Learning how to e-Valuate

As Benjamin Graham's book entitled "The Intelligent Investor" mentions, there are four rules for buying common stocks for the defensive investor. Before we list those rules, we should explain a few definitions. The Defensive Investor is someone who has little to no knowledge of investing but wishes to make a decent/average return. The defensive investor checks his portfolio at most once per year. He also does not do any research of companies or care about how the market is acting. At most he should expect a decent return, not a great one though. Defensive investors are typically people with full time jobs that aren't in finance (or perhaps are) and wish to simply put as much time and effort into common stocks as they do with a tax free savings account.

1. There should be adequate though not excessive diversification. This might mean a minimum of ten different issues and a maximum of about thirty.

A minimum of ten different issues is imperative to allow for the necessary risk to be somewhat minimal in the portfolio. The more, the better -- usually. However, when the number of different common stocks reaches around 30, the investor is putting too much time into his portfolio. 30 is not a strict number, but just a decent estimate.


2. Each company selected should be large, prominent, and conservatively financed. 

Large companies tend to be less volatile and have more steady dividends. Moreover, we assume the large company is an industry leader. A company is conservative if its common stock at book value is at least half of the total capitalization, including all bank debt. Also, to be "prominent", a company must rank at least among the first quarter or first third in size within its industry group.


3. Each company should have a long record of continuous dividends.

To be specific, a company should have a continuous dividend payment for at least 10 years. This ensures that the company is at least somewhat stable in its earnings and dividends, which is always a good sign.


4. The investor should impose some limit on the price he will pay for an issue in relation to its average earnings over, say, the past 7 years. We suggest that this limit be set at 25 times such average earnings, and not more than 20 times those of the last 12 month period. This would ban virtually all growth stocks.

Simply put, the P/E should be no more than 25 of average earnings (say over a 5 or 10 year period). The P/E should also not be more than 20 over a 1 year period. These keep your estimates conservative and make sure you don't overvalue companies.

Merry Christmas everybody, I have not been updating the blog recently due to the holiday season. One thing I can mention is all the delicious food I've been eating -- it's going to be tough to burn those calories off.

Oh, and Happy New Year!!

As most of these posts usually start, I'll begin with a definition from somewhere (wikipedia?) and try to explain it in layman's terms. I like this approach the most.

"A bond is an instrument of indebtedness of the bond issuer to the holders. It is a debt security, under which the issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay them interest (the coupon) and/or to repay the principal at a later date, termed the maturity.[1] Interest is usually payable at fixed intervals (semiannual, annual, sometimes monthly). Very often the bond is negotiable, i.e. the ownership of the instrument can be transferred in the secondary market."
-Wikipedia.org

So, firstly, let's begin with the first part of the definition. No, a bond is not an instrument like a guitar or a piccolo. It's an abstract device that's used by corporations and governments. Essentially, companies sell bonds as a way to raise money to fund for capital expenditures. If a company says "Oh, we need $200,000 more dollars to expand our operations into China.", then they might raise that money by selling bonds. This is a key concept to remember, and one that I had trouble with when I just started learning all these business terms.


Buying Bonds = Lending money to Government/Corporations
Selling Bonds = Borrowing money

Now, why would anyone want to lend corporations or the government money anyway? Is there a benefit to this? The answer is yes. The seller of the bond pays the bond back in payments, with the interest either being blended into the payments, or the payments being pure interest and the principal being paid fully at the end. So if you buy a $200,000 10 year bond with an interest rate of 10% payable annually then the interest payments are either $20,000 a year with a $200,000 lump sum payment at the end or the $200,000 gets blended in with your interest payments (this will lead to higher payments) and you get nothing at the end. There really isn't a difference though, depends on your desire for current income.


The maturity date is self-explanatory; it's when the bond matures a.k.a when it expires and the full payment + interest must be repaid. Bonds are further complicated by being issued in the secondary market, similar to stocks. To be brief, if the bond pays 10% and the market (other bonds) pay 8%, the 10% bond can sell at a premium and you can make a quick buck because the market interest rates went down. When interest rates go down, this is typically how you can profit and sell your bond if you think interest rates might rise again. If you have an 8% bond and the market (other bonds in the market) is paying 12% then you're really at a loss if you're buying bonds because other bonds are paying a higher interest than the ones you have. These are sold at a discount (lower than facevalue).

