A game of risk or a risky game?

The traditional thinking in the world of finance is that to increase returns you need to increase risk. This view is quite logical. Let’s consider an investor who wants a minimum of risk. She can buy certain blue-chip stocks such as Wal-Mart, Home Depot [[hd]] , and GE [[ge]]. The stocks offer low risk because they are all giant companies with dominant market positions; I think it is a fair bet that all three companies will still be around in one form or another 50 or 100 years from now. For such low risk our investor will get a relatively low return because these companies are so huge and have less ability to grow than they had in the past. Now, with such great blues chip stocks available why would our investor choose to buy shares in a company such as DayStar technology [[DSTI]] or Cheniere Energy [[LNG]]? Neither of these companies currently makes a profit nor has any significant revenue. In owning such companies an investor has significantly more risk of losing her capital. Therefore, no rational investor would buy the stock of such companies without being assured that those investments offer the potential of very great reward.

This thinking underlies the Capital Asset Pricing Model (CAPM). Now, for the most part this works quite well. However, there are some problems with the capital asset pricing model. One huge problem is that in this model risk is defined as the stock’s volatility. Volatility is of course a measure of how much a stock’s price changes each day, week, and year. For those of us who are long-term investors, however, volatility is an inadequate measure of risk. What matters more for us is the stability of the future earnings of a company.

For financial analysts and portfolio managers, volatility is most commonly measured by something they call beta. Simply put, beta is a measure of the correlation of the stock’s price to the broader stock market as a whole. Therefore, an index fund would have a beta of 1.0. Let’s say we have a stock that has a beta of 2.0; this means that in general, when the market goes up 10% the stock will go up 20%, conversely, when the market goes down 10% the stock will go down 20%.

Since we’re already talking about beta and financial analysts, I might as well mention alpha. Alpha is a measure of a portfolio’s performance. An alpha of zero indicates that a portfolio matched the market’s return. An alpha of one would indicate that a portfolio outperformed the market by 1% annually.

The goal of a professional portfolio manager, at least according to the capital asset pricing model, is to construct a portfolio with the desired amount of alpha in order to maximize returns without exceeding a certain level of risk (beta). According to the model, it is impossible to consistently beat the market because the market is efficient. This aspect of the model is known as the efficient market hypothesis and I obviously believe it to be wrong. I will deal with why this is wrong in a later article. For now let’s return to risk.

One finding that has been problematic both for the efficient market hypothesis and for beta is the finding that low P/B stocks outperform high P/B stocks. According to the CAPM, this could not happen without low P/B stocks being more risky than high P/B stocks. However, low P/B stocks do not have higher betas than high P/B stocks. The creator of the efficient market hypothesis himself, Eugene Fama, realized then that beta do not adequately measure risk. He and his collaborator Eric French argued that low P/B stocks are more risky than high P/B stocks. I disagree with this but the important point is that as of their paper in 1992 (unfortunately not available free online), beta was officially dead or at least dying.

So how can we measure risk? There are no easy ways to do so. We must rely on sound fundamental analysis. Risk obviously decreases the more products the company makes and the more customers to which it sells. Thus, GE and Berkshire Hathaway are less risky than almost all other companies because their revenue streams are so diverse. Conversely, ExpressJet [[xjt]] and the other regional airlines are very risky because they all have only one or two customers. Similarly, small defense contractors are risky if they sell only a few major products and to only one major customer: the United States government.

Another risk factor is debt. Companies with more debt are much less likely to be able to survive a recession or industry downturn because they would be unable to meet their debt obligations if their revenues drop more than slightly. For this reason, companies such as Fortune Brands [[fo]], Blockbuster [[bbi]], and Ford [[f]] have elevated risk due to high debt loads.

Another risk factor is obviously competition. Companies and highly competitive industries have greater risk than companies with monopolies or that for other reasons do not have much competition. There are many ways that a company can avoid too much competition, including patents, trade secrets, operating in a niche market, and effective branding. Ceteris paribus, a dollar of earnings that is at lower risk from competition is worth more than a dollar of earnings that comes from a highly competitive industry.

This is not to say that companies in highly competitive industries cannot be great investments. Those companies that are wildly successful in competitive industries usually have some key advantage that gives them an edge in that is not easily copied. This advantage is not always easy to identify. For example, Southwest Airlines [[luv]] had the important advantage over legacy carriers of not having an established business prior to airline deregulation. This meant that Southwest was not burdened with the same costs that hindered the larger airlines. In addition, Southwest’s fares were simple and did not penalize travelers for arbitrary reasons such as not staying over a weekend. Another good example of a successful company in a competitive industry is Wal-Mart [[wmt]]. What did Wal-Mart offer that Kmart [[shld]] and other discounters could not? One thing it offered was everyday low prices. By avoiding sales Wal-Mart gained both the reputation as the low-price leader and it gained more consistent profitability. Wal-Mart has also been known for some time for the effectiveness of its distribution system. In an industry with low profit margins and high inventory requirements, any improvement in logistics drops straight to the bottom line.

