Portfolio Management – Page 30

Illusory Investment Income

Posted on 13 May 2014 by David Merkel

Yield is an illusion, whether it comes from stocks, REITs, preferred stocks, bonds, loans,?limited partnerships, etc. ?Yield from investments is not the same as being a farmer with chickens, where each day you can collect eggs, enjoy or sell them, and your net worth is not affected by harvesting the eggs.

I say this because one has to consider the enterprise paying the dividends, interest, or distributions. ?What are the odds that the enterprise might have to scale back or eliminate dividends or distributions? ?What are the odds that the enterprise might default on interest payments?

I have said it, and I will say it again: focus on the health and growth of the enterprises, and not on the dividends (and buybacks). ?The ’70s had many people buying stocks with high yields, dividends often exceeding what earnings could deliver.

Some naively say, “Dividends don’t lie.” ?Well yes, the money you receive is yours, but is the company as healthy after the dividend? ?Will they be able to keep it up? ?Often that is not the case.

In an era of financial repression, where the Fed punishes savers who deserve a better return, many reach to try to get a higher income off of investments. ?In the process they end up taking a lot of risk that their income streams will be cut through dividend decreases, and outright defaults on interest payments.

Income payments rely on the health of the entities making payments. ?This means that an intelligent income investor acts like a value investor, and looks for overall prosperity of the enterprise as security for the payments and growth in payments he would like to receive.

Now dividends and stock buybacks do signal the willingness of management to hand assets back to shareholders and maximize short-term returns to shareholders. ?Even debt finance, with an unwillingness to issue more equity is usually a sign of a management team that is shareholder oriented. ?But both of these findings rely on the idea that the management team has not overextended itself, such that they risk insolvency,?cutting the dividend, or reducing the buyback.

Broader investment variables to indicate growth in the value of the enterprise have more punch than the shareholder income measures. ?Look at earnings, book value, growth in book value, cash flow from operations, and free cash flow?instead. ?And with industrials, sales per share is often the best indicator, particularly in a market like the present one where sales growth is anemic.

Okay, look at the shareholder income-based measures if you must, but analyze:

The payout ratio — are they paying out more to shareholders than they are earning? ?What if earnings decline? ?Will they maintain the payouts?
Times interest earned — how secure are the interest payments relative to earnings?
How likely are they to safely raise the payouts to equity? ?Growth in dividends is often more important the the level of dividends. ?The best performing REITs have had lower payouts that grew more rapidly.

Guard the return of your money, rather than seek a high return on your money. ?When the ?credit cycle turns negative, and it will turn negative, it always does, management teams that have been too aggressive will get punished. ?Try to avoid the punishment.

I write this as an equity manager that has an above average yield on investments, but the yield stems from low price-to-earnings, -sales, -cash flow, -free cash flow and -book. ?15% of my companies don’t pay a dividend, and I don’t care. ?If the management teams have good places to reinvest money to grow value, that is the best place of all to be. ?Buffett loves investing excess cash if he can find highly productive places to do so.

With all that said, analyze companies for growth in value, safety, and prudent use of free cash flow. ?If income is a part of capital discipline, well good, but be aware of the risks in an adverse economic scenario. ?When the tide goes out, we find out who has been swimming naked.

Industry Ranks May 2014

Posted on 11 May 201412 May 2014 by David Merkel

My main industry model is illustrated in the graphic. Green industries are cold. Red industries are hot. If you like to play momentum, look at the red zone, and ask the question, ?Where are trends under-discounted?? Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted. Yes, things are bad, but are they all that bad? Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled ?Dig through.?

You might notice that I have no industries from the red zone. That is because the market is so high. I only want to play in cold industries. They won?t get so badly hit in a decline, and they might have some positive surprises.

If you use any of this, choose what you use off of your own trading style. If you trade frequently, stay in the red zone. Trading infrequently, play in the green zone ? don?t look for momentum, look for mean reversion. I generally play in the green zone because I hold stocks for 3 years on average.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh? Why change if things are working well? I?m not saying to change if things are working well. I?m saying don?t change if things are working badly. Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes. Maximum pain drives changes for most people, which is why average investors don?t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy ? no one thinks of changing then. This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year. It forces me to be bloodless and sell stocks with less potential for those with more potential over the next 1-5 years.

I like some technology stocks here, some industrials, some retail?stocks, particularly those that are strongly capitalized.

