_________ matters.

Nassim Nicholas Taleb

noreply@blogger.com (Nick) — Tue, 01 Apr 2008 01:20:00 +0000

This is without-a-doubt the best background piece on Taleb that I've read. Enjoy:

On a freezing day in March 2007, Nassim Taleb walked into a conference room at Morgan Stanley's Manhattan offices on 47th Street and Broadway to address a group of the firm's risk managers. His message: Your models don't work.

Using a whiteboard to scribble out his calculations, Taleb, now 48, began one of his rants, this time against stress tests -- Wall Street lingo for examining how a market rout will play out. Stress tests are inherently risky because they ignore rare but potentially devastating events, Taleb said.

``Past shortfall doesn't predict future shortfall,'' the options trader turned best-selling author recalls telling the assembled group of about 40. The risk managers, part of a tribe of mathematical model makers known in the finance world as quants, stared back at him blankly, and a debate ensued, according to people who were there..." Continue Reading

Books by Taleb: The Black Swan and Fooled By Randomness

Your opinion wanted: Why is Bear Stearns trading at $6 when it's been purchased at $2?

noreply@blogger.com (Nick) — Tue, 18 Mar 2008 21:03:00 +0000

My blog is brand new and so I have low (read no) expectations of recieving any replies.

That said what are your thoughts? If BSC had been purchased by JPM for $2 a share in stock why is it trading at $6. The government has already approved the deal. Can't we just buy JPM and short BSC and profit on the spread? What am I missing? What rumors have you heard regarding a better bid?

I look forward any responses.

Bear Stearns: The Facts, Some Opinion, and Who Stands to Lose the Most

noreply@blogger.com (Nick) — Mon, 17 Mar 2008 17:47:00 +0000

Wow what a difference a little time makes. In January Bear Stearns was worth $30 Billion and after Firday's firesale was worth about $3.5 Billion and now it sold for under $250 million dollars to JP Morgan Chase (JPM) yesterday. Essentially, BSC investors have been crushed.

The Facts:

The Merger Agreement (PDF)

JPMorgan to Buy Bear Stearns for $2 a Share in ALL Stock Deal

Some Opinion:

Todd Sullivan comments on what he feels like is an incredible bargain:
JP Morgan Dimon's Bargain Purchase
Todd left some room for doubt on whether the shareholders will approve the merger.

See who stands to lose the most and who the large shareholders are here:
A Stake Through the Heart

Weekend Reading

noreply@blogger.com (Nick) — Sat, 15 Mar 2008 22:08:00 +0000

Weekend Reading From Value Investing News

Why Warren Buffet is richer than the Hedge Fund managers - a tale of two business models

Notes From A Conversation with Munger

Does the magic formula work?

Marvel - Superhero Value?

Berkowitz Sees Volatility As An Opportunity

A Solid Bet: The Case For Ternium Steel

Sneak Preview of The Four Filters by Bud Labitan

Free RSS Feeds for Company Filings on EDGAR

Is Buffett's Business Model More Lucrative than a Hedge Fund?

noreply@blogger.com (Nick) — Sat, 15 Mar 2008 02:39:00 +0000

Arohan of Arohans's Investing Life thinks so:

The difference is in the business models. A hedge fund manager primarily derives his income from fees. The assets of the hedge fund are owned by investors in the fund and only a part of the growth in the value of this asset works towards increasing the net worth of the hedge fund manager...If you are a superlative investor (like Mr Buffet or like many of the better hedge fund managers), business ownership model of Berkshire Hathaway will generate greater wealth over a long period of time. Sure, running a hedge fund will get you to great riches quickly (adding lot of investors quickly, in the years where the fund does very well, etc), but it is not a superior wealth creation machine over long term" Continue Reading

Arohan has a great site and has sponsored my blog through Entrecard. So, if you found this article through Entrecard please "drop" on his widget.

Charlie Munger Interview

noreply@blogger.com (Nick) — Fri, 14 Mar 2008 14:09:00 +0000

I highly recommend reading everything you can about Warren Buffett's partner Charlie Munger. If you are unfamiliar with him you are in for a treat. He is incredibly intelligent and he knows it -which adds a certain (well deserved) brashness and arrogance to his message. For me this makes him that much more engaging.

