One of the positive developments of any economic downturn is the number of businesses which are started; young college graduates cannot find work and start a new business, laid-off employees use this as an opportunity to scratch their entrepreneurial itch and some find themselves as accidental entrepreneurs as a way to survive the downturn. Correspondingly, investors are burnt by the stock and real estate market and are looking for something “different” to invest their money in.

Start-up business in need of money meet the jaded investor. Match made in heaven? Maybe. Maybe not.

I saw a lot of businesses practicing law. Some great. Some middling and some that should have never started. For conflict of interest purposes, I never invested in them even though I was offered many times. The advice you give changes once you have an ownership stake. However, I would consider the p2p lending industry for business purposes an example of the growing trend towards investing money in private enterprises.

If you are thinking of investing in a “hot new start up” or some private businesses, there are a few things to consider:

• The best idea is not always the most profitable idea. I believe the most over-used terms I ever heard were “this is a great idea” or “I need to find a great idea in order to start a business.” Great ideas are not necessarily the most profitable ones. Take Apple for example. If you opened up an iPod, there’s nothing breath-taking in terms of its technology. Apple’s value is that it knows its market well and executes on getting the most out of that market. How an idea is executed is more important than the idea. An often quoted mantra in entrepreneurship is “better to have Grade A execution and a Grade B idea than a Grade A idea and Grade B execution. The lesson for the investor being don’t invest purely on how great the idea is, instead invest in …
• Good management who knows how to return cash back to investors. A friend of mine, a successful entrepreneur, said something interesting last month-”you can’t teach common sense in business.” Finding good management is an elusive task in publicly traded companies; think of how hard it is for start-ups or small private businesses. As an investor, you should spend a lot of time looking at management- do they have experience in the field (or are you providing seed money for them to make their mistakes), do they have a track record of success, do they have different skill sets or all they all in tech, sales etc.? What you are ideally looking for is management that has: (a) technical competence; (b) sales acumen; and (c) prior history building a business. If you have a management team that has all three, you have hit upon something. Ideally, ask yourself this question: “does this management team know more than I do about business?” If not, best to run away.
• Invest in businesses which are “scalable”. Venture capitalists use this term often. Scalable is really plain English for the concept that the business can be grown and “scaled” in size and revenue over time. As an investor, the greater the potential the business is scalable, the more likely you will get a better return on investment. An example of a scalable business would be a software company that develops applications for the masses (although tech companies die lots of terrible deaths), a mining company that has test results for a potentially large mine or someone building old age homes: there are lots of growth opportunities in these ventures. Examples of non-scalable businesses would include someone engaged in an arts and crafts business, someone buying a truck to deliver goods or someone opening a non-chain retail store. Chances are that these businesses will hit their peak very quickly and your investment return capped.
• What is the business’ exit strategy and how will you get your money back? This is what stumps most start-ups and private businesses- what exactly is its exit strategy? Is it being built to sell to a larger competitor? Is it going public? Or is it merely going to operate to pay the owner-managers well? As an investor, you need to know this going in just as you would investing in any publicly traded stock. If the exit strategy expectation is clearly set out, you won’t end up in a situation where you mistakenly thought the business was going public but it was instead built to give the owner-manager a comfortable life-style. The best place to find an exit strategy is in the business plan. I am not a big advocate of writing business plans for the sake of writing business plans but, if the business is trying to attract investor money, it better have a thorough plan setting out clearly how the investor will do if the assumptions are met.
• What rights do you have to get your money out? The issue with private-businesses is that it is very difficult to get your money out. There is no real market for your investment so you need to negotiate rights to request your money out when you want to. If you loaned the business money, this is an easy determination to make. At some point in time, the loan will mature. If you purchase shares in the company, this becomes more difficult. The easiest way is to negotiate a shareholders agreement (which is an agreement among the shareholders to govern the operation of the company and exit strategies) where you have a “put option” to ask for your money back plus interest at any particular period of time. You also want to make sure you have the ability to sell your shares without undue interference from the business. What you want to avoid is giving the business an option to buy you out at any particular period of time (unless it is at a premium to monies invested) or restrict your right to sell your interests in the company.

Investing in start-ups can be risky ventures but, with such risk, comes great reward. Remember to look very carefully at what you are investing in. It is your money so don’t be afraid to ask some probing questions. Good luck.

