Growth investing Archives - TheWeFIRE

12 Investing Tenets of Warren Buffett

Jenny Xu — Wed, 09 Oct 2024 23:44:49 +0000

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6 Important Investing Tips

Jenny Xu — Wed, 09 Oct 2024 23:41:23 +0000

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Can You Claim Social Security If You Take Early Retirement

Y H — Sun, 01 Sep 2024 12:29:06 +0000

Photo by Thought Catalog on Unsplash

Retirement planning involves a detailed consideration of factors like when to start receiving Social Security benefits. A worker can choose to retire as early as age 62, but doing so may result in a benefits reduction of as much as 30 percent.

While the opportunity to claim benefits early exists, it comes with important implications that individuals should fully understand before making a decision.

A. Eligibility Age for Early Retirement

You can start claiming Social Security benefits as early as age 62.

B. Reduction in Benefits

If you claim Social Security benefits before reaching your full retirement age (FRA), your monthly benefit amount will be reduced. Full retirement age is between 66 and 67, depending on your birth year.
Reduction Example:
- If your full retirement age is 66 and you start benefits at 62, your benefits could be reduced by about 25-30%.
- The reduction is permanent and will affect your monthly benefit amount for the rest of your life.

C. Full Retirement Age (FRA)

For those born between 1943 and 1954, FRA is 66.
For those born in 1960 or later, FRA is 67.
For those born between 1955 and 1959, FRA is between 66 and 67, depending on the year.

D. Earnings Limit

If you start receiving Social Security benefits before your FRA and continue to work, your benefits could be temporarily reduced if you earn over a certain limit.
Earnings Limit for 2024:
- If you’re under FRA for the entire year, $21,240 is the limit. Earnings above this limit will reduce your benefits by $1 for every $2 earned over the limit.
- In the year you reach FRA, a higher limit applies ($56,520 for 2024), and your benefits are reduced by $1 for every $3 earned over the limit until the month you reach FRA.

E. Planning Considerations

Deciding when to claim Social Security depends on various factors including your health, life expectancy, financial needs, and whether you plan to continue working.
Delaying benefits past your FRA can increase your monthly benefit. For each year you delay past FRA, up to age 70, your benefit can increase by about 8% annually

F. Delay Your Social Security benefits

If you decide to retire early, you have the option of delaying your Social Security benefits. However, you’ll need to consider how to fund your lifestyle from other sources until you start claiming Social Security.
This strategy may work particularly well for married couples because they have more flexibility in how they claim benefits. For example, one spouse can start claiming their Social Security benefits early, providing an income stream, while the other spouse delays their benefits to maximize the eventual payout.

Early Retirement Reduces Benefits

A. Age Eligibility:

Social Security provides individuals with the option to claim retirement benefits as early as age 62.
Your Full Retirement Age (FRA) is determined by your birth year and plays a crucial role in deciding the full benefit amount you are entitled to.

B. Reduced Benefits:

Opting to claim benefits before reaching your FRA results in a permanent reduction in your monthly benefit amount.
This reduction can be substantial, potentially reaching up to 30% when benefits are claimed at 62 with an FRA of 67.

The effect of early retirement for both a retired worker and his/her spouse. Image from the Social Security Administration

C. The Cumulative Lifetime Benefits May be Lower:

Commencing benefits early leads to an increase in the number of monthly payments you receive, albeit at a reduced amount per payment.

While the immediate benefit lies in more frequent payments, the cumulative lifetime benefits may be lower, especially for individuals with longer lifespans. This is because individuals with longer life spans will receive benefits for more years. If they claim early and face reduced monthly payments, the lower payments will accumulate over a longer period, potentially resulting in a lower total benefit compared to if they had waited until FRA or beyond for higher payments.

This might seem unfair, but the Social Security system is designed to balance benefits based on the assumption that some people will claim early and others will delay. The idea is to provide options for different financial needs and life situations.

For those who claim early, the system offers immediate income, which can be crucial if someone has pressing financial needs or health issues. Conversely, delaying benefits can result in higher monthly payments, which can be beneficial for those who live longer.

