Tuesday, April 25, 2006

Is it a Small Caps World, After All?

I always want to follow my strategy when it comes to investing, but I also think it important to recognize when shifting allocation tactics allow me to take advantage of market dynamics, and irrationality.

For some time (starting in mid 2005) I became concerned about the returns I was achieving with small cap stocks. I started allocating away from small caps, but, I was early. Too early. The Russell 2000 has continued to set new all-time records, and has returned nearly 14% since the beginning of the year. This is terrific for holders of small caps (I still have about 20% of my portfolio dedicated to small caps), but the stocks were already expensive. Small cap stocks are trading at 40 times trailing earnings, and 2.6 times book value. Earnings projections (which are usually optimistic), are projected to be about 15% per year.

Small cap stocks now face significant challenges growing earnings. Most small cap stocks do not issue debt, they borrow from commecial banks at rates indexed to the prime rate, which has been rising with federal funds. Higher borrowing costs mean higher interest expense, and slower asset growth, or lower leverage.

Small caps have had a run, because the prime rate dropped to 4.5% in 2003, and during that period smalls could add debt to finance rapid growth. That will become far more difficult. However, small caps' run has been so strong, and persisted for such a long period, many investors comparing mutual fund returns are concluding that "small caps are where its at" at precisely the wrong moment, when small caps will be at significant disadvantage to large caps in terms of capital costs. I heard this morning on Bloomberg radio that retail funds flows into small cap mutual funds was larger in the first quarter of 2006 than all of 2005 (this compares with returns, which were as large in the first quarter of 2006 as all of 2005).

It is therefore time to exit lower quality stocks and move to more defensive territory. Large stocks with strong cashflows and dividends are likely to outperform in the years ahead, both because of economics and also demographics (boomers need dividend income in retirement).

I note that small caps run is likely to continue, at least one more quarter. But sooner or later, thsi is going to end, and potentially painfully. I am reminded of the trader who said to the amateur, "you can have the first 30% and the last 30% [of a price move] and I'll just keep the nice safe 40% here in the middle". Even if the Fed doesn't keep raising rates, smalls will have difficulty gaining access to cheap capital. If the Fed sees the necessity of continuing to raise rates, bank financing could become downright expensive, and profits could actually fall, rather than simply grow slowly.

I will be moving money from smalls to large and international stocks, though I will be holding my most promising small cap stocks.

Saturday, April 22, 2006

New Links

I have just added some new links to some other good sites in the investing blog community. With links, I try and stick to sites that are either aimed at investing, or are important investor references.

These blogs are written by investors, for investors:

Michael Patzer has a site that chronicles the development of his own approach to investing. Particularly refreshing, he shares his mistakes as willingly as his successes.

InvestorGeeks is a site written by a few guys who share a major aim of this site - developing an approach to investing.

Finally, I encourage you to check out the USA's largest community of Financial Freedom activists, NYC Cashflow. This is where I first found a community of investors with the goal of being more succesful than simply retiring at 65 (or 67 if you're born after 1964). The community has several discussion groups of investors who are actually making it happen. We trade views, offer advice, and remind each other that talk isn't enough - action is the key.

Thursday, April 20, 2006

Book Review: Rich Dad's Guide to Investing

Rich Dad's Guide to Investing: What the Rich Invest In, That the Poor and Middle Class Do Not!
Rich Dad's Guide to Investing: What the Rich Invest In, That the Poor and Middle Class Do Not!

If you like to read, you pick up books and tear through them because its just what you do. Most you like, some you don't like, but mostly, they fade into the background and you only think about them when something triggers your memory.

But once in a while you read a book that truly changes your life, and your perpective, and Robert Kiyosaki's Rich Dad's Guide to Investing is such a book. I know, because it changed mine.

My first introduction to Kiyosaki was his informercial that ran around 2000. This was the infomercial where RK was interviewed by the young guy and talked about "50% money, 20% money and 0% money" - the young guy started doing his mock run on the treadmill. I figured that the book was just another "it's easy to get rich, you just need to follow my formula" books, so I ignored it.

A year later, though, I was channel surfing and found Kiyosaki on PBS. It was late at night, so I figured: ok, what does he have to say this time? Kiyosaki wasn't talking about another system for getting rich in real estate - he was talking about financial freedom, that it was essential to have financial education, and, most interesting to me, about the importance of financial statements.

