low-priced securities to discover which were good investments.

It might surprise you to know that times like today, when stocks of nearly all companies are severely beaten down, are when Graham and Dodd would find the most bargains. It’s during manias like the tech bubble and real estate bubble that fairly valued companies are hard to come by.

The trick is figuring out what “fair value” is.

What is a value investor?

Imagine that your cousin Joe started a hero sandwich restaurant a year ago. Its earnings steadily increased for the first few months as customers got word about the place, but now they’ve leveled off, and Joe thinks it will earn about $30,000 this year after paying his rent and employee salaries. Joe’s grown tired of the fast food business and wants to sell it to you for $400,000. You have the money to buy it, but aren’t sure if it’s a fair price.

This is the dilemma facing any stock investor. An owner (the stock’s seller) doesn’t want to own it anymore. The stock’s buyer needs to decide what he’s willing to pay.

You could put your money in a money market account right now and earn about 2% on your investment without any risk. So if you bought Joe’s restaurant, where a competitor could come in and snatch your business in a heartbeat, you’d want a much greater return than that.

Before buying Joe’s company, you do a bit of research. You look in the classifieds of your local business newspaper, and find a lot of other companies similar to Joe’s. One is selling his burger restaurant for $500,000 and it makes $60,000 a year. Another is selling his pizza joint for $200,000, but it only makes $20,000 a year.

All told, you find that restaurants like Joe’s give their investors about a 10% return for their invested money.

But you take it a step further. You go to the local library and look at the microfiche of your local newspaper’s classifieds to find the prices that restaurant sellers were requesting for the last several years. During good economic times, when lots of people are eating out, you find that sellers requested prices that only have 6% or 7% returns. During bad economic times, they sold at prices that would give a 15% to 20% return, mostly because they were afraid that their earnings could keep falling or disappear.

On average, when evening out those good and bad times, companies like Joe’s gave their owners a 11% return.

Now back to Joe’s selling price. He wants $400,000 for a business that generates $30,000 a year. That’s a 7.5% return. On its face, and assuming there’s nothing about Joe’s company that make his earnings more certain than the next guy’s, Joe’s asking price is too high. You think the business is worth more in the range of $330,000 based on historical figures. But since you could buy companies very similar to Joe’s for a return as high as 12% (the burger place), you’re only willing to pay $250,000 ($30,000 divided by $250,000 gives you a 12% return). He declines, and you move on to other investment ideas.

Fast forward to next year. The economy has gotten much worse. Joe’s earnings are falling. His company will probably survive, but until the economy gets better, he only thinks he’ll make $25,000 this year. Right now, it looks like no one’s ever going to buy a hero sandwich again, and in a panic, Joe offers to sell you his company for $200,000.

That’s a 12.5% return. Your research on the economic cycles of restaurants shows that investors earned an 11% return on average. So you buy the company from Joe, knowing that once the economic mess passes, you’ll own a company that’ll still make you good money.

There, in Joe’s panicked sale of his hero restaurant, is your proverbial dollar for 50 cents.

Ok, so that example was a little quick and dirty, but in a nutshell, that’s what a value investor does every day. A growth investor buys shares of companies in the hopes that the company’s earnings will grow rapidly and make his investment worth it. A value investor finds companies with a proven track record of earnings, but waits until the company’s share price has been beaten down enough to make his purchase worth it.

Start thinking about every stock purchase you make as if you were buying Joe’s restaurant. That is, think of it as if you’re buying the entire business and as if your profits rely on how much the business makes in earnings, instead of on how much the stock price goes up the next day.

Even just that change in mindset will put you on the path of thinking like a value investor. Of course, figuring out how much similar businesses sell for, how safe a business’s earnings are, and what price is “fair” takes a bit more practice.

I’ll talk about how to learn to do that tomorrow and Wednesday.

- Joe Light

The “consensus” view of personal finance right now is that we should all be index investors. It’s been well documented that active mutual fund managers have a poor track record of getting above-average returns. According to Standard & Poor’s, the S&P 500 beat 72% of active funds that invest in large companies. So, the theory goes, stick with a mutual fund that simply invests in everything and charges an extremely low fee.

But even if you’re an index investor, you do ultimately have to make choices about your asset allocation. You need to decide how much you’re going to put in a U.S. stock index fund, how much you’ll put in a U.S. bond index fund, an international index fund and on and on.

At first, financial planners and magazines like mine started making recommendations about that allocation based on readers’ ages and risk tolerance. Then “balanced” funds came along. They would let you decide on what mix of stocks and bonds you wanted based on your age or risk tolerance, and the fund manager would maintain that 50-50 (or 60-40, 70-30 etc) mix between a stock index fund and a bond index fund.