The system aims to offer flexibility while managing overall benefit payouts in a way that accounts for various individual circumstances.

Delayed Retirement Increases Benefits

By retiring early, you could miss the chance to increase your Social Security benefits through delayed retirement credits. Social Security raises your monthly benefit for each month you delay claiming after your full retirement age, up to age 70. For instance, if your full retirement age is 67 and you wait three years to claim, your benefit could reach 124% of the full amount.

The table below from the Social Security Administration shows the annual increase rate based on your birth year.

Annual delayed retirement credit percentage varies from 3% to 8% by year of birth

Calculate How Much You’ll Get from Social Security

If you’re curious about your Social Security benefits, you can use calculators to get an estimate. Tools like SmartAsset Social Security Calculator and the Social Security Administration’s (SSA) official calculator can help. These tools estimate your potential earnings based on factors like your annual income, birth year, and the age at which you start receiving benefits.

Social Security benefits are calculated using your highest 35 years of earnings, which the SSA uses to determine your average monthly indexed earnings (AIME). If you retire early, before working for at least 35 years, you might receive lower Social Security benefits—one of the potential downsides of early retirement.

Effects of Early retirement for Spouses

If an individual claims benefits before reaching their Full Retirement Age, the reduced benefit amount can impact the spousal benefits available to their partner.

Spousal benefits are typically a percentage of the primary earner’s benefit amount and are adjusted based on the claiming strategy of the primary beneficiary. The spousal benefit can be up to half of the worker’s primary insurance amount, depending on the spouse’s age at retirement. If the spouse begins receiving benefits before their full retirement age, the spousal benefit will be reduced. This may result in receiving as little as 32.5% of the worker’s primary insurance amount depending on the retirement age. However, if a spouse is caring for a qualifying child, the spousal benefit is not reduced.

If a spouse is eligible for a retirement benefit based on their own earnings and that benefit is higher than the spousal benefit, they will receive their own retirement benefit. Otherwise, they will receive the spousal benefit.

Let’s look at this chart again:

The effect of early retirement for both a retired worker and his/her spouse.

Survivor Benefits:

Early retirement and claiming benefits prior to Full Retirement Age also have implications for survivor benefits.

If the primary earner passes away and the surviving spouse is eligible for survivor benefits, the amount they receive may be influenced by the early claiming decisions made by the primary earner.
The reduction in benefits resulting from early claiming can impact the survivor’s benefit amount, potentially affecting their financial security in the long term.

What If I Want to Work in Retirement?

Continued employment while receiving Social Security benefits can have implications on the amount of benefits received.

The earnings test dictates how earned income affects benefit amounts, with benefits being temporarily reduced if earnings exceed a certain threshold.

A.Overview:

Early beneficiaries who choose to continue working while receiving Social Security benefits might face reductions if their earnings surpass a specified threshold.
The earnings test is a mechanism to regulate the amount of benefits withheld based on the individual’s level of earned income.

B.Earnings Limit for 2024:

In 2024, the earnings limit stands at $21,240 for individuals claiming benefits before their Full Retirement Age.
If an individual’s earnings exceed this threshold, benefits are withheld at a rate of $1 for every $2 earned beyond the limit.

C.Impact on Benefits:

Exceeding the earnings limit may result in a reduction of Social Security benefits to account for the additional income earned through employment.
Once an individual reaches their Full Retirement Age, the earnings test no longer applies, and they can earn any amount without impacting their benefits.

Decision-Making Factors

Retiring early and claiming Social Security benefits can significantly impact an individual’s financial well-being in retirement. When considering early retirement, several factors come into play that can influence the decision-making process. Here, we explore key considerations individuals should take into account when evaluating whether to claim benefits before their full retirement age.

A. Financial Need:

Immediate Income:

Individuals facing immediate financial obligations or a lack of other retirement income sources may find early benefit claiming necessary to address pressing financial needs.
The availability of Social Security benefits can offer crucial financial support to cover essential expenses during early retirement.