What is a worse scenario to face: your stocks falling price or everything costing you more? Or how about both? Last Saturday, I went to the supermarket and went into sticker shock. Everything that I normally buy had gone up in price: milk was up 30 cents, a cup of yogurt up 30 cents, salmon up $2. The U.S. consumer price index, which measures inflation, rose 4.3% last year; food and energy is, on average, 20 percent more than a year ago. A dollar doesn’t buy you what it use to. Of course, our stocks and mutual funds continue to fall in value due to the recession (only the politicians bury their head in the sand and say we are not in a recession).

The average investor is being crunched between a recession and inflationary pressures. The latter stupefies me; it is being fanned by the central banks desperately trying to avert a recession, which is already here, by lowering interest rates to stimulate demand when no one has any money to buy anything (remember we leverage ourselves to death using our homes as collateral?). This is become the most over-looked financial story of the year- the central banks are making the situation worse for political expediency.

What are we to do?

BUY GOLD?

Gold is traditionally seen as a hedge against inflation which is why it is being bid up by everybody. But here’s the problem with buying gold: GOLD IS AN INFLATION HEDGE (IF THAT) AND NOTHING ELSE. YOU GET NO APPRECIATION FROM GOLD ONCE YOU REMOVE INFLATION FROM ITS RETURN. Jerry Siegel authored a book entitled Stocks for the Long Run in which he looked at the real returns (returns after factoring in inflation) of certain investments from 1802 to 2006. If you bought $1 of gold in 1802, your dollar after inflation would be worth in 2006…$1.96. The same $1 invested in a stock would be worth $755,163 (includes reinvested dividend).

Gold would be an important part of a portfolio if you own other instruments which are not protected against inflation (i.e. the portfolio has a lot of principal protected notes in which the principal is not inflation protected- another strike against PPN’s or there are a lot of non-dividend yield stocks in the portfolio). The issue with buying too much gold is that one has forgone upside potential for short-term protective measures.

BUY REAL RETURN BONDS/TREASURY INFLATED-PROTECTED SECURITIES (TIPS)?

As the name implies, these are a type of bond that pays the holder a rate of interest which is adjusted to match inflation. TIPS are issued by the government and are seen as more “secure” than traditional bonds. The problem with TIPS is that, like gold, everyone is rushing to buy them increasing the price meaning that the yield on TIPS before taxes is now 0%. After tax, a TIPS would yield you a negative return.

The double whammy is if one bought a real return bond mutual fund (like me; another argument that I should just buy ETF’s and stop out-thinking myself). Not only is the yield now zero, the mutual fund company takes its fees off on top of that.

KEEP YOUR MONEY IN A HIGH-INTEREST ACCOUNT?

Not a bad idea but, in a falling interest rate environment, financial institutions are starting to lower the interest rate payable on these accounts so the return is diminishing. The disadvantage of this strategy is that interest is the highest form of income taxed so the longer money is parked in a high-interest account outside of a tax-shelter vehicle like a RSP or 401(k) the more money one is giving to the tax authorities.

PAY DOWN DEBT?

A good strategy in good, bad and indifferent times. This may be especially beneficial if one holds a variable rate mortgage and the interest rate keeps resetting downward to reflect falling interest rates. Under this scenario, a home-owner is paying off their mortgage faster. Low interest rate environments may also be a good time to consolidate debt into lower interest rate debt vehicles.

SAVE MONEY?

Buy a car which uses regular gas. Grow veggies in the garden. Buy in bulk. Shop at liquidation sales. Do anything and everything to pinch the pennies because inflation is making everything more expensive. Here is festival of frugality to help you with money saving tips.
BUY STOCKS?

I once got a good piece of advice about stocks which are falling in price- you either sell and lick your wounds or you keep buying at a lower price bringing the average price you acquired the stock down (known as “averaging down”). If one owns fundamentally good stock (dividend paying, health cash flows, expanding with an international presence), it may be an opportune time to look for a buying opportunity. It sounds counter-intuitive to buy while others are selling but, to paraphrase Buffet, you only want stock prices to be high when you are selling and not buying.

There isn’t one magic bullet solution to investing in hard times. The key is not to panic. Anyone else got suggestions?