I previously wrote about my interview with Chuck de Lardemelle and Charles de Vaulx of IVA Funds. As part of my end-of-the-magazine-cycle clearing up of my desk, I listened through the interview again. De Lardemelle and de Vaulx run active funds that cross all asset classes. They can move money to cash, high yield bonds, U.S. stocks, international stocks, gold…you name it.

For a passive investor trying to build out his asset allocation, such a fund is a nightmare. If you invest in a set of mutual funds and an IVA Fund is one of your picks, you might think you have 50% of your money in stocks and 50% in bonds. But if de Lardemelle and de Vaulx decide to, they could swing the balance in one of their funds from stocks to…gold. Or, recently, to high-yield bonds.

So here’s the question: Should you decide your asset allocation or should an “expert” do it?

You can’t answer, “But I’m a passive investor! I invest based on my age and risk tolerance.” To me, allocating based on age is also an active choice. You’ve decided that in the long-term, certain historical trends will continue, making an age-based portfolio the most likely solution to get you to your goals. 50% of my savings will go into stocks today just as 50% went into stocks at the height of the tech boom and the trough of the tech bust.

I’ve seen enough evidence to convince me that most active managers are poor stock pickers. But I haven’t seen a lot of research telling me one way or the other if active managers are poor asset pickers.

Here’s what de Lardemelle said when I asked, “Since they don’t have much time to devote to thinking about investments, shouldn’t our readers just allocate a certain amount of their portfolio to each asset class and be done with it?” When reading his answer, keep in mind that he’s trying to sell his fund.

You’re right that it’s hard to pick companies to invest in internationally if you don’t spend time doing it. But if you try to do it yourself through index funds, what you’re basically doing is trying to figure out an asset allocation. And that’s not that easy either. You need a lot of data. You need a lot of experience. Usually the stuff you want to be in is the stuff that’s been forgotten by anybody and everybody.

There are few funds that have taken on that challenge of being a fund for all weather and that can shift gears from one asset class to another. Usually you have a mutual fund that does Southeast Asia, another fund that does small-cap value in the U.S. or whatever. That is I think how we differ from so many others. We can do high yield, cash, gold. There are few funds like that. I think it is a small piece of the market that’s going to grow. Basically, financial advisors themselves are looking for funds that take the burden of asset allocation off their shoulders.

Is that the right path? I’m waiting for someone to come out with an actively managed fund that only invests in index funds. “That’ll be the day,” you scoff. But is that much different than hiring a financial advisor to determine your allocation?

Update: After thinking about it for a bit longer, I guess actively managed funds of index funds do exist. Many target retirement funds or balanced funds have investment committees that tweak allocations based on what they see in the marketplace. I never thought of target-based retirement or lifestyle funds as being “active” funds before but I guess that’s not far off base.

- Joe Light

Hi Get Rich Slowly readers! Click here to subscribe to my feed. You can look here for a summary of how this blog can help you. Thanks for stopping by.

———

Morningstar, which is one of the biggest mutual fund trackers, came out with its annual review of the best and worst 529 plans today. 529 plans are tax-advantaged investing accounts to save for college expenses. Some states let you take a write-off for contributions. Your earnings grow tax-free, and your withdrawals aren’t subject to federal income tax. It’s a good deal, and one of the best for college savings. You don’t have to invest in your own state’s account, but most people do, since most states only give you the tax break if you invest in its own account.

Each state partners with two or three mutual fund managers, and investors in that state’s plan must choose from the variety of mutual funds offered. The funds include your run-of-the-mill index funds and a smattering of actively managed funds, depending on the state. While under a different name, many of the funds offered are similar to target-date retirement funds. You give them your kid’s age or when he’ll matriculate, and the fund will become more conservative as the date comes closer.

Sounds easy, right? Well, what if your state picks a real stinker of a mutual fund manager?

Such was the case with the five states that chose OppenheimerFunds to manage some of their savings plans. Investors in the Oppenheimer funds might have been allocated properly between stocks and bonds. But the actively-managed bond fund that Oppenheimer allocated them to lost more than 35% in 2008.

Now, the average bond fund was down only about 4.7% last year. What in the hell were Oppenheimer’s bond managers doing? According to Morningstar, “management gained exposure to the battered commercial mortgage-backed securities market through derivatives that had a leveraging effect on the fund, amplifying losses.”

“Mortgage-backed securities,” “derivatives,” and “leveraging” are three words that I would never want to see attached to my child’s college savings plan. What’s even worse, the fund managers were upping their stake in mortgage-backed securities in 2008, even as the market had started to fall apart.