At the time, I had just finished a successful stint as the CFO of a small not-for-profit, where I had helped engineer a turnaround by helping the organization rediscover its cashflow cycle and sources of revenue. I knew I understood financial statements - I had to find out more about what to do with this understanding.

Having seen the PBS special, I decided that I could skip the first two books, Rich Dad Poor Dad, and Cashflow Quadrant, as RK had already covered those topics in detail. So I went for Rich Dad's Guide to Investing, instead.

If the first rule of investing is "Don't lose money", then the core of this book is the very first principle of investing, which is "Don't be average". The distribution of wealth in any system tends to skew towards a few people. The Italian economist Vilfredo Pareto explained this in his Pareto Principle, the 80/20 rule. The exact ratio varies from system to system (it isn't always 80/20), but the math works in every system, even blogging.

This principle is the foundation for one of my major investing strategies: seek extraordinary returns. Since ordinary returns will not get one out of the rat-race they will likely lead to a lower standard of living in retirement.

For the record - high rates of return are available, even the "indexing" studies admit it (they usually throw in a caveat that higher returns aren't available without assuming more risk). But actually, higher returns are available with lower volatility, if you select the right investments. That is what this book is about. It is about pursuing outsized returns through selecting only the best investments. Focus, control, leverage (which you can employ comfortably, once you have control of the right investments) are the ways to achieve these goals. But without education, he stresses, you cannot distinguish the right investments from the wrong ones.

He gives terrific examples of the kind of things that a real investor knows. You need to know SEC Regulation 506D. You need to know about private placements, hedge funds, pre-IPO financing, and how to get access to them (hint, it helps to already be rich).

Kiyosaki does frown on registered securities, in my opinion somewhat unfairly. He rationale for frowning on these investments is *mostly* solid, but there are still opportunities to get rich in registered securities, he just thinks they aren't as good as opportunities in other investments.

Like most things, being really good at something requires work. If you want to be a successful investor, you need the vocabulary and awareness that this book offers. It is a launching pad to begin further investigation of investing.

Above all, he stresses the fact that using the right strategy is also a function of your goals and objectives, and that you need to set these goals high, if you want to be rich, at least.

Wednesday, April 19, 2006

The Kelly Criterion

Investing has often been compared with Poker, in that in both environments it is key to only play when the odds are in your favor.

The Kelly Criterion, explained here by My 1st Million at 33, is an equation that defines how much to risk for each level of winning probability and magnitude of returns.

Its the first time I have seen someone quantify this principle. Essentially the amount you should bet is based both on your odds of having a positive result and the average return that you can expect.

It speaks directly to the second rule of successful investing, which is: Focus your efforts. Put all your eggs in the few best baskets, and watch those baskets VERY CAREFULLY.

Generally, I try to follow the advice of Charlie Munger, and place large bets on high probability events. How much is a "large bet"? Buffett and Munger suggest that you need to be prepared to put at least 10% of your capital on a high probability event. Less than 10% and the positive impact of a terrific investment will be diluted by your next best ideas. Like a pitcher - you don't want to get beaten on your 2nd or 3rd best pitch. When the game is on the line - you want your best ideas working hard for you.

Philip Fisher, in Common Stocks, Uncommon Profits, suggests that holding more than 15 common stocks is a sign of financial incompetence - it is a sign that you cannot make investment decisions, for holding a smorgasbord of stocks is a way of avoiding decision making.

But what about diversification? Most evidence suggests that the vast majority of the benefit that diversification offers for investing returns comes from the first five or ten stocks. Thus it is possible to be both FOCUSED and DIVERSIFIED at the same time.

Dividend Paying Stocks

Thanks to Michael Patzer, who mentioned the Dividend Achievers - a site that lists all US stocks that meet the following criteria:

The Broad Dividend Achievers Index is designed to track the performance of dividend paying companies that meet the "Dividend Achievers™" requirements. To become eligible for inclusion in the Broad Dividend Achievers Index, a company must be incorporated in the United States or its territories, trade on the New York Stock Exchange, the NASDAQ system or the American Stock Exchange, and have increased its annual regular dividend payments for the last 10 or more consecutive years. In addition, Mergent applies certain additional screening criteria to ensure a stocks' liquidity and investibility. The Broad Dividend Achievers Index is calculated using a modified market capitalization weighting methodology.

Index is also available as an ETF on the AMEX, DAA.