It may be too early to call it but 2008 is quickly becoming the year of the dividend increase. Look at the big names that have increased their dividends this year: Coca-Cola, General Electric, Kimberly-Clark, Abbott. These blue chip companies typically have annual dividend increase so it is not that surprising that the dividend train continues to roll. However, a series of other companies not known for paying or increasing dividends have chosen to become dividend payers; The Encana’s, Roger’s and Tim Hortin’s of the world have jumped into the dividend game by increasing their dividend dramatically. In some cases, the dividend increase is predictable- with the price of oil and gas being what it is, Encana is making too much profit not to put money back into their shareholder’s pocket. In other cases (i.e. Rogers), companies with large amounts of debt on the balance sheet are rising their dividends.

Reading between the lines, with the usual bastion of dividend paying stocks- banks- in such flux, non-traditional dividend payers are using this as an opportunity to attract a pool of investors that typically did not buy its shares.

However, are dividend increase necessarily always a good thing? I previously blogged about dividend yields being over-rated and Financial Jungle made the astute observation in commenting: “Don’t forget, earnings and cashflow aren’t the same thing. A cash poor company can still look profitable on paper. Just because a company has a low payout ratio doesn’t mean the dividend is safe. Not to mention companies fudge their earnings all the time.”

He seemed to hit upon something that others have studied. On Friday, John Heinzl’s from the Globe and Mail wrote about Thomson Financial’s study on dividend yield stocks since 1990 which found the following:

1. Companies with decreasing debt, increasing cash and a dividend payout ratio of under 60% (i.e. 60% or less of its profits are paid in the form of a dividend) and did NOT increase their dividend posted an average annual gain of 7.2%; and
2. Companies with increasing debt, decreasing cash and a raising dividend posted an average annual gain of 5.1%.

On paper this makes sense. If you are increasing a dividend but the amount of available cash is decreasing and debt is going up, a couple of different things are happening: (a) a business is using its money to pay its shareholders in lieu of reinvesting profits for further growth which, over the long term, is going to be problematic (unless the business is mature technologically); or (b) to paraphrase the Thomson Financial researcher, the company is using a rising dividends to distract shareholders from the fact it is not a great cash flow manager and, over the long term, the business is going to hit a wall.

To use a real estate investment analogy, it is like paying yourself more from profits but letting the emergency house repair fund decline and stretching out the amortization period on the mortgage. In the short term, you put more money in your pocket but you don’t have as much cash to put back into the house to sell for greater appreciation.

The study is looking at appreciation of stock and here is where one has to take a contextual analysis. A dividend investor who, contextually speaking, cares for nothing but the fact their dividend is paid (and not slashed) and is not worried about how much the share price is will not pay as much attention to these findings.

However, I am in a stage in my life where I want a little bit of both- a steady dividend and an appreciation in stock price. If you are like me, you want to see the balance between returning money to shareholders in the form of dividends and the business reinvesting profits in growth (which, if done properly, means greater cash on hand which allows greater dividend increases). In this case, I am worried about any business where cash is declining, debt is increasing and dividends are being paid regardless- it shows bad cash management which is particularly important as the economy slows.

Just remember though that increasing cash and decreasing debt is not, in and of itself, an indicator that a stock would go up in price. Look at Johnson and Johnson- its share price has gone sideways the last two years not because of bad management but because of other factors beyond its control (general slump in pharma, its business may be reaching a size and complexity where it is suffering from the dreaded “conglomerate discount”). However, over the long term, these well managed companies should go up in price.

As usual, the devil is in the details so make sure you look at the company’s cash flow from operations and cash on hand as well as the normal dividend indicators such as payout ratio, dividend increases over 5 years and dividend yield.

Warren Buffet’s first rule of investing is “Don’t Lose Money” and his second rule is “Don’t forget Rule #1.” Far be it for me to question the wisdom of one of the more successful investors of his generation, but I question how practical this rule is for retail investors like you and me. The missing context in the “invest like Buffet” school of thought (which I whole heartedly agree with) is that Buffet runs a large insurance business and invests the proceeds of insurance policies for a living. I would actually be appalled if someone with that breadth of business experience and acumen did not experience above average investment returns. One other factor we tend to over-look about Buffet: he’s playing with a lot of other people’s money (granted, some of the money is his as well). You tend to sleep better at night if you didn’t lose house money. Having said that, this does not diminish Buffet’s stellar track record; many others have used other people’s money and fared far worse (mutual fund managers line up to the right please…).

