Wednesday, December 27, 2006


Charles Dow, who gave his name to the Dow Jones Average and was also the longtime publisher of the Wall Street Journal, the most indispensible publication anywhere, famously remarked that to understand the movement of the stock markets, it was key to understand changes in valuation of stocks. As I look at valuations, unfortunately, they seem mighty high.

High Valuations

With corporate profits at all time highs, the market trades at 18 times (trailing 12 months) earnings. Bulls suggest that on a forward earnings basis this is more like 15 times, which is historic. They are right and wrong. Forward earnings are obviously more important than past earnings (only assets still held by the company that are available for distribution to shareholders count, but more on this in a bit), and 15 times earnings is a historically accurate figure (but for trailing, and not forward, earnings on which basis stocks have have valued closer to 13.8 times).

John Mauldin (check out his website from my links at right) notes that at profit margins from the 1990s(!) stocks would be trading at earnings of 25 times. Margins have improved primarily from two things, one, lower borrowing costs and two lower tax rates. That is, net income has increased from reductions in non-operating expense. Thus, businesses aren't really better today, external factors have aligned to reduce their costs.

Slowing earnings growth

In my last post, I talked about the expecations of relatively low growth in the earnings of assets in the future. The rates anticipated by Buffett and Gross are significantly lower than either the recent rates growth in earnings (the US economy is now in something like its 18th straight quarter of double digit earnings growth), nor anticipation of future earnings (which continue to call for double digit growth for some time, followed by high single digit growth). Some companies, of course, will experience strong growth in earnings like this, but as noted in my last post, all companies cannot grow earnings (corporate income) faster than overall income (GDP) beyond a few years.

Business have used low interest rates and lower tax rates to improve their balance sheets by refinancing and retiring debt, and by retiring equity in the form of stock buybacks. These conditions are often mistaken by bulls to mean that future earnings and cashflows should be much higher. In fact, business decisions are indicative of a very negative investing climate. Rather than use cheap credit to expand operations, they are using cheap credit to alter their capital structure. This is not a bad thing, per se, but it means that rather than borrow to acquire more assets to scale up and increase business activities, it means that they feel their current level of assets is adquate, and that they would rather reduce the claims on those assets. This may help earnings per share, but not earnings.

Their logic goes something like this. Say you are 10 years into a 30 year mortgage. If you take advantage of lower interest rates to refinance your mortgage and stretch payments out over a longer horizon, back to 30 years - and with cheap money why wouldn't you - you now have much higher cashflows than you had before. You have lower interest cost each month (because the balance is now financed at a lower rate, plus, you have smaller principal payments every month, because you are now going to amortize the principal over 30 years instead of 20). The question is what do you do with those cashflows? To keep this example representative, we have to assume that the property on which the mortgage is held is an investment property, and that it is profitably rented.

If all else remains equal - rent collected, etc - as a result of this change, your income will go up (because your interest expense will go down). But the logical thing to do, if the real estate business looks promising, is actually to relever the property by using the lower interest rate and longer payment horizon to keep the same payment, but take money out and use that money to purchase more real estate (thereby expanding operations and earning more money). If you aren't investing in more real estate in that environment, what does that say about business prospects? Might they be worsening? Might that mean that you would have lower income going forward? Even if interest rates remain low, maybe overbuilding or other conditions mean that rents in your area are falling (or are likely to fall, which is why you aren't committing to expanding your holdings).

Instead, businesses are using that higher income to either pay of other debts, increase cash (which improves balance sheet liquidity) or buy out partners (by repurchasing stock). Now, the stock repurchases are mostly a good idea. They reduce capital and assets, and thereby improve returns on equity (assuming that there is no impact on the business, the remaining shareholders should get more money, because the pie can be cut into fewer pieces).

Understand - this is NOT BULLISH!!! If interest rates are falling, why would you pay off debts, unless returns on capital are falling at least as fast? Think of it this way, if you used borrow at 3% and earn 6% on that money, and did so happily, and now you can borrow at 1%, why wouldn't you try and borrow more, even if you could only earn 5%, your margin would be greater. Plus, as you borrowed more and leveraged up, your returns on equity would improve (just like buying back stock). If instead you simply refi-ed your existing loans and took the extra cashflow and bought out your partners, what does that say about your expectation of growth prospects?

Worse yet, what if the favorable tax environment were to change ?

Thus, as investors, we have to assume lower earnings growth going forward. We also have to be willing to put a premium on quality earnings.

Options, the silent killer

So, values are high and earnings are set to slow down. When it comes to valuations there is one final issue - and that is options. If stock is repurchased, and prices rise, this helps option holders because as each share gets a greater portion of the pie, its value increases (and with it the value of the option). Worse, many of these options are not included in calculations of earnings per share (even diluted earnings per share often exclude significant amounts of options outstanding, because of an accounting convention that I will explain in a later post).

I have no detailed analysis on this, outside of the companies I follow, but I can tell you that P/E ratios on those stocks would be about 10% higher than they already are if all options were exercised. In the case of one stock I follow, complete dilution, including the effects of options and convertible prefered stock would push P/Es to above 30! Yikes! (I really should sell - Credit to the reader who figures out which stock it is).

As an investor, it is key to assume that all options will be excercised (even those that are "under water") because if the investment is a good one, price appreciation will almost certainly result. That is, nearly every good investment assumes that you are purchasing at a discount. The subsequent price rise will likely get options (at least those issued as compensation) above water. On that basis, if my experience is representative, then most companies have about 10% of their stock in options that are not counted in shares outstanding when diluted earnings per share are calculated and therefore the earnings per share is 10% lower than reported, and the P/E must therefore be 10& higher than reported. On a straight basis, that suggests that stocks are trading closer to 20 times earnings today, and on the John Mauldin 1990s margin basis, at 27.5 times.

No wonder finding good investments has been so damn hard.

Bill Gross on the Alpha/Beta Challenge

Well, I have just returned from beautiful and warm Thailand. Thai must mean "snacks" in Thai, because the country is literally full of them. I have to say, it was pretty interesting having 78 degrees (Fahrenheit, that's 24 degrees Celsius) on Christmas Day. I'm now in Munich again, where it's sunny (if only for a few hours a day), but -3 (Celsius, which is 26 degrees Fahrenheit. It is an adjustment).

Any event, with my return to broadband, I am also catching up on my back reading, which has been severely curtailed by vacation travelling and sightseeing, moving countries, leaving my former employer and gearing up for a year at the University of St Gallen in Switzerland, where we compress a 22 month degree (the MBA) into 12 months.

But to the topic of this article, Gualberto Diaz has written a post about the current arguments between bulls and bears. I just read a great assessment by Bill Gross, the Managing Director at Pacific Investment Management (PIMCO) about the dilemma that we as investors are facing, which also sheds some light on the issue of what sort of markets to expect going forward. He describes it as the Alpha/Beta anemia. It's implications are far-reaching for investing strategy.

Start with a basic (and correct) assumption. Since GDP measures the overall income from domestic sources (domestic assets), over long periods, returns on assets are likely to rise in lock-step with growth in (nominal) GDP. Many investors still long for the "good old days" when double digit investing returns were common. This was due to the fact that from 1970-1985, nominal GDP increased in double digit amounts. (In the 1970s, asset price returns - which can diverge sharply from the growth of the underlying business income - lagged overall GDP growth, setting the stage for asset price growth stronger than GDP growth in later years to restore the correlation), and the period after 1993, when real GDP grew at 4-5% per year for most of a decade. While nominal GDP increased around 8%, any selectivity in investment choices meant that returns above 8% were easily obtained (and were easily magnified by using financial leverage, i.e. buying on margin).

Unfortunately, from one perspective, those days are over, at least, it would appear so. Economic growth (GDP by another name), is averaging much closer to 2.5%, with inflation matching that figure for a nominal GDP rate of 5% or so per year. Assets should return, therefore, something like that figure. Applying financial leverage (debt) might enable investors to push that up by 1 or 2%. Since asset price levels (in the very long term) reflect earning power of the underlying assets, asset prices (investor returns) are likely to be in this range. Incidentally Warren Buffett wrote an article in Fortune a few years back, and said about the same thing - he expected 6% returns going forward.

Are you still with me? In short, what Gross is saying is, asset income growth should be between five and six percent in the future, with the opportunity to use debt to improve returns on equity to six to seven percent per year. This figure, also called "beta" which describes how much of an investment's price movements can be correlated to market price movements (a basket of stocks with perfect market correlation has a beta of 1.0) is simply too anemic for most investors.

Faced with these returns, however, investors are essentially saying, "that's fine for other people, but I need at least nine or 10 percent". There are several reasons for this, Gross mentions only one, which is the fact that six or seven percent returns will not be adequate to fund future liabilities. He does not specify which liabilities he means but my sense is that he means healthcare and retirement expenses. This blog has said as much many times over (see retirment crisis).