The last important risk factor is the elasticity of demand for a company’s products. The business cycle is a fact of life; any company that suffers less during recessions, whether because it sells products that are always in demand or because it sells to people who are not greatly affected by recessions, has lower risk than the average company. Big industrial companies such as auto manufacturers and aircraft manufacturers are usually very cyclical. Cyclicality of earnings is not in and of itself a black mark against a business. However, combined with high debt and stiff competition, a cyclical company in an industry downturn can be a very risky bet. See, for example, General Motors [[gm]] or Northwest Airlines [[nwa]].

While it is not possible to exactly quantify risk, it can still be approximated. Any decision to invest in a company should come only after carefully weighing the possibility for reward against the risk that company presents. In certain circumstances, adequate calculation of risk and reward cannot be made, such as with development stage companies with no revenues. In such cases, the conservative investor would do well to watch from the sidelines unless she is an expert in the field and is sure that she is not paying too much.

On a related note, I urge you to read Richard Russell’s article on the perfect business, which discusses the ideal business from the standpoint of a small-business owner. The points Russell brings up are also important to large publicly traded companies.

Disclosure: I have no position in any stock mentioned above. I have a full disclosure policy.

Why short selling is risky

I often write about companies I dislike and companies that I have sold short. I have made a good return on my short sales. Yet I have always recommended against short selling. Why I recommend against short selling was amply demonstrated by the stock of microcap Noble Roman’s (OTC BB: NROM) yesterday. The stock shot up 46% on no news. What happened? My bet is that the critical article on Noble Roman’s that I posted on Monday encouraged some people to short the stock and it encouraged some momentum longs to sell. That drove the price down 30% over the next two days. Yesterday some short sellers started to cover and that drove the stock price up a bit. Momentum players jumped back in long and soon the stock was back up to where it was Monday. Of course, this is just my idle speculation, but the effect on the stock price is quite real, no matter how it happened.

If someone shorted the stock at its low yesterday, that person would now be out a lot of money. They might even blame me for their losses. Yet for any stock, the short term is not indicative of the long term. In the short term the stock market is a voting game. Especially for small, illiquid stocks, prices fluctuate greatly depending upon supply and demand. But in the long term, the stock market is a weighing mechanism, and poor companies’ stocks will inevitably flounder. Most people have a hard time holding on to stocks they have bought (long) despite swings in short term prices. It is even harder to hold on when, with short selling, losses can theoretically be infinite. So stay away from short selling.

Disclosure: I am still short NROM and have not traded it since my first article on it last Monday, as per my disclosure policy.

The Reaper’s Guide to Short Selling Stocks

The point of this article is threefold: to associate the nickname “The Reaper” with me and my short selling activities so that when I become as famous as Jim Chanos or Manuel Asensio or at least Andrew Left, I can appear on the cover of Forbes magazine wielding a scythe (see picture below); to inform investors about short selling so that they realize the folly of buying into stocks just because of a so-called “short squeeze”; and to inform those crazy enough to actually try short selling about different strategies for doing it.

There are a number of websites dedicated to finding stocks that are prone to a short squeeze and recommending that traders buy those stocks. A short squeeze can occur under two different but similar situations. In each case, there is widespread negative sentiment about a stock in which short sellers have sold short a large percentage of the outstanding shares of the stock (leading to a high short interest ratio). In one case, routine speculative buying on the part of traders pushes up the price of the stock, which creates losses for the short sellers and this may lead some of them to cover their short positions (buy back the shares they borrowed and sold), and this buying on the part of the short sellers drives the stock price up even further.

The other case is where some good news comes out about the company which leads to the same outcome. In this case, a quick witted daytrader or momentum trader can easily make a lot of money. The trader might see the headline and quickly buy the stock at the same time the quickest shorts start covering, and by the end of the day there can be a whole lot of profit as mounting losses cause most of the other shorts to cover as well. I found myself on the wrong end of this kind of short squeeze in early February 2007 with Onyx Pharmaceuticals [[ONXX]] (see chart of squeeze). The market expected poor results from a drug trial, but the company reported outstanding results. Considering that the drug in question was one of only a few that the company was developing, this was incredibly good news for Onyx. Shares doubled from $12 to $24 in one day. I was quick and got out of my short position in the stock with only a 50% loss. A quick witted trader could have read the same headlines I read and bought as I was covering and realized a 30% profit in one day. Of course, I do not recommend such daytrading because most people are very bad at it, but I do recognize that some people do it well and they serve a purpose in the markets.

Non-news-driven short squeezes are much different despite looking very similar on the price charts. The problem with this kind of short squeeze is that there is no fundamental reason for the stock price to go up. As I have previously written (and written elsewhere), stocks targeted by short-sellers tend to do worse than the market as a whole, and people who buy a stock just because the short interest is high and just because there’s a possibility of a short squeeze would do well to remember that. Another thing to keep in mind is that if a company is bad enough, the short-sellers are very strongly convinced of their negative opinion of the company, and the short sellers have deep pockets, there is no reason why the short sellers need to cover just because of a temporary increase in the stock price. A good example of this is the various price increase in the stock of Home Solutions of America [[hsoa]]. The critics of the company are convinced that it is both fraudulent and insolvent and that the stock is worth nothing. So they will likely just hold onto their short positions and grit their teeth to withstand the short-term losses because they believe that within a few months or a year they will be sitting on a 100% profit.

