Common Sense Analysis #1- explained much better than me

I found this quote on-line from www.money.com. Fortune Magazine reporter Katie Benner interviwed the managers of Hodges Fund (5 year annualized return of 18.8% according to Moringstar).

In response to a question about investing strategies for a unpredictable 2007 market, the fund manager answers:

"We're a big proponent of pricing power. What allows a company to maintain or even increase its prices is a lack of competition, high barriers to entry and good demand. PC makers can never have pricing power because there's too much competition. Instead, we focus on businesses like railroads and steel, where there used to be a ton of competitors and now there are just three or four."

I note that the examples given, railroads and steel, are in regulated industries (you can't just put a train on the tracks without telling someone and steel is subject to pricing regulations and quotas). Its nice to have someone confirm my common sense analysis.

Life in the trading trenches

One of my trader friends reminded me of something the other day- most of the traders on the "street" do not remember the last recession. The industry is full of newly minted MBA's in their late 20's (who else can work 18-20 hours for months on end but the young?). So when bad news hits, like the subprime mortgage collapse, some traders tend to panic and unload more of their holdings than they should because they have never seen bad times before (you have to keep in mind that traders on the street are momentum traders-which is based on volume trading- so a panic by a trader means tens of thousands of shares or more being sold).

Another helpful tip, at the end of every calendar quarter (so late March, June, September and December), traders tend to profit-take to pad their quarterly results so it is a bad time to sell but a good time to buy.

Investing in Stock: Common Sense Analysis Part 5

Do not invest any money you are not willing to lose

After all that non-technical analysis, you still have to be willing to lose it all if things don't go well. Buffet's first rule for stock investing is "don't lose money" but it pre-supposes the assumption that you will invest in the first place.

If you are going to invest then Buffet's rule is the golden one but before I make that decision, I ask myself at this point in time am I financially ready to lose money. If I am then I follow Buffet's rule (hope for the best, expect the worse). If I am not, then I sit on the sidelines.

Investing in Stock: Common Sense Analysis Part 4

Don't invest in anything trendy

As I may have mentioned before, I am in the business of giving advice to other businesses so I see a lot of businesses. The "trendy" businesses I see either do either extremely well or completely flame out in months. There doesn't seem to be a middle ground. If you are in technology, you basically have 2-3 years at the very most to make it or you are done (someone has better technology, the market has moved to another application or the venture capitalists are chasing the new darlings on the street- as a sidenote, yes I dislike most tech companies as investments, can't you tell?). For every trendy business that does well, I see 5 that do not.

Not great odds eh?

In comparison, the businesses that do well tend to be in tried and true industries (real estate, import/export, distribution). For the risk takers, there are small cap stocks in each of these industries so just because you invest in these industries doesn't mean you are in for a boring ride.

Let me relay one war story for you: venture capitalists invest in risky businesses with the hope they become big- in other words, they invest in trendy businesses hoping to capitalize on the trend. Most venture capitalists will tell you that for every 10 businesses they invest in their return on investment is as follows:

1. 1-2 successes
   
2. 3-4 "living dead"- the businesses make enough money to repay the loan and that's it
3. Everything else is a failure

If your portfolio performed like this, you would probably be able to retire at 102.

Investing in Stock: Common Sense Analysis Part 3

Don't buy anything you don't understand

What does this mean in plain English?

"Nortel's portfolio of telephony and converged IP telephony solutions deliver seamless, scalable real-time business communications with unprecedented flexibility in telephony applications deployment to meet our customer's environment, expectations, timetable and budget."

I don't want to pick on Nortel (or its copywriter) but I don't understand what this means. I suspect 95% of investors don't either. Nortel isn't alone (again not picking on Nortel). I don't understand what 90% of technology companies do. Or how most hedge funds work.

Enron was, towards the end, not an energy company but engaged in (illegally it turned out) in securitizations and other sophisticated financial transactions (someone had to explain a securitization to me).