As a result, investors are instead seeking out riskier investments, those that tend to have higher "alpha" which is the additional "reward" that riskier investments should offer. But with that effort to find higher return investments (like small-cap stocks, a favorite of "foolish" investors, particulalry right now), the ususal price discounts that these investments offer in return for their high risk (the risk premium) has diminished. In fact, small cap stocks, far from trading at a discount to large issues, trade at a substantial price premium (which, to some degree may be mitigated by the potential for faster growth, but this is what these alpha-seeking investors are all assuming).

You know what happens when people are lining up to buy something, particularly something that is sold at an auction (which is the case with stocks!), buyers overpay.

In short, what has happened is that the price of risk, the risk premium, has declined substantially. The implications are significant. First, periods of significant stability can actually create risk, because over long periods investors become accustomed to being rewarded for making ever riskier bets, until, unfortunately, they aren't. When the tide turns, many investors will find they have been "swimming naked" in the words of Buffett.

Worse, systemmic underpricing of risk means that index-weighted portfolios (which are weighted in large part based on price levels) will always over-invest in over-priced assets, and under-invest in (risk-adjusted) underpriced assets, as the overpriced assets have higher market capitalization relative to earning potential, and underpriced assets, by definition, have low capitalization relalitve to earning potential. Indexers, in other words, far from being protected by "diversification" will discover that diversification has them overinvesting in today's high priced assets. While their losses might not be as spectactular as those of an investor who was 100% invested in "optical networking" stocks in 2000-2001, losses of 30-50% in diversified porfolios will be little comfort.

Gross suggests, I believe rightly, that the only thing an investor can do is seek to concentrate his money in the single few best investments he can find. Those that offer opportunities to earn superior (and here he means 7%) returns with comparably little risk.

He does not believe that assuming addtional financial leverage is a smart move at this point. Basically, there are two options, the first is that the Fed will renew vigilance with respect to inflation and again raise interest rates. This will reduce financial leverage in the system, which _should_ make things safer, but might also lead to a collapse in certain overvalued asset prices, thereby provoking the crisis that the Fed hopes to prevent. Or, the Fed can allow higher inflation, which, while it will prevent (at least in the short term) a credit crisis, inflation also generally leads to lower asset prices as the twin effects of taxes and higher discount rates reduce present values of assets thereby leading to price declines or stagnation (like the 1970s).

Finally, unmentioned by Bill Gross, but mentioned by Gualberto, most businesses are at peak earning cycles. corporate profits' share of GDP is at all time highs (which is one way that asset prices have outstripped GDP growth over the past three years). The trend of business income increasing faster than overall income cannot continue indefinately. Tax levels linger near post-war lows as (unrecognized) government liabilities pile up on balance sheets, which foretells of greater tax burdens in the future; corporate income, already at high levels, is a natural target for revenue raising.

Finally, we have the issue of those other pesky liabilities for which assets earning six or seven percent - the ones I call the Boomer-Lifestyle Liabilities. These are the costs associated with retiring in the style the Boomers imagine themselves living. Let me make this clear, Boomers, as a group, will live a retirment lifestyle well below that which they are living now. There are various ways that they can help to reduce the gap - they can continue to work in retirement (or not retire), they can pick really great investments (but not all of them can) and they can win the lottery (again, not all can do this either), which means that Boomer consumption will begin declining.

Lower consumption (and higher savings) means more money chasing assets of declining quality (less consumption means lower business income). I don't have to tell you where that leads.

What does this all mean? Most of the bull arguments I have seen are really trader/herder mentality. It amounts to "ride the wave", with a focus on recent economic reports and stock market price level movements as a reason to invest. I will not tell anyone not to ride the wave. But I will ask, what happens when the tide turns, as it will, maybe next year, maybe 2009. Are your assets good enough to survive a major change? Even good enough to survive a tsunami? As Thais can tell you, bad things can happen even when the weather seems perfect at the beach.

Sunday, November 26, 2006

Commodity Prices, what do they Suggest

Well, I am already on record as paying relatively little attention to commodities, but I do pay attention to prices levels of some commodities, particularly gold, because of what it suggests about the purchasing power of the dollar. The news here is not good. The dollar is hitting 20 month lows against the Euro. Worse, the price of gold has quietly crept up to near $640 and it might go higher.

One cornerstone of any successful investing strategy is maintaining (at a minimum) purchasing power in spite of a dollar that loses its value on a regular basis (inflation).

Now I have perhaps taken both sides of this argument in the past, which is to say, I have purchased (and continue to hold) a position in CL becuase of its ability to have strong earnings regardless of the relative strength or weakness of the dollar. At the same time, I have argued that commodity prices should fall with the next US recession, which will, in my opinion, be deep.

Ironically, I see the very rise in commodity prices as a major factor in provoking the recession. The Fed has finally admitted that its monetary policy was far too loose in 2003-2004. As a result prices have begun rising significantly, because there is too much money sloshing around the system, and not enough goods for them to chase.

While this is not bad, what makes this situation a disaster is the resulting credit bubble. Credit bubbles are very, very bad. When there seems like there is little consequence of borrowing (like low interest rates), people borrow more than is prudent. They take advantage of the lower rates possible, by using variable interest rates on their debt. In short, they set themselves up for a credit crunch when money gets tighter (as it inevitably does). The Fed would like to end the credit bubble without bringing economic activity to a standstill. This is an admirable objective, but as price levels are again demonstrating, it is not a probable result.

I felt that the Fed erred in stopping further interest rate rises, which, after a monetary orgy, the likes of which we have not seen in decades, only aggresive policy was likely to really curb the bubble. Instead, the Fed has just slowed down the expansion of credit, rather than rein it in. Therefore, prices are bound to keep rising. But the Fed cannot continue to allow these higher prices. They will be forced not to trim rates, but rather to raise them. In the 1990s, we watched central banks go on competitive devaluations and cut rates. Now, we will watch them go on competitive "protection" positions - each raising in part because it wants to defend the value of its currency. The alternative is to watch commodity prices, in local currency terms, rise to highly inflationary levels.

As banks keep tightening credit, those who borrowed imprudently when money was cheap will begin to have difficulty making payments. You know the story from there. Imagine the impact on housing if the Fed finds itself raising rates to 5.75% or 6% next year! Brutal.

But, with rates headed higher, it still pays to keep savings in short term vehicles. They are already paying higher rates, are protected against principal loss (which will happen if long rates rise to reflect inflation) and offer liquidity for making opportunistic purchases.

Wednesday, November 22, 2006

Sites to See

Just because I haven't posting with regularity doesn't mean I am not trying to keep up with what's going on in the finance blogosphere. I have come across a few new sites you should check out.

It's not a secret that I like stocks that pay dividends and repurchase stock. I like companies where the pie is growing, payouts are growing and my share of the growing pie (and payouts) is growing. One site that can help develop a short list is stockinvestingx. The site lists many features about top 100 dividend payers and repurchasers. Beware, however, that just knowing companies making significant repurchases is not enough, you also need to consider the stock and option issuance that is on the other side of the repurchases. You can always find information on equity and option issuance in a 10-K and shareholder friendly companies also include this in a 10-Q.

The other site is from a real estate bull and sometime commentator on this blog, Larry Nussbaum who writes the Millionaire Now Blog. He also has a book. His site writes on a variety of finance and investing topics.

Harry Dent Forecast

My friend Jason Tilberg has shared a new Harry Dent forecast. Now, I have to admit that I think the man is far too optimistic about a raging bull market between now and 2009. On the other hand, Dent and I agree that there is a big drop coming and we both believe that it relates to coming changes in Boomer spending habits. After years of "living for today" and spending, spending, spending, Boomers are about to get to "imagine no possessions", because that is what their financial condition will provide them in retirement. The problem is, they are going to take the economy with them.

Boomer consumption is a major driver of economic activity. Since few Boomers will be able to maintain that rate of spending in retirement (in part because their spending already exceeds their income), Boomers will dramatically reduce consumption in retirement. Future generations will not spend the same way and lower aggregate demand will result. The problem will get worse as we get deeper into the Boom.

I actually see the downturn in housing leading to reduced activity starting in 2007, with no boom, and a full on bust in full by 2008 from which there will be no recovery for a decade or more. Stalled earnings growth, or even downright lower earnings should end the rally in the markets.

But maybe Dent has a point. Much depends on Boomer behavior between now and retirement. While there is no way for most Boomers to save enough to maintain their standard of living in retirment (which means future consumption will decline in any event) but Boomers may try and avoid their fate by making major changes in spending and saving habits. Initial moves to increase savings will lead to higher asset prices, most likely in stocks. It won't be enough to prevent the inevitable, the economy simply cannot support that much consumption by non-workers, but as an investor it might be possible to ride that wave.