Now, because I am a reasonable and conservative person, I feel obligated to warn you that short selling is highly dangerous, speculative, and for most people it is simply dumb to do it. In fact, we expect the return from selling short stocks to be about -10% per year because on average that’s about how much stocks go up per year. So unless a short seller has a lot of time, talent, guts, and knowledge, he or she should expect to lose money over time.

Short Selling for Fun and Profit

The one rule of short selling is this: don’t do it. If you ignore the rule you deserve what you get, whether it be fortune (if you have great talent and good luck) or poverty (if you have modest talent or great talent and bad luck). Consider yourself warned.

Now that we have that out of the way, there are two ways to profit from short selling stocks: momentum shorting and what I call steel-gut shorting.

Momentum shorting

As mentioned above, selling on negative news can be profitable. It is hard to tell what will continue to fall and what will bounce back. There are a few strategies to use. I have tried using certain influential blogs as my ‘news’ sources.

I receive emails of updates to those blogs or see the postings within an hour of them being published because I subscribe via RSS and I check my RSS reader often. If I see a negative comment about a stock I can quickly check to see if I can short it and then I can quickly short sell it.

This strategy has been a mixed bag and I have probably broken even. While Terra Nostra Resources (OTC BB: TNRO) gave me a nice profit, and Uranerz [[urz]] gave me a respectable profit, I saw small losses on several others, including Cellcyte Genetics (OTC BB: CCYG).

Steel Gut Short Selling

Imagine selling short a worthless company only to see the market double or triple its market value. You hold on. No–you don’t just hold on. You sell more. You borrow money and sell more. The company approaches a valuation that is absurd and crosses it. You sell more. You take out a loan against your house and you sell more. You borrow from friends and sell more. You sell your car and your house and you sell more of the stock. If the stock returns to only modestly overvalued you will make a fortune. If not, you lose everything.

This story ends in a couple ways. If you were unlucky and sold short Amazon.com or Yahoo or Lucent or any other overvalued tech stock in 1998 or 1997 then you were ruined. If you sold short in late 1999 or 2000 or 2001 then you made a fortune.

There are a few keys to making this work. First, be diversified in time and in stock. Make sure that no loss, no matter how incredible, will put you out of business. Second, stay liquid. Don’t get anywhere close to your margin limit. Have some backup cash or a credit line ready so that if the stock shoots up you can wire in some more money and short more. Third, don’t short a stock unless there is something that will force it down. In other words, don’t go against stock momentum or bet against a ‘high-tech’ company, even if the product is a rumor and the company’s sole asset is a promise and a ‘vision’. At the very least, if you do that, make sure that it is a small part of your overall portfolio.

At the risk of repeating myself I will repeat myself: do not short stocks that are valued at a multiple of promises and dreams. My only significant losses in short selling have come from Research Frontiers [[refr]], Document Security Solutions [[dmc]], and Parkervision [[prkr]]. None of these companies has an operating business worth more than 10% of its market cap. Parkervision and Research Frontiers have great new technologies (that I think are totally bogus) and Document Security Solutions has a patent and a court case. If you take a look at Research Frontiers, you will find that it has been promising for decades that its great technology is just around the corner, and yet it never seems to sell anything (see my previous article on Research Frontiers).

Even after avoiding stocks that sell at a multiple of hope, it is important to avoid companies where there is no clear reason why the stock should go down in the short run. Short sellers of Imergent [[iig]] and Usana [[usna]] would do well to remember that. The sad fact is that companies with a bad business can last far longer than they should.

So what is left to short? There are wildly overvalued stocks that are overvalued only because no one knows about them. This is the type of stock that Continental Fuels (OTC BB: CFUL) was. I sold it short around $2.70 and rode it all the way down to $0.50. It is now trading at $0.60. When I shorted it, its diluted market cap was over $1.5 billion and yet it had maybe $10 million in sales, no promising technology, and a negative book value. However, it is very tough to find such stocks, and getting ahold of their shares to short is very hard.

Then there are the fading stars. These are once-highflying companies that run into problems and have little hope of evading them. Examples include Vonage [[VG]] and Krispy Kreme [[kkd]]. Krispy Kreme I just missed, while by the time I became active in shorting, Vonage was too cheap. This is also the category into which most housing-related stocks would fall. Everything from Countrywide [[CFC]] to New Century Finance (now bankrupt) to DR Horton [[dhi]] and E*trade [[etfc]] (didn’t realize they had a big mortgage operation, did you?). [Note: amusingly enough, when I first wrote about E*trade as a short it was weeks prior to its recent stock market crash. I did not actually short it, though it would have been quite profitable to do so.]