B. Longevity and Health Factors:

Longevity and health factors can significantly influence the decision to claim Social Security benefits early. Here’s why:

Health Concerns: If an individual has health issues or a shorter life expectancy, claiming benefits early can provide a steady income sooner, which might be beneficial given their uncertain lifespan.
Family Longevity: If a person’s family has a history of shorter lifespans, they might consider claiming benefits early to ensure they can make the most of their benefits, rather than risking a delay that could result in reduced opportunities to enjoy them if health concerns arise.

Claiming benefits early can be advantageous for those who prioritize immediate financial support over maximizing long-term payouts.

C. Other Income Sources:

Evaluating additional retirement income sources like savings or other investments is crucial when deciding on early benefit claiming. Determining the sufficiency of these income streams can help individuals gauge the need and timing for claiming Social Security benefits.

D. Balancing Income and Benefits:

Individuals considering early retirement must carefully weigh the impact of the earnings test on their benefits against the benefits of continued employment and additional income.
Understanding how early claiming affects spousal and survivor benefits can help in developing a comprehensive retirement planning strategy.

E. Balancing Immediate Needs with Future Security:

Early claiming offers immediate financial relief but may result in a trade-off between short-term support and long-term financial security.

Claiming benefits early should be based on a holistic evaluation of retirement plans. Consideration of supplementary income sources, future healthcare needs, and other financial obligations is vital in determining the optimal claiming strategy. Creating a comprehensive financial plan that accounts for both immediate needs and future goals can help strike a balance.

Conclusion

Choosing when to claim Social Security benefits during early retirement involves a nuanced understanding of the trade-offs. While early claiming provides immediate income, it comes with permanent benefit reductions that affect lifetime income. Assessing personal circumstances, financial needs, health, and employment intentions can help make an informed decision that aligns with your retirement goals.

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Reviewing The Warren Buffett Way – Is This A Path Average Investor Can Follow?

Jenny Xu — Tue, 16 Jul 2024 08:43:43 +0000

While every other investor and fund manager struggled to consistently beat the market (or even reliably turn a profit, as the case may sometimes be), Warren Buffett towers above it all. At the ripe old age of 25, Buffett opened his first, and only, investment partnership, and in the following 13 years (1956-1969), generated a whooping 24.5% annual compounded return where the Dow only produced 7.2% over this same period (source). This impressive track record continues into the present, with Berkshire earning a 19.8% annual compounded return from 1965 (Buffett’s purchase) to 2022 (source). How does Buffett do it? Robert G. Hagstrom, author of The Warren Buffett Way thinks he’s figured it out. Will The Warren Buffett Way teach us how to achieve even a fraction of Buffett’s remarkable return? Or is it trying to sell readers the false hope of replicating Buffett’s unreplicatable success?

The long and short of it:

The refrain of investors who find themselves unable to recreate Warren Buffet’s astonishing success is familiar to us. It must be because he’s an aberration! A genius born at the ideal time with the ideal upbringing who lucked his way into untold fame and riches! Well, Hagstrom replies, there may indeed be luck involved, but it’s no coincidence that Buffett survived six recessions in his investing career (source) and continues to beat the market with a remarkable consistency to this day. Hagstrom maintains that while luck got Buffett started on his path to wealth, it was his skills and adaptability that allowed him to progress as far as he did. In The Warren Buffett Way, Hagstrom lays out the foundations of Buffett’s investment philosophy, his 12 investment tenets, and the psychological pitfalls that prevent the common investors from effectively investing the Warren Buffett way.

Warren Buffett as a synthesis of thinkers

Before getting into the 12 tenets, we must first acknowledge the thinkers that formed the bedrock of Buffett’s investment philosophy.

By this point, I’m sure everyone and their mom knows that Warren Buffett was a keen student of Benjamin Graham. Throughout the years, Buffett has unfailingly paid homage to the man that formed the foundation of his investing philosophy. To this day, Graham’s notion of a margin of safety and the irrational Mr. Market, as expounded in his classic book The Intelligent Investor, remains at the core of Buffett’s methodology.

In contrast to Mr. Graham, most people are far less familiar with the two other central influences on Buffett’s investing philosophy. Charlie Munger, Buffett’s long time business partner and friend, and Phil Fisher, the author of Common Stocks and Uncommon Profits and the progenitor of focus investing.