I continue to urge caution in investing. Downside risks are large, in spite of bullish predictions and claims that equities are cheap. They are not. Bonds are expensive - but you have to ask yourself, why is that savvy bond market so pessimistic.

Monday, November 20, 2006

What the Phelps Dodge Acquisition Means

So, there is little doubt that I am a bear when it comes to asset prices. Many other commentators agree with me with regards to copper. This is reassuring, since I do not study commodity markets.

People who live this business, however, are suggesting that I am wrong. Had I listened to my friend Jason Tilberg, I could have made some nice dough in Southern Copper. But as I noted above, I don't follow commodity markets, so I ignored it (trying to stay in my zone of comfort). Plus, as noted above, I am an asset price bear, so in my mind, commodities, and companies tied to them, are things to avoid.

However, there is increasing evidence that I have erred. The Freeport acquisition of PD is such evidence. Freeport clearly believes that copper prices will remain high enough, long enough for it to basically pay down the new debt it is issuing to acquire Phelps before prices fall. The transaction is actually accreditive to earnings in the first year. This is rare in an acquisition, since the premium paid is usually too high, and new shares issued for the acquisition, plus other acquisition costs usually put a dent in earnings for at least 12 months, before cost cutting synergies and pricing power take root.

Now, even if copper prices fall, Freeport may have gotten a good deal, since as the largest manufacturer, they should also be the low cost supplier to the market (higher market share leads almost inevitably to lower relative cost), and in an oversupplied market, it is the low cost provider (whic can still reduce prices and make money) that wins.

Even so, this is a bet on higher copper prices going forward, because the increased fixed charges have to be paid by cash coming from operations. If copper can remain at elevated prices for another year or two, however, and Freeport is disciplined at deleveraging, they have the opportunity to reduce those fixed charges by the time prices begin dropping.

Views on the Housing Market

As regular readers know, I am a housing bear. Together with that, I am actually an economic bear. I believe that this housing bubble collapse will lead to wholesale changes in spending patterns, particularly among boomer households, who are as a group woefully unprepared for the retirement that looms for many.

An asset price decline will lead to a negative wealth effect and coupled with actual income declines (most boomers are planning to have only 60-80% of their pre-retirement income in retirement, while they currently spend more than they earn), will lead to a major depression not seen since the 1930s.

In this article from John Mauldin, A. Gary Schilling, a noted Yale professor (and real estate bear) reviews all the reasons why the bear market in real estate is only getting warmed up. He makes frequent mention of how the real estate bubble resembles that of the 1920s. While Schilling does not seem to believe that we are headed to the 1930s he does mention the possibility. It is critical to understand that the depression of the 1930s was NOT caused by the stock market crash. The crash was indicative of (the decline) of other economic activity. The post-crash connection was made by anti-capitalist politicos who played up populist resentment of Northeastern bankers to win elections in 1932, 1934 and 1936. But here I digress.

The depression of the 1930s resulted from an attempt by the Federal Reserve to unmake a massive inflation in caused with easy money in 1926. In that year, the Bank of England wanted to return to the gold standard, and do so at it´s pre-WWI peg. While this action satisfied British egos, it was monumentally stupid. Wartime expenditures had led to a massive increase in pounds stirling in circulation, and gold supply simply had not kept up. So, when the UK returned to its peg, gold started flowing out of the country. The BoE was in danger of dropping the peg when it prevailed on the Fed to cut interest rates to reverse the outflow of gold. The Fed complied, and dropped nominal rates by over 100 basis points, and gold started flowing out of the US and to the UK where it could be put to work at higher rates.

This drop in rates, however, led to speculative borrowing in the US. It also led to a temporary increase in the price of farm products (which had enjoyed war-influenced high prices since 1915: the war had destroyed significant acreage in Europe, and the Continent was forced to import food, leading to high prices). All of this came to a head at the same time. By 1928, Continental acreage was coming back under tillage, increasing supply, while subsequent increases in interest rates (used to reduce speculative purchases of coastal real estate) meant that farm loans, and their interest payments now exceeded the revenue that family farms could generate. While this may seem laughable today, it was significant in a country where half the population still lived on farms. Banks failed all over the place, but most severely in the Midwest and West, where banking laws forced the Bank of Podunk to take deposits and make loans in Podunk. With such concentration of portfolios, substantially all of the assets of the bank (loans to the farmers of Podunk, secured with mortgages against the farms of Podunk) were devalued together. Once the banks failed, even farmers who weren't in default found themselves with their savings wiped out (remember, there was no deposit insurance).

But, I hear the reader say, we have much more sophisticated risk modelling today: banks have better risk management, they are no longer limited to lending in the neighborhood, through securitization, they can lay off significant risks (and purchase risks from other markets), the Federal Reserve has 80 more years of education under its belt, and we have deposit insurance.

All of these things are true, but what we need to recognize is that we have also transferred risk to individuals on a scale we have not had since before the Bad Deal. While this is not a bad thing (it enables those individuals to profit from the risk premia they have assumed, for instance), many of those risk-takers do not understand the risks they are taking. This means that they may not be insisting on the premiums they require. While there may be deposit insurance on savings, there is no such insurance on the equity and mutual fund portfolios that comprise the vast majority of the financial assets of Americans. The Federal Reserve seems just as willing today to make poor economic decisions in the interest of politics, namely the Greenspan inflation, which I have discussed often. Finally, let us not forget that Japan had all the same advantages when it entered its 15 year "lost decade". Asset prices still have nor recovered to pre-collapse levels. And the US lacks the significant exports and current account surplus that Japan has used to bolster economic activity.

This real estate collapse will be unlike any we have seen. I think Schilling´s projections of a 25% drop in prices is quite realistic. Only a major inflation can prevent it.

I continue to recommend defensive positions. An interesting suggestion of Schilling (who believes interest rates are headed lower as part of the deflation) is to purchase long zero coupon bonds. Prices of such bonds are going to skyrocket if rates decline to 3% as he believes.

I am looking to investigate this option seriously.

Sunday, November 19, 2006

Personal Update

Regular readers of this blog will note that postings have become somewhat anemic lately. I have to apologize, because my commitment to investing and to this blog have not diminished, but available time has been hard to come by.

I am making some major changes in my life. I am leaving my nice job here in New Jersey working on strategic management in aftersales to increase my international exposure and earn an MBA at the University of St Gallen, one of the top-5 MBA programs in Europe. The school´s website is here. With this degree (and 12 months in Switzerland, which is going to be awesome in itself), I will look to join the ranks of the strategy consultants, hopefully with BCG. We shall see.

Actually, returning to school will probably help the quality of this blog. I will benefit from academic exposure and the time to think about ideas that school offers. The problem has been that I have been in the process of launching some new programs at work before I leave, and simultaneously moving to another country.

I will endeavor to post more in the next few weeks, before I head to Europe on the 6th of December, and thence to Thailand. Once that happens, on the 9th of December, there will likely be few posts until I get settled in Switzerland in the new year.


Nathan Mayer Rothschild, the oldest of the five Rothschild brothers who established the venerable commercial bank in the late eighteenth and early nineteenth centuries, is said to have remarked, "I never buy at the bottom and I always sell too soon." This sentiment is echoed by the American financier (I believe it was JP Morgan), who, when presented with an investment offering 100% returns, remarked, "Well, you can have the first 30% and the last 30% and I will just take the nice safe 40% in the middle." In other words, he wasn´t interested in buying before he was certain that the return would be positive.

I have recently read that the essence of investing is not managing returns, it´s managing risk. First you want to be reasonably sure of a positive return (capital preservation), only then do you want to consider the potential magnitude of the returns. Too many people look at the magnitude of returns first, and only then consider the probability of achieving these returns. This is why the lottery is so popular - it offers a huge return, for essentially nothing. Of course, most purchasers are simply incapable of appreciating the remoteness of the probability that their return will be positive. So they lose 100% every week, occasionally winning a minor pot of $5 or $10 to desensitize them to the dififculty of the odds they face.

This post isn´t about the lottery, however, it´s about TRLG. I mentioned in a prior post that I had left the temple of True Religion. Actually, I left a few weeks too early. I sold at $22.60 on a day when the high price for the day was §22.80. A few weeks later, the stock actually made new all-time highs in the $24.65 range. I lost out on an extra $800 by "selling too soon". But as my calculations from my DCF model suggested, the stock was near its highs at $22.60, and the probability of further gains were remote. Earnings would have to rise even faster than the 50% I projected for this year (35% for next), or operating margins would have to increase. While the first event was possible, I held out no expectations of the latter.