I?m looking for undervalued industries. I?m not saying that there is always a bull market out there, and I will find it for you. But there are places that are relatively better, and I have done relatively well in finding them.

At present, I am trying to be defensive. I don?t have a lot of faith in the market as a whole, so I am biased toward the green zone, looking for mean-reversion, rather than momentum persisting. The red zone is pretty cyclical at present. I will be very happy hanging out in dull stocks for a while.

That said, some dull companies are fetching some pricey valuations these days, particularly those with above average dividends. This is an overbought area of the market, and it is just a matter of time before the flight to relative safety reverses.

The Red Zone has a Lot of Financials; be wary of those. I have been paring back my reinsurers, but I have been adding to P&C insurers. What I find fascinating about the red momentum zone now, is that it is loaded with cyclical companies.

In the green zone, I picked almost all of the industries. If the companies are sufficiently well-capitalized, and the valuation is low, it can still be an rewarding place to do due diligence.

Will cyclical companies continue to do well? Will the economy continue to limp along, or might it be better or worse?

But what would the model suggest?

Ah, there I have something for you, and so long as Value Line does not object, I will provide that for you. I looked for companies in the industries listed, but in the top 5 of 9 balance sheet safety categories, and with returns estimated over 12%/year over the next 3-5 years. The latter category does the value/growth tradeoff automatically. I don?t care if returns come from mean reversion or growth.

But anyway, as a bonus here are the names that are candidates for purchase given this screen. Remember, this is a launching pad for due diligence, not hot names to buy.

I’ve tightened my criteria a little because the number of stocks passing last quarter’s screen was much higher, which was likely an artifact of earnings expectations rolling forward another year.

Anyway, enjoy the list of purchase candidates — I know that I will:

Full Disclosure: long SYMC

Book Review: The 52-Week Low Formula

Posted on 10 May 2014 by David Merkel

I usually don’t like reviewing books that say, “Follow this formula, and you will make lotsa money. ?Thus it was with some hesitance that I requested this book. ?I did it partly off of Tweedy, Browne’s study, which is aptly titled, “What Has Worked in Investing.” ?For those reading at Amazon, Google “Tweedy Browne What has Worked” for the link. ?Stocks that hit new 52-week lows on average are ready to rebound. ?So why don’t people buy them?

Are you kidding? ?Look at that chart! ?Do you really want to catch a falling knife?! ?You want to throw good money after bad!? ?Why do you want to buy that dog, anyway…

Shhh. ?The competition is gone. ?There are no friends of failure. ?But made some companies get unfairly tarred as losers, when it is simply a good company that made a few mistakes.

That is the idea behind this book. ?Analyze companies from which?most market players ?have fled. ?Look for those with ?the following characteristics:

They must have a durable competitive advantage.
They must must a strong free cash flow yield.
They must have a return on invested capital that exceeds the cost of that capital.
They must not have too much debt relative to free cash flow.

I Had Troubles Getting to Solla Sollew

But here’s the big problem, and advantage, of the book. ?He does not give you the “secret sauce.” ?He gives you the principles. ?Indeed he can’t give a formula, because many of his criteria don’t admit an easy formula. ?You can’t calculate free cash flow from looking at GAAP accounting — you would need to know what portion of capital expenditure is to maintain existing assets, and that is nowhere disclosed. ?Typically, when you see free cash flow in screening software, all capital expenditure is deducted from cash flow from operations, producing too conservative of a figure.

Thus we can’t replicate points 2 & 4. ?What about 1 & 3? ?Companies do not comes with tags saying “Durable Competitive Advantage” and “No Durable Competitive Advantage.” ?That is a judgment call. ?You could use Morningstar’s Moat Ratings, or Gross Margins as a fraction of assets. ?The author does not give explicit guidance. ?As to point 3, the main problem is that we don’t know what a company’s cost of capital is. ?There are a lot of assumptions lying behind that, and they matter a great deal.

The easiest?of his five criteria to calculate is the price vs the 52-week low. ?Still, he doesn’t give us a threshold.

So What Good is This Book?!

Unless you are an expert, not much good, unless you simply want to play the 52-week low anomaly. ?That said, actionable strategy would be to review the 52-week lows, and analyze companies with low debt and high past profitability that seem to have a franchise that is not easily attacked. ?I think the theory is solid. ?That said, it does no give a lot of the details, not that most readers would understand it if they did.