The attached chart shows the power of dividends to help you outpeform and continue to increase your investment capital, by weathering a down market. I believe that a key strategy for investing will be to continue to "front run" the Baby Boom generation, which will be looking for sources of increasing income. Companies with rising dividends will be attractive sources of rising income.

Dividends will also help us weather a down period in the markets, which I expect.

Tuesday, April 18, 2006

Housing Market Woes

It finally appears to be happening. The long-anticipated slowdown in house appreciation appears to be happening. Last week the WSJ had several articles that made use of anecdotal evidence to show the changes in some major markets like Naples, FL.

But now the data seem to be supporting it, and today CNN/Money had more information suggesting that bearishness in the RE industry is widespread, and increasing.

The economics of the housing market are both broad and deep. If there is a real collapse, investors have to be prepared to be defensive, as consumer spending and asset prices are likely to fall. Tactical allocations should reflect that real risk. Worse, as housing remains expensive for many new buyers, who may wait out sellers in a falling market, rents are likely to rise, increasing inflation, which will require further Fed rate increases.

If you are looking to buy however, having strong liquidity will enable you to pounce on bargains, and offer sellers something that they will desperatly need: buyers who have the financial strength to close. This will give you a great deal of flexibility in obtaining favorable seller financing and with rising rents, greater opportunity to cashflow the property.

I'm looking forward to it.

Which is better, a 401(k) or a Roth IRA?

I thought we might celebrate putting tax season behind us by taking a look at two of the most popular tax advantaged savings vehicles commonly available: the 401(k) and the Roth IRA. If you cannot take advantage of both vehicles, we will see that in most all cases, the Roth wins, but, I qualify this by saying that it still depends on your personal finance circumstances.

Like most people, I am depressed when I look at my paystub and realize how much I pay in taxes. I was suprised, however, to learn that taxation is actually the greatest expense you have over your life. I always assumed it was a home purchase. After all, you usually spend north of $300 or $400, and that's before remodelling and mortgage interest. But when you think about it, you pay personal income taxes (federal, state, and sometimes local), payroll taxes (FICA, Medicare, disability, unemployment), real estate taxes and sales taxes. Add it up, and its a big bite out of your earnings.

Given that taxes are your largest expense, any investment strategy must look both minimize the amount paid, and also offer control over the timing of those payments. As we will see, the Roth is almost always superior to the 401(k) on the first count, and always superior on the second.

Let's first look at the differences in taxation. A 401(k) allows you to take a portion of your income and defer taxes on it, by putting it into the account (before-tax, or "qualified" money in the parlance of the IRS). When you turn 59.5, you may make withdrawals at will. You pay "ordinary" income tax (that is, you pay earned income tax, not capital gains tax). Readers of this blog know that income taxes are taxed at higher rates than (long-term) capital gains or dividends. On the other hand, you have the advantage of tax deferral, and compound that money.

The power of compounding is a powerful thing, and tax deferral is a major benefit to investment returns, because you are essentially able to play with the government's money to earn more money. Tax deferral is a interest-free loan, by the government, to you, the investor. Consider the difference between investor A and B in the following example: both investors begin with $100. Investor A, opens a regular brokerage account and earns 10% per year, and pays 30% in taxes every year, while investor B invests his money inside of a 401(k), defering his tax until he retires, at which time he also pays 30% in taxes. After one year, investor A has $107 ($100 plus $10 in gains, less $3 in taxes). After two years, investor A has $114.49, and so on. After one year, Investor B has $110 (and defers $3 in taxes, which are still owed, but can be reinvested). After two year, Investor B has $121 (with $6.3 in deferred taxes, which can be reinvested yet again). You can see that as the deferred amount is compounded, Investor B's advantage multiplies. If Investor B were to take his money out, after two years, he would have $114.70, or $0.31 more than investor A. After ten years the numbers look like this:

Year A
1 $100.00
2 $107.00
3 $ 114.49
4 $122.50
$ 133.10
5 $ 131.08
$ 146.41
6 $140.26
$ 161.05
7 $150.07
$ 177.16
8 $160.58
$ 194.87
9 $ 171.82
$ 214.36
10 $ 183.85
$ 235.79
after taxes $ 183.85

Investor A has been dutifully paying his taxes every year, but investor B has used the government's tax loan to increase his returns. The three dollars he didn't pay in year one earned an extra 30 cents in year two, and the six dollars and 30 cents in year two earned 63 cents in year three. After ten years, he's ahead by $11.21. Now, imagine that instead of a 100 portfolio, that it was a $100,000 portfolio; that $11 is now $11,210. And imagine that instead of ten years, we were talking about 40 years: the difference between the two investors results is $1500! This is a serious benefit. And actually, since the 401(k) investor (Investor B) received a tax deduction for his CONTRIBUTION as well, on an after-tax basis in the contribution year he should have started with $130, not $100. This lifts his advantage by an additional $850, for a total of $2350!

