I just read an article about a reporter who had his finances critiqued by a group of multi-millionaires. The results were surprising.

Tiger 21 is an investment club, where members get together once a month to discuss money. They share investment ideas and personal finance tips. Membership at the club costs $30,000 a year, so it’s definitely not cheap. But guess what, rich people love talking about money. Maybe, that’s why they’re rich to begin with?

The reporter submitted his personal finances and agreed to have the members give him advice. He thought they’d tell him to stop spending so much on eating out. Otherwise, he thought he was in good shape.

But they didn’t care about how much he spent on eating out.

Instead they gave him some really good advice.

One, start saving more.

Saving just 10% of your income isn’t enough. He could easily bump it up to 15%.

Two, stay liquid.

The reporter had a vacation condo in Florida. It was a money sink. Everyone thought is was a bad idea and told him to dump it. Sell, even if you take a loss, was their advice. Rich people are always concerned about maintaining their liquidity. Money-sucking “investments” kill one’s liquidity.

Liquidity helps you take advantage of real opportunities to make money.

For example, when the stock market crashed in late-2008. I know rich people were jumping in to buy great stocks at ridiculously low prices. You can only do this if you are liquid.

Additionally, liquidity provides a safety net in bad times.

Speaking of bad times, the best advice they gave was about his lack of insurance.

Most people are incredibly under-insured.  The reporter was no different.

I remember when my dad died. I can’t believe how little insurance my dad carried. It was absurd.

He had a 30 year Term-life policy which he had paid for 26 years. Unfortunately, he had never increased the policy to keep up with his increasing salary, or inflation. The death-benefit amount my mom received was about 6 months of my dad’s gross income at the time. It was a joke.

Luckily, we were able to sell his medical practice which provided a sizable amount to take care of her. But as soon as my dad was out of the picture, it was worth 50% less. If he had sold it himself, we would’ve received double.

Tiger 21 members said if you’re not spending 1-3% of your annual income on insurance, you’re not spending enough.

In addition to life, you need disability insurance as well. If something were to prevent you from making a living, you’d be surprised how tiny the premiums would seem.

I know a family that made over $500,000 a year. The wife was a dentist who made $250,000. At the age of 35 she developed a problem with her hand and was unable to work. For a few thousand a year in disability premiums, she could have collected $70,000 in tax-free money. Now, she can’t work, and they have to pay someone to take care of the kids even though she stays at home.

Like most things in life, insurance is a thing you miss the most when you don’t have it.

Get insurance folks, its cheaper when you don’t need it!

And if you need a referral for a good insurance agent, let me know.

I’m cheap.

I like to buy stuff when its on sale. The same applies to stocks. I recently bought Johnson & Johnson, and Google. Both are trading at historically low P/E and Price/Free Cash Flow ratios.

But, the market for bubble stocks seems to be alive and kicking.

LinkedIn (LNKD) just went public at 1,000 times earnings. Yeah, its trailing P/E is 1,000!

Even some established companies are ridiculously expensive. Salesforce.com (CRM) is currently trading at a trailing P/E of 300 and a forward P/E of 75. I can’t imagine who’s buying the stock at this level.

The CEO and other insiders are dumping stock like its going out of style. In the past year, they’ve sold $234 million worth of stock. And they’re continuing to sell it. Reminds me of CountryWide insiders selling the stock before the real estate bubble burst in 2007.

Here’s a funny video by someone who shares my disbelief about investing in Salesforce.

Foreclosure is not a fun process.

Losing your house for any reason is a stressful, disheartening experience. And banks are notoriously difficult to deal with. Mainly because they’re not really interested in working out a deal with you. Especially if you have equity in your house.

That being said, I’m greatly amused by people who get the better end of the foreclosure process, especially when it comes to Bank of America. (I’m not a big fan of Bank of America – I have my reasons…)

Bank of America filed for foreclosure on a house in Florida, about six months ago. The strange thing was that the homeowners, Mr & Mrs. Nyergers, owned their home free and clear. They had bought their house with cash. They had never had a mortgage on it.

In court the judge found the bank wrongfully tried to foreclose on them. Basically he said BofA was trying to scam them out of their home, and ordered the bank to pay their legal fees.