Both Graham and Fisher are big proponents of analyzing stocks as a business, but the two emphasize different aspects of the business. Graham is a veteran of the Great Depression and the trauma of losing almost everything in a devastating market crash has led him to eschew unquantifiable value (quality of managers, reputation of the business, intangible assets, etc) in favor of reliable tangible assets like machinery, securities, and property. Meanwhile, Fisher stresses intangible assets. Beyond conducting thorough research of a company’s finances (present and past annual reports), Fisher also puts great emphasis on personally speaking with the company executives, workers, suppliers, competitors, and clients in a way Graham would assume to be a waste of time. Because such exhaustive research is so time-consuming, Fisher recommends investing in approximately 10 companies, irrespective of industry and diversification. Here too, Fisher and Graham differ in an approach, as Graham recommends investing in 10-30 select companies, each an undisputed industry leader.

Complimenting Graham and Fisher, Munger gave Buffett a perspective of short term volatility as price for long term gain. In the first decade of their friendship, Munger’s investing style leaned towards Phil Fisher where Buffett was a firm Grahamite. It’s largely owed to Munger’s influence that Buffett was able to shift away from his Graham-centric thinking and recognize that there is more to investing than hard numbers and cigar butts.

The 12 tenets and how to apply them

In his many years of following Buffett’s investing, Hastrom was able to compile a set of 12 tenets which encapsulates Buffett’s approach. While Buffett does have a lot of flexibility in his investing and has in his long and illustrious career made a wide variety of investments, all his major purchases bear the hallmarks of these 12 tenets.

Business Tenets

1. Is the business simple and understandable?

This calls back to Buffett’s infamous circle of competence. The investor must be able to assess the business before they can pass judgment on its performance. A business that you don’t understand and don’t think is simple is not an investment, but a gamble. The idea of thoroughly understanding a business and cultivating a circle of competence has its roots in Fisher’s philosophy.

1. Does the business have a consistent operating history?

This is the basic requirement of stability, profitability, and a vital part of assessing intrinsic value. Do note though, that this tenet is sometimes negotiable, depending on the circumstance. Buffett invests in people, not entities. What matters more is the quality of the business managers and CEOs, not the corporate entity. If the CEO has a consistent operating history and adheres to the management tenets, then Buffett is occasionally willing to overlook an inconsistent operating history.

1. Does the business have favorable long-term prospects?

Absolutely non-negotiable. If a business has no prospect for growth, it is not a good investment. Assessing this mostly comes down to understanding the market, the potential for market growth, and the business’ capacity to capitalize on these advantages.

Management Tenets

1. Is management rational?

Buffett defines rationality as two main imperatives: generating and maintaining profit. To generate profit, CEOs should have a goal of maximizing profit margins, and cutting costs. To maintain profit, CEOs should seek to effectively reinvest their profits by boosting the aspects of their company that are most profitable. When no opportunities for effective reinvestment are present, the rational CEO will buy back outstanding company shares to raise the value of the company’s stock and give excess profit to shareholders as dividend. Many CEOs commit the folly of blowing excess capital on low-return acquisitions and buttressing inefficient avenues of business, squandering wealth and diluting the company’s profit margin.

1. Is management candid with its shareholders?

Perhaps in part due to his upbringing, Warren Buffett highly values integrity. In a shareholder meeting, the management should be equally as honest when reporting details of their success as their mistakes. This honesty demonstrates an acceptance of responsibility and a commitment to improvement.

1. Does management resist the institutional imperative?

Buffett believes in the importance of what he calls the inner and outer scoreboard. An inner scoreboard is when you are driven by standards that you have set for yourself, Warren Buffett follows an inner scoreboard and he is not easily persuaded by public opinion and the market pricing of stocks. An outer scoreboard is when you are driven by standards others have set for you and it leads to herd-like behavior where you blindly copy your peers without first thinking through the logic behind their behavior. Frequently, money managers and business executives are guided by an outer scoreboard. They would rather fail conventionally than succeed unconventionally. The CEO of a company must have an inner scoreboard and be prepared to do counterintuitive things to do what’s truly beneficial for the company.