Valuing a bond is much easier than valuing a stock, since it can be done mathematically. However, this will be discussed further in a later post as I'm not exactly time-inclined to give a financial math lesson.

Good luck!

Simply put, if you drop a basket that has all of your eggs in them, every egg will break, and you'll have no eggs left. In investing terms, as an extreme example, imagine you invest all your money into one company. If that company manages to go bankrupt, you literally lose all that money. The beauty of diversification is that you can minimize risk and potentially minimize losses too, if you do it correctly. It's a very advanced topic and will thus only be covered briefly for the fundamentals.

To minimize risk in the basket of eggs case, imagine having 10 baskets each with 1 egg. If you drop one basket and the egg breaks, you only lose 1 egg instead of all 10 if they were in the same basket.

2) Don't just invest in stocks

In order to maximize diversification, this cannot be done only with stocks. As Benjamin Graham's book "The Intelligent Investor" states, a portfolio should typically have 25% bonds and 75% stocks. This is a very general statement as things can get further complicated as an investor becomes more adept. This leads us to the next rule.


3) Don't just invest in bonds and stocks, GIC's and TFSA are important too

To further diversify and minimize risk and losses, one can structurally plan to buy stocks in different countries, invest in real estate, private equity, infrastructure, and commodities. If you live in Canada, it is of utmost importance to invest in GIC and Tax-Free Savings Accounts. These are virtually zero risk and although the return is low, it is better than having money vacant.


Summary

Although this post wasn't in depth and possessed a little redundancy, I hope it got the point across. Diversification is a complex topic and there are people who work in risk management -- in fact there are risk management departments at many banks. A solid investor allocates his investments so that if, for example, stocks manage to give subpar returns in Canada, this can be partially offset by higher returns in bonds, foreign stocks, etc.

What is OCI?

Once again, I'll start with a definition from investopedia and go a little deeper.

An entry that is generally found in the equity section of a corporation's balance sheet. Accumulated other comprehensive income measures gains and losses of a business that have yet to be realized.

Basically, each company has a balance sheet which lists at a given date how much the company is worth. (Assets = Liabilities + Shareholder's Equity) Unfortunately, I assume basic accounting knowledge terms are already known so if you're having trouble understanding I would suggest a few very basic accounting textbooks to get you started. The shareholder's equity section of a company's balance sheet simple states how much equity a company has (stocks, retained earnings, etc). Also included in equity is accumulated other comprehensive income. What this does is simply measure gains and losses where the company has not actually received any cash yet. This means they are unrealized gains. Examples of this are simply gains on securities, pension liabilities, options/futures, etc. They are typically intangible objects of some sort.


Why OCI? Why not just include it into net income?

Well to begin with, the fair value of unrealized gains/losses in OCI eventually make it to their way to net income. This happens once companies sell the asset (security, option/future, etc). Companies keep OCI separate at first from net income because, in actuality, OCI really isn't part of a company's main operations (unless it's an investment bank/hedge fund etc). Disregarding financial companies, OCI does not include assets involved in normal, continuous operations of a company. Also, OCI would create higher volatility in net income. From an intuitive standpoint, investments in derivatives in securities are generally a lot more volatile than a company's normal operations and will therefore be very high in some periods and low in others. To keep this bias and volatility at a minimum, it's easier to just create a separate section for it.


What does a smart investor take away from this?

Simple. A smart investor knows that when the equity markets do good, a company's total OCI will increase and can use that as a predictor, even if the company's operations/earnings do bad. It is of course an assumption that a company has relatively competent investing knowledge and performs in a way similar to the market.


Good luck!

One of the points I found most interesting in this article was how even when capital gains were still taxed relatively heavily, people still invested. This shows some evidence against Romney's beliefs that people/businesses will invest more if the rich are taxed less.


Source: http://www.bloomberg.com/news/2012-11-26/buffett-mocks-norquist-idea-on-taxes-thwarting-investment.html

Warren Buffett, the second-richest man in the U.S., pressed his call for more taxes on the wealthy by mocking the idea that higher rates discourage investment.

Legislators should increase taxes on those earning more than $500,000, including minimum rates of at least 30 percent on all income above $1 million, Buffett said in an opinion piece in the New York Times today.


U.S. lawmakers returning this week from the Thanksgiving recess are seeking a budget deal to avoid a so-called fiscal cliff with more than $600 billion in tax hikes and spending cuts set to begin in January. Republicans including Mitt Romney, the defeated presidential candidate, and Grover Norquist, who encourages lawmakers to sign a pledge shunning tax increases, have said lower rates can boost the U.S. economy.