Here are some notes from a recent interview. I recommend visiting him at the Berkshire and Westco meetings so that you can experience him in person. I GUARANTEE you'll learn something.

Tonight I got to see A Conversation with Charlie Munger at Caltech in Pasadena. I took some notes on the discussion below. C refers to Charlie Munger speaking, while T stands for Tom Tombrello, the interviewer. These are not their exact words.

C: I love Occum's Razor (Wikipedia). Einstein once said make everything as simple as possible, but not simpler. In the field of messy social sciences, use a variety of disciplines and look for a confluence of factors when dealing with "lollapaloozas". (significant and strange events, black swans)

For example, I was fascinated about what made people join Moonies, a cult-like group. It didn't make sense until I ran into Pavlov, who experimented on dogs by pushing them to nervous breakdowns (He did this by locking them in cages and then raising the water level up to mouth height, making them think they were about to drown) . Afterwards, they would act in the complete opposite fashion. This was very similar to one of the Moonies conversion methods: "causing the target to snap".

Continue the Interview

Fwallstreet introduces a fantastic time saving tool.

noreply@blogger.com (Nick) — Tue, 11 Mar 2008 17:17:00 +0000

If you haven't visited Fwallstreet you missing out. Joe writes very well and provides excellents tools and instructions on how to deal will difficult investing topics. Today he offered up a real gem:

Trying to separate the news from the noise? Tired of running all over the EDGAR database? Let your company come to you!

This new F Wall Street feature allows you to subscribe directly to a company's filings with the Securities & Exchange Commission's website. Simply enter the company's Central Index Key (CIK) number below and a feed will be generated with the last 100 filings. As new documents are filed, your feed will be updated."

Visit F Wallstreet to get started. (It's Free)

Home Economics

noreply@blogger.com (Nick) — Fri, 07 Mar 2008 14:17:00 +0000

Americans may disagree about nearly everything, but few contest the idea that owning your home is a good thing...[BUT]Homeownership also impedes the economy’s readjustment by tying people down. From a social point of view, it’s beneficial that homeownership encourages commitment to a given town or city. But, from an economic point of view, it’s good for people to be able to leave places where there’s less work and move to places where there’s more. Homeowners are much less likely to move than renters, especially during a downturn, when they aren’t willing (or can’t afford) to sell at market prices. As a result, they often stay in towns even after the jobs leave. That may be why a study of several major developed economies between 1960 and 1996, by the British economist Andrew Oswald, found a strong relationship between increases in homeownership and increases in the unemployment rate; a ten-per-cent increase in homeownership correlated with a two-per-cent increase in unemployment. (In the U.S., it may be worth noting, the states that have the highest unemployment rates—states like Alabama, Michigan, Mississippi—are also among those with the highest homeownership rates.) And reluctance to move not only keeps unemployment high in struggling areas but makes it hard for businesses elsewhere to attract the workers they need to grow..."continue reading

Post of the Day: Great Businesses According to Buffett

noreply@blogger.com (Nick) — Thu, 06 Mar 2008 15:37:00 +0000

Today's post of the day is from George at Fat Pitch Financials:

I finished digesting the latest Berkshire Hathaway 2007 letter to shareholders today. I found the most interesting part of this year’s letter was Warren Buffett’s discussion of what kinds of businesses turn him on.

The companies that he and Charlie Munger look for are:

Understandable
Businesses with favorable long-term economics
Run by trustworthy management
Selling at sensible prices
Mr. Buffett once again reiterates that “a truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital.” Fat Pitch Financials has been all about finding companies with wide moats ever since I first set up this blog in 2004. Given my economics background, I find Buffett’s arguement for the need for wide moats compelling. He argues that companies that lack a barrier to competition will succumb to the competitive forces of a capitalist market that tend to drive profits to zero."

Double Feature:

noreply@blogger.com (Nick) — Wed, 05 Mar 2008 23:06:00 +0000

First Post of the Day from Bloomberg:

Ambac fell $2.02 to $8.70 today in New York Stock Exchange composite trading. The shares have tumbled 90 percent in the past year. A $1 billion equity offering would about double the amount of shares outstanding.