Trends, no matter what kind, tend to last longer than anyone thinks. So if you had waited until after the first mortgage problems had made themselves evident in January and February and after panic subsided, you could have shorted a large number of financial and house-building stocks at attractive prices.

If you short sell, good luck. If not, good luck. But even if you do not short sell it would behoove you to pay attention if short sellers target your favorite stock. Imagine the happiness of those few Enron shareholders that sold after hearing about Jim Chanos’ shorting of the stock.

Disclosure: I have no position in any stock mentioned. My disclosure policy makes for good reading. The picture of the grim reaper above is me. Yes, I do realize that I need to sharpen my scythe. No, I do not take myself too seriously.

What is a Company Worth?

I have established my strategy of buying the stock of good companies that for some reason are undervalued by the stock market. Now comes putting that simple strategy into action. The details are a bit harder than the basic strategy.
Returning to my milk analogy, milk has only one way in which it has value–that is, its ‘asset’ of milky goodness. Thus, we can either consume it or sell it off to someone else who would appreciate its milky goodness. Companies are different, though. They too have their asset value, which is the value of all the inventory, machinery, property, patents and other things that could be sold if we shut the company down. In addition to that, they also have earnings power, or the ability to make a profit. So in evaluating companies, we can judge them to be a good or bad value based either on their actual assets or on their future earnings power. We will start with the evaluation of value based on assets.

The father of value investing, Benjamin Graham, wrote a book that all of you should read, The Intelligent Investor. In his book, Graham asserted that a company would be a good buy if it were valued at less than about 2/3 of its total net tangible asset value. Graham excluded patents and other hard to value ‘assets’ from his calculations, so he only counted the ‘hard’ (tangible) assets. To get the net tangible asset value we take the value of all tangible assets and subtract any debt the company owes. This gives us the company’s net worth, which is just like the net worth of a person.

Why isn’t a company selling at 90% of its net tangible asset value a good deal? The reason is that Graham insisted upon having a margin of safety. In other words, some of those ‘assets’ may be overvalued. To avoid situations where the assets are worth little, we want to only buy companies that are selling for far less than we think they are worth.

You may think that this is unlikely, and recently, this has not been very common. However, during bear markets, this happens a lot. The Washington Post Co. was valued by the stock market at only about $80 million in 1973. However, its assets, including television stations, the magazine Newsweek, and the newspaper, could have easily been sold off for hundreds of millions of dollars.

At least one value investor realized the true value of the company, and he bought many shares of Washington Post. His name? Warren Buffet, the most successful investor in the world. Now the Washington Post Co. is valued at over $8 billion in the stock market, giving Buffett a return of over 100x his original investment.

What if the market never realizes the value of the assets of a company, and the company never sells them off? This is not a likely situation. Nowadays, there are many private equity firms that look for such easy money. These companies will buy a majority or large minority stake in a company and then either find better management or sell off the company’s assets for a profit.

In the current market, however, fairly few companies are valued significantly below their assets. That leads us to the second way of valuing companies, which is based on their earnings power. This is much the same way you would evaluate the relative value of a bond or a savings account.

With a bond or savings account, you receive an interest payment that is your payment for loaning your money. With stock ownership, you have a claim to a portion of the profits of the company. If a company has 10 million shares outstanding and makes a profit of $20 million, then the profit per share (also called the earnings per share or EPS) is $2.
So if you own 100 shares, you have ‘claim’ to $200 in profits. Now, companies almost never pay out all their earnings to their stockholders. Usually they will pay a portion of their earnings to shareholders as dividends. Some don’t pay dividends at all. The profits not paid out as dividends are reinvested in the company.

Presumably, those reinvested earnings benefit the stockholders too, in the sense that they will help grow the company and increase the earnings power of the company. The future value of the company will be greater because of the increased future earnings and the stockholder will be compensated with increased market value of his shares of stock.
Thus, we will treat all of the company’s earnings, even those that are reinvested in the company, as income to us, the shareholders. So, to determine the fair price of a stock, we compare its price to the earnings per share (EPS). We divide the price by EPS to get the Price to Earnings ratio or P/E ratio.

The higher a P/E ratio is, the less current earnings the company has for each dollar we invest. So if we were to invest in a company with a P/E of 20, for each dollar we spend to buy stock, we will only get half as much earnings as if the stock had a P/E of 10. Therefore, we want to find and buy portions of companies that have lower P/E ratios. But how high is too high? Here I will give a brief explanation, but see my post on P/E ratios for a more in-depth explanation.

When you are investing in stocks, you value the stocks based on the future income of the company. To find a fair value for those stocks, though, you need to compare that future income to the future income you could get by just sticking the money in a safe U.S. government bond. Since stocks are riskier than government bonds, the earnings yield on the stock (E/P, the inverse of the P/E ratio) should be higher than the yield on a medium term government bond (let’s say with a 5 year maturity).

Medium-term government bonds are yielding about 5% right now, so if we had a perfectly safe stock investment, we would not mind getting a 5% earnings yield (which translates into a P/E of 20). However, stocks are less safe than corporate bonds, which are less safe than government bonds. Therefore, we want to be paid a risk premium for owning stocks. A 2% risk premium is enough for us to consider a stock a good value.