For the rest of us not blessed with Buffet’s midas touch, I wonder whether this ideal investing rule could not be expressed more effectively. Perhaps for us mere investing mortals, our first rule of investing should be: “invest only what you can afford to lose.” Let me explain.

One of the more recent trends in the personal finance world is the application of psychology and behavioral studies to investing. Coined “neuroeconomics” by some, scientists have attempted to determine why we do the things that we do. For those who have been in sales most of their life, I am sure that some of the findings may come as no shock; people are motivated by negative emotions like fear, anxiety and worry more than positive emotions like happiness. Think of anyone who’s ever sold you insurance. They don’t sell you on the fact your estate will be resolved satisfactorily. They sell you on visions (nightmares?) of car crashes, orphaned children, planes going down- the 1 in a million occurrences that provoke negative emotions. In the investing world, most average investors are motivated by fear and loss. Think of the average investor- they fear loss so much they sell while the market is dropping assuming they are fleeing to safety (while losing money in the process).

A friend passed along this article on why people do foolish things with money. I focused particularly on this passage: “Regret falls under a psychological effect known as loss aversion. Research shows that before we risk an investment, we need to feel assured that the potential gain is twice what the possible loss might be because a loss feels twice as bad as a gain feels good. That’s weird and irrational, but it’s the way it is.” (emphasis is my own)

But Buffet’s rule doesn’t address the other side of the emotional equation: the compulsiveness and loss of control that occurs when we get an adrenaline rush of winning. Gamblers speak about this; you get on a winning streak and you lose your mind. You think you can’t lose. But the house always wins and gamblers end up dead broke believing the next hand is the “big one.” It is what creates bubbles and “irrational exuberance”; we become emotional junkies and shut off the analytical side of the brain trying to get the next high. I called this my “penny stock” phase. It sounds better than my “stupid phase.”

Buffet’s rule focuses on avoiding loss but “invest only what you can afford to lose” addresses our emotional duality: a remainder that we should always have enough even after our losses not to enter into a blind panic and to avoid getting “high” on chasing profits and keep pouring money into investments that we think will never go down (i.e. don’t gamble the house on a stock).

We are seeing both sides of the equation now. Think of the euphoria, as recent as 12 months ago, of people who made large leveraged investments into real estate thinking it would never go down. “They don’t make land anymore.” True, but how many $500,000 houses in distant suburbs does America really need? Now we are on the opposite end of the scale- the world will end tomorrow. Sell Google stock- its worthless! Buy gold bullion, you’ll need wagons of money to buy bread soon!

Investors don’t become average by buying the wrong investment. Investment become average by obeying the wrong emotions.

Thoughts?

If you are interested in neuroeconomics, the book du jour is Your Money and Your Brian by Jason Zweig who is the Malcolm Gladwell of his genre. My Money Blog wrote a great review of the book.

There is no post tomorrow- reminder of the contest ending Friday. Enter for your chance to win.

One of the more curious aspects of dividend investing is that some investors slavishly focus on dividend yield above other indicators of a healthy dividend yielding stock. For definitional purposes, dividend yield is ratio derived from: (amount of dividend paid annually/price per share). The higher the dividend yield, the higher the dividend paid relative to its stock price. Thus, a stock paying $1 in dividends and trading at $20/share has a yield of 5% whereas a stock paying $1 and trading at $50/share has a 2% yield. In the abstract, and if you assumed the stock price never goes up, the 5% yield stock is “safer” in the sense you know you are getting a 5% return a year. So, do we always look at dividend yield first when assessing a good dividend paying stock?

I would argue no. The Globe and Mail has been running a series on the best dividend stocks to invest in during 2008. Last week, they listed some of the following as U.S. Dividend Winners: Allstate, Bank of America, Anheuser-Busch, Home-Depot and JnJ. Home Depot was the only stock on this list which is also made the list of this year’s Dogs of the Dow (the Dogs of the Dow is an annual list of stocks who are members of the Dow Jones Industrial Average which has the highest dividend yield as of December 31 of each year).

