Daily Reading

OPEC decides not to cut production YET. Bloomberg.

Consumer spending and the labor market are weak. NY Times.

This Wall Street Journal article helps to explain the purpose of MOS Investor.

GM is trying to come up with a plan. WSJ.

Don't forget to celebrate the 75th anniversary of the repeal of Prohibition this Friday, December 5th. WSJ.

CNBC compiled a list of companies who have announced layoffs.

Hope is Public Enemy Number One: An Extension of the Margin of Safety Discussion

Hope is a wonderful thing. It allows us to dream of a brighter future. Without hope, all of humanity would exist in a perpetual state of depression. A life without hope would not be worth living.

But hope, for all of its good qualities, is enemy number 1 of the prudent investor.

Hope causes us to believe a situation will improve without a reasonable basis in fact. Let's suppose, for example, we are analyzing a company that has experienced a 25% decrease in annual earnings from its all-time high. Hope causes us to shortcut the analysis by blindly making the assumption that earnings will eventually rebound to the previous highs. If we make the decision to purchase shares based solely on that assumption we become slaves to hope. We run the risk of not making money, or worse, losing money, if earnings do not recover. The only escape is to be hopeful of a brighter future.

It is certainly possible for a company to have a large drop in earnings followed by an equally large increase in earnings. But that is beside the point. The problem arises when the investor's expected return is entirely dependent upon the eventual rise in earnings. If earnings do not rise he loses money, either in absolute terms or in opportunity cost. What he needs is a backstop, i.e. a margin of safety. He has to ignore the hopeful desire for earnings to increase and only purchase shares if he can reasonably expect to realize an adequate return even if the situation doesn't improve.

When analyzing stocks, you should look for situations where you have a high probability of profit even if things do not improve for the company. In other words, buy stocks at a low enough price that even if earnings do not grow you have a good chance of price appreciation and if earnings decrease further you won't lose too much (Mohnish Pabrai calls this "heads I win, tails I don't lose too much"). Do your analysis, and make your decisions, based on reasonable case and worst case scenarios. Ignore the best case because it is the result of hope. If your expected return is not dependent on the best case scenario, but it subsequently materializes, so much the better. You exceeded your expected return. The best case scenario is nothing more than a free option to the prudent investor. GRAVY!

Daily Reading

Black Friday might be Red this year. Bloomberg.

The Federal Reserve Backstop, Money Supply is Growing Fast. I wonder if the Fed's actions will result in unintended consequences. Who can say INFLATION?

Value Investing Part III: Margin of Safety

Be sure to read Part I and Part II of this series.

Warren Buffett calls Margin of Safety "the three most important words in investing."

Margin of Safety is a concept originally described by Benjamin Graham in "The Intelligent Investor" (This is a must read for any serious investor. Follow the link to Amazon and buy it NOW).

Margin of Safety is an integral part of Graham's definition of Investment. It increases the probability that we will achieve "safety of prinicipal and an adequate return." Without a Margin of Safety we are not investing, we are speculating.

The process of determining the value of a stock is imprecise. It is dependent upon estimates and projections of future events. There is a high probability that even the greatest investor will make mistakes when valuing a company. To compensate for errors in our estimate of value we must purchase stocks for less than the value. For example, if I think XYZ Corp. has a value of $20 per share I wouldn't want to buy it for $20 a share. Sure, if my value estimate is spot on, I probably won't get hurt by paying $20. But the chance that my value estimate is absolutely correct is nearly zilch. As a result, I want to buy XYZ Corp. for less than $20.

How much less? The answer is completely subjective. It depends on how comfortable you are with your estimate of value and the risks the company faces that could impair its value. If you are confident that your value estimate is highly reliable and there are few risks that could impair value, then you might be willing to buy at $15. Conversely, if the risks of impairment are high you might require a price of $10 to trigger a purchase of shares. You should think of Margin of Safety as a concept rather than a specific number. The Margin required in any specific situation depends on the circumstances surrounding that situation.