Credit-default swaps tied to Ambac's AAA rated insurance unit rose 10 basis points after the announcement to 530 basis points, according to CMA Datavision in London. A basis point on a credit-default swap contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.

Bank Losses

Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company's ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements. A rise indicates deterioration in the perception of credit quality; a decline, the opposite.

Banks would lose as much as $70 billion if the top-rated bond insurers lose their credit ratings, Oppenheimer & Co. analysts estimated in January. MBIA's ratings were affirmed by Moody's and S&P last week.

Continue

Better Yet Check out this Video:

Hat Tip to Value Plays

Post of the Day: 10 Investing Tips From Warren Buffett

noreply@blogger.com (Nick) — Wed, 05 Mar 2008 04:03:00 +0000

From the 2007 Letter to Shareholders:

1. When you know you're the best, you can afford to tell it like it is. Buffett says: "Our insurance business had an excellent year... that party is over. It's a certainty that insurance-industry profit margins, including ours, will fall significantly in 2008. So be prepared for lower insurance earnings during the next few years."

2. Only four things really count when making an investment (or buying whole companies if, like Buffett, you have $141bn to spend) - "a business you understand, favourable long-term economics, able and trustworthy management, and a sensible price tag". That's investment, everything else is speculation.

3. Invest this way and you don't need to constantly look for the next "new" thing, with all the risk that necessarily entails.

Buffett's biggest investments (companies he doesn't own in their entirety) include American Express, Wells Fargo, Procter & Gamble and Coca-Cola.

These four businesses, he notes, were founded in 1850, 1852, 1837 and 1886 respectively. "Start-ups are not our game".

4. Businesses are run by people and the best people are not necessarily the ones with the flashiest CVs. Buffett singles out Susan Jacques, chief executive of his jewellery retailer Borsheims. "Susan came to Borsheims 25 years ago as a $4-an-hour saleswoman. She's smart, she loves the business and she loves her associates. That beats having an MBA degree any time."

Continue Reading
Hat Tip: Controlled Greed

Post of the Day: A Magic Formula Stock from 1972?

noreply@blogger.com (Nick) — Mon, 03 Mar 2008 23:10:00 +0000

Shai Dardashti share with us Warren Buffett's Magic Formula Stock from 1972:

Let’s look at the prototype of a dream business, our own See’s Candy. The boxed-chocolates industry in which it operates is unexciting: Per-capita consumption in the U.S. is extremely low and doesn’t grow. Many once-important brands have disappeared, and only three companies have earned more than token profits over the last forty years. Indeed, I believe that See’s, though it obtains the bulk of its revenues from only a few states, accounts for nearly half of the entire industry’s earnings.

At See’s, annual sales were 16 million pounds of candy when Blue Chip Stamps purchased the company in 1972. (Charlie and I controlled Blue Chip at the time and later merged it into Berkshire.) Last year See’s sold 31 million pounds, a growth rate of only 2% annually. Yet its durable competitive advantage, built by the See’s family over a 50-year period, and strengthened subsequently by Chuck Huggins and Brad Kinstler, has produced extraordinary results for Berkshire.

Post of the Day: Berkshire Hathaway Annual Report

noreply@blogger.com (Nick) — Sun, 02 Mar 2008 07:30:00 +0000

Berkshire Hathaway Annual Report 2007

Post of the Day: Consistent Cash Creators

noreply@blogger.com (Nick) — Fri, 29 Feb 2008 22:33:00 +0000

This topic will cover some math that is well beyond many novice investors ability to apply; however, the discussion about projecting future growth rates is very helpful. George, does a great job explaining the difficulties businesses face when trying to compound their capital for long periods of time. This is the primary reason why Warren Buffett looks for a business with a "Moat." We will discuss moats and competitive advantages in future posts. Check out Fat Pitch Financials:

Exponential growth is seen in nature when reproduction is not limited by food, space, or disease. When bacteria colonies first form, they often grow exponentially. In the business world, when a radically new product catches on with the masses, or goes “viral”, its sales can grow exponentially for a time.

