Let’s get that Snowball Rolling…

Last time I talked about compound interest and how time and the rate of return were able to supercharge the effects of compounding.   Time in the market is something that can’t really be controlled as there’s only so many years until retirement or some other goal.  So long as you remain invested through the good and the bad and try to squirrel away some money each month you’re doing pretty much the best that you can on that count.  So, that leaves us with trying to maximize the rate of return.

There are two things to remember here:  1.)  It is hard to beat the market consistently and 2.)  One bad bet can wipe out years worth of returns.  We’ll actually start with #2.  Capital preservation is both the first and second name of the game.  Sure you may make 1000% return on those speculative biotechs for awhile, but all it takes is one 0 to wipe you out.  A good rule of thumb:  Can you figure out what the company is going to be doing in 10 years?  No?  Then don’t invest.  Simple as that.

Getting back to maximizing our rate of return.  The historical rate of return on equities is somewhere in the realm of 8% per year.  Bonds somewhat less than that.  So, if you compounding at 8% or less meets your long-term goals, your job is easy.  Just buy the market, use dollar cost averaging, and stick with it through thick and thin.  If you want to compound your returns at a higher rate, you’re looking at some sort of active investment management.

To make money in the market, you have to buy something and then sell it at a later time to someone else who is willing to pay a higher price for it. If you’re lucky, you will be able to sell for substantially more than you paid and you won’t have to wait long between buying and selling.  Life doesn’t typically work out like that.  The time between buying and getting a good offer to sell at can be years and in between the price may oscillate all over.  Knowing this, how do we identify companies that are trading for less than their worth?  Or put another way, how do we identify companies who should trade at higher levels either now or in the future?

The typical answer to this question is that you have to do a lot of research on your own.  The lazy man’s route is to simply contract this job out to someone else.  The problem is that it’s very hard to find money managers or funds that have long term rates of return in excess of the equity market.  And by long-term we’re talking an investing lifetime.  They’re out there, but they’re difficult to find, and you have to find them at the right time.  Finding one at the end of their career certainly isn’t going to help you, and by then they may have too much capital to invest anyway which will hurt their returns going forward.

For example, Warren Buffett and Charlie Munger run Berkshire Hathaway like an investment firm.  They reinvest the earnings and cash flow thrown off by the companies and stocks they own for you by buying other stocks or companies.  So by buying Berkshire, what you are actually doing is betting that their managers (Buffett and Munger or whoever replaces them) are good enough at allocating capital that you will end up with a decent rate of return down the road.  Now historically this was a good bet as they’ve compounded Berkshire book value at around 20% if you look back the entire history of the company.  The thing is, they aren’t likely to have this degree of success going forward.

The problem comes with managing large sums of money.  Eventually there’s nowhere that you can put it that will give you a rate of return that is much greater than the market.  Sure there’s occasional opportunities (such as 2008/09), but that only takes you so far.  I would tend to bet that Berkshire continues to ‘beat the market’ in the future, but its degree of outperformance will be less than in the past.  If you read their annual shareholder letters, you’ll find that they agree.  So if you’re looking for a 15% compounded rate of return by simply buying and holding Berkshire stock for 20 years, I think you’re likely to be disappointed in the future.

So what can we do then?  Well, let’s say that Berkshire will compound book value at 10% year over year into the future.  This is slightly higher than the long-term rate of return of the equity markets, but not overly so.  Thus, I think it’s a fair target as it gives them credit for good asset allocation decisions, but recognizes that they manage such a large sum of money that their opportunities are limited.  So, Berkshire’s going to compound their value at 10% year over year into the future.  How do we make a 15% compounded return off of this?  The answer is by buying Berkshire stock at less than book value.  Right now Berkshire is trading around book.  So I think it’s likely that you can make around 10% per year if you buy and hold it for a long time.  But, if you managed to buy Berkshire at 66% of book value how would you do?  Well, we take our 10% compounding of book value and divide by 0.66.  This works out to 15%.  So, for us as owners, if Berkshire compounds at 10% and we buy at 66% of book value, we actually compound the value of our investment at 15%.  Pretty neat huh?