Why was Home Depot the only stock to make both the analyst list and the Dogs of the Dow? This requires a look at context. If you are like me, and you have a 20-30 year window for investing, chasing the highest dividend yield is not necessarily the best strategy. Remember that dividend yield is a function of both dividend paid and stock price. The issue is that high dividend yield stocks occur in the following situations:

1. The dividend paid is extremely high BUT that means, in most cases, there isn’t much room for dividend increases. If you have a long investment window, you want steady dividend increases since it generally indicates that the business is healthy enough over long period of time to return cash to shareholders.
2. The stock price is, relatively speaking, low which means either the market believes the business is not going to grow that rapidly (remember that a stock price is really a predication of future performance) or the business has suffered a set-back and you may better off investing in a healthier competitor (Citigroup is a good example of this phenomenon; it had a dividend yield of over 7% entering into 2008 based on rapidly declining stock prices; its smaller rival, Wells Fargo (Buffet’s favorite bank) had a lower yield and, arguably, better prospects going forward).

There’s also a larger contextual issue with chasing the highest dividend yield if you have a long investing window. High dividend yield stocks traditionally consist of leaders in mature industries. This year’s Dogs of the Dow consists of members in stodgy and mature businesses like: General Motors, DuPont, AT & T and Altira (a tobacco company). They are under competitive pressures which they have not faced before. I am not sure if the highest dividend yield stocks today will be leaders 10-20 years from now. We are living in an age where massive political and economic change is occurring and we can’t rely upon the industrial leaders from by-gone eras to boast our portfolio.

In a perfect world, my analysis is not to chase dividend yield but to find dividends yielding between 2% -4% in a normal market (I would not rely on dividend yields for financial stocks in this market), with a 5 year annualized dividend growth of 15% and a conservative dividend payout ratio (the % of profits paid out as dividend and written about in my post is my dividend payment safe?). If I had to prioritize these three factors, I would pick the following:

1. 5 year dividend growth: This shows the business is healthy from a cash flow perspective, committed to raising dividends over time and, statistically speaking, the best stocks to invest in relative to their steadier dividend paying peers and non dividend paying stock.
2. Dividend payout ratio: This shows whether the business has room to grow its dividend. Once you have a dividend payout ratio over 50%, there isn’t too much room to grow the dividend payments. This is not desirable if you have a long investment window and are looking for a “raise” every year.
3. Dividend yield: If a dividend yield is high, the stock price is relatively low (which, I readily admit, may present opportunities to engage in value investing) or the dividend payment does not have too much room to increase. I want the happy medium- a growing dividend which can grow year over year and an appreciating stock price.

I wanted to make one final point. Chasing the highest dividend yield is tantamount to investing in bonds on steroids. No one would argue that dividend payments are desirable but extremely high dividend yield stocks (5% plus)  do not appreciate that much relative to its lowest yield counterparts. You create an appreciation ceiling in many respects by investing in too many high dividend yield stocks (having said that, if you can find a stock that has a high yield because the price has been affected negatively in a one-time event, then it may be worth investigating). The point of good dividend stock investing is to benefit from the best of both worlds- cash flow and appreciation. If you chase yield at the expense of increasing dividend payments, you are forgoing appreciation potential.

Do I avoid high dividend yield stock altogether? No. One suggestion I have heard is to anchor your dividend stock portfolio with a high dividend yield stock where the stock appreciation is limited but the dividend is quite secure (typically in a sin industry or utility where profit does not need to be reinvested into the business). Then, invest in several high-fliers- stocks that have increased dividends rapidly over time. The anchor stock mitigates any issues that may result from the high-fliers. I am looking for an anchor now.

As I mentioned, my analysis is contextual to my own situation. For some people with varying risk tolerance, different life circumstances etc., investing in the highest dividend yield stocks may be right for them. As usual do your own due diligence before investing.

Finally, if you want to know more about dividend investing, I would start with the Dividend Guy Blog and Dividend4Life as good resources. Financial Jungle has also constructed a 4.69% dividend yield portfolio for informational purposes.

Inflation- basically, the trend for a dollar to buy you less and less over time. On Friday, I put an order to withdraw some cash from my money market accounts in my RSP in order to be in a position to start buying the Gold ETF (TSX: XGD). This is not a buy and hold strategy but rather, to use Jim Cramer’s phrase, a capital preservation move. Let me explain.