I am a real subscriber in the KISS principle. If the company cannot explain what it does in a couple of sentences, I do not invest in it. Maybe I am a simpleton but investing in simple to explain businesses makes me comfortable (see rule #2).

Investing in Stock: Common Sense Analysis Part 2

Invest in what you are comfortable with

This has more to do with the psychology of investing than my first rule. I never invest in a business where my gut says its not perfect even if the investing community says it is: it is either over-priced, in an industry with a lot of fizzle and not a lot of substance (most of the tech industry in my opinion), in a country/region which isn't what the experts say it is (see my post on China- go to the country before you invest in it), its trendy (income trusts or hedge funds), I don't understand what it does exactly (see Nortel in the 1990's) or its being managed by management with a mediocre track record.

The temptation is to always go with the crowd but if it doesn't feel right, I don't do it (there are no style points in investing).

Investing in Stock: Common Sense Analysis Part 1

I have posted for approximately a month now and you must be asking: when is he going to say something about what he invests in?

Ok, ok- here goes. For reasons I'll explain later, I invest in stock and not real estate. I tend to look for two things before investing in anything: (1) common sense analysis and (2) technical analysis. With respect to the common sense analysis, I tend to look for certain things (in multiple parts).

Investing in a business that is highly regulated

By this I mean you have to obtain permission from some regulator to enter into the industry, make changes or leave. Regulation limits the number of players in the industry and creates a high barrier to entry. High barriers to entry limit the number of competitors, a limited number of competitors avoid price wars (typically the best way to gain market share is be the lowest price competitor), lower prices means less profit, less profit means lower share price/less cash flow to pay dividends.

Think about industries that are heavily regulated: banks, insurance companies, utilities (electricity, pipelines, telephones)- they are all typically good stocks to buy.

Now think about industries with have very little regulation: restaurants, retail & technology- all very boom and bust businesses (if you have invested in the Gap, you know what I mean).

For this reason, my two largest stock holdings are TD Canada Trust and Transcanada Pipeline- heavily regulated industries where competition is limited and pricing relatively secure (this is not an endorsement to buy these stocks, please do your own research before investing).

Investment Trends: Things I look for

I am a big history bluff. My favourite show right now is HBO's Rome (ok, its not very historically accurate). The one thing that history teaches us is that big events sometimes begin with a series of really small incidents that go under the radar. For example, the Tienanmen Square protests of 1989 was sparked by the death of reformist bureaucrat.

How does this relate to investing? Little things tend to become investing trends. For example, I first heard of the peak oil theory when the price of oil was about $30/barrel and people were quietly buying up land in Alberta and junior oil stocks.

So, while the media coverage is focused on the downturn in the U.S. housing market and the subprime mortgage industry, I keep noticing a common story popping up buried as small stories in the back pages. People are buying up a lot of infrastructure:

1. Remember last summer when a Dubai company attempted to buy U.S. ports (ultimately they dropped the bid because of political pressure)? Dubai has one thing- a lot of money.
   
   
2. On February 22, 2007, the Infrastructure group of Morgan Stanley announced that they were purchasing 80% interest in the Port of Montreal- the 3rd largest container port in North America. Morgan Stanley- over $400 billion in assets.
   
   
3. On Monday (while everyone's attention in Canada was on the latest budget), Deutsche buy announced it had bought container ports in New York and New Jersey. Deutsche bank has $1.1 billion Euros under management.

According to GE's latest annual report, infrastructure spending will reach $15 trillion world wide by 2015- mostly driven by international trade.

So maybe we have found the new thing to buy now that the commodities market has peaked?!? Maybe the latest investing trend has already started to take hold but the media hasn't grabbed onto it yet?

Time will tell but I tend not to bet against Dubai money, Morgan Stanley and Deutsche Bank.

Getting a Tax Refund- is it always a good thing?

The IRS reported today that with nearly half of this year's taxes filed, the average refund is up nearly $125 to $2,458.