I work for a manufacturer. Like all companies with independent distribution, we regularly consider whether we wouldn´t be better off if we could capture more downstream revenue. Since pricing is usually based on cost-plus margining, capturing retail sales would significantly increase revenue, without actually capturing market share (we would benefit from selling at the retail price, which , for spare parts, is usually 65-100% greater than the wholesale price). The problem is that in order to do this, we would also have to absorb retail inventory, which would significantly increase working capital. We would also have to pay the expenses at retail that the distributors bear, personnel, rent and overhead. Worse, as a manufacturer, we would only really have one product line, whereas most distributors can amortize expenses over a wider product assortment available to them (since they can sell products from many manufacturers). This is essentially the difference between a specialty retailer and a department store. The department store also finds it easier to attract new customers, since it can easily cross-sell shoppers in the store for other promotions or products.

In fact, what we have begun to see from True Religion is that sales outside of the US are flagging, or at least, not increasing. Sales in the US are increasing, but primarily due to growth in the retail segment (i.e. the company is capturing that downstream revenue). However, this means that revenue is increasing faster than product volume, which raises serious questions about the acceptance of the brand on a broader scope. Worse, they are seeing increasing overhead, which management insists is required for future product introductions, but managing a retail chain is difficult. The company has brought in experience for this. The current management team has demonstrated success with retail, but what we are seeing is collapsing operating margins. For a company whose primary value is in future earnings, lower operating margins have to terrify investors.

In fact, while I was in Mexico on a business trip (I was in the buffett line at lunch actually), two other attendees started talking about the collapse of the stock price of TRLG, which has since declined to the mid $15 range. At this price, you might very well be able to round-trip the stock back up to $20, if management can find the new revenues to justify the ramp-up in expenses. But for the first time, management has failed to deliver the goods and so their ability to win converts on the street will come much harder.

At this point, I am sitting on lots and lots of cash. Buffett notes that this is no fun, and I concur, but at the same time, its better to sit on cash than watch your positions collapse. I am still looking for another investment that I find as attractive as TRLG. Right now, the only investment I consider worthwhile is BAC. I am even beginning to doubt the CL. Since I purchased in October 0f 2004, I have watched the stock price rise 50%, from $44 to $66, at the same time, I have earned nice dividends, which have been hiked twice, from 24 cents to 32 cents a share (for a 33%) increase over the same period. My shareholdings have increased by nearly four percent, giving me a total return of over 56% for the period (If you are wondering why my return isn´t 54%, the sum of the two, the reason is that the shares purchased from dividend reinvestment have also benefitted from rising prices, so my total return exceeds the price increase plus dividend payments).

Generally speaking, your return should reflect the dividend yield plus the rate of increase of dividends. (I have another post explaining why this is so, but essentially, with dividend paying stocks, prices tend to increase at the same rate as dividend increases). With CL price increases have outstripped dividend increases, so the dividend yield has fallen. This suggests lower returns going forward. Indeed, to return to the dividend rate of Oct 2004, when I purchased, dividends would have to increase about 17% or 5 cents per share, from here with no increase in the stock price. This would then offer a return of about 2.6% (the dividend yield at 37 cents per share, per quarter). Such a dividend increase is actually quite probable. The company tends to maintain a dividend payout ratio of around 50% of earnings, with much of the remaining money going to repurchase stock, both preferred and common. In the latest quarter the company earned $0.73 per share. With forward earnings expected to run about $0.80 per share per quarter the company could raise to 38-39 cents per share per quarter. Organic growth, plus benefits from the company´s restructuring make these very reasonable projections. But even with this strong dividend increase rate, the stock should have only moderate price appreciation. Of course, as I have suggested many times, I own the stock because it offers a reasonable return with a high degree of safety, but even stocks like KO can take big dives (granted, at its all-time high Coke was trading at a ridiculous 45 times earnings).

The real kicker with CL is that it trades at 27 times earnings, but that is before the stock is fully diluted. There are 39 million options on the stock. While repurchases are easily oustripping option issuance, redemptions and forfeits are reducing the overall stock of ourstanding options, but with all options exercised, the stock trades at over 30 times earnings. There have to be better options. Unfortunately I haven´t had the time to find them.

Thursday, September 28, 2006

An offer from the Strategic Investor

A couple of people have contacted me about getting the excel sheet for the DCF analysis. You could also make one yourself, but why reinvent the wheel? The issue is, blogger isn't terribly helpful with sharing excel files (if someone knows how, please tell me), so I have to send via email. I ask that you subscribe to my feed by entering your email address in the the box at the right (just enter your email in the white box on the right hand side and then confirm via the email confirmation) and I will send you the file as an email attachment.

Wednesday, September 27, 2006


In my last post, I mentioned a DCF (discounted cash flow model) for TRLG.
Unfortunately there was a problem with Blogger photos, so it didn't embed.

So, I will try again.

The model covers a ten year valuation of the company. Basically, what I have done is take the actual net cash and equivalents as of December 31, 2005, and the actual number of shares outstanding, plus the number of options outstanding, plus the number of restricted stock shares issued, and project the following: annual revenue growth, operating margins, tax rate, net income and owner earnings (net income plus depreciation less capital expenditures), and future equity dilution.

Starting with 2006, I project revenues of $150 million. This represents a 50% increase over last year's $102 million, and is roughly the amount that management projects. Going forward, I expect slower growth. It is possible that my growth rates are too conservative, but how mainstream can $300 jeans be? International sales are also flagging, though management has insisted that this will improve shortly. Management insists that it can turn the brand into a $1 billion per year business, though how long is not clear.

Next up is margins - a measure of how profitable those revenues are. The company appears to be consistently running an operating margin of 30.3%. It is important to distinguish between gross margins and operating margins. Gross margins is the spread between the sale price and the cost of the product sold, expressed as a percentage of the sale price. Thus, if sell for $300 a pair of jeans that cost you $150 to produce or purchase, your gross margin is 50%. However, there are still the other operating expenses, like employee, marketing, legal, and others, to pay. These are generally lumped together under Selling, General and Administrative expense. After you pay those expenses you arive at operating margins. That is, your profit as a percentage of sales after you have paid all operating expenses.

(Please note that the spreadsheet is in a German version of MS Excel, so don't be thrown by the commas. Germans use commas where US uses decimal points, and vice versa. Funny, isn't it? But I digress).

TRLG has benefitted from higher margins in recent months, expanding to about 52-53%. Most of this margin expansion is coming from the impact of retail stores, which enables the company to capture the additional gross profit between wholesale and retail. Unfortunately, it also means the company has proportionately higher selling, general and administrative expense, because there are rent, employees, utilities and other expenses to pay in operating that retail store, so operating margins are remaing about the same as before the retail stores. (The amount of revenue is higher, because revenue is now happening at retail, and not only at wholesale prices, so that margin is being earned on a higher top line number).

From there one has to consider interest expense (none, since the company has no debt, and appears to require no major investment to grow revenues, since all products are produced by contract manufacturers). This leads us to taxes. I assume a tax rate of 35% for all years. Here, I am simply projecting the current maximum corporate tax rate into the future. This is actually one area where I have not been conservative. It is likely that the US government will raise taxes, particularly on corporations, in the next 10 years, in order to combat rising deficits.

After the taxes are paid, we have Net Income. To this we need to add depreciation (a non-cash expense), and subtract capital expeditures. In mature businesses, these numbers are often very similar, as the business tends to need relatively little capital. What makes TRLG interesting is that it has virtually no cap-ex at all. In fact, it has virtually no long term capital commitments, other than some leasehold improvements at its corporate offices and retail stores.

So, Net Income and Owner Earnings are essentially the same.

The Discount Rate
One of the most crucial numbers you can chose in investing is an appropriate discount rate. The discount rate is used to reflect the time-value of money. Obviously, if I offered you $1 today or $1 in ten years, you would rather have the $1 today. I have to "discount" the value of the dollar in ten years to reflect the risks that you assume in waiting so long to get your money.

The first time they hear this, most people think of inflation, and in fact the idea is very similar. But where inflation measures the discount that would be required to maintain purchasing power, investors need to use a different number. We have to ask ourselves, what is the opportunity cost of the capital? Since if we didn't put our capital into this investment we could put it into a different one, we should really use a number that reflects what would happen if we were to earn the market return. I estimate this at about 10% (though in my first post I mentioned that the compounded rate of return of US stocks since 1926 is actually 9% - and that was in 1999 at the height of the bubble).

Once I have discounted those earnings into the future, I then need to divide the discounted earnings by the anticipated number of shares outstanding, so see how much earning power one share should have.

Thus far this year, management has cut out issuing itself options. Instead, it issues itself restricted stock. This year, the company issued employees 450,000 shares of restricted stock (it also issued some as settlement to outsiders). I see no reason to expect that management will become more frugal going forward, so I estimate the increase in shares outstanding by 469,000 per year. I then divide each year's discounted earnings by the anticipated shares outstanding.

All that is left to do is sum up the values. This produces a Net Present Value (reflecting the sum of all the present values) of the future cash flows of the company. Those cash flows are worth about $22.