Now, I think it’s unlikely that Berkshire will ever trade at 66% of book value.  As they recently announced a perpetual share buyback program that allows them to buy back their own shares if they trade below 110% of book value, there would have to be massive selling pressure to drive the price down much below book.  So, this buyback is good for current Berkshire shareholders as it supports the price (and increases intrinsic value), but not so good for anyone looking to acquire shares at cheaper prices.  So, we’re back to square one.  Sort of.  What if we could find another company like Berkshire that had a good long term track record at allocating capital?  Well it turns out there are a number of other companies run like this.  All of them operate on different principles, but they all have good long term results.  One example is Fairfax Financial Holdings (FFH) which is a Canadian holding company.  They’re somewhat similar to Berkshire in that they have a great investment team investing their insurance float, and they’ve recently started acquiring other companies.  The difference is that they’re a lot smaller and have a lot more room to grow in the future.  As FFH’s stated goal is to compound book value at 15% per year (a goal which they have met in the past), to compound your investing dollars at 15% all you have to do is buy them at book value, hold for the long term, and let them continue allocating capital as they see fit.  Other companies in a similar vein are Loews, Leukadia, and Markel.   All have good long term track records at creating shareholder value, and all are available at different prices in the market.  In fact, if you look at Loews, it has a historical record of compounding book value at 10% and is trading at 66% of book value.  So, if you’re looking to compound your money at 15% into the future, investing at Loews at these prices may help you to achieve that.  Then again, it may not.  Only time will tell.

Until next time,
Nathan @ EngineeringIncome.com

Disclaimer:

The data and opinions presented above are for educational purposes only and should not be construed as individualized investment advice or as a recommendation to buy or sell the securities in question.  The investing methodology outlined on this site assumes that a stock will perform in the future as it has in the past.  This is generally not true.  It is the responsibility of individuals to perform their own due diligence and/or consult their investment adviser to determine the suitability of any given investment product for their specific situation.  For more information, please see my disclaimer.

Full Disclosure:  Long BRK.B, L as of the time of this writing.

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It just takes a little snowball to start an avalanche…

So I’ve decided to take a break with the discussion on stocks and investing styles and the like with this post.  Instead I’m going to talk about the 8th Wonder of the World (as Einstein famously noted), compound interest.

Compounding occurs when the returns earned one year are re-invested and allowed to grow in future years.  For example, say you have $1000 in a ‘high interest’ bank account that pays 1.5% interest.  After 1 year, you’ll have $1015 in the account, $1000 of which was your initial investment and $15 of which is your return.  Now, if you decide to leave the $1015 in the account for a second year, you would end up with a total of $1030.23 at the end of year two or a total of 23 cents more than if we had withdrawn the $15 at the beginning of the year and spent it.  So much for the 8th wonder of the world…

The thing about compounding is that it requires two things to make it effective:  time and a decent rate of return.  A good rule of thumb to remember is that the doubling time of an investment is approximately 72 / R where R is the compounded annual rate of return.  This leads us to the following handy little table relating the rate of return on an investment and its doubling time:

Rate of Return

Doubling Time

1.5%

48 years

3%

24 years

5.5%

13 years

8%

9 years

9.5%

7.5 years

12%

6 years

13.5%

5.3 years

15%

4.8 years

 

As can be seen, if we keep all of our money in our ‘high’ interest savings account, it will take 48 years for it to double.  At that rate of return, the so called savings account may not be working actively against you, but it’s certainly not working for you either.

Now, let’s look at the effects of compounding another way, say we have a 30 year investment horizon and hypothetically $10,000 to invest.  At the end of 30 years, how much money are we going to have if we compound our returns at different rates?  Let’s take a look:

 

Rate of Return

Initial Value

Value After Year 10

Value After Year 20

Value After Year 30

1.5%

$10,000

$11,605.41

$13,468.55

$15,630.80

3%

$10,000

$13,439.16

$18,061.11

$24,272.62

5.5%

$10,000

$17,081.44

$29,177.57

$49,839.51

8%

$10,000

$21,589.25

$46,609.57

$100,626.60

9.5%

$10,000

$24,782.28

$61,416.12

$152,203.1

12%

$10,000

$31,058.48

$96,462.93

$299,599.2

13.5%

$10,000

$35,477.96

$125,868.60

$446,555.90

15%

$10,000

$40,455.58

$163,655.40

$662,117.7

 

So, at the end of 30 years, we end up with a total return of 56.3% if we compound at 1.5% per year, or a total return of 6621.8% if we compound at 15% a year.  THIS is why compound interest is the 8th wonder of the world.

So practically, what does this mean?  It means that as investors, we need to try to maximize both the time we are invested, and the rate of return we receive.  Start early and contribute often.  Take a look again at the last table.  $10,000 can be worth a lot in 30 years time.  Or not.  It just depends on what you do with it.  Which will be the topic of my next post.

Until next time,
Nathan @ EngineeringIncome.com

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Being Prepared

So the Scouts had it right after all.  After all the craziness in the markets over the last few weeks, the importance of being prepared becomes all the more evident.  Whether this means having an appropriate asset allocation, cash to put towards investments, or just the guts to hold on and not sell while the chips are down, being prepared for events like those that unfolded over the last few weeks is important.

Was I prepared for this most recent market downturn?  I’d like to think so.  One of the things I do is maintain a watchlist of high quality stocks that I would consider owning should they become available at an attractive price.  Over the last two weeks, the number of stocks below my target ‘buy’ price more than doubled with most of the additions to the buy list being high quality mid- to large-cap companies and not the typical cheap micro-caps that are always available.  So, with some of the available capital I had lying around (due to the lack of enticing opportunities), I added to and initiated a number of new positions in the market.  In addition, I sold some positions and moved them into higher quality stocks.