In one way this is good news- extra money in the pocket is always a good thing but if you really think about it, it is a tax refund. That means we over-paid our taxes and the government made interest on our money. IRS reports they have refunded $128.7 BILLION this year so far- that's a lot of interest for someone else to be making on your money.

If you have good self-control, opt to pay less on your salary (there's a tax form you can file with HR) and invest the excess money you save in a high interest account (or invest it in your RSP/401K if you have excess contribution room to lower your taxes). Even if you have to pay more taxes than was taken off your pay cheque, at the very least, you get to keep some of the interest you have earned.

Real Estate Quote of the Day

I have a friend who's a commercial real estate agent who said this to me the other day:

"Good real estate is one of those things where you think its really expensive but then a few years later its even more expensive and you feel like a fool for not buying it when it was expensive and not really expensive."

Good advice for anything in life worth buying.

Mutual Funds to Avoid: The Wrap Account

I am not as negative about mutual funds as some of my fellow bloggers- like everything in life, context is everything and I believe mutual funds have their time and place for certain individuals.

However, if someone is trying to sell you a mutual fund of funds, also known as a "wrap" account, run for the hills immediately-context be dammed!

A wrap account is basically a mutual fund that holds other mutual funds. The primary advantage is that they are suppose to be a one-stop investing solution because you are invested in a little bit of everything.

Here's why I avoid these funds:

1. On principle alone, I find that giving someone fees to pick other mutual funds is basically rewarding a lazy person. These fund managers are saying to me that they are too incompetent to pick their own investments so they'll get other people to do their job. I might as well buy exchange traded funds indexed to the stocks and bonds and reward my own laziness.
   
   
2. Fees: in a previous life, I did some work in the hedge fund industry. Some hedge funds are also packaged as a fund investing in other hedge funds- we use to nickname these structures "fees on fees" in private and the same applies here. A WRAP account's performance is reduced twice by management fees: once at the fund level that the wrap account has bought and another at the wrap level- you have two middle-persons skimming off the performance of the fees.
   
   
3. I'll let this quote from the March 16, 2007 edition of the Globe and Mail Report on Business speak for itself (page B10 for credit purposes) : "Some fund companies are using wraps as a means to sweeten compensation of financial advisers and, ultimately, to build business...recent offerings...pay above-average 'trailers', an annual fee based on the client's assets invested." (emphasis is my own)
   
   
4. I learned this the hard way (sins of my youth one supposes)- some wrap accounts lock you in for 5 years or more so you can't get out without paying a penalty (explaining why the trailers are higher).

One way of benefiting from a WRAP account would be to find out who the leading sellers of Wrap Accounts are (in Canada, by assets under managment, it is CIBC, TD and IGM according to the Investment Funds Institute of Canada) and buy their stocks and not their WRAP Funds. As the above indicates, WRAP Accounts are cash-cows for financial institutions- might as well make money buying common shares of these institutions.

How the Rich Think

What I have noticed by observation is that the financially secure do things differently than middle class citizens are conditioned to think and, based on that thinking, they do things differently than middle class citizens. Having just read Harv Eckler's Millionaire Mindset, a lot of these observations crystallized for me and I wanted to share some observations:

1. The financially secure take their time: Our first reaction is to typically act on our impulses/emotion and one over-riding emotion is fear (fear, in a hunter-gatherer society sense of the word is good, it keeps us alive but when dealing with money it can be really bad). Thus, more often than not, our decisions about money are driven by fear (I must have that new gadget for fear of being left behind, I must sell that stock for fear of a market crash, I fear I will be too successfully). What I have noticed is that the financially secure deal with fear too but they take a step back, analyze the situation, sleep on it, talk to their advisers, sleep on it some more and then act. This obviously takes some time, but with the benefit of taking a step back, our decisions about money are not driven so much by emotion but by rationality and money at the end of the day should be a rational decision.
   