Therefore, stocks that are neither increasing nor decreasing their profits should be a fair value at around a P/E of 14 (and an E/P of 7%). However, because we are value investors, we do not want to pay fair value. Rather, we want to pay below fair value. Therefore, it is a good rule of thumb to avoid companies without significant earnings growth with a P/E over 10. For companies with significant earnings growth, a P/E below 20 should be fine. But, as with buying anything, the cheaper we can buy a good product (in this case, a company), the better.

When we buy something at a price less than it is worth, we give ourselves a margin of safety. That way, we are protected from losing a lot of money should we err in our estimation of the quality of a company. If we were to invest in companies that seemed to be selling at a fair value, we would be at greater risk of losing money if our estimation of the company’s value turned out to be wrong.

Disclosure: I hold no shares of any companies mentioned herein. See the disclosure policy.

An ETF Asset Allocation Plan for Everyone

If I have not said it much before, I will certainly say it in the future: the best way to invest is with low-cost index mutual funds or low cost index ETFs. I like Vanguard, but it is even cheaper to get an account at Zecco.com and then invest in low-cost ETFs. They give you a certain number of free trades per month which is more than adequate for a long-term buy-and-hold investor. What I suggest below is not quite as simple as one of Vanguard’s excellent low-cost target date funds (see The Default Investment), but it will give you a portfolio that is more appropriate for your individual circumstances.

In the article on the default investment, I suggested talking to a financial planner if you wanted a tailor-made portfolio. However, the problem with financial planners is that they cost a lot of money relative to investable assets, particularly if you are not rich. A couple hundred dollars an hour or .5% of invested assets adds up quickly if you have a small portfolio. So for those with under a few hundred thousand dollars, it may be best to go it alone. You will need to first determine your risk tolerance. Buy Index Funds: The 12-Step Program for Active Investors; this book will help you think through how much risk you can handle. There are also 20 sample portfolios in the appendix for all different risk profiles. Those portfolios are designed for DFA mutual funds (which can only be accessed through a financial advisor). So I found suitable ETF substitutes for those funds and they are listed below along with their ticker and annual expense ratio. So buy the book, choose an appropriate portfolio for the amount of risk you can handle, get an account with Zecco, and then buy the following ETFs in the proportions recommended for your risk profile in the book. You will pay very few fees, your portfolios will be tax-efficient, and you will not have to think very much about your investments.

US Large Company: Vanguard Large Cap (VV), 0.07%
US Large Cap Value: Vanguard Value (VTV or VIVAX), 0.11%

US Microcap Index: iShares Russell Microcap Index (IWC), 0.60%
US Small Cap Value Index: Rydex S&P Smallcap 600 Pure Value (RZV), 0.35% or Vanguard Smallcap Value (VBR), 0.12%

Real Estate Index: Vanguard REIT ETF (VNQ), 0.12%

International Value Index: iShares MSCI EAFE Value Index (EFV), 0.40%
International Small Company Index: SPDR International Small Cap (GWX), 0.60%
International Small Value Index: WisdomTree Small Cap Dividend Fund (DLS), 0.58%

Emerging Markets Index: Vanguard Emerging Markets Index (VWO), 0.30%
Emerging Markets Value Index: WisdomTree Emerging Markets High-Yielding Equity (DEM), 0.63%
Emerging Markets Small-Cap Index: WisdomTree Emerging Markets Small-Cap Dividend Fund (DGS), 0.63%

One-Year Fixed Income Index: (see below)
Two-Year Global Fixed Income Index:
Five-Year Government Income Index:
Five-Year Global Fixed Income Index:

There are no funds that are very close to the above, but you can use different weights on Vanguard’s bond funds to approximate the average duration of the mix of the above funds. Vanguard Short-Term Bond Index (BSV), 0.11%, has an average maturity of 2.7 years, while Vanguard Intermediate-Term Bond Index (BIV), 0.11%, has an average maturity of 5.7 years. Both are invested primarily in Treasury and government agency securities. For very-short term bonds (or just buying government bonds of any maturity), you could enroll in Treasury Direct and buy 1-year treasuries direct from the US Government. If you hold them to maturity you pay no fees.

I see no great need to invest in foreign bonds, considering the safety of the Vanguard funds. While more diversification is good, there is a limit to how safe something can get–and it doesn’t get much safer than one to five year government and AAA-rated bonds. So if Index Funds says that you should have 10% in each of the four bond categories, your weighted-average maturity would be 3.3 years. So you could put 10% of your investable assets in 1-year bonds through Treasury Direct, 15% in the Vanguard Short-Term Bond Index, and 15% in the Vanguard Intermediate-Term Bond Index. This gives you an average maturity of 3.4 years.

When investing in these ETFs, you should rebalance every year. You could also choose to put a portion of your funds in one or more of Vanguard’s target date funds and then just add on the extra funds (value, small-cap) to the main target date fund. Then you would not have to rebalance as often.