Inflation is caused by many different factors but one of the easiest ways to create inflation is to print more money. The more money you print, the greater the money supply. The greater the money supply, the less our money is worth (it is basic supply and demand). Let me explain it another way. Imagine you bought an art print from a famous artist who promised she would only sell 1,000 copies of the print. This would make the print pretty valuable and, if you sold it, you could buy a lot with the money you received from the sale. However, over time, the artist sells another 1,000 copies then another 1,000 and so on and so forth. After a while, your print isn’t worth as much and selling it won’t give you the same amount of money in your pocket. It is not a perfect analogy but I hope I convey how inflation works if you substituted art prints for money (for those who collected baseball cards in the heyday of the 1990’s, you know what I mean).

What do we read in the news? The central banks injecting money into the banking system. Proposed bailouts in the U.S. in the hundreds of billions. The feds under pressure to lower interest rates. All of these moves or proposed moves require the printing of more money which pushes inflation up.

If you, like me, have a lot of the portfolio in cash what this means is that the value of cash held is being eroded and the erosion of that dollar is speeding up assuming the government starts a massive bailout in an election year (it is estimated the value of money is halved every 30 years).  Since there is nothing really good to buy now (despite how the markets are doing in 2008 the price to earnings ratios still indicate stocks are too expensive), I am trying to protect the value of my money.

Why gold? The price of gold has a very close correlation to the inflation rate. It is seen as a hedge against inflation and the falling U.S. dollar. There are other inflation protection instruments you can buy- mainly real estate and commodities- but I still think the other shoe has yet to drop on real estate and commodity prices are more closely linked to how the economy is doing than inflation. I am also holding gold for a very short period of time (12-18 months) to preserve capital and nothing else.

I do have a high interest bank account but the issue with putting money in there is that, in a falling interest rate environment, I am not sure whether the bank can continue to pay me 4% interest; real inflation, depending on what you read, is between 2-4% which also does not give a lot of breathing room if inflation rises about 4%.

This strategy is particular to my own personal situation. Thus, as usual, do your own due diligence before you decide to buy or sell gold or any other security.

What is everyone doing to protect themselves in this market?

As a personal finance topic of debate, the whole “is your primary residence actually an asset” debate appears to have taken on a new life recently. The Financial Blogger is an example of the latest bloggers to comment on whether calculating your primary residence in net worth is, indeed, correct. I agree with his findings- you have to include your primary residence as part of your net worth calculation (as a complete side-note, I would recommend an interesting debate between Brip Blap and the Money Gardener on even the relevance of calculating net worth). On a liquidated basis, a primary residence, stripped of the fact it use to be your primary means of shelter, has value in the market regardless of whether it produced any cash flow during the time you owned it.

There are those who argue that a house is not an asset; some of these supporters cite the book Rich Dad, Poor Dad  as an authority on why a house is not an asset. Respectfully, these supporters are mixing apples and oranges. While attempting to prove a point, I sometimes wonder if the enduring legacy of the book Rich Dad, Poor Dad is to confuse a generation of investors on the difference between balance sheet items and statement of cash flows. Robert Kiyosaki, the c0-author of the book, does plead guilty to the fact he is not a writer by nature and his often clumsy attempts at getting across his point muddles the waters more than helps it. In Homer Simpson-esque fashion, I am going to take a new job for a day without any formal training and be an editor and re-word his thesis:
To begin with, Rich Dad, Poor Dad argues the following (this is a condensed version of his argument):  the difference between the rich and the poor is that the rich think of assets as those that produce income and a liability as anything that creates an expense. This is a very simple version of the book.

I do not argue for a second that positive cash flow is the key to all personal finance. If you have read my blog for any period of time, you know I like looking at two things in a business: cash on hand and cash generated from operating activities. You also may have picked up in some of my blogs about small business, I always talk about looking at cash and not sales.