Unlike most DCF models, I am assuming no residual value beyond the measurement period (generally, investments in stocks are considered to have infinite valuation periods, and you have to do that special calculation. In the case of this stock, where the true long term sustainability of the business is really a question it makes no sense to assume an infinite valuation period. The extra margin of safety is key).

Tuesday, September 26, 2006

I've left the temple of True Relgion

On Thursday, I unloaded my entire position in TRLG at $22.60. The stock hit an eight month high, near its all time high of $24.61, and this time I became concerned about valuation, and decided to take my 66.7% gain and run. The stock may head higher, but I believe that it will go lower again; indeed, it closed at $21.45 yesterday.

It should be noted, however, that evaluating an investment is an art, and not a science. While the math is straightforward, you have to make many estimates, because there are many possible outcomes. Buffett speaks of the need to have a range of values for a stock (and then watch developments and re-handicap the possible outcomes as events unfold). The quality of these estimates and the ability to estimate the probability of one of the outcomes over the other are the keys to success. So let’s break down my rationale for believing that the above estimate is approximately correct.

Reason 1: Valuation

The primary reason I sold was that my numbers told me to. I ran the numbers and concluded that the fair value of the stock is about $21-$22, so I sold at a slight premium to that value. As you can see from the embedded Discounted Cash Flow analysis, I estimate pretty strong revenue growth going forward, with ten years of growth above 15%. At the moment, the company is growing 50% over the prior year, but this is already a slower growth rate than 2005 was over 2004 (you can only compare the fourth quarter). As the revenue base continues to grow, I expect that in percentage terms revenue growth will continue to slow.

Revenue growth is the key to this company’s share price. The company’s price has almost nothing to do with the assets on its books. The price is entirely dependent on the expectation of future earnings growth. Thus, if earnings falter, even a little bit, the stock price is going to be hurt. Of course, that happens for all companies, but companies that have a market cap closer to their book values have a natural buoy to their share price – the fact that the assets on their books have value, and could be sold.

As of the second quarter, TRLG has $57 million in assets, against $7 million in liabilities. This is enough to get any investor’s attention. Better yet, $50 million of that is in current assets. The company has far more money in cash and short term investments than it has in liabilities. In short, the creditworthiness of the company is tremendous. In fact, almost none of its assets are actually used in the business. The company has about $20 million in working capital, and $2 million in property plant and equipment, substantially all of which is leasehold improvements at its corporate offices, warehouse and retail locations. In fact, the company appears to require no long term assets to run its business. This is a wonderful thing, in my mind, because its return on capital employed (ROCE), the capital actually used to run the business, is about 125%. These are the kind of numbers that had me buying at $13.50. But at that time, I estimated that the stock was conservatively worth $20 per share. While intrinsic value has grown somewhat (to almost $22), the market has come to value the company at that level, too. I don’t want to speculate on the market now overvaluing the company substantially, as betting on the market’s irrationality also requires me to bet on which direction that irrationality will take. Since by its nature the behavior would be irrational, it’s a fifty-fifty bet. I look for better odds.

The problem is, with $50 million in net assets, the company trades at over $500 million – for a price to tangible book of 10 times. The market is offering this company a tremendous amount of goodwill, because it is very well managed, but if there is even a small slowdown, Jim Cramer will be shouting “CLEAR!” as the price drops painfully. Since even well managed companies tend to miss “whisper” numbers on the Street (sometimes their very good management is actually the problem, as the Street gets too optimistic about management’s ability to deliver). I think this could happen in either the 4th quarter of this year or the 1st quarter of 2007.

It is also true that if revenue grows faster than I project, particularly in 2007 and 2008, the stock’s value should be higher. If operating margins were to increase, the company should also have higher intrinsic valuation. I don’t expect higher revenues (see reason three below) and I also don’t see higher operating margins (see reason four). It is also worth noting that there can be no assurance that the company’s products will remain fashionable for the next ten years, so future revenue growth could be negative, which would have a significant negative impact on the shares. Is the risk worth it?

Reason 2: Me

A successful investor has to control his own emotions. He also needs to know the limits of his competence – his circle of knowledge where he can make decisions better than others. In my case, TRLG does not fit that profile. This stock is really outside of my area of expertise. I purchased the stock not because I saw great visions for True Religion (though the company’s management does). I purchased the stock because I loved the growth rate and the balance sheet (check out the balance sheet on Yahoo or at your broker’s research site. It is as pristine as can be, with more cash than liabilities).

Back in early 2006, about 75 days after I purchased my shares, the stock hit an all-time high of $24.61. I decided not to sell, because I let the market convince me that I should trust my most aggressive estimates that showed an intrinsic value of $27-$30 a share. I was the fool in this case, since the stock then took a major dive, back down to $15. Had I sold, I could have bought back in when the stock hit that price point, which was a significant discount to my low-range value of $17 per share. I don’t want to make the same mistake again.

For what it’s worth, my lack of special knowledge means that I may be underestimating the company’s prospects. But I would rather underestimate them than overestimate them.

QUESTION: If think my revenue projections too conservative, please tell me why.

Macro Trends

While I lack special knowledge of fashion brands, I can see how macroeconomic factors will likely impact retail – negatively. The economy, while still strong, continues to slow. With a stabilization, or even decline of home prices, and the imminent retirement of spendthrift boomers, we face a high probability of declining consumer spending, which should put the entire category at risk. While the high-end of any market usually holds up best in a downturn (wealthy folks have wide, deep income streams), strong growth rates mean acquiring new, “mass affluent” customers. Faced with the need to save more, these folks are less likely to splurge on $300 jeans, so I expect that more aggressive growth rates that would further lift intrinsic value (and ultimately share price) are less probable than the rates reflected in my DCF analysis.

Company specific issues

Apart from the foregoing, TRLG has some other company-specific risks. The stock is controlled by a single shareholder, who also happens to be the CEO. In fact, insiders control a significant amount of the stock, and therefore not only have control of management, they also control the board. While this is not necessarily a problem, after all, some of the best run companies in the world are controlled by single shareholders, it is even more important than with other companies to see if management is acting in the interests of all shareholders.

While management appears to be running the business well, they are taking steps that are not nearly as shareholder friendly. While they have stopped issuing options (the remainder of which will eventually be exercised, rest assured), they are instead issuing large amounts of restricted stock. Thus, as shareholders, we are seeing our slice of the pie get smaller. The pie is getting bigger at a very fast pace, so the size of our slice is getting larger, but it is doing so by getting thinner and longer. I like to look for companies that are net-repurchasers of stock. That is, the repurchase more than they issue (including options). That way, I know that my slices are getting wider as well as longer.

True Religion is not doing so. They are not repurchasing stock, nor are they issuing even a small dividend. While this is not uncommon among small fast-growing companies, TRLG has demonstrated that it doesn’t need additional assets to fund its growth. No where has TRLG indicated that it has definite capital plans that might require the cash to be reinvested in the business. So why not return cash to shareholders?

Likewise, why pay employees with stock? Why not pay them cash bonuses (from current year revenues). This will reduce the cash-hoard slightly, but again, the cash doesn’t seem to be required. Employees can purchase the stock in the open market if they consider it such a value.

Finally, when management controls a company like this one and cash starts piling up, management gets all sorts of ideas about various projects that would be interesting to undertake. Usually these ventures produce far lower returns than the business itself, and ultimately destroy value. With no real checks to prevent this, as a shareholder I must be concerned about the uses to which the cash will be put.

Market environment

TLRG has been a favorite stock of the shorts. As of August 10, it had nearly 40% of the float sold short. This, ironically, is often a bullish signal. Since the short shares have to be bought back, large short positions guarantee future purchase volume (though not higher prices). However, as the stock has been rallying in the last few weeks, various shorts have undoubtedly been closing their short positions by repurchasing the shares, potentially at a loss, as the stock market has rallied, rather than faltered, during this unusual third quarter.

Once that short-covering purchase demand dries up, however, we are likely to see a downward drift in the price. Some shorts, convinced that technical factors will drive the stock down to the mid-teens again, will start selling short again. Such a reversal is likely to see us head lower.

The bullish case

The bulls can argue that revenue growth will remain strong (the third quarter is the biggest, revenue wise for the company. If we see continued strong growth in the US coupled with a recovery of revenue in Asia, the stock should head higher.

However, the bullish case also relies on continued short squeezing, and potentially on a sale of the company. I believe that, at current valuation, no such sale is likely. An acquirer would get some cash, the trademarks, and a heap of goodwill. And that is BEFORE paying a takeover premium. Similarly, an effort to take the company private, which is possible because insiders could commit their stock, would still require significant amounts of debt, at least $300 million worth, which the company could probably pay, but would significantly impair net revenues, as the interest payments would be on a scale comparable to operating earnings.

In short

I still like the company, so if there is a significant pullback (below $15.50), I would consider repurchasing, indeed, I hope there is such a pullback. But at these prices, I’m an apostate from the church of True Religion.