Even though the markets have somewhat recovered from the worst of it, there are still a lot of stocks that are off significantly from their highs.  Hopefully they’ll stay there for just a bit longer to let me finish loading up.  Buy low, sell high.  The last two weeks have provided plenty of buying opportunities.  Hopefully you took advantage of some of them.

Until next time,

Nathan @ EngineeringIncome.com

Disclaimer:

The data and opinions presented above are for educational purposes only and should not be construed as individualized investment advice or as a recommendation to buy or sell the securities in question.  The investing methodology outlined on this site assumes that a stock will perform in the future as it has in the past.  This is generally not true.  It is the responsibility of individuals to perform their own due diligence and/or consult their investment adviser to determine the suitability of any given investment product for their specific situation.  For more information, please see my disclaimer.

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Berkshire Hathaway

Though I am working on a few posts with some more substantial valuations and thoughts of my own, I haven’t managed to get them done yet so I’ve decided to give a quick recap of what I think is one of the most undervalued and safest large-cap opportunities out there at the moment, Berkshire Hathaway (BRK).

For those of you who don’t know, Berkshire Hathaway is the conglomerate controlled by the legendary investor Warren Buffett.  In the past, Berkshire traded with what was known as a ‘Buffett’ premium. This meant that Berkshire was generally valued by the market at a higher multiple than would be given to a similar business under different management to account for the asset allocation abilities of Buffett.  However, in recent years this Buffett premium has disappeared and currently the gap between Berkshire’s share price and intrinsic value is arguably as large as it has been any time in the last decade.

A nice (though slightly out-of-date) valuation of Berkshire has been written up by T2 Investment Funds and can be viewed here.  As outlined in Tilson’s presentation, even using very conservative estimates for Berkshire’s intrinsic value places the value of Berkshire’s ‘B-class’ shares at over $100 per share as of the end of the 2010 fiscal year.  As they’re trading at around $77 currently, just trading up to this conservative intrinsic value would result in a 33% gain from the current price.  Accounting for Berkshire’s 2011 earnings, it’s not hard to project an intrinsic value of almost 50% higher than the current share price (~$115).  Berkshire is also trading at a price to book ratio of approximately 1.1 which is at the very low end of its historical range (between 1.1 & 1.7).  Given the quality of Berkshire’s businesses, it’s hard to argue that Berkshire doesn’t deserve some premium above book value which can be thought of as providing downside protection for the investment.

A number of things have conspired to drive the share price down including the standard fears that Buffett may pass away (as he’s now into his 80’s), the catastrophic losses incurred by Berkshire’s insurance divisions due to the Japanese earthquake and other disasters, and the David Sokol scandal.  Berkshire’s insurance division will actually report its first combined loss in a decade this year due to losses incurred from the events in early 2011.  However, the flip side is that these losses will also cause insurance and reinsurance rates to rise in the future which bodes well for future returns.

In any case, I think it’s hard to argue that Berkshire is over-valued when compared to any of the major North American stock indicies and I personally think that it’s one of the best large-cap values out there.  Combined with the high quality business, initiating a long-term position at these levels should result in acceptable returns into the future.

Until next time,
Nathan @ EngineeringIncome.com

Disclaimer:

The data and opinions presented above are for educational purposes only and should not be construed as individualized investment advice or as a recommendation to buy or sell the securities in question.  The investing methodology outlined on this site assumes that a stock will perform in the future as it has in the past.  This is generally not true.  It is the responsibility of individuals to perform their own due diligence and/or consult their investment adviser to determine the suitability of any given investment product for their specific situation.  For more information, please see my disclaimer.

Full Disclosure:  Long BRK.B as of the time of this writing.

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Solitron Devices

As one of the highest quality net-net investments in the US market, I was going to write an analysis of Solitron as part of my due diligence prior to initiating a position.  As it would have it, someone else beat me to it!  Oddball Stocks recently posted a good series on Solitron that I think covers the investment prospect well.

Introducing Solitron Devices
Solitron:  The Assets and Liabilities
Solitron:  Wrapping things up

Anyone who’s interested in net-net investing should definitely take a look as Solitron represents a potentially interesting opportunity.

Until next time,
Nathan @ EngineeringIncome.com

Disclaimer:

The data and opinions presented above are for educational purposes only and should not be construed as individualized investment advice or as a recommendation to buy or sell the securities in question.  The investing methodology outlined on this site assumes that a stock will perform in the future as it has in the past.  This is generally not true.  It is the responsibility of individuals to perform their own due diligence and/or consult their investment adviser to determine the suitability of any given investment product for their specific situation.  For more information, please see my disclaimer.