So how did the couple end up foreclosing on the bank?

After more than 5 months of the judge’s ruling, the bank still hadn’t paid the legal fees, and the homeowner’s attorney did exactly what the bank tried to do to the homeowners. He seized the bank’s assets.

According to CBS, the attorney said, “They’ve ignored our calls, ignored our letters, legally this is the next step to get my clients compensated.”

Sheriff’s deputies, movers, and the Nyergers’ attorney went to the bank and foreclosed on it. The attorney gave instructions to to remove desks, computers, copiers, filing cabinets and any cash in the teller’s drawers.

After about an hour of being locked out of the bank, the bank manager handed the attorney a check for the legal fees.

“As a foreclosure defense attorney this is sweet justice” said Allen.

The unfortunate sad part is that bank errors like this are quite common.

The couple’s foreclosure attorney said he sees happen a lot in court, because banks didn’t investigate the foreclosure and it becomes a lengthy and expensive battle for the homeowner.

At least this story had a happy ending.

I remember being in college back in 1998, when Yahoo! (NYSE: YHOO) was the leading search engine.

Around the same time, two graduate students at Stanford came up with a better way to search the internet. They started Google (NYSE: GOOG).

Now, Google is the number one internet search engine. Every day, Google processes 1 billion search requests. It’s also the leader in online advertising.

And Google’s always looking for new opportunities. Over the past decade, they’ve bought nearly 100 companies Almost every time they enter a new market, they become the dominant player.

Three things contributed to their success…

1. They buy the best company in the sector.

In 2006, they paid $1.65 billion for YouTube. It seemed like a lot of money at the time for a free service. But they’ve been able to monetize it with online advertising. YouTube also started renting movies, just like Netflix and Amazon.

2. They develop or buy the technology cheaply, and give away the service for free.

Google paid $80 million to buy internet telephone technology. They got the technology by buying Grand Central and Gizmo5. That’s 1/100th of what Microsoft recently paid to buy Skype. And they’ve already merged the technology with Gmail, and Android OS. The technology is Google Voice. It’s free for U.S. calls.

3. Google make its services easy to integrate with other software.

Microsoft, Apple and Sony don’t do this. They keep their technology secret, and it hurts them in the long run.

Google takes a different approach. For instance, Google opened up their mobile phone platform, Android OS to programmers, manufacturers and carriers. And they gave it away for free. Within 18 months, Android OS-based phones have become the largest segment of smart phones. With 33% of the market share, they’ve even overtaken the Apple iPhone.

And unlike Apple, they’re giving a third of the application revenue to the telecomm carriers. Understandably, the telecom companies are falling over each over to support Android phones.

Now Google is entering the laptop sector. It’s releasing the Chromebook, a Google OS-based laptop. It plans to rent it out to students and businesses on three year contracts.

Google has seen amazing growth. But the stock is cheaper than it’s ever been.

Google is valued at $172 billion. It has $36 billion in cash, and only $5 billion in debt. In the past twelve months it generated over $31 billion in revenue.

Over the past five years, revenue grew at an average rate of 35%, and net income at 42%. But the stock sells for less than 14 times next year’s earnings. Growth companies like these, with little debt and large cash reserves, usually sell for 20-24 times earnings.

The market is undervaluing Google’s future growth. Even at 18 times earnings, Google’s stock is worth 33% more.

I just bought two shares of Google for my Roth IRA account at $525. The only thing preventing me from buying more is the lack of dividends. But the growth is compeling at this price. If the share price drops below $500, I might pick up a few more.

I remember the good ol’ days of the Internet Bubble in late 1999, early 2000. I bought Qualcomm (QCOM) at around $300 a share and watched it skyrocket to $800 a share in less than a year. Valuations didn’t matter, only the stories behind the stocks. I had lofty ambitions of early retirement and life of luxury. Warren Buffett was widely derided (amongst my friends) as an old fool who didn’t understand the new economy – this time it was surely different.

Sadly, no one told me the party was going to end and I rode that pony all the way back down the hill.