This book is good, in that it is realistic. ?Though not explicit, it informs you that it is very difficult to choose superior stocks, and it it does not give you a cut-and-dried method.

So If You Can’t Do It Yourself, Then What Is This Book?!

Though the disclosure at the end says otherwise, this book is an advertisement for the author’s method of money management. ?In none of his five criteria does he get sharp. ?The general principles are correct, but you aren’t given the tools to use them. ?That means if you want to use them, you must go through the author.

Verification

They have a website –?52weeklow.com, but it is not laden with data as the book intimates, as of the day that I write this. ?That would be worth seeing.

Quibbles

On pages 74-75 he gives a strained view of margin of safety,?comparing free cash flow yields to the 10-year Treasury yield. ?Margin of safety is more of a balance sheet construct, asking how likely is is that a company will get into financial stress. ?What he is actually measuring here is valuation. ?What he is doing is not wrong, but it is mislabeled. ?Also remember, you can estimate free cash flow, but you never know for sure.

Also, as mentioned before, we have no idea of what his thresholds are and how he actually implements the strategy.

Thus after this article are two attempts to work out the strategy. ?What should not be surprising is that there are no companies on both lists.

Summary

This is a good book, but average investors should not buy it, because they can’t implement it.??If you still want that, you can buy it here:?The 52-Week Low Formula: A Contrarian Strategy that Lowers Risk, Beats the Market, and Overcomes Human Emotion.

Full disclosure: The PR flack asked me if I wanted the book, and I said “yes.”

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

Application Attempt One

These were the companies selected — Morningstar Wide Moat, 5% Free Cash Flow Yield, Less than 20% above the 52-week low.

And here is the second try: Gross margins as a ratio of Assets over 13%, free cash flow yield over 5%, Long-term debt as a ratio of free cash flow greater than five,?less than 20% above the 52-week low.

Not one alike on the two lists. ?Tells you that his book would be very difficult to implement. ?*I* don’t know how I would implement it.

A Letter From a Reader with a New Investing Website

Posted on 9 May 20149 May 2014 by David Merkel

Okay, here goes… this is an experiment. ?I received the following letter:

David,

?You know investing inside and out. Given your expertise (as well as your ability to translate from financial speak to something that readers can really understand), I was hoping to get your opinion of the Market Power Indicator app from Stocks for the Week (http://stocksfortheweek.com/).

?We?re not pitching for coverage ? currently, we?re looking for feedback to make sure we?re creating a financial tool that will be really useful for people.

?We?re both looking for your insight as a financial expert, but also as a writer with an audience that looks for in-depth information in order to make financial decisions.

?In particular, we?re looking for answers to these three questions:

How do you look up stock information now?

How does Market Power Indicator compare to how you typically look up stocks now?

What would help you trust the Safety Score and other information in Market Power Indicator?

What features or changes would convince you to use our app on a regular basis?

If you?re willing to help us out, we?ve tried to keep things simple.

Sign up is really easy: if you go to http://stocksfortheweek.com/ and click the ?Sign Up? button, you can just click to create an account with a social media account like Twitter or Facebook. You should wind up at a page to create a stock watchlist.

From there, click around and see what you think. Just hit reply and let us know what you think through email.

We appreciate any time you can give us.

I did find it easy to create the account, and in general the site seems pretty well organized. ?I took all of my portfolio, and put it into the watchlist. ?28 of 38 companies were accepted. ?Those that weren’t accepted were small cap or foreign. ?Your coverage is spotty.

On the page where I could look at my watchlist, I tried sorting it by recommendation date, and it did not sort well.

I could not figure out what your algorithm was for investment-worthiness. ?My portfolio scored highly on your safety rankings, but 2 were “buy,” 35 were “hold,” and 1 was “sell.” ?If so much of my portfolio was hold, it does not make much sense. ?My portfolio is very strongly a “value” portfolio.

You need to be explicit as to what the holding period is for your recommendations. ?What time period are these over? ?How frequently do you expect people to turn their portfolios over? ?And if you do show performance on your recommendations, whether long or short, you should compare it to the S&P 500 or Russell 1000 over the same period.