Sunday, September 17, 2006

What's your Sloth Story

Tell us about your story of successful "slothful" investing. Maybe your grandmother leave you shares of XOM or GE? Or you got in on the Google IPO and are still holding (or MSFT?)

We'll take stories slothful waste as well.

Mine actually involves using a full service broker. My parents are successful people, but not what you would call successful investors. They are employees who have saved diligently and profited from the long bull market.

Anyway, when I was 12 (and definately no investor), I decided I wanted to purchase stocks. So my dad took me to Merrill Lynch (which a savvier investor would not have done) and helped me open an account. At the time Merrill was offering a program that enabled you to purchase based on dollar increments and not round lots (which I could not afford). I decided to invest in the bluest of blue chips. T. Yes, American Telephone & Telegraph. I purchased 7 plus shares with about $200.

I was excited about the dividend and the strength of the company. After 12 years I had shares in Lucent, AT&T, NCR, Comcast, Avaya, Agere and other companies. I think my position was worth nearly $1000, which wasn't bad. But I had never really collected any dividends because of the account fees. When the telecom market collapsed, I wound up with an account balance not significantly different from my initial investment and I still had fees I owed.

I sure had been slothful, but I had missed the boat.

The Slothful Investor

As Empty Spaces, who writes the tremendous blog, Adventures in Moneymaking (go check it out), notes in a comment to my last post, Warren Buffett remarks that successful investing consists of long periods of inactivity, bordering on sloth. So, perhaps I should have titled this blog The Slothful Investor, since this accurately describes my trading activity.

Before I continue, however, I would like to give a shout to the Oracle of Omaha, who finally married his long-term girlfriend. For those who do not know, the Buffetts separated in 1977, but incredibly never divorced. Susan Thomson Buffett, Warren's late wife, remained on the board of Berkshire, and by not going through divorce proceedings enabled him to keep control of Berkshire. With her death in 2004, however, the Oracle has changed his plans for his fortune and has decided to finally tie the knot with Astrid Menks.

Back to the issue of sloth, however. Slothful investing is the natural correlary of focus investing. Since your few best ideas are going to be much better than your other ideas, you spend alot of time just sitting on your existing positions and looking for something better. Only occasionally will you find it. Isn't this a major reason why trading is so much work? Following the market obsessively takes huge amounts of time. Worse, much like executive focus on meeting the quarterly numbers, it takes your focus off of what really counts - the intrinsic value of the businesses. Much, much worse, it tends to generate fees. Lots and lots of fees.

Buffett as a Slothful Investor
The best example of sloth I know is Buffett's purchase of the Washington Post in the early 1970s. This stock gets far less play than his investments in Coca-Cola, Geico, or even L3 Communications (a position that has since been liquidated). To understand this purchase, zou have to appreciate the publishing business and Buffett's timing.

Unlike most public companies, nearly all media outfits are controlled by a family or major shareholder. This is true regardless of the medium, everything from television (CBS, Fox) to to newsprint (NYT, Wall Street Journal, Washington Post, USAToday). Most newpaper companies operate with multiple classes of stock. This is the result of the fact that most of these companies were originally closely held family businesses. When they went public, the family wanted to make sure that it could maintain editorial control. Unusually for companies with multiple classes of stock, this has probably benefitted shareholders. News outlets obviously have editorial slants and their readers are often motivated to purchase that content based on their own views. A sudden change of control, and concomitant change of editorial direction could have readers scrambling for the exits. (Can you imagine the shrill cries of Daily Kos if the NYT were acquired by Rupert Murdoch?) So protecting the editorial direction is part of protecting the franchise.

But back to 1973. Buffett valued the company at $400 million. In one of his annual reports, he notes that anyone he asked felt the company was worth $400 million. Mr. Market was asleep that day, because it was valued at $80 million. Buffett purchased $11 million in a tender offer, which gave him a 15% share of the Class B stock.

He wanted to purchase more, but Katherine Graham, the publisher who had IPOed the paper after the death of her husband and ran it for years, was influenced by her son who felt that no one but the Graham family should have a larger share. Sticking with his strategy of investing only with management he likes, he complied with their request. (I actually had the tremendous pleasure of sharing a limo with Mrs. Graham on two occasions. She received the Benton Medal from the University of Chicago, my alma mater, and I was working in the office of special events. I picked her up at the airport and took her to the president's house. When she departed, I shared breakfast with Mrs. Graham, the University president and his wife, and then rode in the limo back with her. She was quite a conversationalist and down to earth.)

Today, his 1.7 million share position is worth $1.4 Billion ! The stock also continues to pay a solid dividend. At $7.80 per share, the annual dividend that Buffett collects exceeds his initial investment, and he has been able to use it to invest in other projects over the years. This one investment counts for the bulk of the tremendous outperformance of Berkshire since 1965. He has never sold shares in the company. Essentially, he has been able to sit on the position and experience rising dividends.

Life as a Slothful Investor
The best thing about slothful investing is that it enables you to live your life. Once your investments are on autopilot, you can focus on the things that are really important to you, like travel, or education, or your family.

In my case, I made very few moves last year. My three big changes were to liquidate a position in a small cap mutal fund. I sold FBRVX and kept PRCGX. While this hasn't been a horrible decision, it turns out I would have been better off with the FBR fund (I orginally purchase in 2001 and had made no move since). I sold it becuase I wanted to reduce my exposure to small cap funds.

Instead, I decided to make a "major purchase" of 200 shares of BAC. I will cover this in more detail in another post, but basically I purchased it because the stock was cheap, large cap financials were unloved, I expected a rally after the Fed stopped raising rates, and I was going to be paid handsomely to wait. I purchased in the mid 40s and one year later we are around $51, but I have also collected the dividends.

Finally I made a purchase in November that turns out to be my one position where trading would really have helped. TRLG is one of my favorite companies. Since we are now $10 above where I purchased last November, I need to reevaluate this stock, but had I traded, I could have sold at $24 only weeks after purchasing at $13. I could then have repurchased the stock at $15 and rode it all again to $22 where we are now. But the truth is, I am not looking to call tops or bottoms. I am simply looking to purchase dollars on the cheap.

I have not made a trade in nearly a year. Still, I am up over 20% since this time last year. My limited work on this has enabled me to refocus on my quadrant "e" work, apply and get accepted to business school, sail and still find a little time to remind my girlfriend why she is so important to me. (Ok, I could do better on this last point).

Wednesday, August 09, 2006

How Wealthy do you Want to Be?

Publishing magnate Felix Dennis has established the following wealth scale in an article published online in the Sunday Times (London). I guess my old objective was to be in the comfortably wealthy camp ($10 million US is approximately 6.8 million British pounds). But are there really so many levels?

I wonder, th0ugh, how this scale might look were it based on income (or cash flow). What do you think? At what point does additional income cease to make a difference, since it really increases neither your control of your time nor your standard of living?

For me, of course, I still measure wealth in time. One thing is certain, though. If you aren't born to wealth, then the only way to get to the other levels is to get control of your time, and use it to focus on expanding your wealth.

Dennis's Wealth Scale

Total assets

£1m-£2m The comfortable poor

£2m-£5m The comfortably off

£5m-£15m The comfortably wealthy

£15m-£40m The lesser rich

£40m-£75m The comfortably rich

£75m-£100m The rich

£100m-£200m The seriously rich

£200m-£400m The truly rich

£400m-£999m The filthy rich

More than £999m The super rich

Thursday, July 06, 2006

Retirement Calculator

I came across a new "retirement calculator" from A.G. Edwards. (Read the press release) The scoring is based on the idea of credit scores, with ranks between 450-850. Anthing over 750 is considered excellent, 650-749 is good, 550-649 is fair and below 550 poor.

You answer 14 questions, including age, income, work years, home equity, savings and the like and it assesses the strength of your nest egg.

Your humble writer came in at 738, but mostly, I believe, because I do not own a home.

I like it because it compares you to other households, but my complaint is that unlike credit scoring, which have a predictive value (they tell a lender how likely you are to be late on a payment), A.G. Edwards offers no probability that you will reach retirement with x% of income. They also do not ask what your retirement goal is. Still it is worth checking out.

Monday, July 03, 2006

Retirement: How Much do you REALLY Need?

In my previous post, I noted that I believed that a sensible target for being able to retire (this applies even more if you want to retire early) is to plan to have significantly more income in retirement than when you are working. This enables one to have more "walking around money" to pay for leisure time activities. I have found further evidence of this at the end of the Retirement Report from the EBRI.