Financial Tenets

1. Focus on return on equity, not earnings per share.

Earnings per share value is an inaccurate metric and should not be used to calculate a company’s intrinsic value. Earnings from previous years are frequently retained which can distort the perceived growth of company profits. Return on equity is a superior metric.

(source)

1. Calculate “owner earnings.”

Owner earnings is a method of company evaluation devised by Warren Buffett himself. This method was first publicized in Berkshire’s 1986 annual report. The formula for calculating owner earnings is thus:

Owner Earnings =

- reported earnings + depreciation (loss of asset value over time, say a rusting oven)

- amortization (periodic repayment of a loan over time)

+/- other non-cash charges (reductions of value that doesn’t translate to cash flow, such as depreciation, depletion, and amortization)

– average annual maintenance capex needed (necessary recurring expenses required for a company to maintain operations and sustain growth)

– additional working capital needed (working capital = current assets – current liabilities)

Keep in mind, of course, that the final number this calculation yields is not going to be a precise calculation, especially as average annual maintenance capex, aka capital expenditures, and additional working capital are both estimates pertaining to the future. The owner’s earnings is meant to provide investors with a general idea of value, not a strict number.

1. Look for companies with high profit margins.

This is a reiteration of the importance Buffett places on rational company managers. Managers with high expenses will always find new ways to add to the overhead while managers with low expenses will always find ways to further reduce cost. This is a matter of temperament and habit. Businesses with a wide moat (a unique competitive edge in the form of intangible assets like brand name, customer loyalty, pricing power, and secret recipes) will also contribute to long term success and high profit margins.

1. For every dollar retained, make sure the company has created at least one dollar of market value.

A spin-off from the tenet on high profit margins. Companies that have the capacity to reinvest their earnings to boost business (which, in the long-term, translates directly to higher market price for company shares), should do so. This means upgrading their factories, expanding their labor, or clever business acquisitions. If the company is unable to do so, then the profit earned should be passed onto shared holders in the form of dividends or buying back outstanding shares.

Market Tenets

1. What is the value of the business?

The value of a company should be calculated as one calculates the value of a bond. By treating future dividends and the projected growth as the coupon, the value of the stock can be roughly derived. Additionally, Buffett employs a margin of safety by deducting the long-term US Treasury bond rate from his calculations. Adapting this technique to the current economy, as the return on US Treasury bonds is lower today than in the past, it may be wiser to add an additional 5% to the present bond rate. One can never be too safe.

1. Can the business be purchased at a significant discount to its value?

With the value of the business thus (conservatively) calculated, we can figure out if the shares are selling at a discount. As always, Buffett says it best, “value investing is buying a dollar for 40 cents.” It’s not always possible to find a good deal in the market, so that’s why continual research is vital for investors. If out of 10 good companies, only one is significantly discounted (with the margin of safety intact!), then only purchase that one company. Be patient, and keep your eyes peeled for better opportunities.

Market psychology – what to weary of

Overconfidence

Everyone, but investors most prominently, tend towards assuming themselves to be above average. Usually this is an innocent mental fallacy. It’s not a serious problem that most interviewed drivers think they’re above-average when, mathematically speaking, some of them have to be average and below-average drivers. For active investors however, success is defined by beating the market, which means an above-average performance. This leads to a serious case of overconfidence, where investors put too much stock in their incomplete research and knowledge.

Overreaction Bias and Loss Aversion

This is similar to a concept we went over in The Psychology of Money by Morgan Housel, the seduction of pessimism, and the importance of mental fortitude discussed in Howard Marks’ The Most Important Thing. Bad news hurts more than good news helps. In fact, in numerical terms, it hurts about twice as much to lose $100 than it does to gain $100. For this risk to feel equal to your loss averse emotions, you’ll have to gain $200 to make up for the odds of losing $100. For this reason, people have trouble following through on doing things the way Warren Buffett does. Intellectually, they know that long term gain is far more important than unrealized loss, but emotionally, they can’t handle performing poorly for 30% of their investment career so they sell their strong long term positions to make short term profit and hold onto bad positions in hopes of a rebound.

