Day: July 19, 2014

On Learning Compound Interest Math

On Learning Compound Interest Math

When I read articles like?this where people get scammed borrowing money, I say to myself, “we need to teach children the compound interest math.”

Even my dear wife does not get it, and she sends the children to me when they don’t get it. ?But beyond learning the math, a healthy skepticism of borrowing needs to be encouraged, especially for depreciating items like autos.

The compound interest math is really one of the more simple items of Algebra 2. ?Everyone should be able to calculate the value of a non-contingent annuity at a given interest rate.

Once people learn that, they might have more skepticism regarding the long-dated pension-like promises that the government makes, because they can look at the future payment stream, and say, “I can’t see how we fund that.”

All for now.

A Letter from a Young Investor

A Letter from a Young Investor

Before I get to the letter, I recommend reading,?You’re Ready for Retirement, but Your Savings Aren’t by Jonathan Clement, if you have access to the Wall Street Journal. ?Main point: if you can work until age 70, do that, and then retire.

Here’s the letter:

Hi David,

A little background about myself. ?I am a 24-year male, and have been working for a little over a year. ?The only knowledge I have on investing is passive index fund investing through the book Bogleheads.? I don’t really look at my holdings other than to re-balance every year.

I am currently investing for retirement by maxing out a RothIRA, maxing out a 401k? (that allows a Brokerage account) and some in a taxable Vanguard index fund.? My holdings consist of the total stock and total bond market index funds (90/10). From my current positions my portfolio return has been 20.6%. I calculated the return by return = (market_change + dividends) / total_money. I don’t know if this is a correct formula. The time frame of my holdings is from Jan2012 – June2014.?

I went to a finance workshop that my church was hosting and there was a panel of finance experts (CPA, lawyer, financial advisor) that were indirectly encouraging active investing over passive investing through personal anecdotes.?

Looking at my current portfolio performance, I have a hard time seeing the value in spending time in learning how to actively invest and about finance in general. Currently, I do not follow up on business and market news nor am I reading any economic/investing blogs or magazines. Again, my only investing knowledge is from the Bogleheads book, and so I feel that active investing would be a daunting task.?

Do you have a comparison of an active investment portfolio’s returns (that uses your 8 portfolio rules) against an index fund (such as the Vanguard total stock market) during a bull and bear market? ?Also, do you have any advice on where to begin learning about active investing in general? How should one invest for different goals, say investing for retirement in 40 years vs. investing for a home purchase in the Bay Area in 5-10 years? I’m having a hard time seeing how I would balance time in regards to learning about investing, advancing my career through outside studying, serving in my local church, spending time to witness to family, friends and co-workers, and communion with God.? It seems like passive investing is a simpler solution with a decent average long-term return of 7%. I know I am young, have a lot to learn about life and sometimes stubborn in my thinking, so any thoughts and/or advice would be greatly appreciated.

These are the questions I will try to answer:

  1. Should you move to active investing, and are there some alternatives that would allow you gain some of the benefits of active investing, without costing you a lot of time?
  2. Do I have a track record that is publicly available?
  3. Where to learn about active investing?
  4. How should I invest if I want to buy a house in the Bay Area in 5-10 years, and how does that differ from investing for retirement?
  5. Is the time put into learning about investing really worth it when I have so many other social and spiritual commitments?

But ?I will answer them in a different order.

Is the time put into learning about investing really worth it when I have so many other social and spiritual commitments?

You can’t be good at active investing without putting time in at least at the level of a hobby, say, one?hour per day, six days a week. ?When I launched into studying investments at age 27, I already had two advantages — A mother who was self-taught in investing (and beat most mutual fund managers handily), and an academic background in economics and finance (which had its pluses and minuses).

But my commitment to learning about investing was one hour per day, six days a week. ?After 5 years, I was an investment actuary, which was pretty rare at that time. ?After 11 years, I was hired into the investment department of a medium-sized life insurer. ?17 years later, I worked for a notable hedge fund. ?23 years later, I started my own firm.

Now, there were some spillover benefits for serving the church. ?I have served on various boards of my denomination, chairing some of them, but my knowledge of finance has been a benefit to many of them, and I have been able to prevent a wide variety of errors. ?Even this week, a Christian group in western Pennsylvania reached out to me regarding a “too good to be true investment,” and I told them it was likely a fraud. ?There are ways that we can serve the church with such knowledge. ?Brothers and sisters that I know come asking for advice, and I do not turn them down.

Now, all that said — no, it is probably not worth your time to learn about active investing. ?I wrote two articles a while ago taking both sides of the argument:

Decide what you want to emphasize in your life and service to God. ?The church benefits from a few “numbers guys” (as some refer to me in my denomination), but it doesn’t need a lot of them, if the group trusts them, and they are wise and upright.

Should you move to active investing, and are there some alternatives that would allow you gain some of the benefits of active investing, without costing you a lot of time?

I don’t think you have to move to?active management — you might move to some sort of tilt on you passive management, though. ?Over the long run, tilting to value stocks and smaller stocks has been a smart idea. ?Cap-weighted indexes have most of their assets invested in behemoths that like Alexander the Great, have “no more worlds left to conquer.” ?Investing a disproportionate amount passively in mid- and small-cap stocks can be a wise idea, as can passive investing with a value bias. ?Two sides of the issue:

But,?maybe wait a while before you add some mid- and small-cap value index funds… valuations are relatively high for small and mid-cap stocks at present. ?I have a hard time finding truly cheap stocks at present.

Where to learn about active investing?

As for books, you could look through my book reviews, and scan for the word “value.” ?You could visit the website Valuewalk.com; I have to admit I am impressed with what Jacob Wolinsky has done — it is the “go to” site for value investing.

You can also read the letters of notable value investors — Buffett, Klarman, Marks, and more…

How should I invest if I want to buy a house in the Bay Area in 5-10 years, and how does that differ from investing for retirement?

Let me tell you a story. ?My congregation is near DC. ?My congregation asked me to manage the building fund, and for years, I beat the market, but DC area real estate still appreciated faster.

At the same time, many congregations in the denomination, had received buildings for low prices, or virtually free, but those were mostly in rural areas. ?So at prayer meeting in January 2009, after losing a large amount of the building fund, I asked God to drop a building in our lap, as I could not see any way that I would ever do it through my investing, good as it was.

Two months later, we bid on a short sale for a house with a church use permit. ?We had the assets free and clear for it, and closed in May 2009.

Here is my point to you: geographically constrained markets like the Bay Area — there is no good way for the liquid stocks and bonds to keep up with real estate price increases.?Buying a house in the Bay Area is a tough matter, and it might make sense to match assets and liabilities.

You might want to try to buy real estate related assets in the Bay Area — not sure how you could do that, but it would be the investment closest to funding what you want to own.

As for investing for retirement 40+ years from now, maintain a posture of 70-80% risk assets, and 30-20% safe assets. ?I have been 70/30 most of my life. ?Optimal is 80/20, but I take more idiosyncratic risk, and 70/30 just feels better to me. ?My investments are more concentrated, and the cash levels out the jolts.

Do I have a track record that is publicly available?

Yes and no. ?I send it to those who inquire after my services, but I will send you a copy after I publish this. ?I’ve done well, but I know that it might be due to chance. ?That said, my clients get the same investments that I have, so my interests are aligned with them, aside from the fee they pay me. ?I have no other compensation from my investment management.

On Several Questions from a Reader

On Several Questions from a Reader

As time has gone along, I realize that my blog is different. ?I do things that most bloggers don’t do, e.g. book reviews, answer e-mails publicly, and a few other things. ?Also, my audience is far more international than most, with a large contingent from India. ?Well, here is another e-mail from a reader in India:

Hi David,

I am a big fan or your articles and read regularly when I get time. I respect you for what you are trying to do with your blog – it is a free education for people like us. I also write a blog but it is mostly a commentary sorts than educating blog like yours.

I am writing to you today because I want to seek out your advice on my portfolio (and my ongoing investment education).?

Screening technique

I normally use Reverse DCF with 15% discount rate, 3% terminal growth rate and future growth assumption of a quarter of historical (5 or 10 years) FCF growth rate. For eg. if historical FCF growth rate of a company is 40%, and reverse DCF suggest market is factoring 10%, that company gets shortlisted.

I also try to invest in companies with 5 years avg ROCE of more than 25% – assumption being management being prudent and high quality will generate good returns on capital available to them.

When I am done screening the stocks, I read their previous 2-3 annual reports to get the feel of the business, how do they money and what are the underlying risks etc. I also read their commentaries on the business prospects and any extraordinary or hidden/ contingent charges they might have. I try to find out what makes the business earn so consistent results.

The screen I use normally allow me to avoid the folly of forecasting. I avoid making an elaborate model and try to forecast future earnings and cash flows. I just try to buy the security at a good discount to what my Reverse DCF model suggests.

Selling strategy

Now, lot of my stocks (8/13) have doubled in 1-3 years duration. I, as a rule, take out my capital when my stock doubles i.e sell half of my holdings. I assume that whatever I have thought about the future prospects of the business could be wrong. Some of my stocks are trading below the level I took out my capital and some of them have turn out to be multi-baggers. What are your thoughts on this selling strategy.

I also have issues with a stock if it has been on my watchlist and has run up a bit. I think this is anchor bias everyone talks about. But I still want to know your thoughts. Do you buy in a single trade or do you build your position slowly.

One more thing, I know you write a lot about portfolio structure, what do you suggest to do if the business you have made the highest allocation to is generating lower returns and vice-versa.

I know I am bothering you a lot, but knowing your thoughts will help me a lot.

I also tried my hands on liquidation analysis that Peter Cundill speaks about in his book – There’s always something to do.

I bought a stock, which was trading way below its liquidation value ( if you buy the entire market cap, sell all the assets at half the prices, and pay off all the liabilities, you still will be left with some cash). I have read their ARs and have found nothing wrong with management, of course their business is not generating lot of profits. I have put a google alert on company’s name if there is some news report or some analysis on the company that may alert me if they’re fraud. So my question is how do you (or a retail investor like me) make sure that management is not fraud or accounts are not cooked.

I know these are lot of questions – that too from a stranger sitting in India but I’ll be happy if you give me some sense of direction – whether I am doing things right or what should I change.

Keep writing and educating,
Thanks,

I don’t use DCF or reverse DCF because of the many assumptions employed in DCF. ?I am happier using simpler techniques like P/E, P/B, P/S, and then trying to critique them considering what I know about the company and industry in question.

As for you insistence on a high ROCE — that can work in India, but is less likely to work in the developed world, because few companies can beat the 25% threshold, that have reasonable valuations.

I take out assets from companies as they rise. ?I do it more regularly and slowly than you do — it is a risk control mechanism. ?On the downside, it is a way to make more money, by buying quality companies when they are down.

For more thoughts on selling, look at my portfolio rules seven and eight.

Regarding watchlist assets that have risen in value, I follow portfolio rule eight, and only buy assets that would be a net improvement to the portfolio. ?Timing will almost never be right, but if you have a favorable?valuation for the asset in question, and a sound balance sheet, you will do well.

Regarding portfolio construction,?I only look at the likely future. ?I will hold onto a company that has done badly, but still offers an opportunity of doing well in the future. ?The objective is to be forward-looking.

I buy positions all-at-once, or as close to it as I can, because a few positions are illiquid. ?There is no reason to delay in investing if your thesis is a good one.

Regarding crooked managements — the first question to ask is how are you going to grow revenues. ?If the answer is at all unbelievable, run away. ?There are other tests:

1) look at their results over many years, and compare it to their commentary. ?Don’t give any credit for one-time (negative) events because over the long run, managements that have too many one time events are bad managements.

2) use statistics like normalized operating accruals to see if the accounting is conservative or liberal.

3) Analyze growth in book value plus dividends versus earnings. ?Growth in book value plus dividends is a better measure of value than earnings is.

4) look at management incentives — the best managers are idealists. ?They love what they do, and would do it for free. if they could. ?You want a management team that is hungry; you son’t want a management team that feels full.

Thanks for writing me, and I hope you prosper in your investing in India.

Sincerely,

David

Theme: Overlay by Kaira