Young innovative companies with low capital reinvestment requirements can sometimes grow their free cash flows exponentially. However, as time passes on, these exponential growers face resource scarcity, market saturation, and labor scarcity. The law of diminishing marginal returns kicks in and it becomes increasingly more expensive to produce additional units of goods or services because each additional input added is less and less productive. Often while this is going on, competitors seeing these excess profits enter the market and start to drive down prices. It is exceptionally difficult to maintain exponential growth for long in competitive markets. This is the reasoning that has always made me hesitant in using exponential growth rates in my valuations..."

High Hopes for VISA, Another MasterCard? Google?

noreply@blogger.com (Nick) — Thu, 28 Feb 2008 15:12:00 +0000

I was first exposed to the very bright, very concentrated (small number of positions in his portfolio) Mark Sellers at last year's Value Investing Congress West. He is an investor worth listening to. In this article he talks about great companies and their IPOs (Initial Public Offering). His article discusses some relatively recent, successful IPOs and more importantly he is excited about the upcoming VISA IPO. Enjoy!

When Google completed its initial public offering in August 2004, the stock seemed overpriced. Even after reducing its IPO price from $108 to $85, the company’s trailing price/earnings ratio was well over 200. Journalists, analysts and market pundits exclaimed that Google was the most overpriced IPO in years, and warned investors to avoid it.

Shortly after the IPO, analysts were confused about how to model the company’s earnings. The average analyst estimate for Google’s first quarter as a public company was 56 cents a share, but the range of estimates was all over the map. Clearly, there was no “consensus” earnings number. Most analysts were cautious.
When Google then reported earnings in October 2004, its earnings per share were 70 cents a share, and the stock jumped 15 per cent in one day. Analysts then rushed to increase their estimates for the following quarter, but were again too cautious. The next quarter, Google beat the average analyst estimate by 15 cents, earning 92 cents a share compared with estimates of 77. The quarter after that, Google earned $1.29 compared with the average estimate of 92 cents.
As it turned out, Google’s stock was incredibly cheap at its IPO price of $85..."

Post of the Day: On the History of Gillette

noreply@blogger.com (Nick) — Wed, 27 Feb 2008 13:00:00 +0000

One of Warren Buffett's more famous investments is his purchase of Gillette stock (now owned by Procter & Gamble (PG). This story detail the history of Gillette and his marketing campaign. Investors can learn alot about building a moat from this article.

At the age of 40, King Gillette was a frustrated inventor, a bitter anticapitalist, and a salesman of cork-lined bottle caps. It was 1895, and despite ideas, energy, and wealthy parents, he had little to show for his work. He blamed the evils of market competition. Indeed, the previous year he had published a book, The Human Drift, which argued that all industry should be taken over by a single corporation owned by the public and that millions of Americans should live in a giant city called Metropolis powered by Niagara Falls. His boss at the bottle cap company, meanwhile, had just one piece of advice: Invent something people use and throw away.

One day, while he was shaving with a straight razor that was so worn it could no longer be sharpened, the idea came to him. What if the blade could be made of a thin metal strip? Rather than spending time maintaining the blades, men could simply discard them when they became dull. A few years of metallurgy experimentation later, the disposable-blade safety razor was born. But it didn't take off immediately. In its first year, 1903, Gillette sold a total of 51 razors and 168 blades. Over the next two decades, he tried every marketing gimmick he could think of. He put his own face on the package, making him both legendary and, some people believed, fictional. He sold millions of razors to the Army at a steep discount, hoping the habits soldiers developed at war would carry over to peacetime. He sold razors in bulk to banks so they could give them away with new deposits ("shave and save" campaigns). Razors were bundled with everything from Wrigley's gum to packets of coffee, tea, spices, and marshmallows. The freebies helped to sell those products, but the tactic helped Gillette even more..."

continue the article here.

Post of the Day: Index of Companies Trading Below Net Current Asset Value

noreply@blogger.com (Nick) — Tue, 26 Feb 2008 18:17:00 +0000

Clyde of CHEAP STOCKs has created a great Index worth tracking. His site is dedicated to Benjamin Graham's method of buying a basket of stocks for a price below their Net Current Asset Value. Please visit his site.