The report found that while most workers believe they can live on something like 60-80% of pre-retirement income (and assume that they can live well, since their retired parents appear to have far less income), more than half of retirees actually reported equal or greater income in retirement than when they were working. with one in five reporting higher income. Today's workers believe that they can have a retirement at least as comfortable as their parents, because a) they have earned more throughout their lives, b) they have a large home and c) their parents appear to do fine on low incomes. The problem with this logic is one of competition for services. Todays retirees compete with other low-income retirees for "retiree services". Many of their actual expenses (especially taxes and healthcare) are heavily subsidized by todays workers. Those subsidies may not be available tomorrow, and today's "high-income" workers will find that they are competing for services with other retirees with similar circumstances, so prices for those sevices will likely rise above present levels.

Finally, it is important to note that while today's retirees seem poor compared to their boomer children (at peak earnings), they find themselves in a lifestyle with which they were accustomed. Thus, their needs and wants are simply lower. Todays workers will find the experience far more jarring, and sadly, they may actually not have more income in retirement than their parents do today (while still facing higher prices). Unlike their parents, who won all sorts of subsidies to keep themselves in their houses, todays workers may find that they need to sell their house just to provide income for basic necessities in retirement (thus eviscerating the value of the tax subsidy for which they would otherwise be eligible).

This is why my personal monthly investing cashflow target includes a cushion that significantly exceeds my current net income (not to mention my expenses, which are at this time a fraction of my net income). I have built this cushion into my model to allow for three things. The first is inflation. It will take some time (at my current pace at least) to build this passive income and I want to protect my purchasing power. Second, I want to have walking around money. What is the fun of being a full-time investor, if you can't take advantage of opportunities to use the time-flexibility that investing offers. Third, and most important, I want to ensure that I have streams of income to serve as further capital to make investments.

Indeed, if you are fortunate enough to be able to retire in your mid-50s (or younger), you should plan to expand your capital base. The reason for this is simple. You will need to plan for a rising income in retirement to keep up with inflation (or even better, wages). There are two ways to do so, either you increase the returns on capital invested, or increase the amount of capital invested. Unless you can assume higher risk of loss in retirement than when you were working (unlikely for most people), you had better assume lower returns on capital, and lots more of it.

I am curious to know how others are preparing for retirement. What strategies are you using? How prepared are you?

Saturday, July 01, 2006

Retirement Crisis

This blog is about investing strategy, but it is important to realize that strategies support goals. One of the most important for everyone (including your humble writer) is retirement. While I have noted that my goals have changed from a retirement-centered net worth model to a cashflow-centered investment model, my strategy involves a plan to be able to retire, even if I fail to meet my primary investing objectives.

It is therefore saddening to read in todays Wall Street Journal that the Employee Benefit Research Institute has found that most Boomers believe that they are well prepared for retirement, and yet, have failed to save for it. Most workers are literally planning to be poor in retirement, which I consider to be a very bad strategy indeed.

Before we dig a bit deeper into the findings of the report, I want to note that I believe the only intelligent strategy for retirement planning is to expect to need MORE MONEY in retirement than you need when you are working. I realize that my target it iconclastic, and contradicts conventional retirement planning wisdom. The conventional wisdom is simply unwise.

Here's why: free time is expensive. I went to the barber this morning, and in the course of the normal bullshitting that goes on, I asked if they were going to take Monday off to make a three day weekend out of it (in Bergen County, New Jersey, blue laws prohibit most businesses from being open on Sundays, and Tuesday is the 4th of July). He mentioned that, no, it was a normal week, apart from Tuesday the Fourth. Then, sagely, he remarked, "If we had the day off, I'd just spend money. You know, you do a few things, and you ask yourself, where did it all go?" This is exactly the problem. If you are the ueber-achiever that I suspect most readers of this blog are, you currently work something north of 45-48 hours a week (plus commuting time). What will you do when you are no longer working? No doubt, you will volunteer or find other "low-cost" activities like blogging to fill your time, but how many of us also want to travel, have a second home play golf at nice courses and/or own a boat? (Personally, I find that you can either sail, or golf, but not both there simply isn't enough time. Maybe, in retirement I will find a way).

The secret of retirement is, free time is expensive. Since so many of us are reaching retirement healthier than former generations, we will want to do more active things, not spend time playing bocce in retirement communities and sitting by the pool complaining about Medicare (though I suspect that many will do so).

Of course, you could always work. In fact, the concept of retirement is really a relatively new creation. Before Bismarck created state pensions in Germany in the 1880s, almost no one retired. According to the study, many people (67% of workers, actually) expect to work in retirement. This will help to mitigate the expensive free-time problem and it will provide some income, but most of the jobs that people expect to do will not replace their peak earning incomes.
And any Boomer who falls ill will likely run through their meagre savings quickly, since they do not have the same retirement benefits offered to those born before 1940.

Since most people are failing to meet even the insufficient standards of preparation suggested by the retirement planning industry, as investors, we need to consider how we can protect ourselves (and profit) from Boomer financial folly. Make no mistake, since profligate Boomer spending has been a major driver of economic activity in the US and the world, when it comes time to pay the piper, Boomer spending habits will cause significant upheaval in the markets.

So what does the report actually suggest? You can read it in its entirety here. The survey was of 1252 American adults over 25 (1000 workers and 252 retirees) in 21-minute telephone interviews.

The scariest finding is that 30% of people saving nothing for retirement and that of those, 44% of believed that they would have a comfortable retirement, because of money from employers, inheritance and "faith".

Even though only 40% of people had a defined-benefit (traditional pension) plan 61% expected to receive benefits from one!

More than half had saved less than $50,000 for retirement. It should be noted that the youngest workers cannot be expected to have saved large amounts, and the oldest workers are likely to have additional income from a traditional pension. Current retirees have about 3x their salaries in savings when they retire. Still, what does it say about people's spending habits that they have essentially saved NOTHING? How can they expect to live on much less than their salary, when they are consuming all of it today? Remember, free time is expensive! Even traditional retirement formulas that assume a good target is 80% of pre-retirement income begin with the presumption that much of that 20% differential represents pre-retirement savings. That is, just before retirement, you are already living on only 80% of your income, because of savings. Once you retire, you can stop saving, so you essentially have the same standard of living in retirement that you had just before it.

Finally, 42% of workers have not made even an estimate of their needs in retirement, so it is no surprise that they are confident and unprepared. 22% of very confident people are not currnetly saving for retirement, 39% have less than $50,000 saved, and 37% have made no estimate of how much they need. Ignorance is bliss, but like faith, it is not a good retirement strategy.

So, what can you do to protect yourself and profit from this coming generational debacle? Well this writer fully expects a major asset-price collapse, a collapse that will be compounded by an effort among central banks to deflate the asset bubble their easy money has created.

You must protect capital in stable-value, even insured, products. In a demand driven deflation like the 1930s, cash is king.

If you are nearing retirement, consider (even with seemingly low interest rates) putting some of your nest egg into a single premium immediate annuity, which will guarantee income for life. Do this with a highly rated insurer, as weaker insurers will likely default in an asset-price crash.

Reconsider your equity investments carefully. In a major economic downturn, consumer staples will hold up best. Make sure that the companies whose stocks you purchase are not highly leveraged, as falling prices will make it dificult to generate sufficient cash flows for debt service. Count your dividends. These are real returns, and retirees will need the dividend income, so such stocks will be the least hard hit.

Think high taxes. As government revenues fall, making a bad fiscal picture absolutely terrifying, governments will look to raise taxes everywhere, but especially on incomes and businesses (though, in an effort to placate angry, near-destitute retirees (voters), they will likely continue to keep them low on investment income). Think about ways to generate income from investments.

Consider international investments in countries with better demographics and favorable economic conditions. Note: China does NOT have favorable demographics and will be very hard hit in a major downturn as outlined above.

Sorry for the gloom and doom. I am really an optimistic person (I guess I count myself among the "very confident" crowd). But whenever I see numbers like these, I am truly dismayed. I believe that the Boomers are fomenting an economic boom and crisis much like that of the 1920s and 1930s, when the last "idealist" generation - that of Hoover and FDR - hit retirement. Already we are seeing Smoot-Hawley tariff style protectionism. A collapse in global trade, forcing consumer prices up, together with a collapse in asset prices, driving purchasing power down, is a recepie for disaster.

Tuesday, June 27, 2006

Investing Myth: Buy and Hold is the Best Investment Strategy

I am a contrarian. Since my goal is to have serious money and since most people are poor (see the Pareto rule), I want to avoid following the mistake of being conventional.

One of the most common conventions in investing is that you should "buy for the long term". Advocates of this position cite a few major reasons for doing so, namely, that you minimize taxes and transaction fees. Taxes and fees can indeed be large drains on investing portfolios. Warren Buffett, who is famous for saying that his favorite holding period is "forever", took substantial pains in his latest letter to shareholders (pg 17 "How to minimize investment returns") to explain how the financial services "seduced" Americans into trading assets, and paying for the privilege. In fact, Buffett, arguably the greatest investor of all time and one of the people whose approach to investing I study carefully, is often cited by the "buy and hold" crowd as proof that buy and hold is the best strategy.