   
2. The financially secure have a lot of advisers: This may rub some do it yourself investors the wrong way but most financially secure people I meet have several lawyers, a few accountants, some type of "money person" (bankers or people who run their own financial institutions) and some uber advisor (usually a "grey hair" who has seen it all and lived to tell about it). These advisers are not $500/dollar advisers- they are people experienced in life who can impart specialized knowledge and also have certain distance from a particular situation to give good sound advice. As a matter of fact, Thomas Stanley and William Danko's book The Millionaire Next Door noted that most American millionaires spend more per capita on lawyers, accountants and financial advisers than non-millionaires.
   
   
3. The financially secure "stick to their knitting": This is another way of saying "keep it simple stupid" or they are focused. Most financially secure people I have met are basically one-trick ponies- they know one thing and they know it really well whether it is investing in stocks, investing in real estate, building businesses, teaching others their knowledge etc. etc. They obviously practice risk management and asset allocation with their money but how they get to be financial secure is really quite boring and simple. For example, one of the receptionists at a company I use to work at quit her job to manage her 5 rental properties full time; very slowly and quietly, she had learned about real estate investing and bought properties over 10 years until she could leave the rat race. She didn't find one house and then flip it for 200% returns in a year; she just bought places that gave her nice steady cash flow and multiplied many times over.
   
   
4. The financially secure socialize with other financially secure people: I believe this is where the myth arises that there is some "special club" where the rich bar the poor. Some financially secure people may look down on others and want to socialize with those they deem worthy but most I have met are positive and social people. However, have you ever gone to a party and met someone who was negative about everything? Didn't you want to walk away from that person as fast as possible? I feel it is the same with the financially secure- they probably don't want to hang out with someone who complains about how they aren't making enough, the world owns them something, no one gives them a break etc. They want to socialize with people who are positive about themselves and money.
   
   
5. The financially secure don't look it: They tend to drive middle of the road cars, wear modestly priced clothing and live in nice, but not outlandish, houses. This seems to confirm the observation made in the Millionaire Next Door about the life-styles of the American Millionaires they studied.

Reviewing the above list, the only theme unifying these characteristics have is the fact that they seem counter-intuitive to what society tells us. It seems to confirm my belief that if follow what the average person does in life, you'll end up average as well.

Lessons I have Learned from Others

My life story will jump around quite a bit in this blog. Approximately 4 years ago I started my own business helping other businesses:

This has had several impacts on how I look at money:

1. I like paying taxes. Yes, I like paying taxes. I don't like paying too much tax but paying tax means that I am making money.
2. A good business understands revenue recognition- every expenses should be tied to a corresponding revenue source. An outgoing expense should match incoming revenue. If it does not, the money should not be spent. It sounds simple but if you ever read the business news how many times have you heard about a business that started "empire building" and met financial set-backs (Time Warner-AOL comes to mind)? Or, closer to home, I always worry about people who buy investment property and say "at the very worse, I can write off my losses and pay less tax?" It sounds like a strange proposition that someone would invest money with the goal of losing it.
3. The most successful business people do not have access to different products or networks than middle class citizens. They just think in a manner middle class citizens are not conditioned to.

I'll expand on this last point in my next blog.

How the Rich Get Richer

In a week that U.S. Investors are selling shares in New Century Financial Corp. and other subprime mortgage lenders (at a loss) for fear that the housing and subprime mortgage industry is collapsing, the Wall Street Journal reports that Goldman Sachs Group Inc. is looking to go deeper into the subprime mortgage business.

I looked this up- Goldman Sachs made $12.73 BILLION dollars in the last financial quarter. Suffice to say, they know how to make money.

If institutions that have a track record of being profitable are going deeper into a troubled industry while the average investor is fleeing it, what does that say about the average investor?

Investing Mistake #2

The following is a quote from an Associated Press article of March 9:

"In the week of the market's Feb. 27 sell off, when the major stock market indexes surrendered their gains for the year, investors pulled an estimated $3.84 billion from global mutual funds that invest in stocks and dumped $1.35 billion into bond funds, according to Trim Tabs Investment Research."