This principle is one of the reasons that many investors prefer capital gains (stock price appreciation) to dividends. The gains in stock prices can be deferred indefinately - until the asset is sold. It gives you, the investor complete control over when you pay your taxes.

The Roth is a slightly different animal. With a Roth the government makes a GIFT of your taxes (earnings are Tax Free, not simply tax deferred). For this benefit, however, you have to pay taxes on your contributions (this is a significant cost). If your investment horizon is short - you often do better off with the 401(k), especially if you expect to be in a lower tax bracket in retirement. (I believe that this is unlikely, and that we are likely to face higher taxes in the future, not lower taxes). Young people, who tend to have lower earnings and are therefore in low tax brackets, also do better, since, for making the small payment of tax on their contributions, they get all of their earnings tax FREE.

But the Roth has anothe benefit: no mandatory withdrawals. With a 401(k), the government is loaning you the money. Eventually, the government wants to be repaid, so at 70.5 you MUST begin withdrawing money, even if you don't need it. With the Roth, since the government has gifted you the money, you never have to make withdrawals, and the account balance is excluded from your estate, so there are no estate taxes to pay, if you leave it to your heirs.

Finally, you can always withdraw your contributions to the Roth tax and penalty free, provided that they have been in the account for at least five years, so in an emergency, you can get at the money less expensively.

The flexibility and the tax free nature of earnings makes the Roth a clear winner here.

Chances are, if you have money in both vehicles, the 401(k) has a bigger balance. That is because the 401(k) does have a few advantages. The most obvious is that it has higher contribution limits than an IRA. $15,000/year in employee contributions for 2006, and $20,000 for people over 50, who are entitled to "catch-up" contributions. Your company may impose lower maximums, however. Usually, companies do this to ensure that the 401(k) plan does not descriminate in favor of highly compensated employees. That is, the government doesn't want 401(k) plans where everyone outside of top management contributes $2000 a year, and top management uses the tax deferral to stuff $20,000 in the account. Such a plan, the government reasons, is not a corporate savings plan, but an executive deferred compensation plan (which has separate tax rules).

Another critical feature of a 401(k) is that, since it is an employer sponsored plan, employers often offer a matching contribution. (This amount does not count against the $15/$20,000 mentioned above - those are limits for employee contributions. Total contributions - both employee and employer - cannot exceed 25% of an employee's gross salary). The employer match is an important return-booster. If someone is offering you a 50 or 75% match, this is essentially offering you a guaranteed 50 or 75% return for the first year. You really cannot beat it, even with the tax advantages of the Roth, so my recommendation is that you contribute to a 401(k) until you get the maximum match.

There is one downside to this, however, which is that you are limited to the investment choices selected by your employer. They may be limited, and in some cases, inappropriate.

Finally, while this probably doesn't apply to readers of this blog, contributions to a 401(k) are usually automatic, and done as payroll deductions -before you even get to see the money in your paycheck. This makes the contributions regular and easy, which means that you are more likely to stick with your strategy.

So, 401(k) or Roth? Why not both? If you like the options that your employer offers, get the match. Then fund the Roth until you hit the limit, and then you have to decide if you want to max out your 401(k) before funding a regular, taxable, brokerage account.

Monday, April 17, 2006

My Investment Goals

One of the most imporant things I have learned about investing is the importance of having the right objective. When I started investing, I was looking for a Net Worth figure that I believed would allow me to safely produce the income level I desired. What I have learned is that it is far more important to focus on the income, or cash flow itself., and focus less on the actual net worth figure.

To their credit, my parents gave me a good understanding of both the need to save, and the importance of using special savings vehicles, like 401(k)s and IRAs to do so. So when I first started working. I immediately enrolled in the company's plan, which is pretty generous, offering 75 cents on the dollar for the first 8% of salary (all the more so, because the company still has a traditional annuity pension).