Here’s the problem: an “asset” in an accounting sense is a balance sheet item (a balance sheet balances assets to liabilities). Cash flows go into the statement of cash flows. They are two different concepts in accounting and, by effectively removing the barrier between balance sheet analysis and cash flow analysis, it stands to reason in Kiyosaki’s world that you remove assets from the balance sheet that do not contribute to the statement of cash flows. This leads to the interesting phenomenon of not including a primary residence as an asset since it produces no cash flow. I am a supporter of technical accounting accuracy- keep the barriers between balance sheet and statement of cash flows. They measure different things but you should pay more attention to cash flows than balance sheet.

Thus, if I was the editor of Rich Dad, Poor Dad, I would rewrite the thesis as follows to be much clearer:

Do you want to know the difference between the rich and the poor? Despite what Hollywood would make you believe, the rich do not subscribe to the theory that “whoever dies with the most toys wins.” The rich do not accumulate for the sake of accumulating. Instead, the rich purchase assets that produce income- whether they be stocks, bonds or income-producing real estate. Do the rich own a lot of assets? Of course they do, but they own assets which are income producing. The poor buy assets but the wrong kind. They keep buying assets which produce no income or little income such as cars, big-screen televisions and time-shares in Mexico. The result is that the assets which the poor buys ends up owning them because they cannot produce cash from it. Worse still, the poor buy these assets by using debt. The assets of the poor don’t actually own the poor- their bank does!

What about a house? Many middle class people think their house is an asset. It is. But the difference between the rich and the poor is that the rich do not focus on how much their house is worth on the market and, instead, focus on how much cash flow they can produce from other assets they own. The poor focus on how much their house is worth on the market. Meanwhile, they own assets which produce no cash flow. What would you rather be- asset rich (a big house, fancy car, lots of electronics) but dependent on your job as the sole source of income (i.e. poor cash flow) or asset rich and cash flow rich because the assets you buy produce investment income for you?  Of course we all want to be asset rich and cash flow rich!

If you want to think like the rich, think about buying assets which produce cash on hand. Avoid assets which produce no cash or the value of the asset is based on subjective valuations which do not give you cash on hand until you sell the asset.  Good luck buying those cash flow producing assets!

I believe this restates the Rich Dad Poor Dad thesis without overly confusing the issue and putting the emphasis on producing cash flow rather than debating whether a house is an asset or not.

Anyone else care to be an amateur editor and take a crack at rewriting Rich Dad, Poor Dad?

Lately, I have been in a real investing funk. I cannot find any stock I want to buy at the prices I want. Despite, the subprime mortgage and commercial paper crisis knocking the market side-ways, I still find stock I am interested in way too expensive. I keep the number 12 in mind; the average p/e of the S & P 500 over the last 50 years is 12 (this means you are willing to pay $12 for each $1 of earnings). But I look at the stock I am interested in and they are way above 12- Procter & Gamble (23.16 p/e), Johnson and Johnson (18.79 p/e) and Pepsi (20.40 p/e) are all really expensive (figures as of Dec. 31, 2007); there is no way I am paying over $20 for $1 of earnings no matter how impressive the company.

Then I keep thinking that I don’t necessarily have to buy anything; cash is an over-looked portfolio allocation. Buffet has to buy; Berkshire Hathaway is an insurance company so he has to keep investing all those premiums the company receives in order to make a return which are above premiums paid out plus administration fees (the big secret of insurance is that it doesn’t make money on selling policies- it makes its money investing the cash it receives); he simply can’t sit in cash. Most good mutual fund managers sit on at least 5% cash. A lot of value mutual fund managers have a lot more than that (noted fund manager Francis Chou has 39% cash in his flagship fund).

It is always an internal struggle not to be fully invested. You watch investing shows or read the paper and you get the impression you always have to buy or sell something but the professionals keep a lot of money on the side. However, I keep getting concerned as my RSP has over 15% in cash and my non-RSP portfolio is over 30% in cash- am I over-allocated in cash?

The struggle continues between buying and doing nothing. Thoughts?

The S & P 500 hit market correction status earlier last week which means I am beginning to read a lot of articles on making sure you diversify your portfolio to avoid putting all your eggs in one basket. I am not going to argue with this piece of advice since it is a prudent and conservative approach to take. However, this piece of advice also stumps me for several reasons.