And then my brokerage called me and informed me that not only was my investment account worth zero, I also owed them an additional thousand dollars! Yeah, leverage works both ways.

That’s when I realized that investing isn’t about excitement, it’s about buying dull, income-generating stocks and as Buffett would say, sitting on your hands for extended periods of time.

I realized that I didn’t need to be invested in growth stocks that double every year. I just need to find stocks that generate 8-12% a year in capital appreciation and dividends, and I’ll be able to beat 90% of money managers on the planet.

So why am I bringing this up today? I recently read an article about how an investor was abandoning his position in Johnson and Johnson (JNJ), citing lack of growth as the main reason.

I am not suggesting that JNJ is about to collapse or slowly fade into the background. As I said, JNJ is a strong cash flow generator and the company does generate very strong returns on capital. With such a large amount of reinvestable cash, there will always be at least the hope of better days.

The problem, though, is that JNJ just isn’t a dynamic player. If you want a company that will produce large amounts of cash, and send a fair bit of it back to shareholders in dividends and buybacks, JNJ is a fine choice. But if you really want to harness the growth potential of the healthcare market with a top-notch operator, JNJ simply does not fit the bill.

Based on the 150+ comments, it seems like the investor and numerous readers were tired of the lack of stock performance of JNJ. How anyone would mistake a humongous, global conglomerate for a growth stock is another story, but is it really a dog of a stock?

After holding it for a decade (like some of the readers claimed they did), should you sell it now in favor of a tantalizing growth stock, like maybe SalesForce (CRM) that sells for 260 times earnings?

The problem with growth stocks is that everyone knows they’re a growth stock destined for great things, and investors usually overpay for this privilege, or should I say, excitement.

Studies have shown that over the long run, growth (or glamour) stocks underperform boring, value stocks.

So are people correct in giving up on boring, no-growth JNJ?

Well, JNJ’s story sure isn’t getting any more interesting. In fact, the 100+ year-old stodgy company is so unexciting, I can’t even be bothered to read what it does on its profile page on Yahoo! Finance. I know it makes medicine and related products. It had a slew of recalls and maybe it even makes Splenda. But seriously, who cares?

I don’t need to be swayed by some BS management story. I went to business school, I know how those yarns are spun! Just show me the numbers…

JNJ has a market cap of $166B and it has zero net debt – always a good sign.

Over the past decade (2001 through 2010), income has almost doubled from $33B to $61.6B. Operating cash flow has almost doubled from $8.8B to $16.38B. And most importantly, free cash flow (or as Benjamin Graham would say, the Owners Share of Income) also nearly doubled from $7.1B to $14B.

In terms of valuation metrics, the P/E fell from 32 to 12.7 over the same time period, and the P/CF fell from 20.5 to 10.3. Which meant that it went from being grossly overvalued in 2001 to being favorably-valued in 2010.

At today’s prices, the P/FCF is currently 11.84, which is quite cheap for a blue-chip stock and it has a projected yield of 3.6%, which incidentally, puts in on par with the yield of the 10-year US Treasury.

However, JNJ has been growing its dividend around 9-10% every year since 1972. In fact, it has increased the dividend every single year for 48 years!

If you had invested in JNJ 10 years ago, your entry price (adjusted for splits and dividends) would be about $37. It’s currently trading around $60.50, so while a 64% increase over a decade may not be the dreams that growth stocks are made of, at least your initial quarterly dividend payment of 0.16 cents has more than tripled to 0.54 cents.

And even though you made the wrong decision in buying an overvalued stock a decade ago, you’re still not doing too badly. At your entry price of $37, you’re almost making a 6% yield today.

Buying this boring, no growth stock today gives me an annual yield of 3.6%. If it repeats its performance over the next decade and the dividend triples again, I’ll be making 12% annual yield from the dividends, based on my purchase price. I can live with that sort of sub-par performance!

And if the P/E expands to growth-stock levels, causing the share price to soar and the dividend yield to drop back under 1% like it did 2001, I’ll be happy to sell it to some growth-story-chasing investor.  But until then I’m happy eschewing the glamor stocks in favor of the cheap, boring, no-growth, value stocks.