The Lemming factor

If CEOs are susceptible to the pressure to copy their competitors, investors definitely are. It boils down to the fear of missing out and preferring to look dumb alongside everyone else, rather than be the lone fool. Just as Howard Marks said in The Most Important Thing, contrarianism is difficult and uncomfortable. But to get above average returns, it’s a necessary evil.

What makes The Warren Buffett Way unique?

Short of Buffett finally writing a book himself, Hagstrom’s The Warren Buffett Way is by far the best cumulative analysis of Buffett’s overall performance in the stock market. Buffett’s letters to shareholders, while veritable goldmines of information in their own right, is not nearly as readable or as succinct as The Warren Buffett Way. Hagstrom has completed for us the difficult task of collecting all the relevant information on Buffett’s most prominent investments over the years, combing through them for common thoroughlines, and presenting the important takeaways alongside practical background information, a series of case studies, and various psychological downfalls investors need to watch out for if they want to produce even a fraction of Buffett’s remarkable returns.

When Buffett says, “What we do is not beyond anyone else’s competence. I feel the same way about managing that I do about investing: it is just not necessary to do extraordinary things to get extraordinary results,” many people write it off as modesty and the case of a smart person underestimating the true difficulty of things they think are easy. Hagstrom has decided instead to take Buffett at his word, which means there must be an underlying system and logic to Buffett’s investment decisions. And so resulted The Warren Buffett Way.

Final thoughts:

The Warren Buffett Way serves as an excellent resource for anyone looking to improve their stock picking abilities but we must also be vigilant of the limitations of imitation. Buffett, being a world famous investor and multibillionaire, is naturally privy to audiences common investors are not. It’s simple enough for Buffett to call up Tim Cook, the CEO of Apple, and personally assess his competency as a business manager and ask him direct questions about how the business is run. The average investor has no such access. No matter how helpful the internet may be, it’s still a long way from getting an in person audience with the likes of Jeff Bezos and Elon Musk.

I don’t raise these points to dissuade you from doing as Warren Buffett does, but to point out the ways we must adapt rather than adopt Buffett’s methods. There are some aspects of his investing technique that you will not be able to replicate. Of course, don’t let your lack of access to CEOs of mega corporations and relative anonymity be an excuse to write off the valuable lessons you can learn from Warren Buffett. Buffett was only able to achieve and maintain his legendary reputation through genuine returns, both before becoming famous and after.

So where does this leave us?

Well, The Warren Buffett Way is a good starting point and it’s short enough (234-320 pages, depending on the edition) that it shouldn’t take too long to get through. I most recommend Chapter 3, when Hagstrom gets into Buffett’s 12 tenets and parts of Chapter 4, for case studies, so you can see Buffett actually applying these tenets.

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Reviewing The Most Important Thing – How Do People Beat the Market?

Jenny Xu — Mon, 15 Jul 2024 04:48:55 +0000

As an investor, Howard Marks is an impressive but unglamorous fellow. Currently worth 2.2 billion USD (source), Marks has achieved his sizable pool of wealth through slow and steady accumulation rather than sudden bursts of income. As a writer, Marks is known for his memos, short notes containing valuable insights on the stock market. Warren Buffett himself has been quoted as saying, “When I see memos from Howard Marks in my mail, they’re the first thing I open and read. I always learn something” (source). Does Howard Marks’ book live up to his impressive investing track record? Or should you save your time and go read a couple of memos online instead?

The long and short of it:

Howard Marks noticed that in many of his conversations with people who invest in his fund, he’s constantly saying “The most important thing is…”. Marks decided then to compile these “most important things” into a book, The Most Important Thing, in which he fully lays out these ideas and explains how they correlate. These are the most enlightening of Marks’ “most important things”:

To beat the market, you can’t be average

The market price of a stock is the aggregate evaluation of all stock investors. When most investors value a stock highly, the price soars, and when most investors feel the stock is worthless, the price is depressed. All investors have access to the same public information and investors are generally well-educated adults looking to make money in the stock market. Honestly ask yourself: are you truly better than the average investor? What is it about you that makes you better? Being able to give a good answer to these questions is key to achieving returns that surpass the market average.