If your recommendations have an aggregate performance, that should be revealed. ?Even with individual stocks, my initial test was?Leucadia National — the trades suggested by your model regularly lost. ?I suppose I could go through your universe, but I don’t have time. ?So, what proof do you have that your selection methods work?

To my readers, this site is worth trying out, ?but I do not give it a full endorsement. ?If you manager your own stocks, give it a try, and see what you think.

An Alternative to the Efficient Markets Hypothesis

Posted on 8 May 20148 May 2014 by David Merkel

I read an article today, The Fallibility of the Efficient Market?Theory: A New Paradigm.?? Good article, made me look through a major article cited:?An Institutional Theory of Momentum and Reversal.

The former article explains in basic terms what the authors have illustrated. ?The latter article, provides all of the complex math. ?I get 50%+ of ?it, and I think it is right. ?This explains value, momentum, and mean-reversion, the largest anomalies that trouble the?Efficient Markets Hypothesis.

This article deserves more attention from quants and academics. ?The only thing that troubles me about it is that they assume a normal distribution for security returns.

Have a read, and for those that can understand the math, if you disagree with it, let me know.

Book Review: Clash of the Financial Pundits

Posted on 6 May 2014 by David Merkel

Josh Brown?s last book, Backstage Wall Street, was four books in one.? This book, Clash of the Financial Pundits, is three books in one.? The authors cover three things:

Punditry in history
How to understand modern pundits
Interviewing modern pundits

I will take them in that order:

Punditry in history

The book covers the following eras in punditry:

The Crash that Started the Great Depression
The South Sea Bubble
Joe Granville
Harry Dent, Charles Kadlec, Dow 36,000
Martin Zweig
Jim Cramer was right during the 2008 crash

Roger Babson warned people about how high the stock market was, while Irving Fisher talked about stocks hitting a ?permanently high plateau.?? The South Sea Bubble had many in the 1700s media stoking the flames of speculation.? Joe Granville was hot stuff in the late ?70s and early ?80s, but was dead wrong the rest of the time.

Harry Dent, Charles Kadlec, and the crew that put together Dow 36,000 created their own sensational predictions which proved to be controversial and very wrong.? Martin Zweig was right about the 1987 crash, while Jim Cramer controversially was right during much of the 2008 crash.

How to understand modern pundits

Then comes the basic advice to help us weather the storm of advice that floods the media.? The main topics are:

How to use financial media intelligently?
Need for humility
Hedge fund managers that talk to the public
People who act certain attract belief
Wall Street maxims often contradict each other
Making predictions that are squishy (surprises lists)
There are no experts

Using financial media intelligently means limiting the intake, and limiting its effect on you.? We must be humble in what we understand and accept, and we should listen to those that are humble in what they say.

When hedge fund managers speak publicly, realize that they are speaking their own interests.? They may not be right.? Also, those who speak with certainty on TV tend to attract more belief than those who are more humble and nuanced.

There are many soundbites in financial television, radio and writing.? For every maxim, there is a counter-maxim.

There is an art to making predictions that can?t be falsified, such as surprise lists.? It would help us all if we all realized there are no experts in investing, and that even includes me.

Interviewing modern pundits

Jeff Macke, Josh?s Co-author interviews the following pundits:

Jim Rogers ? former manager of the Quantum Fund, author of many books.
Ben Stein ? speechwriter for Nixon, written a scad of books, etc.
Karen Finerman ? founder, owner & head of Metropolitan Capital, on CNBC?s Fast Money
Henry Blodget ? Internet stock analyst 1998-2002, and now the editor and CEO of?The Business Insider, a business news and analysis site, and a host of Yahoo Daily Ticker, a finance show on Yahoo.
Herb Greenberg ? wrote for the San Francisco Chronicle?s business section, for theStreet.com, and has appeared on CNBC many times.
James Altucher ? Entrepreneur and blogger.? He contributes content in many journalistic outlets.
Barry Ritholtz ? Writes for Bloomberg.com and his own popular blog.? Also writer of the excellent and early crisis book Bailout Nation.? Josh Brown works with him at their firm.
Jim Cramer ? Former hedge fund manager, founder of theStreet.com, host of the show Mad Money which appears on CNBC.
Jeff Macke ? Josh?s co-author, currently working for Yahoo Finance, who relates a tale of when he screwed up badly as a pundit.

These are good interviews, and it gives the readers an internal look as to what it is like to be in front of the media, particularly amid controversy.? Each of the nine interviews sheds light on being a pundit, but in different ways.