If you follow the above plan, you should expect to outperform 80% of other investors, because they will incur more taxes and more fees. You will also end up with investments tailored to your unique circumstances. And you will only have to think about your investments once a year. This sounds like a good deal to me.

P/E Ratios: Part 1

What is a good P/E ratio? Well, good P/E ratios are low. But how low is low enough? Is 20 good? Is 15 good? There are a couple ways to look at this–in terms of a business in general, and in terms of what the markets have determined to be an average P/E in the past. I address historical P/E ratios in the stock market in a future post.

Let’s say you own Acme Brick, and your company makes an average profit of $1 million per year. As the owner, you can pay that to yourself or reinvest it in the business. Let’s say you want to sell, though. What is a fair value? To do this, you need to compare the return that you would make on your business relative to the risk-free interest rate (the rate of interest that you could earn on a U.S. government bond). The rate is now about 5%.

The person to whom you are selling Acme Brick should (at a fair selling price) be able to make a somewhat better return on his money than if he just bought government bonds. This is because he is taking on more risk in buying a company than he would be if he bought government bonds. The company may see its profits shrink, whereas the return on a government bond is guaranteed. So we then fire up a handy interest rate calculator and learn that at 5% interest, it takes about 14 years to double your money.

So what price would a buyer of Acme Brick have to pay so that it would take him 14 years to double his money? He would have to pay $14 million dollars. (In 14 years, his $1 million per year profit would have doubled his original investment to a value of $36 million, including both the company and cash.) I must note that it would actually take less than 14 years for Acme Brick to double the initial investment, because when earnings are paid out each year, they can be invested elsewhere and will thus compound, just like interest on a bond compounds.

Because there is more risk in Acme Brick than in the U.S. government, $14 million is too high, so we subtract some money from his buying price to compensate the buyer for his risk. Therefore, about $10-12 million should be a fair price for buyer and seller. This price translates to a P/E ratio of 10-12. So is this the fair P/E ratio of all businesses? No. In our example, we assume Acme is not growing more profitable. If the company is growing its profits rapidly, a higher price would be in order. However, if the company is becoming less profitable, a much lower price is in order. But the price is always determined from the future profits we can expect from the company. When we take into account the other possible uses of our money, such as buying government bonds, what we have done is an over-simplified discounted cash flow analysis (only the really courageous should follow that link). Again, this is simplified, but the future introduces so much uncertainty that more precise calculations are rarely helpful.

So, with current interest rates very low (around 5% for medium-term government bonds), a fair P/E for a company that is not growing more profitable is about 12. We don’t want to buy companies when they are fairly valued. We want to buy them when they are good values or great values. Thus, for companies that do not show strong growth, we will prefer to pay less than $9 for every $1 in earnings (or, a P/E ratio of 9). For companies with strong growth, we may be willing to pay up to around a P/E of 20 (although the lower, the better).

By paying less than the fair value, we give ourselves a margin of safety, so that we are protected in case we make a mistake in our calculations or in case the company in which we are investing suddenly starts to do worse. Half the battle of making money in the stock market is avoiding big losses, so in buying great values, we are halfway to success.

Bad Investment Advice

I’ll take a break from disparaging penny stocks and fraud to discuss some hyped up claims of certain investment services.

The first ‘victim’ (I put that in quotes because everyone listed deserves to be excoriated) is Doug Casey (or Dave Forest, who is listed as the managing editor of the Casey Energy Speculator). This advertisement I received in the mail receives my ‘duh’ award. Is it not amazing that some of his picks have been up 570% (Cameco), 1500% (International Uranium), or 1000% (Strathmore Resources)? It would be, until we realize that the newsletter in question specializes in energy. Even a chimpanzee specializing in energy stocks, picking them randomly, could have easily compiled a similar short list of stocks with great returns, simply because we have been in an energy bull market these past few years.

Some might argue that point, saying that at least they knew to invest in energy. That is not the case–the newsletter has been around for awhile, so that is simply their specialty. But what if they predicted this energy bull market back in the late 1990s? Since they are specialized, they have to believe that their specialty will do well. In other words, no specialized newsletter can succeed if the author does not believe that his area will do well. Therefore, specialty newsletters, whether they be in technology or energy, will attract perma-bulls. Those that become bearish will leave the specialty or the field.

So do I think Dave Forest is an idiot? No. He may be brilliant. I simply do not know. In fact, if one had invested only in energy for the past 20 years, one would have done very well. That being said, a specialist in energy is in no place to say whether energy is a better investment now then real estate or chemicals. His expertise in one area will prevent him from impartially considering which industries will do better or worse than his own specialty. So if you do subscribe to a specialized investment newsletter or service, be wary of any claims about anything but that newsletter’s specialty. Also, make sure to diversify into other industries as well.

Okay, so Doug Casey is not exactly a charlatan. At worst, his newsletter was guilty of exaggerated advertising claims. Let’s move onward and upward to criticize worse investment advice. This time, let’s play with options.

If you do not know what an option is, then let me first tell you: do not use them. That being said, if you wish to learn more, then visit Investopedia’s article on options.