Here's a perfect example of how a rational decision about money is being driven by emotions and not rationality. Head says "buy low, sell high"; heart reads the news, panics and sells equity based securities when the market is going down.

Lesson to be learned: When the market starts to fall let your head, and not your heart, make the decisions.

Or, for fans of the Hitchhiker's Guide to the Galaxy- DON'T PANIC.

For the record, I have increased my bond holdings- but from cash not from selling equity. I intend to make some interest income then buy some boring old cash machine stocks near the bottom (its sheltered in my retirement account so the interest is also earned tax free).

If anyone is reading about the collapse of the subprime mortgage lenders in the United States today, breathe deeply, sleep on it and please talk to a professional before you do anything rash.

Oh yeah- DON'T PANIC.

Best Defensive Sector Stocks

Found this from some research from Thomson Financial: best long terms earnings growth by sectors in the S&P 500 since 1980 (highest returns by % to lowest)

1. Health Care
2. Consumer Staples
   
3. Financials
4. Industrials
5. Consumer Discretionary
6. Materials
7. Energy
8. Technology
9. Telecom
10. Utilities
    

China

Last week's 400 pt. plus drop on the DOW started with a sell-off on the Shanghai stock market. Now that the dust has cleared somewhat, I wanted to share my experiences with China and why I don't investing in China directly.

I have been to China twice since 2002- once on vacation, once on business. The last time I was in China was August 2005. The last time I was there my business associate and I took a cab into downtown Beijing from the airport. As we drove in, all we saw was construction crane after construction crane putting up new office towers. Here's the catch- all the finished buildings were vacant. One building would be built, be completely empty and another new office tower would be built right beside it. We ended up having drinks with a North American ex-pat and I asked him if office towers were built before anchor tenants are secured in 5 to 10 year leases (like in North America). He said no.

Basically, buildings were being built for the sake of being built. If anyone studied Japanese economic history, a similar patten emerged in the late 80's (and the Japanese banking system went into crisis in the 1990's). At some point in time, the banks can only finance so many office towers with no cash flow before the country's economic system experiences some shocks.

The other thing that worried me was whether economic growth was being fueled by throwing bodies at the problem with concern for efficiency. We took a walk in Shanghai one night and there were at least 20 men at a construction site surrounding construction equipment- one guy operating the machine, one guy supervising and the rest of the guys standing around. Its not like they didn't want to help but you can't put 18 guys at work on a construction site which is 10x10 at the very most. However, statistically speaking, this company employed 20 people.

So I wonder if these economic growth is being made by just employing people for the sake of employing people (whether for economic or political reasons) or there is proper productivity gains being made.

Third observation- while we were there, the news reported that the government was bailing out the 5th largest investment bank in the country since it was in financial trouble. Does this inspire confidence if a supposedly pillar of the financial community is in trouble? Imagine what the American economy would be like if the 5th largest investment house in the United States needed to be bailed out?

These observations really scares me- I wonder how stable the fundamentals of the financial system are if this is what is happening on the street level. Peter Lynch, who is a successful mutual fund manager and author, teaches his readers that you should invest in what you know and what you are comfortable with.

Based on my experience, I am not comfortable with the economic development of China supporting a public traded company I would buy (note I am not down on China, I am down on investing on a Chinese publicly traded company). I do believe the country is growing and becoming an economic super-power but at this point in time, I do not want to invest in any public traded company based in China based on concerns about the underlying economic fundamentals.

An investment advisor once told me that the cheaper way to invest in a trend is to invest in fundamentally solid companies that support the trend. For example, when eBay was at its peak, purchasing stock in UPS or FedEx would have been a good idea (after all who's going to deliver all of these purchases?). If China is growing, and you want to invest, think of shipping companies, warehousing and logistics companies- companies that would benefit from the growth of the country.

Investing Mistake #1

My first mistake occured the first time I ever bought a RSP (a 401K for American readers). Great start eh?