Jim Rogers has talked about macro issues, and with a varied track record in the short-run.? Ben Stein has said many controversial things over time.? Karen Finerman has the story of being invited onto CNBC?s Fast Money, and taking a sip from the firehose as the first woman, one with no TV experience, and surviving.

Henry Blodget goes through his errors in the Internet Bubble, and how he has found redemption in writing about finance.? Herb Greenberg, the consummate skeptic, describes what it is like to take unpopular positions versus popular stocks.? James Altucher oozes blood over much of what he writes, telling of his own failures and successes in excruciating detail.

Barry Ritholtz, skeptic par excellence, describes the attitudes of interviewers, and the limited range of thought they have.? He delights in giving them answers that trouble them, like, ?I don?t know.?

Jim Cramer is perhaps the most controversial of all.? I have known him, albeit distantly for 15 years.? He is very bright, but falls into the trouble of making too many predictions.

And so it is for most pundits.? Amount of predictions is inversely proportional to their quality.

The last ?interview? is where Jeff Macke relates a failure of his on CNBC, tells a story of how pundits are human.? They have stresses in their lives.? They make mistakes.? They are people, humans, like you and me.

Summary

This is a good book, and will educate average people regarding financial media.? You will see the financial media from an insider?s view.?If you want that, you can buy it here:?Clash of the Financial Pundits.

Full disclosure: I received an advance copy of the book via NetGalley.

I Have My Doubts

Posted on 3 May 2014 by David Merkel

I try my best at Aleph Blog to phrase things in a way that conveys my level level of certainty. ?But I have my doubts. ?Learning to live or deal with doubts is a hallmark of a good investor.

So as the stock price drops, drops, and drops again, what do I do? ?I reread the fundamental data to see what I might have missed. ?I read contrary opinions. ?Then I ask the question: knowing what you know now, would this qualify to be in the portfolio? ?If not, I sell it. ?In rare cases, if I think it is unfairly trashed, I will make it a double-weight. ?So far, I have not lost on anything I made a double-weight.

All investing involves doubt. ?We don’t know the future; we are making educated guesses at best. ?Am I sure about future earnings? ?No. ?Do I know what industries will outperform? ?No. ?In general I have done well with both, but it is an art, not a science.

I like my methods, partly because they are designed to live in a world of uncertainty. ? Why do I diversify? ?Uncertainty. ?Why do I do rebalancing trades? ?Uncertainty. ?Why do I limit my ability to trade, except at mid-quarter? ?Uncertainty. ?Why do I focus on value and use of free cash flow? Uncertainty.

I could go on and give the same answer: “Uncertainty.” ?My methods attempt to thrive in uncertainty by choosing factors and companies that seem to be able to do well given uncertainty.

I don’t always win, but my wins have exceeded my losses versus the market over the last 13 years. ?Does that mean I will do as well over the next 13 years? ?No. ?I mean, I hope I do as well, ?but there is no guarantee. ?The math on investor performance is such that Bill Gross and Warren Buffett could be random flukes. ?I don’t think they were lucky — I think they were skilled. ?But the statistics won’t prove it.

I also have my doubts about the US economy. ?Is it growing? ?Is the labor market healthy? ?I don’t know. ?Short-term data is volatile. ?Wise investors will wait and see, unless they have a differential insight that most others do not have.

I lean toward the idea that things are weak,but I don’t know that for sure. ?Thus I seek for contrary data.

This is the life of the investor who has ideas, but knows they might be wrong. ? What will happen to my overweight in Energy? ?Am I overexposed in Tech and Insurance?

In the end, doubts are a part of investing. ?You can’t avoid them, despite hard work in analysis, because you can never know what you missed.

That said, when my doubts grow, and the price has not fallen in tandem, I sell. ?My quarterly purge of a few companies lets me express my doubts, but in a reasoned way, not merely responding to a fall in the stock price.

Therefore, be reasoned in your decisions in stock investing, and always be forward-looking, because you can’t change the past.

Avoid Easy Money

Posted on 2 May 20142 May 2014 by David Merkel

There is no reliable way to invest in an environment of easy money. ?I’ve worked in a wide number of environments and studied many approaches that I don’t use, and I can tell you one thing: there is no approach that will give you easy money.

The easy money promoters make money off of subscription revenue. ?They are not investing alongside you, as I do with my clients. ?What I own, they own. ?80%+ of my liquid assets are invested in my strategies, and most of the rest is in cash. ?Our interests are aligned. ?This is like not true of those that suggest easy money strategies.

When you see books suggesting that you can flip houses, avoid them. ?Few make money off that regularly. ?If that were true, someone would form a REIT to do it, and do it far better than you could.

The same applies to books offering a simple trading strategy. ?If that worked, there would be a lot of stupid people losing money. ?Wait, there are a lot of stupid people losing money, at least on a relative basis. ?But that doesn’t mean that particular simple trading strategy works.

Wherever it appears the lure of “easy money” brings out the worst in people economically. ?The love of money is a root of all?kinds of?evil. (1Tim 6:10a) ? ?Organically, value grows bit-by-bit, but often prices move in a more volatile fashion. ?Try to win by buying stocks that grow value. ?Winning from speculation is a crapshoot. ?Avoid it, the odds are against you.

Imagine for a moment that we did not have financial markets. ?Who would do the best? ?Those that compounded their economic activities the best — those who were the most productive. ?The same is true for us today. Focus on companies that are productive, growing organically. ?That is almost always a good road to profits.

Look to the Liabilities to Understand the Assets

Posted on 1 May 2014 by David Merkel

There’s a puzzle of sorts in asset allocation, and it falls under the rubric of uncorrelated returns. ?When a new asset class arrives, and it is small and few invest in it — lo, it is uncorrelated!

But then the word spreads, and more investors begin investing in the alternative asset class. ?This has two effects:

It drives up the price of the alternative assets, temporarily boosting performance, and
It makes the asset class returns more sensitive to the actions of large institutional investors, such that the correlations rise with stocks and other risk assets.

How an asset is funded matters a great deal as to future price performance. ?I often talk about strong hands and weak hands in investing, but I can make it simple:

Strong Hands — Well capitalized, little debt, and what debt there is, is long-dated. ?Such people can buy assets and ride out storms, not worrying about mark-to-market losses.
Weak Hands — Poorly capitalized, much debt, and what debt there is is short-dated. ?A storm will capsize them, making them forced sellers of the assets they acquired with debt.

Buffett understands this. ?His insurance companies have relatively low underwriting leverage, but they benefit from high allocations to stocks. ?He can own stocks because there is a core amount of liabilities that will fund the stocks that he owns.

Think of housing for a moment. ?Asset prices were highest when the ability to use short-term low-cost financing was abundant. ? Eventually, there was no demand for housing when prices would lock in losses for buyers who would rent the property out.

If an asset is owned by entities that have weak financing, there is a real risk of loss if the financing can’t be maintained. ?You become subject to the credit cycle, which governs much of investing. ?Invest when credit spreads are wide; don’t invest when they are narrow.

I know that advice is vague, but that’s a part of the game. ?You have to adjust the riskiness of your portfolio to overall conditions, and resist trends, if you want to make money over the long run.

How people and other entities fund the assets that they own has an effect on the future price performance, because it affects how they might buy or sell.

On a Letter From A Younger Friend

Posted on 29 April 2014 by David Merkel

A younger friend of mine sent me an email asking for investment advice. ?Here is the redacted version of it:

I’m not sure if you are aware of a blog called mrmoneymustache.com. The guy who runs the blog retired in his late twenties just working a software development job. Granted, he was really fortunate to have graduated college and started his career in the dot-com bubble, but he didn’t have a really high-paying job by any means during that time. Anyways, his main strategy was saving 70-80% of his income and investing heavily into Vanguard index funds. He stopped contributing to his 401Ks early on and started putting the rest of his savings into taxable accounts with Vanguard (index funds) in order to retire early and withdraw his 4% from his portfolio every year for living expenses. I think it’s a pretty interesting blog and might be worth checking out if you had the time. I’d be really interested in your general thoughts about him and his blog and if you think he gives wise investing advice.

[Wife] and I both have IRAs ([Wife] has a traditional 401k and I have a Roth). [Wife]?actively?contributes to her 401k every?paycheck and I think it has about $XX in it. I put the max contribution amount into my Roth every year, currently $XXXX, and it is at about $XX. I always hear it’s important to max out your tax deferred and tax free accounts before opening a taxable account. I think we’re at the point where I want to start investing in a taxable account. I like Vanguard and their low expense ratios and I know index funds outperform actively managed funds in the long-term.