Disclaimer: I bought some JNJ for my retirement account yesterday around $60.50. I’m happy to keep it for a decade, or until they cut their dividend. I also shorted CRM at the same time.

My investments are well diversified. I’m invested in foreign and domestic real estate, commodities, precious metals, domestic and international equities and foreign sovereign debt. However, I haven’t spent much time analyzing my portfolio allocation. While making money through investments is good, protecting what you have is paramount. As I grow older each year, volatility becomes a greater issue. In a few more years I”m not sure I ‘ll be able to stomach a 40% loss that the market experienced in 2008. (Luckily, I my retirement account was down only 4% that year so I didn’t have to stomach anything!)

There are tons of great books available on the subject of portfolio allocation, but I wanted something easy to understand (and thus, remember). One of the better models I can across was Harry Browne’s Permanent Portfolio.

The basic premise is to cover all possible scenarios in your porfolio:

25% of portfolio to protect against Inflation (eg. Gold)
25% of portfolio to protect against Deflation (Cash)
25% of portfolio to do well in a Bull Market (equities)
25% of portfolio to do well in a Bear Market (bonds)

Taking it a step further you can add in protection against Devaluation (eg. invest in foreign currencies and foreign bonds).  You can also add in real estate or REITs as an inflation hedge, and foreign equities. The the basic premise is simple. You try and benefit from any sort of market. 

This is pretty simple to implement. All you need is to do is buy low-cost ETFs and check your portfolio once a quarter to rebalance to the appropriate percentages.

If you like this philosophy but don’t want to implement it, you might want to take a look at the Permanent Portfolio Fund (PRPFX) which is modeled and named after Harry Browne’s  Permanent Portfolio. Over the past 27 years, it’s been down only 4 years. Maximum annual loss was 12% in 1984. In 2008, it lost less than 9%! It’s expense ratio is also reasonable at 0.82%. It’s 5-year average return is a respectable 10.3% vs say an S&P 500 index fund like (SWPPX) which had a 5-year average return of 0.99%.

 It’s portfolio consists of gold, silver, Swiss franc assets such as Swiss franc denominated deposits and bonds of the federal government of Switzerland, stocks of U.S. and foreign real estate and natural resource companies, aggressive growth stocks and dollar assets such as U.S. Treasury securities and short-term corporate bonds.

Some of the best advice is timeless. Here’re some nuggets of wisdom from the late Harry Browne.

  • Your career provides your wealth
  • Don’t assume you can replace your wealth
  • Recognise the difference between investing and speculating & speculate only with money you can afford to lose
  • No one can predict the future
  • No one can move you in and and of investments consistently with precise and profitable timing
  • No trading system will work as well in the future as it did in the past
  • Don’t use leverage
  • Don’t let anyone make your decisions
  • Don’t ever do anything you don’t understand
  • Don’t depend on any one investment, institution or person for your safety
  • Create a bulletproof portfolio for protection
  • Keep some assets outside the country in which you live
  • Beware of tax-avoidance schemes
  • When in doubt, err on the side of safety

These topics are covered in the timeless classic – Fail-safe Investing, probably the best $10 you’ll spend on personal finance and investing!

Let’s face it, European countries are bankrupt. First it was Greece and Ireland. Now it’s Portugal. Pretty soon it’ll be Spain and Italy.

Politicians will never admit there’s a problem. Portugal’s prime minister just said that they don’t need any financial assistance. Just like Greece’s prime minister said last March, he claims they want to help themselves out of this mess. And like Ireland’s minister of foreign affairs said last November, there’s no need to panic. Of course a couple of weeks later both prime ministers came begging for aid. Portugal will probably do the same.

Everyone wants someone else to bail them out, and pay for their transgressions.  And other nations are rushing in to buy the sovereign debt – using freshly minted money of course. Maybe these saviors know that their own balance sheets are somewhat murky and hopefully someone else will return the favor in the future?

After all, printing more money to buy another country’s debt is a splendid idea. Keeps the world economy chugging along without having to deal with any of the difficult issues. Like reducing debt. (I’ve never quite understood the notion of solving a country’s excessive debt problem by rolling it over in to more expensive debt. But financiers make money selling debt, so that’s what economists (who secretly harbor dreams of working on Wall Street) will advise the governments to do). But there is a crisis of sorts and whenever there is a crisis anywhere, people flock to the US and to the relative safety of US treasuries.