“Let’s forget about the rich and ultrarich going on strike and stuffing their ample funds under their mattresses if -- gasp -- capital gains rates and ordinary income rates are increased,” Buffett wrote. “Only in Grover Norquist’s imagination does such a response exist.”

Buffett, worth $46.5 billion according to data compiled by Bloomberg, is using his clout to urge Congress and Obama to include measures that raise revenue as part of a deal to resolve the fiscal cliff, which may push the U.S. economy back into recession.

“We need to get rid of arrangements like ‘carried interest’ that enable income from labor to be magically converted into capital gains,” Buffett, chairman of Berkshire Hathaway Inc. (BRK/A), wrote. “And it’s sickening that a Cayman Islands mail drop can be central to tax maneuvering by wealthy individuals and corporations.”

Cayman Islands

Romney’s returns show investments in funds located around the world, including Ireland, the Cayman Islands and Bermuda. The former governor of Massachusetts has said it is fair for him to pay a lower tax rate than a worker making the median annual income of about $50,000.

“It’s the right way to encourage economic growth, to get people to invest, to start businesses, to put people to work,” Romney said in an interview with “60 Minutes” on CBS, broadcast on Sept. 23. Romney, who paid a 14.1 percent tax rate on $13.7 million in income last year, makes most of his income from investing a fortune estimated at $250 million.

Buffett has said his tax rate is the lowest among the about 20 employees at Berkshire’s headquarters in Omaha, Nebraska. Capital gains from most assets held for longer than a year are taxed at a top rate of 15 percent, while wage income is taxed at a top rate of 35 percent. The difference between those two accounts for Buffett’s lower rate.

Middle Class

Buffett managed funds for investors from 1956 to 1969 through partnerships. Taxes never led any of his clients to forgo an investment during that period, he wrote today, even though the capital gains rate was as high as 27.5 percent and the top marginal rate was at least 70 percent.

“Under those burdensome rates, moreover, both employment and the gross domestic product increased at a rapid clip,” Buffett wrote. “The middle class and the rich alike gained ground.”

Buffett continued to make investments under Berkshire, a textile maker he took control of in 1965 through a partnership. Since then, he has built the firm into a business with operations in insurance, retail, energy, freight and manufacturing. Its market value as of Nov. 23 was $220 billion. Buffett is the company’s largest shareholder.

Hi guys,

As a person who wants to learn as much as possible about finance, I have taken a little interest in trading. I am going to be doing paper trading first (trading with fake money) to get the hang of it. I will be doing it on this website:  http://questrade.com/platforms/free_trial.aspx . After that, I plan on learning futures. Since many people have serious trouble with these concepts, I feel it'll definitely give me an edge of competition. As someone mentioned about finance, "It's not hard, nothing is really hard. There's just a lot to know", and this is 100% true. In order to be absolutely great in finance and make accurate and sound decisions, you have to really know how everything works. You have to know all the terms, you have to know all the different types of investment strategies. These things, in my opinion, are the fundamentals. Many people say "blahblah you need a good temperament, focus on emotions first". This helps once you know actually how the heck to invest in the first place. If you have no idea what a bond, derivative, or even a security is, then even with the perfect temperament you will still suck at investing.

In preparation for paper trading, I've been watching a few of these videos as of late.  http://www.youtube.com/user/InformedTrades It's a guy named Simit (if I recall correctly) who works as a trader and teaches you important skills in a concise way. Really informative and great.

Over the past while I've been reading a few articles on Bloomberg here and there. Some of the articles are really interesting and informative and really give you some insight on how certain industries work. For example, I was reading an article on how the Hewlett-Packard share price has dropped significantly due to a write-down of $8.8B. HP wanted to expand into the software industry due to a competitive disadvantage (Apple, Microsoft, etc are all hardware and software producers) and an attempt to reach new markets. They acquired Autonomy, a software company, and everything went great, until auditors figured out that Autonomy counted resales of Dell computers as revenue, when in fact it was Dell's revenue. Therefore, the executives at Autonomy cooked the books and let's just say they're in some deep doo-doo. Unfortunately, HP had to pay the price since it now owns Autonomy.

Recall that price per share = Total Equity ($) / (Total Shares Outstanding)

It's easy to see that if equity goes down, price goes down. If shares outstanding increase, price goes down. Simple math.

..until next time folks.