?I was thinking about opening a vanguard taxable account and starting off small (5-6k) with my investments into VTSMX and VFWIX with a 50/50 split. Do you think this would be a wise move? I don’t want our money sitting in savings accounts and not even keeping up with inflation. I almost feel like it’s foolish not to invest as much as possible.

Anyways, looking forward to your response and thoughts on MMM and his blog.

Thanks Dave!

First, I want to commend you for making an effort to save and invest early. ?Most people don’t do that, and it is a major reason why they never become financially secure.

Second, I want to thank you for introducing me to Mr. Money Mustache. ?As one that has sported a full beard for the last 20+ years, I can appreciate the name. ?He saved lots of money in his twenties, and invested it in stock index funds at Vanguard. ?I am a Vanguard fan also, though I use them less often now, because my stockpicking has done well.

MMM reminds me of a more severe version of Dave Ramsey, minus the Christianity. ?If you can deny yourself in the early years, work hard, keep expenses down, and build up a nest egg early, wow, do it. ?Most people can’t do that. ?You and your wife have already accumulated more than most have at similar ages. ?Keep it up. ?Having a bias against unnecessary spending is a good thing. ?When my kids ask me why we don’t get new cars, I tell them that they run, and I will drive them until the cost of maintaining them is greater then the cost of buying and maintaining another car over the long run.

It is wise to avoid too much debt, and wise to pay it down early. ?I have been debt-free for the past 11 years, including the mortgage. ?Excluding the mortgage, 22 years. ?It changes you, and frees you, because when you don’t have worries over paying debts, you don’t have the same degree of concern of are you going to run into financial trouble.

In inflation-adjusted terms, you are roughly as well-off as my wife and I were when we were your average age. ?Good job, and keep it up.

Third, you are young, so investing 50/50 in US/Foreign Total equity index funds from Vanguard is fine, especially the Foreign part of it. ?I say that because the US Stock Market is priced to deliver 5.5%/year returns for the next 10 years. ?Foreign markets offer more return now. ?When MMM was investing his savings the market was priced to earn 9-13% or so per year.

This brings up another point. ?I don’t like earning nothing on my money, as it is with most banking and savings accounts, but sometimes that is the best option. ?In September of 2000, the US stock market was priced to earn -2%/year returns for the next 10 years. ?That was a time to throw stocks out the window. ?I didn’t do that, and my value investing made money in 2000 and 2001, though I got whacked hard in 2002.

Not every moment in the market offers the same degree of opportunity to make money. ?To the degree that you can, be ready to invest when markets have fallen, and things look bad. ?If you want to be clever, after a severe fall invest after the S&P 500 is higher than its 200-day moving average.

But investing regularly to some degree immunizes market environments. ?You will invest in good times and bad. ?In the end, the discipline will benefit you. ?You have saved, invested, and did not panic when things went bad. ?You lived to prosper when things went good.

But, you might tilt your US assets to the US value index fund, and if Vanguard has a foreign value index fund, you might do that as well. ?Value outperforms over the long haul, so do that if you can. ?If small stock valuations weren’t so high now, I would tell you to look for small cap value, but I won’t, it doesn’t make sense now.

Fourth, yes, start the taxable brokerage account with your excess money. ?I started mine at age 29, and the economic help it has been to me has been significant. ?I would not have been able to start my business in 2010 if I had not done that. ?Or survive the low earnings years 2008-2012.

Fifth, all that said, I have one more insight to add. ?I’m sure that MMM enjoys his life and works, even though he is “retired.” ?The Bible warns us about not wearing ourselves out to get rich, in Proverbs and Ecclesiastes. ?Hey, it is nice to live off of a passive income, but the Lord made us to work six days, and rest on the seventh. ?Work is an ordinary part of life even if you are managing your assets, and it is to be enjoyed.

What MMM suggests may be harder to bear than many people are capable of bearing. ?We should appropriately enjoy life and not be misers. ?The Larger Catechism in talking about the Eighth Commandment encourages us to enjoy what God has given us. ?As we prosper, we should thank God for it, and enjoy it.

You have a wonderful wife, and that is reward enough. ?But save and invest in good times and bad, and it will work out far better for you than those that don’t do so.