Mohnish Pabrai, in The Dhandho Investor, describes Margin of Safety as buying $1 bills for $0.50. A value investor searches the market for situations where he can buy a stock for half of what it is worth and sells it when the price is at or near value. In Pabrai's words, buy a $1 bill for $0.50 and sell it when the price recovers to $1; an extremely profitable proposition. The Dhandho Investor is another book on my 'Must Read' list. Follow the link and buy it now.

What should be clear by now is the relationship between Margin of Safety and Graham's definition of investment. A larger Margin of Safety lowers our probability of permanently losing money and increases our probability of earning an adequate return. Said another way, Margin of Safety decreases risk and increases expected return.

This concept runs counter to what our emotions would have us do. When stock prices are going down, fear sets in and we want to sell. But if you believe in the Margin of Safety concept, declining stock prices is exactly when you should be buying. Because when prices are declining the Margin of Safety is going up.

Value investing is contrarian by nature. Prices go down when there are more people willing to sell then there are people willing to buy. Therefore you have to be able to operate against conventional wisdom. Warren Buffett says it best, "Be greedy when others are fearful, and fearful when others are greedy." To be a successful value investor you must be able to think independently and trust your judgement. If the prices of your stocks are going down and you are questioning the wisdom of your purchases take solice in the words of Ben Graham, "You are neither right nor wrong because the crowd agrees with you. You are right because your facts and reasoning are right."

Daily Reading

Although I realize nobody is actually reading this, I apologize for not posting yesterday.

This Bloomberg article describes the problem with making decisions based on fear.

This CNBC article discusses the problems baby boomers face because of the stock market crash. Maybe the credit crisis will solve our Social Security problems. Boomers can't retire thus they continue to work and add to the system rather than retire and take from it.

OIL IS NOT GOING TO STAY CHEAP FOREVER!!! Take the appropriate measures to protect yourself.

The AP reports that there is a new source of economic pain.

Things are tough all over, as this CNBC article explains.

Ouch, Fitch cuts Toyota's AAA credit rating. It happened a couple of days ago but I forgot to post it at the time.

Daily Reading

Reading for 11/25/2008

The Fed throws a Hail Mary.

Daily Reading

Reading is of the utmost importance to any successful investor. Warren Buffett says to "read everything." As you saw in the Investment Analysis post, we spend a great deal of time reading company specific reports. But it is also important to be aware of general business and economic news.

I am going to have a 'Daily Reading' post, ironically enough, daily. It will contain a number of the articles I feel are appropriate for all investors. I plan to edit the post throughout the day adding new links as I find them. Enjoy.

Citigroup receives government bailout.

A great post by a friend of mine about crude oil.

A Wall Street Journal article about the Federal Reserve's monetary policy tools. $$$ requires subscription.

An interesting take on the current market turmoil.

If you are curious about who is receiving funds from the bailout program, check out this interactive tool from the New York Times.

In this NY Times op-ed, Tyler Cowen, of George Mason University, says that most fiscal stimulus policies will do little to aid economic recovery. I agree and tend to think that most fiscal stimulus policies do nothing more than aid in the re-election efforts of our esteemed members of Congress.

The stabilization of home prices is a critical ingredient for the resolution of our economic woes. But as this CNBC article explains, we aren't there yet.

Before you go buy a new SUV read this CNBC article.

The government is going to spend a lot more money. I wonder where it will come from?

Value Investing Part II: Investment Analysis

Be sure to read Part I of this series.

The analysis of an investment must be thorough. We should strive to understand the company in all material respects. Without a solid understanding of the business (its capital needs, the competitive nature of its industry, etc.) we will not be able to value the business with any level of confidence. The first question you must ask yourself before beginning an analysis is: Is this business simple and understandable? If the answer is no, forget about it and look for a different company to research.