I managed to save up some money as a teenager from a part-time job and decided, upon turning 18, that I should start saving some money. As way of back-ground, I was labelled as a child as someone who couldn't save money so this was my attempt to fight this image.

I walked into my local financial institution where I kept my bank account and asked the woman at the investment desk that I wanted to open up a RSP. If you have ever done something similar, the remainder of this story may sound familiar to you:

She took my personal portfolio. I believe I was a "moderate risk" individual. Based on this portfolio she put my into three mutual funds (all owned by the same institution of course) and here's where things get pear shaped as the English would like to say:

1. I was put into a science and technology fund as part of the growth allocation of my portfolio;
2. She put me into a mortgage fund for the "value" allocation of my portfolio; and
3. She put me into a bond fund as the conservative allocation of my portfolio.

Here's the rub:

1. I had no idea what stocks were in these funds;
2. The science and technology fund was at its very height at the time of my purchase. It had nowhere to go but down (any Canadian who owned Nortel in the early 1990's know this story all too well). I laughed the other day when I saw the fund continues to be one of the worse performing funds - over 10 years later;
3. Thank god they were no-load funds but I didn't know what a MER was from a hole in the ground.

So it comes to no surprise that, with the exception of the bond fund, my portfolio went side-ways for years.

With over 10 years of hindsight, I can say I learned the following lessons.

1. Do your research.
2. Don't rely on other to manage your money better than you.
3. Visiting a person behind a counter at your local bank may not be the best way to set up your retirement.

I wish I could say I learned these lessons quickly but you learn from failure one supposes.

What Are You Buying?

Have you ever been asked this question?

I hate this question- for three primary reasons.

1. The cart before the horse: The question presupposes that you have an investment strategy in place. This question should only be asked once you understand your investment style.

2. Context is everything: A 35 year old single person is in a different life situation than a 42 year old married person who is in a different situation than a 58 year old widow. Where you are in life should ideally dictate what you buy. This reason dove-tails with reason #1.

3. Missing the boat: How many people tell you about their investment losses? I suspect very few. But people will tell you about their successes. However, by the time they do so, the investment product will most likely be a lot more expensive than when they bought it. In many respects, the answer to the question will be: a really expensive product.

Because of what I do, I always believe that you should always answer "where do I want to be?" before "how do I get there?" but we sometimes chase the glitter before knowing whether we want it or not.

So before we ask others what they are buying think about a strategy first. In the next post, I'll share my worse investing mistakes- many starting from the fact I asked "what are you buying" before figuring out what I wanted.

How to be rich- stay boring

Fortune Magazine published a survey in its March 5, 2007 issue outlining how households with investable assets of $1 mil-$10 mil invest their money by asset allocation as of 2006. The results are:

45% domestic equities
15% bonds
13% cash
11% international equities
7% investment real estate
5% private equity
2% other
1% hedge fund
1% commodities

A couple of observations:

1. Pretty boring stuff don't you think. It reinforces the point there is no "magic bullet" solution to financial freedom.

2. only 7% in investment real estate. very interesting. I have some thoughts on this matter in later posts.

3. 13% cash- the rich understand the concpet of liquidity. Having cash around always gives you the feeling of security.

The discipline of investing

I have the privilege of being friends with traders for large financial institutions. This allows me to get some top-notch reserach from them and to paratake into their insights into investing.

The day after the world markets dropped based on fears of an economic slowdown, one of my trader friends made an interesting obvservation to me. He believes 70% to 80% of his clients would realize greater investment gains if only they had the discipline to stick to their plan. They didn't pick bad stocks and/or bonds. They just didn't stick to their plan.

It reminds of something I once heard- success in life depends on hard work, discipline and a little good luck. I suspect the same applies to investing in the stock market- do a lot of research (hard work), stick with the plan (discipline) and hope for good times (good luck).

Having been told this by my friend, I am thinking of ditching a lot of stock market research I read and refining a plan I can stick to. I'll keep you posted.