We’ve designed what we believe to be the first index of companies trading below their net current asset value. The main purpose of this index will be to track a passive portfolio of net/nets. This index is chock full of small companies many of which have been beaten down, and some of which may not survive. We’ve developed this index primarily as an attempt to gauge net/net performance using a basket approach.

The Cheap Stocks 21 Net/Net Index is a market cap weighted index comprised of companies that met the following criteria at index inception on Tuesday, February 12th, 2008"

Post of the Day: Notes From Buffett Meeting 2/15/2008

noreply@blogger.com (Nick) — Tue, 26 Feb 2008 03:53:00 +0000

I've got a treat for you today! Here is a link to a Q&A session from students from Emory's Goizueta Business School and McCombs School of Business at UT Austin.

Excerpt:

Emory:

Could you comment on the current rise of sovereign wealth funds from the Middle East and Asia and how they are playing an increasing role in how corporations raise capital. Is competition from these sources for the cash flows of corporations affecting your investment strategies or opportunities?

Buffett:

Any competition is competition. The situation of sovereign wealth funds is interesting. A lot of it is China bashing, OPEC bashing and plays right into politician’s hands. Today, the US will buy $2 billion more from the world than they buy from us. In exchange we give them little pieces of paper and they have to buy assets. As long as we consume more than we produce we have to let the rest of the world invest in us. We created sovereign wealth funds and that $2 billion gains interest. US funds feel they can get the best terms from these foreign investors and lately, enticed them into buying equity. China wanted to buy Unocal, a 3rd rate oil producer with production overseas in places like India. US Congress went ape and 395 representatives signed an anti-Chinese resolution to block the deal. For 100 years the US companies went around buying the world’s assets and bribing officials, but told China they couldn’t buy Unocal..."

Continue

Weekend Reading

noreply@blogger.com (Nick) — Sat, 23 Feb 2008 01:37:00 +0000

From Value Investing News:

Sham Gad : Has Eddie Lampert Lost His Touch?

Consider the following scenario: A great company faces a languishing stock price. A few quarters of managerial efforts fail to revive profits. The stock continues to decline. As a result, the CEO is ostracized for having lost his ability. Sound all too familiar?"

Motley Fool

American Eagle Stock Report(AEO)Interesting Article On American Eagle Outfitters. I should disclose that I have a postion in AEO Jan 2010 Calls. College Analysts

From Value Plays:

MBIA Dismisses Ackman: Got A Better Idea?

The bottom line is they have no plan. What they are waiting for is a State or Federal bailout. They have been "talking" to insurance regulators for months now and nothing has been forthcoming from them. There has been no plan, only stonewalling.

They have dismissed plans from Berkshire Hathaway's (BRK.A) Warren Buffett and now Bill Ackman. Wilbur Ross has stated he was interested in investing in them but talks with management have gone nowhere."

Enjoy!

Post of the Day: Credit Squeeze Still in `Early Days'

noreply@blogger.com (Nick) — Fri, 22 Feb 2008 01:14:00 +0000

One investor worth watching (and listening to) is Prem Watsa of Fairfax Financial (FFH). In this Bloomberg article he states that we are still going to see more pain in the Credit Markets.

If you haven't read about the "Candian Warren Buffett" then you should read this excellent story on Watsa.

Here is an quote from the Bloomberg article:

We're just rolling through mortgages right now, but we haven't gone through all the other areas yet,'' such as credit- card debt, commercial real estate loans and automobile lending, Watsa said."

Enjoy!