Simple and understandable means different things to different people. Larry Ellison's (the founder of Oracle) understanding of Oracle is second nature. I, on the other hand, couldn't begin to understand how Oracle makes money. I would not attempt to research Oracle because the effort would be futile. As Charlie Munger would say, "that one goes in the too hard pile."

To ensure my research is thorough I like to use two checklists, the Preliminary Workup and the Final Workup. The two checklists are as follows:

Preliminary Workup

Where do I expect to find value in this company?
Balance sheet?
Income/Cash Flow?
Intangibles?
Others?
A combination thereof?
Is the company heavily dependent upon human capital, e.g. investment banking?
What risks does the company face that could impair its value?
What factors influence the balance sheet values?
How sensitive is the balance sheet to those factors?
What are the risks to income/cash flow?
Factors?
What is the competitive structure of the company's industry?
Is the industry in decline?
What is the company's position in its industry?
Does the company have pricing power?
Is the company a slave to its suppliers?
Is there a risk/history of unethical or criminal behavior within the company?
Others?
Does the company have negative exposure to, or benefit from, commodity prices?
Explanation.
What is management doing with free cash flow?
Does it make sense? Is it in the best interest of shareholders?
Or is it stupid?
What are the risks of financial distress?
Look at various metrics, e.g. Cash Flow to Debt, Debt to Equity, Net Current Asset Value
Other risks.
Other positives
If the price is right, would I want to own this company?
If the answer is yes, perform the Final Workup.

Final Workup

What is the company's normalized cash earning power?
What is the intrinsic value of future earnings? Provided in a range, not one absolute number.
List and explain assumptions. Are they reasonable?
Is there excess capital?
What is the value of excess capital? Provided in a range, not one absolute number.
What is the range of total value?
The range should be the "reasonable scenario" (neither best case nor worst case).
What events, actions, etc. could permanently impair the value?
What is the probability of these events happening?
What is the total value under a worst case scenario, given reasonable assumptions?
What is the probability of the worst case scenario?
I do not consider a best case scenario.
What is the market price? How does it relate to value?
What is my margin of safety?
Non-existent? Not sufficient? Neutral? Sufficient? Excellent?
At what price would I commit 10% of my net worth to this company?
At what price would I commit 50% of my net worth to this company?

Decision: After performing your thorough analysis you have a decision to make. It comes down to 3 choices: Start a position, Wait for a better price, Throw it in the trash.

The Thesis

If I decide to buy, I like to write a little statement in which I answer two questions: Why am I buying this security? Under what circumstances would I consider selling?

It should be clear that you have to put forth a significant amount effort before you can begin the workups. You should be able to answer all these questions with the 2 or 3 most recent annual reports of the subject company. Find the reports on the company's website and start reading.

Value Investing Part I: The Basics

Value Investing, for all intents and purposes, is the only method of investing (if executed properly) that promises long-term investment success.

Investment Defined

Before I define and explain value investing, let us first consider the definition of an investment. Benjamin Graham, in his classic investment treatise "The Intelligent Investor", defines an investment as follows:

"An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return."

The act of simply buying a common stock does not qualify one as an investor. According to Graham's definition there are several criteria that must be met. We have to thoroughly analyze the stock. After such analysis, we must concluded that we have a low probability of permanently losing money and a high probability of generating a return that exceeds a threshold. We'll call the threshold our opportunity cost, i.e. the return we could realize on other investment options.

Price vs. Value

There is a distinct difference between price and value. Warren Buffett says:

"Price is what you pay, value is what you get."

The decision to buy or not buy a common stock boils down to two numbers, the price of the stock and value of the stock. Price is easy, it is given to us in minute-by-minute market quotations. At any given moment, price is a specific and known number. Value is a bit more tricky. It is the number we hope to arrive at following "thorough analysis." Determining value is a tedious, yet imprecise, task. We will discuss the process of valuation later in the series.

Value Investing is simply buying stocks, or other assets, for less than their value.

Investing is as simple as that statement; determine the value of a stock and buy when the price is less than value.