My Record so Far

Following is my record so far on all stocks I have disparaged or praised in this blog (not just the ones on which I made a good call):

Disparaged:

American Realty Investors [[ARL]]: Down 1.4% since I pilloried this over-indebted real estate company.

Home Solutions of America [[hsoa]]: Down 49.4% since I discussed Andrew Left’s criticism of the company.

Document Security Solutions [[dmc]]: Down 33% since I criticized the company on August 21. While short the company at the time, I closed my short position at a loss to concentrate on other opportunities. Oops.

Remote MDX (OTC BB: RMDX): Up 96% since I criticized the company and its management. I was short at the time and I am short now. Ouch.

Sun-Cal Energy (OTC BB: SCEY): Down 82% since I slammed this stock back in mid-July.

Octillion (OTC BB: OCTL): Down 60% since I wrote about this horrid little penny stock. I was not short at that time but have since been able to sell short some shares.

Fox Petroleum (OTC BB: FXPE): Down 18% since I compared it negatively to Stormcat Energy [[scu]]. Going long Stormcat and shorting Fox would have resulted in a hedged profit of 8% since my article.

Continental Fuels (OTC BB: CFUL): Down 85% since I first pilloried this horrid little company. Down 65% since my second critical article was published October 12. I shorted this stock most of the way down, although I am no longer short. I do believe that the stock has quite a bit farther to fall, eventually to around $.01 per share or less.

H2Diesel (OTC BB: HTWO): Down 43% since I criticized it less than one month ago.

Praised:

International Shipholding [[ish]]: Up 39% since I discussed the sell-off in this stock on August 8.

TSR Inc [[tsri]]: Up 10.3% since I praised this undervalued microcap with lots of cash.

Hastings [[hast]]: Up 23% since I noted its great earnings on August 21. I owned the stock at the time and I sold it off a couple weeks ago at $9.12 per share.

Stormcat Energy [[scu]]: Down 10% since I compared it favorably to Fox Petroleum (OTC BB: FXPE). Going long Stormcat and shorting Fox would have resulted in a hedged profit of 8% since my article.

Neutral:

Movie Star Inc. [[msi]]: Down 14% since I discussed it July 10. In that article I explained that I thought it was fully valued despite being a good company.

Regent Communications [[rgci]]: Down 24% since I discussed the company’s annoying management back on August 16. I sold out my stake at a loss since then, although with John Ahn of Riley Investment Management (an activist hedge fund) getting on the board, maybe the future will be brighter.

My Overall Record

I was perfect on stocks that I liked (if we consider Stormcat to be a pair trade with shorting Fox Petroleum). I was 8 out of 9 on stocks I disliked. Both the stocks on which I was neutral or uncertain went down.

So should you buy the stocks I like and short the ones I dislike? Buying the stocks I like might work, but I like few enough that it would not lead to a diversified portfolio. Avoiding the stocks I dislike would be a very good idea. My record on stocks I dislike reveals an excellent reason why shorting stocks is so risky (and why most people should avoid it): while 8 of 9 stocks I criticized dropped, often by a lot, the 9th stock almost doubled.

Disclosure: I am currently short Octillion (OTC BB: OCTL) and Remote MDX (OTC BB: RMDX). Ending prices used in the return calculations are as of November 2, 2007 when this article was written (one week before it was published). My disclosure policy is batting 1.000.

How the SEC & NYSE aid and abet stock fraud

I’ve been going over Regulation T (Reg T; you can see it in its full glory here), which is the SEC rule that governs margin loans, as well as the NYSE margin rules for margin accounts. And if I were designing regulations to increase stock fraud, I could think of no better way to do it.

Why is this? The margin requirements for short selling stocks are greater than for buying stocks, at least for cheap stocks (below $2.50 in value). Here is how it works for stocks above $5. You will note the nice symmetry between short and long margin requirements. While the margin requirement for buying stocks is 50%, the requirement for short-selling stocks is 150%. Here’s an example: if I buy a stock for $10 per share (let’s say 100 shares), I only need to put up $500, or half the total value of the stock. If I want to sell the same stock short, I need to put up $500 (plus the $1000 in proceeds from the sale of the borrowed stock). So there is symmetry between short and long margin requirements. (Investopedia has an in-depth explanation of this). If the price of a stock is below $5, there is no margin allowed on either long or short sales. So if I want to buy 100 shares of a stock at $3, I must have $300 in cash (or margin from a higher-priced stock). If I want to short sell the same stock I would likewise need the same amount of cash or margin available.

The symmetry between long and short breaks down, however, with stocks under $2.50 per share. The NYSE has a rule (rule 431 (c) 2) that requires $2.50 in cash or margin for every stock below $2.50 per share sold short. A comparable rule does not exist for long positions. So if I want to buy 1000 shares of a penny stock trading at $0.40, I need $400 in cash or margin ability from marginable stocks. But if I want to short 1000 shares of a $0.40 stock I need $2,500 in cash or margin. So any time someone shorts a stock under $2.50, they have negative leverage: the position value ($400) is but a fraction of the money needed to hold the position ($2,500). For this reason, very few short sellers sell short cheap stocks. Fraudulent companies or worthless shell companies trade at absurd valuations because their share prices are too low to attract short sellers.

Most of the financial fraud in public companies nowadays is with penny stocks. The reason is because short sellers cannot afford to sell short cheap stocks. If the NYSE $2.50 rule were eliminated, more short sellers would be willing to take short positions in such overvalued companies as Hepalife (OTC: HPLF), My Vintage Baby (OTC: MVBY), and YTB (OTC: YTBLA). Pump and dump scams would not be as effective because short sellers like myself would easily be able to short sell the pumped-up stocks earlier, at cheaper prices, reducing the harm to the poor rubes who fall for such scams.

Removing the $2.50 rule would increase the amount of information available about penny stocks as short sellers like myself would write critically about the overvalued stocks they sold short. This would give the poor rubes a chance to learn the truth about the worthless stock they were considering buying and this would further reduce the success of pump and dump scams.

Please, contact the NYSE and urge them to stop supporting scammers and fraudsters. Urge them to remove the $2.50 requirement.

Disclosure: I have no interest in any of the stocks mentioned above.

The effects of index funds on the market

I admit it. I am a glutton for knowledge. My daily reading includes many different websites and financial blogs. I also try to investigate new companies multiple times per week, often by running stock screens at Yahoo Finance or Morningstar. I occasionally go to the local university library and just pick up a magazine or journal and start reading.

I read a lot, yet I find very little of what I read to be truly illuminating or even interesting. Every so often I have an ‘aha!’ moment, and today I had one as I read John Mauldin’s Outside the Box newsletter, written this week by Louis-Vincent Gave and Anatole Kaletsky of GaveKal research. The text of the newsletter can be found online at Mauldin’s website. This letter is an excerpt from their new (if un-originally entitled) book, Our Brave New World.

I have yet to buy the book, but I certainly will do so because of my enthusiasm for this letter. I will not summarize the newsletter, so read it before you continue.

It may seem odd, but I disagree with much of the authors’ reasoning. I do agree with their main point, however, that indexing can only work when it is the minority strategy and when active investing is the majority strategy. To explain this, I will give a simplified analogy.

Imagine that we live in the country of Tinagra. There are only two public companies: Darmok Inc. and Jilanco. Both companies combined produce most of the goods and services. They each have revenues of $1 trillion and earnings of $100 billion. Thus, any difference in their market capitalization is due to investors’ prognoses of the companies’ respective growth prospects.

We will assume that the vast majority of investors actively deploy their funds and make their own investment decisions. Most of these investors believe that Darmok has better growth prospects, so they bid the stock up to a point where the company’s market cap is $1.5 trillion (for a P/E of 15), while Jilanco has a market cap of $1 trillion (P/E of 10). Over time the market caps of the two companies will fluctuate as the investors continually evaluate their future prospects. For the moment, let us assume that those fluctuations are small and thus irrelevant.

Suddenly, some investment advisors start to herald the benefits of indexing. They say (rightly) that any fool could have invested his money in an index fund over the last 10 years and received a return equal to that of the market while paying no fees and doing no work! Proponents of indexing form a company called Rearguard and their index mutual fund becomes very popular.

How the index fund works is simple: it buys shares of stocks according to their market capitalization: for every $2.50 invested, $1.50 is invested in Darmok and $1.00 is invested in Jilanco. Due to the simplicity and ease of this index investing, everyone switches too it and there are no more active investors. Now this would be fine if the past perfectly predicted the future. This is not the case. There is a scandal at Darmok: their newest blockbuster drug is found to have caused blindness in millions of people. The prospects for future lawsuits and lost sales means that Darmok will be a worse investment than before.

Oddly enough, nothing happens to their stock price. Since everyone is investing in a Rearguard index fund, everyone continues to buy more of Darmok than of Jilanco. The price of Darmok cannot fall, nor can the price of Jilanco rise. To any rational investor, this seems irrational, and with good reason. Circumstances have changed and the relative pricing of the two companies (1.5:1) is no longer warranted. Even if investors sell out of the market completely, the relative value of Jilanco will be greater than Darmok because their stocks will be sold off by the index funds in proportionate amounts.
Any intelligent investor would at this point sell out of his index fund, short Darmok and buy Jilanco. While the above is a bit of reductio ad absurdum, the point remains valid even if index investing is not total and even with 7,000 stocks.

As Gavekal points out, many mutual funds now behave like closet index funds because the managers are afraid to deviate too far from their benchmark. Gavekal believes that we have reached the point where this indexation has become a large enough factor to lead to serious mis-pricings in the stock market. The math to back them up is probably beyond me and I lack the data with which to do the calculations, but judging from the amount of money invested in the largest mutual and pension funds I would have to agree with them.

I mentioned before that I do not agree with all of what Gavekal say in their article. One point with which I most strongly disagree is their argument that indexing will lead to lower overall returns for the stock market and slower economic growth. I am not aware of their reasoning, for I have not yet read their book, but my first reaction when reading that is to argue that the stock market has very little to do with the conversion of savings into investment anymore. For a full explanation of why that is the case, consult John Burr Williams’ classic book, The Theory of Investment Value.

Williams’ basic argument is that since buying old stock is simply a transfer of ownership and is rarely used to finance new capital goods (except in the case of IPOs, secondary offerings, and rights offerings), it does not affect the interest rate nor the allocation of capital. The money paid for a share of IBM pays the seller of the share, who may then invest it in a share of a new venture; buying IBM does not allocate money to IBM. Thus, the stock market does not directly affect the economy very much.

Minor caveats aside, while indexing may not cause capital mis-allocation, it does cause investment mis-pricing, leading to exploitable changes in the prices of traded securities. Simply put, indexing helps the stock picker by reducing the price differences between companies that have different values. It remains the stock picker’s job to decide which companies are the better investments.

Are there any a priori identifiable mis-pricings? I believe so. In an efficient market, firms would not be priced differently solely because of their market cap. Index funds cannot invest enough in the smallest mini- and micro-cap stocks, because they must invest according to market cap. Therefore, even though small cap outperformance of the market is well-documented, and such well-documented findings tend to be discounted by the market (and thus disappear), small-cap outperformance of the market is likely to continue. The only thing that could prevent this would be for individual investors to increase their overweighting of small-cap stocks (note that in the last newsletter I mentioned that individual investors already overweight small-caps in their portfolios).

The second clear mis-pricing I can identify a priori is that indexing may lead to stickiness in the prices of some large-cap stocks (or any stock that has a large proportion of shares held by index funds). I must first note that this is a bit speculative. The basic premise is that index funds (and most non-index mutual funds) will own the largest stocks (and thus the majority of these companies’ shareholders will not be prone to selling except when the market cap changes significantly). When the company begins to perform better than expected, the price will not increase nearly as much as it should, because the largest holders, index funds, will not need to buy. The stock price will thus rise more slowly than it should and more slowly than if there were no index funs.

This hypothesis leads to the predictions that stocks without index fund owners will be more volatile (but in a good way—in response to news) than companies with index fund owners. Any problems with the above? Unfortunately, yes. The increasing size and clout of hedge funds should reduce the importance of index funds (and similar managed funds). I do not believe that we can count on indexers making it easy for those of us who choose to invest more actively.

The effect of index funds is not negligible. Any trading strategy that is widely used will affect the market. Unfortunately, we must try to predict how different strategies interact to affect the market. The question of whether the market is becoming more efficient (due to the prevalence of hedge funds) or less efficient (due to increased indexing) is too complex for me to answer at this time. The problem may be too complex to solve. I will certainly return to this question in the future. Even coming up with a poor approximation of a solution to this problem could be quite profitable.

I do believe that indexing could become a much larger part of the market without making the market less efficient. A brief discussion of the issue can be found in this academic paper [pdf].

Disclosure: I first penned the above piece some time ago. It does not necessarily represent my present views.

Improving the ETF Asset Allocation Plan for Everyone

I just learned that WisdomTree introduced an emerging markets small cap dividend ETF (DGS, 0.63% expense ratio). This fills a small whole in my previous ETF asset allocation plan (I just added it to that post). I just bought a bit today. The bid/ask spread on this is huge for an ETF, 1%, so place a limit order in between bid and ask. However, if you buy and hold for a number of years, the bid/ask cost will become less and less important as the years pass by.

Disclosure: I bought DGS this morning. 

The best companies you can’t buy

Here is my list of some of my favorite private companies or subsidiaries of public companies in which I would love to invest:

  • Chemtool — how can you not love lubricants? These guys mint money and their customers don’t care because lubricants are such a small but vitally important part of all sorts of machinery.
  • Logoworks — Bought in Spring 2007 by Hewlett Packard [[hp]]. This company is to logo and website design what Infosys [[infy]] is to technology outsourcing.
  • Forever21 — Excellent merchandising and great distribution make this one of the best clothiers to fashion-conscious teenyboppers. The husband/wife team that runs the company has no intention of taking it public.
  • Trader Joe’s — Whole Foods quality at Aldi’s prices. Did I mention Aldi’s? TJ’s is owned by the same German family that owns Aldi’s. The original Trader Joe sold out back in the late 1970s.
  • Ted Drewe’s — The original frozen custard. With only two locations it could easily expand in St. Louis–there is certainly enough demand.
  • PlentyofFish.com — Dating website has only 3 employees (the founder, his girlfriend, and one PR person). It also has at least $10 million in annual profits. Not bad.

Leave a comment if you have any favorite private companies.

Disclosure: I am a customer of Logoworks and Trader Joe’s and Aldi’s.

The Classic Blunder: Going up against a short seller with death on the line

See my article at the Motley Fool on why buying highly-shorted stocks is a bad idea.

By the way, my editor cut what I thought was one of the most important paragraphs, the second to last:

“However, Finance professors have done similar research on much larger samples of stocks and have ended up with the same result. The article An Investigation of the Informational Role of Short Interest in the Nasdsaq Market, by Desai, Thiagarajan, Ramesh, and Balanchandran, explains how as short interest increases, the future returns of stocks
decrease. A more recent paper, by Boehmer, Erturk, Sorescu of Texas A&M University, Why do short interest levels predict stock returns? finds that the reason highly shorted stocks under-perform the market is because short sellers tend to be well-informed.”

If you like the article, please give it a recommendation.

The best retirement account for the self-employed

What is the best retirement plan for a self-employed person with no employees and modest income? With SIMPLE IRAs, KEOGH plans, SEP IRAs, and 401(k)s, the choices abound and they are all confusing. Now there is a clear winner.

Without a doubt, the winner is the 401(k), with Roth 401(k) option available, from T. Rowe Price. This is a great option for a few reasons:

  1. Low costs. There are no setup fees. There are no ongoing fees except for a $10 yearly fee for each fund with under $4,000. I would investing in just one fund until it is over $4,000 and then starting other funds for diversification. This should keep fees under $10 per year for the first couple years (you should need no more than a couple different funds).
  2. There are a couple decent index funds and other funds with low expense ratios. I’d prefer there to be more and cheaper index funds, but there are some. I like the International Equity Index Fund (PIEQX) with an expense ratio of 0.50%, the US Total Equity Index Fund (POMIX) with expenses of 0.40%, and I like a little less the target date funds (such as the 2055 fund, TRRNX, with expenses at 0.74%).
  3. Roth 401(k) option. For most people, Roth IRAs and Roth 401(k)s are better than the normal options. With a Roth option, you invest post-tax money. You get no deduction, but your retirement money (including the money you make in it) is never ever taxed again.
  4. 401(k)s allow for greater contributions as a percentage of income (particularly for low-income people) and greater total contributions for high earners than SEP IRAs or SIMPLE IRAs.

For those making a lot of money, it may make since to choose another 401(k) provider that charges higher fees but offers funds with lower expense ratios. While Fidelity offers a good solo 401(k) plan, it currently does not offer the Roth option. If Fidelity does offer that, it would probably be a better choice.

The one problem with 401(k)s is that they were designed for bigger businesses. The paperwork is a hassle but the increased contribution limits relative to SIMPLE and SEP IRAs is worth the effort. Remember to also contribute the maximum to a Roth IRA as well as to a 401(k).

Disclosure: I use T. Rowe Price for my solo 401(k) for my freelance writing business.

Should you buy individual stocks?

Before you go out and start buying stocks on your own, let me say that not everyone should invest on their own. Only those that Ben Graham called ‘enterprising investors’ should do this. Those that fit in the category of ‘defensive investors’ should only own broad-based index funds or ETFs.

If you are not willing to spend at least five hours per week on your investments, then you are a defensive investor. If the thought of losing large amounts of money scares you greatly, then you are a defensive investor. If you do not know anything about investing and do not want to take the time to learn, then you are a defensive investor. If the thought of making a fortune in the stock market makes you giddy, then your emotions will interfere with your intellect, and you would be better off as a defensive investor.

There is nothing wrong with being a defensive investor. There is more to life than investing. If you fit the profile of a defensive investor, then stick your money in a low-cost stock index fund (such as those run by Vanguard). I particularly like Vanguard’s target-date funds. You will not beat the market, but you will do about as well as the market as a whole, and you will have plenty of time to enjoy life.

Now, for those of you who fancy yourselves as enterprising investors. Picking stocks is not for the faint-hearted. There will be times when your stocks will decrease in value. You will need the courage to either hang on to them (if they are still good companies) or sell them (if they are becoming bad companies). If you do wish to continue, though, you should know that value investing is the most tried and true approach to investing in the stock market.

Ben Graham averaged over 20% returns per year for two decades. Besides his two partners, there were four employees of Graham-Newman Investing. Three of those four later made incredible money investing on their own. Walter Schloss was one; he averaged a 16% annual return over 25 years, doubling the average yearly return of the S&P 500 of 8%. Tom Knapp was another; his investment firm doubled the average yearly return of the S&P over 15 years (16% per year). The third was Warren Buffett. Over the last 28 years, his Berkshire Hathaway has averaged over 20% annual returns.

So, if you choose to be an enterprising investor, know that in investing based only on value and price, you will do well. You may not always beat the stock market averages, but if you work hard and are willing to learn from your mistakes, you just might be the next great value investor.

Before you begin buying stocks, think about how much money you have to invest. If you do not have more than $10,000 to invest, then take that money and put it in a low-cost index fund (again, I like Vanguard). If you have less than $10,000, you will not be able to achieve adequate diversification, and the ups and downs of your portfolio will be harder for you to take.

Once you have your $10,000 in the mutual fund, keep it there. As you get more money, you can take that money and buy individual stocks. That way, if you do some really stupid things and lose a lot of money on your individual stocks, you will still have money sitting in your mutual fund. This will also help you sleep at night.

Now, as to buying individual stocks, the key is diversification. There are three kinds of diversification. First, diversify in time. If you buy all your stocks at one time, events that harm the market in general could cause your investments harm. Since you know value investing works in the long run, buying stocks for the rest of your life will give you this diversification. The next kind of diversification is industry diversification. If you were in tech stocks in 2000 you know what I mean. Also, certain industries can do badly for long periods (like the airline industry).

The last kind of diversification is diversification as to country. It is hard to buy many foreign stocks, so I recommend putting some money in an international index fund or two (Vanguard has those as well).

Disclosure: I invest in Vanguard ETFs. I have no connection to the company. My disclosure policy wears a wombat on its head to keep warm.

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.

Price does not matter

What if I told you that price does not matter? Would you laugh at me? I do believe that, however. Price does not matter–what matters is value. Whether I pay $2 for cereal or $10 matters little–what matters is the value. If the $2 is for 2 cups of Cheerios, while the $10 is for 10 boxes of Cheerios, I would say that the $10 represents a better value. Yet there are plenty of people who will automatically go for the cheaper item, without considering its value.

The same thing happens in investing and in the stock market in particular. People make a big deal out of the price of stocks or stock indexes. Ooh, “the Dow is at a new high, we should buy now”. Or “ooh, the Dow has risen too much–it is bound to fall!” This is stupid. What matters is the value. Sure, stocks have risen a lot recently (before the recent fall), but much of that is rightly due to solid earnings reports. As always, what matters is the cost of a company relative to its future cash flows. To the extent that its future improves, its price should increase; to the extent that its future dims, its price should decrease. Also, the price of the stock itself does not matter–a company could have few shares priced high (such as Berkshire Hathaway) or many shares priced low (such as Nortel), but that does not affect the value.

So buy when you get a good value for your money and sell when your holdings are overpriced. That is the key to winning in any type of investing.

Mark Hulbert has written about how fast price rises do not mean a stock index will likely fall.

Disclosure: I like Cheerios, though I have been known to eat the impostor Joe’s O’s (from Trader Joes). I own shares of BRK-B. See my disclosure policy, which currently sells for $13.89.