I have a hobby of studying how financially independent people got to where they are (yes, I am a geek). Not what they are doing now but how they got there; its easy to make money when you have a whole bunch of it already. I am always stuck by how many of them are specialized in one particular facet of finance, learned it well and stick to their knitting. Warren Buffet, with the notable expectation of Petro-China, knows the American stock market like the back of his hand; he doesn’t invest in anything outside of stock. Jim Pattison (who’s a bit of a local legend in British Columbia) once said you can only really know one or two countries really well and works primarily at building businesses in Canada in the media space (the Pattison Group owns all those advertising displays in every major city in Canada). Trump does real estate; I never read about Trump buying stock.

Here’s the one thing they do well- they always have a lot of cash on hand (Trump may be the notable expectation since real estate works on leverage) and they control when they use it. Cash allows you to sit out the bad times in your niche or to pick up bargains. You don’t always have to be in action in investing.

It also bothers me that the financial industry tells people to put money in a wide variety of industries and geographies- in mutual funds of course. Most mutual funds underperform the market and, suddenly, I am supposed to trust the financial industry which can’t pick investment products in their backyard properly to pick investments abroad? What knowledge does the industry have about stocks trading in India or Brazil when it can’t pick North American stocks properly? It seems like a huge leap of faith to trust an industry to find far off bargains when it can’t do it domestically. The logic conclusion is to buy an ETF that tracks an industry or geographic area but I really do not trust the transparency or stability of markets in the BRIC region (last time I was in China, the government had to bail out the 5th largest brokerage in the country; imagine the scandal if that happened here? And this was during good times).

Finally, there’s an old military saying- “strong nowhere, weak everywhere.” Most people I know have modest sized RSP/401K’s etc. I don’t why you would take this modest amount of money and put it in 5-8 different industries/geographic areas- you really can’t benefit from any gains properly because your holdings are too small.

Which comes back to me initial point- successful people learn one facet of investing well and stick to it. There’s nothing like expertise and discipline to beat the market.

Warren Buffet had himself quite a week last week; it was announced that he added holdings in banking and railways, gave advice on Alex Rodriguez on re-signing with the Yankees, giving A-Rod advice on making an end-run around his agent who gave him horrible advice (if A-Rod was really smart he would refuse to pay his agent’s fee as well) and a soon to be released study by two professors at the American University and UNLV found that buying what Buffet bought for the last three decades would have yielded you 24.6% on your money (or approximately twice the return of the S & P 500 over the same period) even accounting for the fact that Buffet would not legally have to report his earnings for up to four months after his purchase.

Just a couple of comments on Buffet’s latest moves:

1. Buffet’s buying banks:  Buffet added positions in U.S. Bancorp and Wells Fargo- two regional powerhouses (as a side-note, there is speculation that U.S. Bancorp could be a take-over target for a Canadian bank) with reputations for maintaining prudent lending practices (recent history notwithstanding). Over the long term, banks tend to make money in bad times and outrageous money in good times but many seems to be forgetting this lately.  Love the unloved as the saying goes.
2. Buffet’s buying railways: Buffet increased his stake in Burlington Northern Santa Fe Corp. (the 2nd largest railway in the U.S.) but reduced positions in two other railways. Railways interest me for several reasons: Buffet and Bill Gates (through his charities and trusts) own significant stakes in railways and these guys aren’t stupid. I did some research and it makes perfect sense: there are only 5 major railway players in North America, each has a dominant market share in their region (for example, CNR and CP split up Canada into east and west), barriers to entry are very high (you require government approval, a new market player would have to rent the lines off a competitor or build a whole new one (where?), significant capital investment is required etc. etc.), the technology is pretty stable so there is a lot of free cash lying around to buy back shares or increase dividends rather than put money in R&D and its not a “sexy” stock which means there is less speculation on it than, say, a tech or bio-tech stock. Finally, it is a domestic stock that will benefit from the rise of China as trains are needed to transport goods from ports into the interior. The share price of Canadian Railways is taking a beating lately because of the Canadian dollar- I am keeping a watch on it (please do your own due diligence).
3. Buffet loves old people. Buffet has now purchased 61 million shares in Johnson & Johnson: makers of pharma and health-care related products. What is interesting to me is that Buffet has been adding J n J even though the share price has increased- makes you wonder if there is more appreciation in store…

Here is a more detailed summary of  Buffet’s stock holdings. Has someone created a ETF that tracks what Buffet holds? That would be a product I would buy…