To beat the market, you need superior insight

Insight comes with knowledge and doing your due diligence. You have to be able to assess the intrinsic value of a stock and you have to be aware of the current state of the market cycle. Marks thinks of the market as a pendulum: it swings from one extreme to the other and spends very little time in the middle. Investors have a short memory because market cycles occur over decades and up-and-coming 20 and 30 something investors regularly dismiss the patterns of history in favor of modern innovation. “It’ll be different this time!” is the frequent refrain, repeated in every economic boom before the inevitable collapse. To beat the market, you need to know the intrinsic value of your stock, know where you are in the pendulum swing, and follow through on your assessment.

Awareness of overall market fluctuations is only one aspect of being a good investor and finding good buys. No matter how good the company is, you will lose money if its stock is overpriced, and vice versa. Even poorly-run companies can be a good investment, provided the stocks are cheap enough. Of course, good bargains can be found in bull runs just as bad deals exist in bear markets. For less experienced stock pickers, however, what matters is that in a bull market, more companies are more frequently overpriced, while in a bear market, more companies are more frequently underpriced.

To beat the market, you need superior fortitude

You must be open to not buying what everyone says you should buy (FAANG comes to mind) and buying what everyone feels you shouldn’t (Howard Marks was known for purchasing the debt of nearly bankrupt companies). Of course, this doesn’t mean you should automatically forego Silicon Valley’s tech giants in favor of bad companies, it means that you must keep your mind open to the possibilities and be a contrarian.

However, being a contrarian is uncomfortable because humans are built to be social and to make judgements based on what everyone around us is doing. If everyone says an overpriced stock is an excellent buy because the company will revolutionize communication, we feel a strong urge to join in or risk missing out. You purchased a value stock for $30 because you believe it’s worth $50, you should be glad to buy more as the market price drops from $30 to $25 to $17. Instead, you instinctively start to wonder if your initial assessment of the stock’s value is wrong and wonder if you should sell before the price hits zero. “Buy low sell high” is easy to say, but actually selling overpriced stocks even when it continues to go up and averaging down on bargains even as the price keeps dropping, is difficult and requires enormous mental discipline.

To beat the market, you need to give up on the short term

As Marks writes, “Being too far ahead of your time is indistinguishable from being wrong.” Sometimes you can be completely correct in your assessment of a company’s fundamentals and in your decision to buy but the market is not likely to promptly vindicate your decision. Selling a stock in a bull market frequently means watching from the sidelines as the stock goes to the moon and buying a stock in a bear market means watching your stock picks drop week after week, month after month. It may take months (or even years) before you see the true result of your fundamental analysis. To beat the market, you must accept that while you can’t anticipate the market, you can maximize your chances of making a profit by choosing companies with strong fundamentals, purchasing them for a reasonable price, and committing to long-term investments.

To beat the market, you must control risk

In the short-term, it’s difficult to see the importance of risk management but in the long-term, the value investors who can minimize risk really shines. There are many investors who have wildly successful but despairingly short careers because they took risks that paid off… until it stopped paying off. I like to think of it this way; the amount of risk involved is the amount of luck an investor needs to make money. If someone flipped a coin 20 times and got heads each time, would you bet your retirement fund on them getting another heads on the next coin flip? I should hope not. Yet this is exactly what we do when we give our money to mutual fund managers who don’t control for risk, or take on risky investments ourselves.

However, unlike flipping a coin, the risk involved in investing is frequently concealed. Something that looks safe, for example mortgage debt, might in fact be dangerous. Make sure to do your research so you understand where the money comes from and how the value is generated. Do not take anything for granted, especially things everyone thinks is “risk free.”

Marks also notes the importance of accepting a certain degree of risk. Let’s say you got to know the coin flipper, and realized that their coin is heavier on one side, greatly increasing the probability of getting heads. Additionally, they offer you a risk premium; for every $1 you correctly bet on heads, you can get $2 in return, where if you’re wrong, you only lose the dollar. In this scenario, the risk is worth consideration. Such is the case with investing. Risk can never be fully avoided, but it can be controlled. