Peter Lynch: How To Beat The Stock Market

Peter Lynch was a famous mutual fund manager, managing the multi-billion Fidelity Magellan Fund and handily beat the market over his tenure.

I’m not sure whether it was his humility, his intellectual, or his unwavering optimism that lead to this stock-picking genius’s market-beating returns, but his success made him a household name in the 90s.

In fact, his stock-picking prowess made him a legend in the investing field for nearly 20 decades.

Lynch was widely known for his “invest in what you know” philosophy. While many people assumed this meant you should just buy stocks in the companies whose product you like and use, he warned against this reckless behavior and advised to look deeper and study the financials of the companies first.

Whether you have heard of him or not, here’s a great video from 1994 where he talks about investing and how to develop a winning formula.

Stocks shouldn’t be considered lottery tickets. There’s a company behind every stock, and earnings behind every company. You can become an expert investor, but you need to do your homework, which most “investors” usually skimp on.

When seeking stocks in troubled companies, always look for companies with sound financial balance sheets. Bankruptcy is a real concern, and he famously said companies with no debt can’t go bankcrupt. They can try, but it’s awfully hard!

Here’s a great video that distills quite a bit of his knowledge in a short period of time. It’s a must-see for any investor who’s interesting in picking individual stocks.

Even though this 45 minute video is over 20 years old, the wit and wisdom is timeless.

You can learn more about his timeless strategies for picking winning stocks in this classic book: One Up On Wall Street.

This was one of the first investment books I read and I highly recommend it.

 

How To Be Wealthy: The 2-Minute Guide

There are tons of books devoted to building wealth through various endeavors. If you could build wealth by reading books, then Americans would all be billionaires!

In order to become wealthy, you need to stop being a laborer and become a capitalist.

Laborers exchange time for money. Capitalists have investments that generate money for them.

It doesn’t matter if you’re a doctor, a lawyer, or a minimum-wage grocery-bagger – you’re stilling exchanging time for money. Unless you accumulate income-producing assets that replace your income, you’ll never become a capitalist, or achieve financial freedom.

So here’s the 2-minute guide that contains pretty much the gist of building wealth.

There are three basic things you need to do in order to be a financial success.

1. Spend less than you make 

Surprisingly, less than 60% of Americans implement this crucial step. Regardless of how much, or how little, you make, if you can’t afford to save even 10-15% of your income, you’ll never be wealthy.

Understand your needs vs wants. If you can cut down on your wants, you should be able to free up money to save. That brings us to step 2…

2. Invest your savings in a portfolio that includes equities

Only 75% of Americans who save their money actually invest it (so this is 45% of all Americans).

Investing in equities will ensure your money outpaces inflation in the long run. Of course, you should have a rainy-day fund for emergencies before you start investing.

3. Use low-cost index funds

Only 20% of Americans who save and invest use low-cost index funds – that’s a meager 9% of Americans who do all three!

Most people have neither the time, nor aptitude for picking individual stock. So instead of speculating in individual stocks, which can be very profitable, the average investor is better off investing via index funds.

A large majority of those who do all three of the above steps are very wealthy. You can be too if you follow their lead.

 

Bill Bernstein on Staying The Course

With asset valuations at record highs, it’s easy for investors for decide they’re going to move to cash, or change their asset allocations to something more conservative.

Here’s a good video by one of my favorite investment experts, Bill Bernstein. Unlike other TV “experts”, who are always selling doom and gloom on CNBC, Bill is a sound voice of reason who’s basic investment philosphy is always consistent.

Taking Investment Advice from the Federal Reserve

Unless you’ve just woken up from a week-long coma, you already know that Ben Bernanke, Chairman of the Federal Reserve, announced the Fed is going to maintain its Zero-Interest Rate Policy for the next 2-3 years. It is also going to buy $500 billion worth of mortgages every year until the economy improves.

One opponent of this measure was president and CEO of the Dallas Federal Reserve, Richard Fisher. Fisher maintains that buying bonds probably won’t help stimulate the economy. Instead, it will however increase inflation, and expectations of inflation.

As one of the richest members of the Fed, we should probably listen to him. Worth an estimated $21 million, Fisher has worked as a Banker and a Hedge Fund Manager. And he’s been voicing inflation concerns since 2005.

While opposing the Fed’s stance on bond purchases, his personal portfolio is well positioned to benefit from any inflation that might occur due to it.

Fisher owns about $1 million worth of gold in the form of the gold ETF (GLD), $250,000 in uranium, and over 7,000 acres of land in the Mid-West.

In a prior post, I mentioned that everyone’s portfolio deserves an allocation to gold. As a percentage of his portfolio, Fisher’s allocation to gold is sitting at about 5%. In addition to gold, real estate is also inflation hedges. (While I wouldn’t necessarily recommend uranium as an inflation hedge, it is a commodity and thus being somewhat uncorrelated to either stocks or bonds, would provide some value in a portfolio).

So he’s definitely set up his investments to benefit from inflation.

What else does he own? Several million in Texas Municipal Bonds – earning him tax-free interest on his money. And a lot of blue-chip stocks like Eli Lily and Du Pont along with MLPs like Magellan Midstream Partners. You can check out the entire list here.

Nothing like a well-balanced portfolio to live out your retirement years in case your cushy government pension runs out!

Most Financial Advisors Suck

I’ve been seeing a lot a recent press warning investors about Financial Advisors.

Most FAs aren’t your advisors. They are just salesmen of financial products. The titles on their business cards don’t mean anything. Financial Advisor, Wealth Manager, Private Wealth Manager, Your Personal CFO….they’re just made up titles with no minimum qualification. See this article in the New York Times cautioning you against advisors with fancy titles.

For the most part, they’re brokers (and thereby fully commissioned salespeople), whose main objective is to make as much money for their firm and for themselves. They do this by “selling” you a financial product like a mutual fund or insurance vehicle with an investment component.

Only they don’t call this “selling”. They call it “investing” your money.

But when someone puts my money in a vehicle with high up-front fees and ongoing expense ratios, I call that selling. Plain and simple.

One of my friends recently had an “advisor” put him in a bunch of mutual funds offered by Mass Mutual. These funds all came with a 5.75% front-end load (or fee) and an annual 1.75% expense ratio. All of the front-end load and part of the expense ratio was a commission back to his advisor.

One of the funds was a unit trust and even came with an expiration date. After a couple of years the fund automatically sells everything and you get the cash value of the stocks at that time. At that point your “advisor” is free to put you in another fund with an upfront fee and restart the whole process again. Read this excellent article about the mutual fund industry’s rating scam.

It’s not uncommon for unsuspecting victims, I mean customers, of such “advisors” to pay 6% in upfront fees and 2% a year in mutual funds fees. And then pay an additional 0.5% or 1% as the advisor fee!

But that doesn’t mean advisors don’t add value.  Here’s a great piece by the White Coat Investor on the benefits of using a Financial Advisor.

Before hiring a financial advisor, or planner, make sure you ask a few important questions.

Are they your fiduciaries?
That is, do they have a a legal obligation to put your interests first? Or does their firm come first?

How are they compensated?
Do they get commissions from any of the products they sell? If so, will it be disclosed upfront?

Ideally, you’d want to use a fee-only advisor – they only get compensated by the fees you pay them and don’t except any commission. This removes any conflict of interest.

What’s their investment methodology?
Do they just put you in a bunch of stocks or mutual funds? Or do they use Modern Portfolio Theory to put you in a well-diversified portfolio where they show you (and take the time to explain) the portfolio’s alpha, beta, standard deviation and sharpe ratio (see definititions at investopedia.com). If they use mainly low-cost ETFs instead of mutual funds, they might be able to pay for their services just by the reduction of fees alone. For example, if their portfolio of ETFs has an expense ratio of 0.4% and they charge 1%, that’s like you buying a mutual fund charging 1.4% on your own. But without the upfront load fees and mis-management that comes with it.

If you’re looking for financial planning advice then you want to make sure they have a background in finance, or a CFP to make up for it if not. Many ex-pharmaceutical sales reps (read pretty blonde women) make a career change and become financial advisors. Don’t just go for the cutest saleswoman. Make sure they understand investing and all the aspect personal finance like estate planning, and taxation.

When looking for a financial advisor, try looking for a Registered Investment Advisor Representative. People with this designation usually have a fiduciary duty and are more often than not fee-based instead of commission based. Go to Brokercheck.finra.org and put in the advisor’s name and you’ll find out whether he’s just a Broker or an Investment Advisor Rep. If he’s both, you definitely want clarification on how he is compensated.Investment Advisor Reps are required to provide prospective clients with a firm brochure called the ADV-2, which describes the services they provide, how they are compensated, their investment philosophy. Brokers are not required to provide this document. Make sure you ask for, and get this document from your advisor.

A trusted advisor can be a great resource. A salesperson can be disastrous to your financial future.

Do you have any advisor horror stories to share?

Does Gold Belong in Your Portfolio?

But despite the panic of 2008, the belief that gold is a foolish “investment” still persists.

I’ve been a strong advocate of gold and silver since 2005. Back then, I sold my condo and used some of the proceeds to buy some gold coins. When I started buying, the price of gold was $495/oz. Today it’s hovering around $1,600/oz.

A lot of people I know complained that gold is relic from olden times. That it has no use in the modern era. Of course, this was before 2008 when it seemed like the entire financial system was about to crumble.

Even Warren Buffett, the Oracle of Omaha, took an opportunity to ridicule gold in his latest shareholder letter.

Buffett wrote,

“Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce — gold’s price as I write this — its value would be about $9.6 trillion. Call this cube pile A.”

“Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?”

While I have a lot of respect for Buffett’s views and also own stock in Berkshire Hathaway, I’m going to have to disagree with him on this one.

Gold has always been a store of value. And a valuable hedge against monetary mismanagement – something we (and Europe) are currently experiencing.

David Einhorn, manager of Greenlight Capital, World Poker Champion and author of Fooling Some of the People All of the Time also disagrees. He had an excellent comeback for Buffett’s derision of gold.

In his recent shareholder letter, he referenced Buffett’s analogy, but with an interesting twist.

“The debate around currencies, cash, and cash equivalents continues. Over the last few years, we have come to doubt whether cash will serve as a good store of value. If you wrapped up all the $100 bills in circulation, it would form a cube about 74 feet per side. If you stacked the money seven feet high, you could store it in a warehouse roughly the size of a football field. The value of all that cash would be about a trillion dollars. In a hundred years, that money will have produced nothing. In a thousand years, it is likely that the cash will either be worthless or worth very little. It will not pay you interest or dividends and it won’t grow earnings, though you could burn it for heat. You’d have to pay someone to guard it. You could fondle the money. Alternatively, you could take every U.S. note in circulation, lay them end to end, and cover the entire 116 square miles of Omaha, Nebraska. Of course, if you managed to assemble all that money into your own private stash, the Federal Reserve could simply order more to be printed for the rest of us,”

As gold dropped 21% from its peak of $1,921 last summer, to $1,544/ounce in May, the media was quick to announce that gold was in a bear market, and that the massive bull-run in gold over.

But gold isn’t an investment. It’s a store of value. Just like cash. And over the centuries it is more likely to retain is purchasing power than any currency or business.

And despite short-term fluctuations in its price, gold will always be worth something. If you don’t believe me, just ask the Greeks!

Gold is also uncorrelated with other asset classes like stocks and bonds. Owning some in a diversified portfolio helps reduce your volatility.

In the past week, the S&P500 was down over 3%, while the gold ETF (GLD) was up 4%.

While I prefer owning gold and silver coins, owing an ETF like GLD is an easy way to get exposure to gold.

How much gold you should own depends on your risk tolerance and other investments. But as a general rule of thumb, gold should be between 2.5% and 15% of your portfolio. Although, Harry Brown’s Permanent Portfolio has done exceedingly well with an allocation as high as 25%.

Disclosure: I’m long BRK-B, GDX, and gold and silver coins

Profiting From the Collapse of the Euro

The Euro is on the verge of collapse.

Yesterday, the Euro closed below $1.30 – the lowest level all year. And the yield on the 10-year Italian bonds closed above 7%. The last eurozone countries who’s bonds closed at 7% were Greece, Ireland and Portugal.

The market considers these countries to be credit risks. If you have bad credit, you’d pay 30% or more on your credit card. But a sovereign nation has the ability to tax it’s citizens. So the chance for a total loss is remote – which is why it’ll pay a comparatively lower rate.

But even at a low 7%, Italy can’t pay the interest on it’s bonds. At this rate, as more of the debt rolls over at a higher interest rate,  it will eventually have to default on its debts.

The European Central Bank will make some half-hearted effort to bail out Italy and save the Euro. But in the end, the Federal Reserve will have to step in to save Europe. And it will.

The Federal Reserve will print money to buy up Eurozone bonds. This monetizing of debt will eventually result in massive inflation,

Regular readers know I’ve been talking about inflation for a while.

I’ve been moving my assets in to gold coins, silver, and globally-diversified undervalued large cap stocks like Walmart (WMT), Microsoft (MSFT), Cisco (CSCO), Johnson and Johnson (JNJ) and Berkshire Hathaway (BRK-B).

So what else is going to benefit from looming inflation?

Credit card companies like Visa and Mastercard.

These companies provide transaction-processing services. Unlike the banks that issue these credit cards, they bear no risk if the credit card holders default. They’re more like a toll booth on a bridge that collects a fee each time someone drives through.

But unlike the toll booths, which charge a fixed dollar amount, these companies charge a percentage of the transaction amount.

As the amount of money in circulation increases – and the prices of things goes up – they’ll collect more money for doing the same thing. Unlike other service companies, they don’t have to even explicitly increase their fees. Since it’s a percentage, it will automatically adjust upwards.

And if the Euro actually does collapse, travelers to Europe are more likely to use their credit cards for purchases. This is more convenient than exchanging currency at every border.

I looked at four stocks in this sector: Visa (V), Mastercard (MA), Discover Financial Services (DFS) and American Express (AXP).

Visa and Mastercards have significantly greater global appeal and penetration.

And between these two, I liked Mastercard more.

Over the past five years, it’s revenue and free cash flow has been steadily increasing. It’s currently selling for a P/E of 20 and a Price/FCF of 18.27.

As Warren Buffet demonstrated with his purchase of Lubrizol this year, paying 20 times free cash flow is a fair price to pay for a domainant company.

But unlike Lubrizol, Mastercard isn’t the market leader.  It’s second-place to Visa. But Visa’s cashflows have been somewhat erratic, and it’s stock is a bit too pricey.

So Mastercard is little expensive for my taste. I prefer to buy stocks at a discount. It’s on my watchlist – I’ll pick it up if it trades below 15 times FCF.

Barrons Likes Vodafone

In April of last year, I made the case of going long Vodafone (VOD).

Since then, I’m up nearly 44% on my purchase price (including dividends). Vodafone currently yields nearly 7.5%.

Recently, Barrons had a good article on why investors should still consider investing in Vodafone.

Its ADRs, which trade on Nasdaq and each represent 10 ordinary U.K.-listed shares, could rise more than 20%, to $35-$38, over the next two years. Including dividends, the total return could top 35%, with significantly less volatility than the average stock, given Vodafone’s relatively stable business. (Vodafone ordinary shares closed in London Friday at 180 pence. The ADRs finished near $29.)

There were also several quotes from fund managers:

“Vodafone’s stock is significantly undervalued,” avers Bruno Lippens, a portfolio manager with Pictet Asset Management, “essentially because the market still doesn’t appreciate Verizon Wireless” and the way the dividend will translate into reliable future cash. While there’s no formal annual commitment, Verizon Wireless has little net debt and produces about $1 billion monthly in Ebitda. “Absent massive investment needs, I don’t see an alternative” to paying out a regular annual dividend, adds Lippens, who sees some 40% upside in Vodafone.

The author of the article also thinks that a liquidation of Verizon Wireless could occur within five years, which could be as high as 50% of VODs current market cap.

Using Options To Go Long Berkshire Hathaway

In my last post, I mentioned that Berkshire Hathaway was undervalued and a good buy that the current price of $76 per B-share.

It turns out that it’s probably a better buy than anyone expected.

Buffett just announced that he’s spent $10.7 billion buying IBM stock, as well as a few billion dollars on CVS and VISA.

I currently own BRK-B, and I’d like to increase my exposure to it. But I’m strapped for cash.

So how do I make money from being LONG BRK when I’m short on cash?

Time to look at option strategies.

When most investors are bullish on a stock, they buy CALL options on it. They fork over some money (called a premium) and have an option to buy that stock at a specific price (called a strike price) at a future date. If the stock price exceeds your strike price, then you’ve made money.

One problem with this approach is that the recent volatility in the market has increased the premiums on options.

Another problem with this approach is that usually,  investors lose money on options. Most commonly, the options expire worthless because the stock price didn’t hit your strike price. And sometimes investors paid too much premium, so that despite exceeding the strike price, they still end up losing money overall.

Let’s look at an example.

Consider the BRK-B, Jan 2013 $75 CALL option. It’s currently selling for $10.50, which means on each contract (1 contract is 100 shares), you’d pay $1,050.

So, in January 2013, unless BRK-B is trading for more than $85.50, you’ve lost a thousand dollars!

A better way is to use PUT options.

When you buy a PUT option, you’re paying a premium and you have the right to sell a stock to someone at a specific price at a future date. You make money if the stock price declines below the strike price. You would enter this contract if you were bearish on the stock.

However, if you SELL a PUT option, you receive a premium. In return, you must buy the stock if it declines below a certain price. If the stock goes up in value, then you get to pocket the premium. So you would only enter this contract if you were bullish on the stock.

Being bullish on BRK-B, and short of cash, I’ve taken a short PUT position.

As I outlined in my previous post, I think BRK-B is worth $112 and has a floor below $72.

I sold the Jan 2013 $60 PUT for $4.50. This means I collected $450 per contract.

If BRK-B drops below $60 per share, I will be forced to buy the stock.

However, based on the premium I collected up front, my purchase price will be $55.50 or 50% of what I think is the intrinsic value.

Mostly likely, the option will expire worthless and I’ll get to keep the premium.

This also how you can turn around the high premiums to work in your favor.

If I didn’t already own BRK-B, I would go for a higher strike price. Most likely, I would sell the Jan 2013 $80 PUT for $11. This would allow me to collect $1,100 per contract.

Of course, the risk that I would be assigned the stock would also be much higher. But I would be comfortable owning this stock at an effective price of $69 per share ($80 strike price – $11 premium = $69).

Option trading is not without risk.

It’s easy to over-leverage and wipe out your portfolio. I use this strategy with great caution and with a lot of forethought.

You also need the highest level of option trading and a margin account in order to sell puts.

A trade like this one usually has a 20% margin requirement. Which means, I need at least $1,200 in margin. Based on that margin a $450 premium would represent a 37.5% gain in 14 months. Not too shabby.

If you’d like to learn more about option trading, I strongly recommend The Bible of Options Strategies: The Definitive Guide for Practical Trading Strategies. It’s a excellent primer on various option strategies.

Disclosure: If it wasn’t already obvious, I’m long BRK-B. Both the stock and by selling puts.

Cisco Shines: What To Buy Next?

About four months ago I made the case for going long Cisco. At the time, Google shares (GOOG) had popped 20%, and I was looking for a new company to invest in.

In the middle of July Cisco (CSCO) was trading at $15.66.  From a fundamental perspective, Cisco was cheap – selling at less than 10 times free cash flow, and had just started paying a 1.5% dividend. However, the market was discounting the stock price  because they didn’t believe the CEO, John Chambers, could revitalize the aging tech giant.

But regardless of the management, based on just the numbers, the stock was too cheap too pass up.

And numbers don’t lie.

Yesterday, Cisco announced stellar results. It seems that growth is picking up.

Since that last post, shares of Cisco are up almost 20%, at $18.61.

Cisco isn’t the only company doing well this economic environment.

Large cap blue-chip companies like Intel (INTC), Microsoft (MSFT), Walmart (WMT), Johnson &  Johnson (JNJ) are also doing well.  Even my old favorite Vodafone (VOD) which I bought over a year ago is doing well. The share price, currently at $28.39, is up nearly 23% from my purchase, and it currently yields 6.75%.

So what stock is worth buying today?

Believe it or not, it’s Warren Buffet’s Berkshire Hathaway (BRK-A or BRK-B).

Buffett recently announced that Berkshire would buy back shares below 1.1 times the book value. The world’s best value investor definitely recognizes value in his company stock price and has effectively put a floor underneath the stock.

Currently trading at a Price/Book  of 1.15,  the stock is close to that floor.

Let’s look at the B shares, or the baby Berkshires (BRK-B), which currently trade at $76.

Buffett’s 1.1x of book value puts the stock price floor at $72.69. But how much is the stock actually worth?

This is actually very simple to calculate.

The value of the publicly-traded securities owned by Berkshire is $63.66. The rest of the companies made $4.8 in earnings. These companies are worth about 10 times the earnings or another $48.

Add the $48 to the $63.66 and we get $111.66.

So buying Berkshire today means we have a floor at 5% below today’s price, and an upside of 31%.

Disclosure: I’m Long CSCO, BRK-B, MSFT, INTC, WMT and JNJ