Now before I start with my rant, I will regal you with my analogical abilities. Let us say that you and I have a bet on who will win the Superbowl next year. I bet on the Chicago Bears; you bet on everyone else. Because the odds of some team other than the bears winning are so good, I will get a large payout should the Bears win (say, $100). However, should any other team win, you get a small payout (say, $1). Now, let us suppose that I am really sure the Bears will win. Why not increase my bet by 10 times? Then if they win I’ll make ten times as much, and if they lose I lose only a little? That is how leverage works–it does not change the odds of winning or losing, but increases the possible losses and gains.

In the above analogy, I am like a buyer of an option, whereas you are like the seller (writer). The buyer pays a small amount of money, has a relatively low chance of winning, but will generally make much money if he is right. The seller is almost certain of being paid a small amount of money, but has the risk of losing a whole lot more.

When looking at actual stock options, it is important to realize that the sellers are mostly divided into two types: one type is the arbitrage seller or market maker, which is only interested in making a small, guaranteed profit (basically, their profit amounts to a fee for the service of writing the option the buyer wants). These sellers will always take the opposite side of their bet in the stock market, so they do not have any risk. If this is above you, do not worry–the important thing to realize is that no matter what, they make a small profit. The other types of options sellers are in it to profit from superior knowledge. They are usually quite smart and experienced. In fact, they have to be, since their risk is huge if they miscalculate. For example, Richard Russell has a side business selling options.

The vast majority of options that are bought expire worthless. Keep that in mind as you read on about THE BULL MARKET THAT NEVER ENDS! That is what the advertisement for the Mt. Vernon Options Club screamed at me. Steve McDonald, I have to say, is either an idiot or a charlatan.

I will explain the common idiocy of covered calls a bit later, but first I have to take umbrage with his winning LEAP strategy with Chesapeake Energy (CHK). He recommended buying a $12.50 call option (option to buy) when the stock was below $10. Smart move. The next move was not so smart: he recommended selling the $15 call option. While this turned out okay, what this did was remove any possible gains should the stock continue to appreciate, while the downside risk was still present. What is even more amusing about this example is that for a heck of a lot less risk, an investor could have simply bought the CHK shares at $10 per share, and would now have a 300% profit!

Next up on my list of charlatans is Bernie Schaeffer, of Schaeffer Investment Research. Now, I have subscribed to his Options Advisor newsletter and found it to be okay–I did not lose much money. Of course, I did not pay for it–my brokerage gave me the subscription for free to try to increase my trading. (The long term record of the newsletter, according to Mark Hulbert, is horrid, though–an average annual loss of 4.7% per year for over 20 years, during the greatest bull market in history.) Besides a horrid track record, why do I suddenly call Bernie a charlatan? I do this simply because he leaves me no choice: his most recent actions have proven that he has no respect for his subscribers. He decided to offer a covered-call options newsletter for the low price of only $795 per year! What a great deal! So why do I not like covered calls?

A covered call is simply writing (selling) a call option when you own the underlying shares of stock. With a covered call, you benefit if the stock does nothing or goes up a little, and you lose when it goes down a bunch. Hmm, that sounds an awful lot like selling a put option! Wait, umm, yes–it is! A covered call is mathematically equivalent to selling a put. The only differences between the two are that with a covered call, you receive any dividends that the stock pays, and you pay twice as many commissions to your stock broker. Also, a put has more leverage. To be truly equivalent to writing a put, a covered call writer would have to have a lot of margin.

Would the dividends make the covered call strategy more effective than simply selling puts? Maybe if the stock pays a large dividend, but it turns out that stocks that pay large dividends are either not very volatile, reducing the payment you would receive for selling the call (such as utilities and REITs), or they are smaller or thinly traded, meaning that there is no market for the options. So that is not generally a good reason to use covered calls. The only good reason I can think of is in the case of large institutions that perhaps become short-term bearish on a stock, but cannot exit a large position in that stock without depressing its price. In that case, selling covered calls may make sense.

So why do so many advisors recommend covered calls? They do this simply because it is much easier to qualify (with a stock broker) to sell covered calls than to sell puts. In other words, they give this advice because there are plenty of fools who can take it. Shame on them.

Okay, now it is time for the worst investment advice of the day! I will now debunk the art (do not dare call it a science) of what I call squiggles, or chart analysis. At the very least I will debunk post-hoc model development and back-testing.

What is chart analysis? Simply put, it derives from the idea that everything that is known about a stock is evident in the price action of that stock. Therefore, certain types of price action (certain chart patterns) should predict certain near-term outcomes. At some level, this is quite logical. For example, as William O’Neil emphasizes with his CANSLIM stock trading method, big increases in the price of a stock are often caused by big money (institutional investors) buying that stock. Therefore, seeing a series of days in a short period of time during which the stock is up on very high volume would be a good indicator that a big mutual fund has started buying.

I have problems with technical analysis in general and charting specifically, because too often those who engage in it either do things wrong or they give themselves too much leeway, by saying “it may go up, but if this happens and it goes down, then it may go down some more,” or similar things. However, that is not the purpose of this article. The problems with charting I mention here are egregious and are not problems of the best technical analysts.