Post of the Day: "Katsenelson Predicts"

noreply@blogger.com (Nick) — Thu, 21 Feb 2008 01:51:00 +0000

For my inaugural post of the day I'm linking to the Value Investing Congress's Blog. In this post Vitaliy Katsenelson talks about the difficulties the financial markets are currently experiencing and the ways he predicts that it may play out. Here is an excerpt:

- The US economy will slip into a recession which will last longer than those of the past. The longer this recession lasts – the longer it will last. Economic weakness will feed on itself and cause higher unemployment, which will cause further defaults on loans, and so on.
- The defaults in the financial sector will reach higher levels than we saw in the last recession.
- Lending standards will go from extreme promiscuity to the level of a store manager in the sitcom Married with Children, when a store manager, tired of Al Bundy’s bounced checks, asked him for “cash and three forms of ID”.
- This will also spill over into the corporate sector. In many instances it already has: access to capital markets has of late been considered a birthright, but it is quickly turning into a privilege reserved for an elite few and, in many, cases a source of competitive advantage.
- Oversupply of houses and tighter lending standards will cause the housing market to recover slower than many expect (or are hoping).
- Worst case, we will take the rest of the world into a recession. Slowdown in growth will send the Chinese economy into a deflationary spiral. We’ll learn that the prosperity of the Chinese economy came at the expense of a pile of bad loans which were covered up by high growth. Exposure to BRIC countries that used to be considered an asset may quickly turn into a liability. The global commodity boom will turn into a bust.
- Finally, corporate profit margins will prove unsustainable. They are at all time high (40% above the mean), soon to embark on the journey toward mean reversion, where corporate earnings will either decline or growth will decelerate. Stocks may not appear so cheap anymore."

Click HERE to read the rest of the post.

John Burr Williams says "Discounting Matters"

noreply@blogger.com (Nick) — Mon, 18 Feb 2008 07:15:00 +0000

Intuition

In his 1938 investing text "The Theory of Investment Value" John Burr Williams introduced the ideas of discounting and intrinsic value to investors.

For our purposes "intrinsic value" is synonymous with the value of a business. The value can be expressed as the value of the entire enterprise or (to make easier to compare to the stock price) as a per share value.

"Discounting" is a way of expressing something we understand intuitively, that a dollar today is worth more than a dollar a year from know.

No this isn't another dig on the U.S. dollar. This is true even if our currency wasn't under pressure. No one likes to wait around to reinvest their earnings. If we have to wait then we reasonably expect to be compensated for our time. This compensation for waiting is expressed as a rate, in this case as a discount rate. A discount rate represents our opportunity cost of waiting for a certain cash flow.

A Little Math: What should we pay today to receive $100 in the future?

Let's explore for a moment the math behind discounting the cash paid to us in the future. Here is the formula:
Example: What should we pay today to receive $100 in the future? Let's make a couple of assumptions.

We will take the money to purchase the future $100 out of our savings yielding 5% (Our opportunity cost or discount rate).
We are willing to wait 1, 5, or 10 years.

Using those assumptions: Future Value (FV) = $100; Discount Rate (i)= 5% or 0.05; Number of Periods (n) =1

What should we be willing to pay for a cash flow with those characteristics? $95.24

What if we wait 5 years (n=5)? $78.35

And 10 years (n=10)? Only $61.39

Clarification

The implications of the Future Value of money might not be entirely clear. Discounting future cash flows helps us avoid overpaying for money received in the future; our required rate of return is built into the equation. Said another way, should you decide to purchase that 2018 cash flow of $100 for $61.39 today you are assured a 5% rate of return. Clear as mud?

More on why discounting cash flows matter in future posts...

Valuation Matters: A Case for Business Valuation

noreply@blogger.com (Nick) — Sat, 16 Feb 2008 07:00:00 +0000

Every Business has a Value

Off Wall Street and outside of lecture halls the idea that every business has a certain value that a prospective owner would pay for the complete enterprise is intuitive. In fact, playing Monopoly with my eight year old and watching her haggle for Illinois Ave. illustrates just how intuitive price vs. value is, but somewhere between elementary school and when we first look at a stock's ticker we get lost. We start assuming that the stock price represents the business's value. This is usually not true.

Ignore Stock Prices

Let's look at a large stable company's stock price over the last year. I'm going to use Johnson & Johnson (JNJ) as my example, but any company would do. Here is a one year chart of the stock price:

Theoretically, an investor could have purchased JNJ for as little as $173 Billion or as high as $196 Billion over just 52 weeks. Do you really think that Johnson & Johnson's business value fluctuated by $23 Billion? That is what the stock price suggests. Let's look at another company's stock price Apple (AAPL) to see if its price gyrations are equally irrational.