Looking a little closer, however, we can see that, in fact, buy and hold, for all its apparent tax and transaction cost advantages has a great many weaknesses.

First, most retail (small) investors do so inside of tax-advantaged savings plans, where most of the tax advantages of holding are wasted. Since taxes on earnings are already deferred until withdrawal, what tax benefit does long-term holding really offer? In fact, if you are investing in a 401(k) or IRA that is not a Roth (e.g. traditional or SEP-IRA), even the benefit of lower capital gains and dividend tax rates is lost, since all withdrawals are taxed as ordinary income - the same tax rate that short-term traders pay on their gains. (Gains in a Roth are tax free, which is the main reason that the Roth is the best savings vehicle the US government ever devised, at least from a tax perspective).

What if you aren't investing in a tax-advantaged vehicle? Well, depending on what you are doing, you can often defer taxes indefinately through use of a 1031 exchange, which is a tool to help people swapping a piece of property for a "like-kind" property. This does not only apply to real-estate, it can also apply to business assets, though, unfortunately, not to common stocks, which nevertheless, qualify for beneficial tax treatment after only one year (cap gains), or even less (dividends requires 90 days). This hardly represents a "forever" holding period.

Second, buy and hold fails to protect you against downturns in the market. If you purchase the diversified mutual fund, and buy, hold and pray, you are exposed to significant amounts of market risk (which peversely has people worried about how "the market" is doing and not how their investments are doing). "The market" has historically had huge drawdowns, from which you have no protection. While the long, long-term trend in the market has been upward, you can find at least two occasions in the past 80 years where "the market" has failed to increase in value for decades. It took until 1954 for the Dow to surpass the high of 383 it set on September 3, 1929: 25 years, and again between 1964 and 1981 the Dow remained flat (with plenty of volatility). Sure, if you held, you got your dividends, so you got even before the Dow did, but what if you were forcibly "retired" in 1930 or 1973 due to the downturn and needed those assets to provide for your livelihood? Are you investing to be able to live off the dividends alone? Forced to sell in an unfavorable environment you could be wiped out before a market recovery.

In fact, no real investors have become rich by simply "buying and holding", not even Warren Buffett. When asked at an annual meeting of Berkshire if he agreed with Phil Fisher, Buffett admitted that when he was younger he would sell, when something better came along, but now that he had more money than ideas he stood pat.

This is a key insight: neither I nor you are Warren Buffett. An investing strategy for becoming wealthy is quite different from an investing strategy for when you are already wealthy. Why use the wrong one?

One of Buffett's main reasons for holding forever is the fact that with over $100 billion in assets, it is actually difficult to find investments that are both good and meaningful. In his case, the transaction costs involved in moving such large amounts of money in and out of securities would eat most of his additional gains (after all, he can seriously influence pricing of a stock). Unlike you or I, Buffett has another reason for sticking to his policy: it helps him purchase the businesses he wants.

Buffett looks to become a controlling shareholder of a business. One of the reasons that he can avoid overpaying, is that he offers something really unique among buyout firms: he allows management to retain control of the busienss after they sell it. If management suspected that Buffett would resell the business anytime a better investment came along, they would ask for much larger control premiums, because they would know that Berkshire might sell its stake to another, less management friendly, shareholder.

Again, if you aren't purchasing control, why would you assume that the best strategy is simply to copy what Buffett does now?

So, if buy and hold isn't such a clear-cut winner, why is it so often followed? I think the first reason is emotional. It feels good to think that you made a "good purchase" and then, like a favorite piece of furniture, or a home, stay with it for decades. Second, most of us are purchasers, not sellers. We are consumers first, we rarely go through the process of selling. We sell our labor, or our home, and the sales pitch is a stressful, once in awhile activity. Given our inexperience and our general inclination to shop, buying is simply our natural mode.

Contrast that with what rich people do. Rich people are selling all the time. They are selling securities (to the public), selling real estate (to emotionally charged homeonwers), even selling themseves (their latest book). Strategic investors know how they are getting out, before they get in. That is why they are investors (and strategic), not savers looking for a better savings account.

A much better strategy is to do what Buffett did on his way to becoming rich - analyze the value of your investment, and when it becomes fully or overvalued, sell. Set this price when you purchase the investment, so that you do not become emotionally attached. It is so easy to tell yourself that that winning investment has another point in it, and then watch it tumble.

Always be watching out for a better idea. Keep most of your money in your 1st and 2nd ideas. If you have lots and lots of ideas, either you have a very favorable market (possible), or have difficulty descriminating between ideas. Force yourself to narrow your focus and decide, even between good options.

Just remember, most of the people who are telling you that you need to buy (and right now!) are selling securities. If they represent such a great value, how come they are not suggesting to the people who are selling the securities that they should hold out for another day when prices are more favorable? Perhaps they are.

Sunday, June 11, 2006

Charlie and the Money Factory

The 80/20 Rule (Pareto's Principle) suggests that 20% of your ideas will produce 80% of your investment returns. Actually, there is an argument that says that 20% of your ideas produces 120% of your returns, and the other 80% cost you money.

Assuming that you can evaluate businesses, your best ideas (the 20%) are a money factory. They will multiply your wealth over and over again. Why would you put money in something else, if you can put it to work in your best ideas?

Well, my obsession with focus investing is well known but why take my word for it, when you can get it straight from one of its most successful practitioners, Charles Munger, Vice-Chairman of Berkshire Hathaway?

In the Question and Answer portion of the 2006 Berkshire Annual Meeting, (read the notes here), the following question came up:

If you were starting with $1 Million today, what strategy would you follow?

And Munger's response:

CM: Finding a single investment that will return 20% per year for 40 years tends to happen only in dreamland. In the real world, you uncover an opportunity, then you compare other opportunities with that. And you only invest in the most attractive opportunities. It’s all about opportunity cost. The game hasn’t changed at all. That’s why modern portfolio theory is so asinine.

If Warren were starting today, he’d put together a concentrated portfolio. Your 1 or 2 best ideas are way better than the rest. So when you act, you’re thinking about how the alternatives compare to your best idea. But you don’t want to own your 10th-best idea when you can use that cash to invest in your best idea.

Focus on your best ideas. They will mint money for you.

Saturday, June 10, 2006

The Infidel: Herb Greenberg takes on True Religion

Herb Greenberg has a long-standing campaign against True Religion. He hates the company. One has to wonder why he hates it so much - did he feel slighted by something the company did, like refusing to comp him some test merchandise? Did he discover he can't fit in them? I don't know.
At his blog, Gualberto has done a good job of documenting Greenberg's take on the company.

Gualberto also takes the opportunity to show how some of Greenberg's other personal crusades have turned out. Read the comments to the post. Incidentally, unlike blogger commentators, Greenberg doens't actually own any stocks (except his employer's) according to the WSJ, which owns DowJones MarketWatch, where Greenberg is a senior columnist.

The column, which appears on pg B4 of today's (Saturday 10 June) WSJ, has this to say about TRLG:

Blue Jeans Lady
Whenever a brand claims to be hot, proff that it's not - or possibly not as much as it once was - is when its products start showing up at discounters.

Enter True Relgion Apparel, know for its pricey jeans. Until recently, the company insisted that the only place you can find its "damages," at discount prices, was Nordstrom Rack, the discounting arm of the upscale department store. In response to a questioner on its most recent earnings call, [CFO] Charles Lesser said that if the heans can be found elsewhere, 'call me immeidately so I can, in fact, get the New York Police Department on them.'

That's just what [Greenberg] did several weeks ago when [he] heard the jeans were showing up in New York's Century 21 department stores. Mr. Lesser told me the company had indeed sold some "voerstock" items to Century 21 - and that Century 21 and Nordstrom Rack were the only two discounters buying directly from True Religion. He said that if I could find them elsewhere, they're likely to be counterfeit.

So [Greenberg] called him again, this time asking about those True Religion jeans at a few BJ's Wholesale Club stores in New York and Mass. ...

If they are legit, how would they have gotten there? Probably by way of some small retailer that, if found, won't be a retailer for long, [Lesser] says. ... The question, of course, is why would a retailer have a hard time selling something that's supposedly in such high demand? Good question.
So, who's right? It is, of course, possible that the brand or the product category, could suffer a setback. I am not really an expert on fashion, which is why I generally avoid the category, but the company's overall earnings and revenues are very small relative to the categories in which they compete. They have room for growth but the key thing is, even if they had little topline growth, the stock would still be reasonably priced! You would have to assume a complete collapse of the brand, which I think unlikely. If, in fact, they couldn't hold their high pricepoints, they could always take their product downmarket, in terms of price point, and add huge volume.
Until management demonstrates that a)they are abandoning their strategy, or b) that they cannot deliver what they promised, even while following the strategy c) the company is sold, or d) the price rises about $22, the stock will remain among my investments.