Everyone and their mother seem to be making financial and investment predictions for the rest of 2011. So I’ll do the same.

1. For the first half of the year the US dollar and government bonds will appreciate – especially against the Euro.

2. Also during the first half of 2011, Gold and Silver prices will drop from their spectacular highs as the US dollar appreciates. But I think Gold prices will stay above $1000/ounce.

3. But eventually, probably during late-summer, people will realize that all the major countries are printing money and using it to prop up failing countries and companies by buying debt, the US dollar and treasuries will slide. And Gold and Silver prices will start to rise again.

4. This collapse in treasuries will be precipitated by multiple bankruptcies in the municipal bond markets.
In the past 2 years, 15 municipalities have filed bankruptcy. According to a recent article in WSJ:

Mr. Bernanke downplayed the notion that many state and local governments run the risk of defaulting and that the municipal bond market could be headed for turmoil. The muni market, he says, has been functioning “reasonably well,” with lots of bond issuance and liquidity in trading. “We’re not seeing extraordinary stress,” he says. Some analysts have been warning that a crisis is looming in the muni market. Mr. Bernanke described these warnings as overly pessimistic. He also said the Fed, which has some limited authority to buy short-term municipal debt, has “no expectation or intention to get involved in state and local finance.” If states are to be bailed out, he said, “it would have to be Congress.”

Isn’t that exactly what he said right before Fannie Mae and Freddie Mac went bankrupt? Let’s face it. There will be a muni-bond meltdown, and Bernanke will scare congress into bailing them out. Bernanke is just a bare-faced liar. Actually, he got tired of being called a bare-faced liar which is why he sports a beard. But regardless, the only reason he brought it up is because it is an issue that will become pertinent within the next 18 months.

Incidentally, previous Fed Chairman, Alan Greenspan, said exactly the same about the housing bubble back in 2005. That it wasn’t an issue and there was nothing to be worried about. As an economist, he should have seen it was a bubble, of his own creation.

This collapse of muni-bonds will scare the pants of regular Americans and foreign investors. As the last bastion of fixed income for the retired, the wealthy and global pension-funds, muni-bond defaults will trigger a major panic. Citizens and investors will realize that they’ve been hoodwinked by the government and Wall Street, and they can’t trust either of them.

5. This will cause a flight to gold and silver, possibly the last and most intense run in this bull market.
I predicted back in December 2005 that “the US is going to enter a period of inflation and recession brought on by the trade & budget deficit and precipitated by the devaluing dollar” and that at $508, it was a great time to buy gold. I still believe it is. If you haven’t already established a position, make sure you buy both gold and silver on dips. If you don’t know how to buy, read through the previous posts on gold and silver. Hopefully, this major rush in gold will not trigger the complete collapse of global currencies. And if it does, it’s still a few years away, so it’s not an 2011 prediction.

Disclaimer: I’m short a Euro ETF, long gold and silver (bullion and mining stocks). None of this should be construed as investment advice.

I’m always in search of good books to read and a few people recommended Michael Lewis’ new bestseller The Big Short. I put off reading it because I didn’t really want to read yet another book about the subprime mortgage meltdown. However, I finally got the kindle version to read on my new iPad and was pleasantly surprised by how good it was. Actually, I wish I had read it earlier – the book was rather amazing. It was as fast paced and entertaining as his first book, Liar’s Poker.

Lewis describes the financial industry collapse induced by subprime mortgage bond derivative market from the point of view of a couple of hedge fund managers who shorted them. Not very large hedge funds either. Instead of focusing on well known managers like John Paulson, he focuses on relatively unknown and minor investors, with interesting personalities.

There’s Steve Eisman, the most pedigreed of the bunch with actual wall street experience, who’s abrasive personality insists on telling the truth even if it rubs everyone the wrong way. Running a fund that was owned by Morgan Stanley, Eisman desperately wanted to short his parent company but was prohibited by his lawyers. At one point in the book his partner asks “Who takes out a home loan and doesn’t make the the first payment?” to which Steve Eisman responds “Who the #$%^ lends money to people who can’t make the first payment?”  But that’s what happens when you lend $700,000 to a strawberry picker who makes $14,000 a year.