52 weeks ago you could buy Apple for about $73 Billion then it shot up $100 Billion to $178 Billion and now you can buy it for less than $110 Billion. Talk about a roller coaster! Unlike amusement parks -watching charts, stock prices, and the market is hazardous to both your health and your wealth.

A business's value changes much more slowly than the quoted stock price. Over the short term the stock price is a proxy for investors expectations and emotions (two things that, for the most part, should be ignored).

Price Equals Value

Price is what you pay for, value is what you get"
-Warren Buffett

As investors we can profit by purchasing business when there is a large discrepancy between the price the market is offering a company for and the value of the underlying business. It is important to note that business's value isn't quoted on the stock market (or anywhere else) so it will take bit more work to find bargains. In future posts we will explore business valuation tools.

Efficient Markets

If you disagree, believe the market is efficient, or find that the idea that there is a disconnect between price and value inherently flawed, then I suggest investing in a low cost index fund. Please read my post on why indexing matters. There is nothing wrong with investing passively AND earning your fair share of the market's return. I'm very happy that many people subscribe to the Efficient Market Theory (I.e. Price = Value Theory) it creates opportunities for the enterprising investor.

Tea Leaves, Soothsayers, and Technical Analysis

Worse yet, if feel that the charts, and therefor the price, is signaling you and believe in soothsayers, tea leaves, and fortune tellers then you should search for "technical analysis" on your favorite search engine.

Indexing Matters

noreply@blogger.com (Nick) — Tue, 29 Jan 2008 18:44:00 +0000

Want to invest better than most professional and amateur investors alike? Then stop chasing mutual fund returns and heed this advice:

By periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals." -Warren Buffett

Time Frame

Year to date the market is down around 9%; not since July 2006 has a month ended with the S&P 500 trading below 1300. Does that matter? No. An investment's success (and failure) should be measured over time frames longer than 17 months. How long? That is topic I'll tackle later. How about a 10 years? Certainly a decade is a sufficiently long enough time frame to determine an investment's success.If we wisely invested in a market tracking low-cost index fund ten years ago, how much would our purchasing power have increased?

S&P 500

To test our 10 year performance let us explore the performance of the Standard & Poor's 500. This index represents the largest 500 companies in the United States with each company's relative weight based on market capitalization (think market price times the number of shares outstanding). Many investors simply refer to the the S&P500 as "The Market." So this index's job is to provide us with our fair share of the stock market's return.

Performance

What has the largest 500 companies in the USA returned to their investors over the last 10 years? 3% (and yes that includes the dividends)! What!?? A lousy 3% including dividends. Let's not even talk inflation.

Three Alternatives to Index Funds: Mutual Funds, No Stocks Market (Bank CD), Do-It-Yourself

#1 You might be thinking to yourself "Certainly we could have done better in mutual funds." That depends on a couple of things. First, what expertize do we have in selecting mutual fund managers? And what does that fund manager's hard work, research, and market beating performance cost?We might have beat the market if we properly selected one of the less than 1 out of every 100 mutual funds that successfully beats the market over longer time frames. That means that for every 1 that does beat the market 99 don't. For that manager's exceptional performance we'd probably pay at least 1.5% annually. That means that our manager needs to earn 4.5% every year that the Market earns 3% just to match the returns of the market. Otherwise we would have been better off just buying the index fund.Ultimately we need to be 100% confidant in our ability to select fund managers that can constantly beat the market in excess of their management fee. With probabilities like that you'd be well advised to stick with the index.

#2 At this point it is easy to get frustrated, run to your nearest bank and get yourself a certificate of deposit yielding a guaranteed 4% and forget the stock market all together. That would be a serious long-term mistake. If you are unwilling (or unable) to explore alternative #3, investing in an Index Fund is a very viable option (much more attractive than a CD). Don't give up.

#3 Fortunately, there is a better alternative than Wall Street's mutual funds, index funds, ETFs, hedge funds, and whateverelse-funds! Using a couple of tools and a few mental models we can successfully invest in businesses (stocks), earn an acceptable (if not damn-right fantastic) rate of return, AND sleep well at night. More on this in my next post.

And alternative #3 is what this blog is all about!