Almost laughably, the Oppenheimer Limited-Term Government bond fund and U.S. Government bond fund also experienced losses even though U.S. government-backed bonds were pretty much the only asset class last year to make money. The reason? Oppenheimer made bets on non-government, mortgage-backed securities in those funds too!

Some states, like Illinois and Oregon, plan to file or have filed lawsuits against Oppenheimer. I say, it’s too little, too late. The last couple years have shown that every investor needs to pay extremely close attention to what his fund is invested in. But if a state is going to attach its name to a fund, and even restrict its state’s residents to investing in certain funds, state officials better pay attention to how the fund managers invest the money before something like this happens.

If you’re deciding between 529s right now, keep in mind that you don’t have to invest in your own state’s plan, though you may lose a tax break if you don’t. Nearly every plan will also let you choose between fund managers and fund styles. (Illinois’ college savers could have chosen Vanguard funds, for example.) For this category of investing especially, I would stick with index funds with low fees and have a relatively low amount of money allocated to stocks. Unless you’re saving for your kid’s college tuition before he or she is born, there’s just too short of an investment window to take big risks.

Savingforcollege.com is a great resource to research and choose 529 plans. Just make sure you get the mutual fund prospectus also.

- Joe Light

First, I’d like to welcome any Get Rich Slowly readers still trickling in. Thanks again for visiting the site. There’s a quick summary of what the site’s about here. And subscribe to this site’s feed here.

Recently, I’ve written about allegedly shady practices at a popular mutual fund company, why many popular assumptions about stock returns might be false, and a big problem with target-date retirement funds.

——-

Onward.

Yesterday, I wrote a basic intro to bonds for J.D.’s site, and a follow-up, slightly more complicated post on how to screen for and choose bonds.

Today, I’m going to address two areas:

1) How to build a bond portfolio or a bond ladder, and

2) How to actually buy a bond

How to build a bond portfolio

You probably already invest in mutual funds or might even have a portfolio of individual stocks. If so, you’re probably familiar with the concept of diversification. In short, you want to spread your investments among many types of securities to make sure that if any one of them gets hurt, your portfolio doesn’t unduly suffer.

Bond portfolios are no different. Here are the considerations you should have as you pick bonds.

1) Pick only high-grade bonds.

Yesterday, I defined this as a bond with a rating of A3 or higher by Moody’s. You might want to pick an even higher grade. Why? In the current environment, the ratings agencies have been downgrading bonds like crazy. Even Warren Buffett’s Berkshire Hathaway recently lost the highest investment grade rating. If you don’t have much to invest in bonds (Say, $200,000 or less), I would stay with bonds that have a AA rating or higher and whose companies are known as conservative, stable earners.

2) Diversify the maturity dates of your bonds.

Let’s say you’re saving for a son or daughter’s tuition payment that comes in 10 years. The highest yielding bonds that you see are probably ones that mature right around the time you need the money. But that doesn’t mean you should put all of your money in those bonds, even if they’re with highly rated companies.

A bond portfolio’s greatest risk actually isn’t that companies default. It’s that interest rates could rise before the bond matures. Imagine that you bought a 10-year bond yesterday at face value ($1,000) that yields 5%. Today, the Federal Reserve surprises the world by letting its target interest rates rise by 3 percentage points. Now, investors can find corporate bonds similar to the one you just bought that yield 8% instead of 5%. You can’t just sell your bond for $1,000 and reinvest the money. Any investor who buys the lower yielding bond will want to purchase it at below face value to compensate for the lower interest rate.

You’re holding your bonds to maturity. Small investors get ripped off when they try to sell bonds on the secondary market. So the only way that the change in interest rates really hurts you is that your $1,000 is tied up in a bond with a lower yield than what you could get now.

So, instead of buying $100,000 worth of 10-year bonds, the college saver might buy $10,000-worth of bonds that mature in 10 years, $10,000 that mature in 9 years, and each year until next year. That way, even if interest rates go up, you’ll always have bonds maturing whose principal you can reinvest in the higher yielding bonds.

Some folks argue that no one should invest in 10-year bonds right now, because interest rates are most certain to go up. I’d answer that the market should already be pricing those fears into the yields of 10-year bonds (that’s why they’re higher than one-year bonds). If you think you know better than the market, good for you. But for those building a simple bond ladder, since you’re holding bonds until maturity, you’re not going to get hurt if they’re right.

3) Diversify among industries in addition to companies.