Dr Mark Burry, a one-eyed doctor with Aspergers syndrome,who quits his medical career to start a hedge fund with his own money and makes nearly $750 million for his investors.  And an almost comical garage-band hedge fund called Cornwall Capital that starts out with $110,000 and ends up with a whopping $135 million.

The book explains in great detail exactly how the great investment banks were creating junk bond securities with AAA ratings and selling them to institutional investors.  Companies like Bear Stearns, Lehman and Goldman Sachs blatantly lied about the quality of investment-grade bond products they were selling. The ratings agencies weren’t competent enough to properly rate these securities and they got hoodwinked like everyone else. In the end, everyone wins (except the US taxpayer) and no one goes to jail!

In all it’s a fascinating read on the excesses of wall street, the complexities of the financial derivative markets, and the crooks who run the show.

In my last post, I hinted at using QE2 to your advantage by investing in companies that benefit from a steepening yield curve. But I didn’t have time to get in to specifics. Which is what I’ll do right now, seeing that I have a couple of hours to spare at the Fort Lauderdale airport.

The Federal Reserve let the market know that it plans to keep short term interest rates at extremely low rates for the next few quarters (if not longer). Companies that can borrow short term, can do so at very low rates. So long as you have AA-rated collateral, you can borrow money at about 0.30% on a 30 day basis. If you plan to borrow for a longer term, you just need to keep “rolling” your loan every 30 days or so.

So if you can invest in a AA-rated bond that pays say 3% or 4% and borrow money at 0.30%, you’re going to profit from the spread. Do such bonds exist?

They do – they’re called Agency RMBS and they’re just large pools of single-family residential mortgages that are bundled together in to large multi-million dollar securities and guaranteed against default by a government sponsored agency such as Freddie Mac or Fannie Mae. They also yield about 3.75% or higher.

So you can borrow money at 0.30% and invest it at 3.75% and you’re guaranteed against loss of principle by a government agency! Sounds too good to be true? Well it gets better!

Companies that use this business model to make money are set up as REITs and pay out a hefty dividend to shareholders. Companies like Annaly Capital Management (NLY),  Hatteras Financial Corp (HTS), Cypress Sharpridge Investments (CYS) are mortgage REITs that are set up to do exactly this. And they all pay approximately 15% in dividends.

An RMBS is basically a bond and all bonds have 3 types of risk:

  1. Credit Risk
  2. Prepayment Risk
  3. Interest Risk

Companies which invest in Agency MBS don’t suffer from credit risk. If the borrower of the mortgage defaults, the government-sponsored agency just buys it back and you get your money back. There is no fear of loss of principle!

Prepayment risk is when the borrower pays off the loan early and returns your principle back to you. This usually happens in environments when interest rates are dropping and borrowers can refinance their mortgages at a lower rate. If you get your money back early, you need to reinvest the money, typically at a lower rate. Given that mortgage rates are so low and refinancing is much more difficult than it used to be, the risk of prepayment is limited. There are some always some prepayments though which occur as regular amortization of the loan. Some companies will calculate how much of their portfolio and try to enter forward contracts to purchase more RBMS and thus mitigate the prepayment risk. CYS is one company that does this.

The third and major risk is interest rate risk. As the cost of borrowing increases, the spread between borrowing and invests decreases. Your profit margins drop and are no longer able to make the kind of returns you’re used to. Again some companies hedge against this event, and incur some cost in doing so. But hedging maintains long-term predictability of cash flows and may be worth the drop in potential yield. Again CYS does this and it’s net spread after hedging is 2.55%. It also uses 7.5:1 leverage to maintain a $4.5 billion portfolio against $600 million equity position. When you earn a 2.55% spread and can leverage up 7.5%, that’s a whopping 19% yield! CYS has about a 17% dividend yield.

Disclosure: I bought a 33% position in CYS on Friday and am going to be buying more under $13.50.