Full Disclosure:  No positions as of the time of this writing.

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CSS Industries Analysis

Even though it’s been awhile since my last post, I haven’t forgotten about the blog or investing in general.  For those of you so inclined, my most recent analysis of CSS Industries has been published on Gurufocus as an entry in their June Value Ideas Contest.  Hope you enjoy and I’ll be back with more value investing ideas shortly!

Until next time,
Nathan @ EngineeringIncome.com

 

Full Disclosure:
Long CSS

Disclaimer:
The data and opinions presented above are for educational purposes only and should not be construed as individualized investment advice or as a recommendation to buy or sell the securities in question. The investing methodology outlined on this site assumes that a stock will perform in the future as it has in the past. This is generally not true. It is the responsibility of individuals to perform their own due diligence and/or consult their investment adviser to determine the suitability of any given investment product for their specific situation. For more information, please see my disclaimer.

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Micro-Cap Investing is for Me!

A few posts ago, I put up an analysis of Crystal Rock Holdings where I mentioned that it is a micro-cap stock.  What this means is that the total market value of all of the outstanding common shares at the current share price is less than $100 million.  Some people like to define micro-caps as having a market cap of less than $25 million, but that’s really just splitting hairs.  The important thing is that companies of this size are small enough that they are essentially out of the reach of professional investors.  This makes investing in micro-caps perfect for amateur investors as mispriced bargains are generally easier to find if professionals aren’t looking for them.

Micro-Caps – Ignored by the Big Guns

Most institutional investors, hedge funds, and mutual funds can’t invest in micro-caps as they are illiquid stocks.  Depending on the company and the amount of money to be invested, it can take weeks to establish or get out of positions without drastically affecting the share price.  For most funds, not being able to trade in and out of positions when required disqualifies these stocks immediately.  Funds are also generally looking to invest in opportunities where they can accumulate a significant position in relation to their total assets under management so that if the underlying stock does well, it is reflected in the fund’s performance.  However, with micro-caps, a large fund may run up against ownership limits while establishing even a relatively modest position.

Examples of a Micro-Cap ‘Mispriced Bargain’

Recently while browsing through a list of Canadian micro-caps I found a stock that for a good portion of last year traded at a price that was below its net current asset value (current assets minus total liabilities).  This basically means that at the price the stock was trading at, for every $0.90 you put in, you ‘bought’ $1.00 in cash, receivables, and inventory with the rest of the assets and earning power of the business thrown in for free.  This was also an established company that had turned a profit in 9 of the last 10 years.  The company’s board of directors, being at least somewhat insightful, authorized an unlimited share repurchase plan that would remain in effect as long as the stock was trading below its net current asset value.  In doing so, the company was able to repurchase a relatively significant number of shares on the open market to enhance the return to continuing shareholders at the expense of those who were silly enough to sell out.

If you’re wondering, as far as I know the only time in the last 100 years that profitable large-cap companies sold for less than their net current asset value was at the end of the Great Depression.  In general, securities analysts know exactly the asset backing that their companies have on their balance sheets and what their underlying businesses are approximately worth.  Because of this, highly covered stocks rarely trade far from their fair value, and will almost always trade far above their net current asset value (NCAV).  However, for stocks with no analyst coverage (like all micro-caps), investors actually have to look up, read through, and understand the company’s financial statements to determine a company’s financial position.  By just referring to the earnings per share and other ‘standard’ data aggregated by the financial sites such as Morningstar, Yahoo, or Google, investors that sold out of the abovementioned stock at a price less than the net current asset value got hosed as it is unlikely that they could have found a cheaper, higher quality company to invest in at the time.  (Note that the stock in question has run up over 50% since this time and while it is still trading at a discount to what I would consider fair value, it is no longer the screaming buy it once was).

Here’s the Catch
Now, the biggest advantage of investing in micro-caps is also its largest drawback.  As analyst coverage of micro-caps is virtually non-existent, the only way to find suitable investment candidates is to research them by going through exchange listings, one by one, and reading through company’s annual reports and financial statements.  Most of the time, companies can be eliminated from further consideration after looking at their most recent annual report.  However, some of the time, you’ll find the hidden gems like the stock mentioned above.  Then you just have to make sure that you invest with a big enough margin of safety, be patient, and wait for the market to recognize the value you’ve uncovered.

Until next time,
Nathan @ EngineeringIncome.com

Full Disclosure:
No Positions

Disclaimer:
The data and opinions presented above are for educational purposes only and should not be construed as individualized investment advice or as a recommendation to buy or sell the securities in question. The investing methodology outlined on this site assumes that a stock will perform in the future as it has in the past. This is generally not true. It is the responsibility of individuals to perform their own due diligence and/or consult their investment adviser to determine the suitability of any given investment product for their specific situation. For more information, please see my disclaimer.

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