You probably already gathered that you wouldn’t want to put all your money into bonds put out by one company. You should also consider spreading your bonds out among as many industries as possible. Your portfolio should not only have industrial manufacturers, but utilities, retailers, foodmakers, and so on.

Buying a bond

I’m just going to say this at the outset: Buying a bond is not as easy as it should be. Whereas stock and mutual fund platforms have gotten easier and easier over the last decade or so, bond buying still has silly impediments that the big brokers either can’t or don’t want to sort out. Until a few years ago small investors couldn’t even find out how much some bonds traded for! It’s gotten better, but not by much.

1) Use a broker who gets most of his business from bond trading. The reason for this is simple: The bonds you can buy will often be limited to what bonds the broker has in his inventory. If he doesn’t trade bonds often, he won’t control many bonds himself and won’t know good sources to find the bonds you’re looking for. As an alternate, you can use an online bond platform, like the one at E*Trade, which will aggregate the inventories of many different bond brokers. But when using a platform like that, you effectively pay two commissions. More on that later.

2)Start with “newly issued” bonds. Investors get better deals on bonds if they buy them right when the company is first asking to be lent money. As a small investor, if you can get in on a new issue, you’ll get a much better price on the bonds than if you bought them on the secondary market. Depending on how much money you have to invest, you might not be able to get in on many offerings, but it doesn’t hurt to ask.

3) Try to buy at least 10 bonds of the same company at once. The bigger the purchase of bonds you can make of a company, the better the price you’ll get. Some financial advisors say that an even better increment is $25,000 worth of bonds (about 25 bonds). If you try to purchase smaller amounts, you will get very poor prices.

4) Bond prices are negotiable. Don’t take your broker’s first offer. I can’t emphasize this enough, and this is the primary mistake I hear small investors make. Unlike a stock broker, bond broker’s don’t make a flat commission. In fact, they don’t specify their commission at all! Instead, they make money on the “spread” between what they can buy the bond for and what they sell it to you for. So a broker might buy a bond at a price that yields 6% but sell it to you at a price that yields 4%. His commission is difference in price that causes that 2% spread.

Brokers don’t disclose that difference. So it’s important that you come to the phone call armed with information. You can find the prices that bonds recently traded for here. Click on “Corporate Market At-a-glance” and search for the company whose bonds you’re considering or for the CUSIP (the bond’s id number) if you have that. Once you get to the bond you’re looking for, you should see a list of recent trades of that bond.

The “price” on the screen is given in cents on the dollar. So a bond sold at “100.000″, went for $1,000. Under “size” you’ll see how many bonds were bought at once. So in the first line of the preceding image. An investor (or a bond broker, it’s difficult to tell) bought 10 bonds of GE at $1,000 each.

When you negotiate with your broker, try to get a yield as close to what you see at SIFMA’s website as possible. If he wants more than 1.5 percentage points as his commission, look for the bond elsewhere or try for a different bond. Honestly, a 1.5 percentage point hit on an investment-grade bond is already pretty high.

A note on online bond platforms: An online bond platform aggregates many bond brokers onto one site. That’s good because you have access to more inventory. But in exchange, you’ll probably pay a higher commission. The online broker will take the first cut, usually somewhere in the range of $1 per bond. The live-person broker will still earn a commission on the spread. I know E*Trade allows customers to make an offer on a bond and negotiate its price down. But some online brokers don’t let you do that.

5) Monitor your portfolio and reinvest bond payments. One of the biggest mistakes financial advisors tell me they see is that someone sets up their bond portfolio but doesn’t reinvest bond payments or even the bond’s principal as it matures. Unlike with a mutual fund, you can’t instruct your broker to simply reinvest your bond payments. Brokerage accounts generally pay extremely low interest rates. So even though your bond yields 5%, if its bond payments simply sit in the account, your portfolio’s yield will be less.

If you’ve set up a bond ladder by having bonds mature regularly (such as once a year), revisit your portfolio at least that often to find bonds to reinvest in and to keep that income stream coming. Someone who is investing in bonds for income and who wants to keep an average maturity of 5 years, would want to buy a 10-year bond every time one of his bonds comes due. That way, he’ll always have a bond coming due in the next year.

Phew, I hope this post, the two others made yesterday, and the story in Money have given you at least a basic understanding of how bonds work and how to build a portfolio. As you can imagine, there’s more to learn and entire books have been written on the subject. I will recommend two, whose authors I’ve spoken to extensively:

Bonds: The Unbeaten Path to Secure Investment Growth by Hildy and Stan Richelson, and

The Bond Bible by Marilyn Cohen (this one is a little older)

Thanks for reading and hope you come back tomorrow — when I won’t be talking about bonds.

- Joe Light