At the time, I figured that I was likely to retire between 60 and 63, and set a target of having $10 million by that time. My rationale in establishing this number was an assumption that I would want to have an annual income in retirement of $250,000 in today's dollars. Unlike most investment guides, which often suggest that one needs something between 60-80% of pre-retirement income after retiring, I believe that in fact, you need something more. After all, work takes lots of your time. Once I don't have work occupying my day, I want to have enough money to be able to afford to travel, or fund my hobbies. I don't want to be sitting in front of the TV watching bowling.

So, how do we get from $250k to $10 million? Inflation. I assumed that, conservatively invested, $10 million should earn 5-6% per year, or $500-$600k per year. This is significantly more than the $250k I need, but the $250k is in present dollars! The $10 million would be in 2034 dollars (when I turn 60). Since inflation runs around 2-3% per year, over the 40 year horizon that I was envisioning, the purchasing power of the dollar would fall by more than half. (It would lose half its value after 24 years at 3% and over 36 years at 2%). This means that we have to cut the $500-600k in half, which gets us to $250-$300, which leaves some cushion. If inflation runs higher, we can make up some of this by investing more aggresively.

So, having established these targets, I then began concocting a contribution and earnings plan for the next 40 years, playing with variables such as the rate of growth of my income, and the rate of return on my assets, and worked numbers that actually got me to my goal.

The bad news is that the numbers that I worked up are certainly flawed, and probably fatally so. I compounded my returns at 11% per year (which was what everyone said was the "historical" return on stocks). I have already commented on why compouding "average" returns is NOT a good idea in my first post. So, $10 million may not be in my future, at least, not by saving from earned income.

The good news is that $10 million was the wrong objective. Since money really represents freedom, my goal has changed - my focus is on developing monthly cash flow. Enough cash flow, in fact that I can a) only work when I want, and at things I want to do, b) afford myself all the travel and hobby activity that I want to participate in and c) provide for my family and loved ones.

I have changed my goal - my first goal is to develop cash flows in excess of my expenses. To that end, I have actually taken some steps to reduce my expenses (which means that more of my cashflow goes into the asset column, to create more cash flow), and I am working at purchasing some cash flow investments.

My second goal is $10,000 a month in passive income - at which point, I could stop working, and have excess cash flow that could be used to increase my passive income. At this point, I could really focus on creating and building businesses, writing, and selecting investments (which, together with sailing, travelling, and studying language and history is what I like to do).

The important thing is that chaning my goals has also meant changing my strategy. Rather than focus on capital gains investments that I hope to convert to income in the future (though I certainly look for capital gains investments), I start by looking for income producing investments that can also increase in value. Thus, I like dividend-paying stocks. I also like cash-flow real estate - though I think the best approach now is to build a cash position and prepare myself to take advantage of the downturn coming in the real estate market, so that I can actually make it flow cash, right?

I will share my portfolio in a future post, and discuss my thinking in investment decisions.

Friday, April 07, 2006

Bill Gross on Asset Prices

Here's the link to John Maudlin's Investors Insights.

Bill Gross on Asset Prices

I'm posting from Munich, Germany, where I have been vacationing for the past week. The city is terrific - the people, the culture, of course the beer, but what I love most is actually the bread and the sausages.

Ok to business. I subscribe to John Maudlin's newsletter. He is generally bearish, but usually right on the money. for the record, I am also bearish, because I believe that the Greenspan inflation is just starting to be recognized for what it is, and this will have a very negative impact on asset prices. Tactically, I am moving toward assets with less speculative ("absolute") risk, and toward assets with more consistent investment returns - for stocks this means dividends, and overseas exposure, in the event of a dollar decline.

It turns out, this is what Bill Gross is also recommending. Pay particular attention to his discussions of risk premiums and the danger of indexing in a world without risk premia. In this environment, funds tend to focus on avoiding "benchmark" risk, which means underperforming one's benchmark and watching the herd flee your fund, much like the late 1999s. Managers instead pile into index assets to ensure that they don't get killed.

I believe this trend is the result of the continued highs in the Russell 2000, and the reason that the Nasdaq is outperforming - small caps have had such a run, retail investors are piling in at the worst time, since small caps are bound to be hurt by the more expensive financing that is coming their way. Given that they trade at 40x earnings, and with increasing difficulty increasing leverage, this market is due for a drop, led by the dollar, which will raise commodity prices further, then by further Fed hikes, and then a collapse of small caps earnings.

Right now, it is critical to maintain selectivity, and consider increasing liquidity in anticipation of an asset sale. You may not want to hold those assets in USD, however.