In the advertisement for The Options Optimizer, there are plenty of great examples of how much money could have been made using the system. There are pretty graphs of the prices of commodities and stocks with arrows saying “sell” right before a big price decrease or “buy” right before a big price increase. There are statistics of all the millions of dollars that you could have made by following this system on these occasions.

There is only one problem with this. Nobody made any profits using this system. Every single example is a hypothetical example of trades the system would have chosen. What’s wrong with this? In statistical terms, selection. It is incredibly easy to examine past results of any strategy, no matter how bad, and find some examples where the strategy worked. In fact, your strategy could be as simple as selling companies whose names begin with vowels on Mondays and buying them on Fridays while doing the opposite with companies whose names begin with consonants.

Amazingly, this strategy would work about half the time; the results in any given week will be randomly determined. When you later start your investment newsletter a year later, you can give hundreds of examples where your system worked beautifully. Just ‘forget’ to give any examples of when your system failed and you will be on the road to riches.

A second problem with many trading strategies that is also a problem with the Options Optimizer is that it suffers from over-optimization. Here is an example not from investing: let’s say I have an algorithm for predicting college grades from SAT scores. It is only correct about 60% of the time (which is nevertheless good). I want it to be better. So I use my sample of past students and I look at other factors. I throw in high-school grades, ethnicity, and a measure of the difficulty of their high-school curriculum. All these are logical predictors of college grades. However, I am still only correct 70% of the time. I look back through my data and find that when I factor in eye color, waist size, length of name, and number of vowels in the last name my predicative power increases to 95%.

The problem comes when I use this new algorithm on a new sample. I suddenly find that its predicative power has fallen below 50%. Where did I go wrong? Simply put, I optimized the algorithm for a specific group and I included many variables that most likely have no effect on college grades. This is called over-optimization. If you include enough variables, you can develop a system that is right 100% of the time for the sample from which it was developed. For all other samples (of students or periods of time in the stock market) the system will be very bad. Thus, any successful trading system should have as few variables as possible so that it can be effective with wildly different samples.

So what can you do to protect yourself from these problems? The simplest answer would be to stick to a simple, effective, proven investment strategy (such as value investing). If you wish to take large risks and probably lose money, then at least make sure that any ‘trading’ system you use has actually been used profitably by someone.

Disclosure: Net, I have made money buying and selling options. I do not subscribe to any of the services I mention above. I used to subscribe to Ricard Russell’s newsletter, and I enjoyed reading it, but I stopped because it was too expensive. I own CHK. I have a disclosure policy.

Hedge funds for everyday investors

If you are intrigued by hedge funds and want a mutual fund or two that are less correlated with the market, then you are in luck. I am invested in one such fund and just came across another.

The fund I just came across is Weitz Partners III  Opportunity (WPOPX). This fund is a partially-hedged mutual fund. Wally Weitz has the discretion to short sell stocks and borrow to increase the long positions as well. Currently the fund is 18% short, 103% long, and 15% in cash. While the fund has not done well in the past two months, very few long/short funds have. The fund’s short positions should give it some downside protection, and if they are good shorts, could juice returns even in an up market. The modest proportion of short selling and leverage in this fund means that even if the short-selling is not very good, the fund will still do okay. This fund has a 1.21% expense ratio, very low for a fund that does short selling.

The other fund I would recommend is the Merger Fund (MERFX). I have been invested in this myself for a couple months. The fund practices merger arbitrage–buying the shares of companies that have agreed to be bought out. This strategy is risky if you or I were to do it, because there is a risk of a large loss with each trade and only a small possible gain. However, a fund such as The Merger Fund is diversified enough so that its returns are not very volatile. This fund should not outperform the S&P 500 in the long run, but it is a consistent performer with low-volatility. It is high-turnover, which means that it belongs in an IRA. Consider it as a replacement for a small portion of your bond portfolio. The fund’s expense ratio is 1.37%.

Disclosure: I am invested in MERFX.

The Value of Sloth

Are you worried that you aren’t doing enough to increase your investment performance? Perhaps all you need to do is go on a 2.5 year vacation. According to Mark Hulbert, the best performing investment newsletter over the last 5 years has not been published in the last 2.5 years. So by doing absolutely nothing it has garnered great profits. Surprisingly, this is not an isolated instance–mutual funds and individual investors who trade less often make more money. Partly because they reduce their costs and commissions, but also because the urge to always do something often leads to stupid mistakes.

Another good example of the benefits of sloth comes from investing in the S&P 500. As shown by a recent research article, you would have done better holding the original 500 companies in the S&P 500 and doing NOTHING rather than investing in the actual S&P 500 index (which adds or drops about 20 stocks each year). So even a 50 year vacation can be beneficial! And remember that the less frequently you trade, the fewer taxes you pay (because you are compounding pre-tax money–if you sell each year you compound after-tax money).

Disclosure: it has been far too long since I took a vacation!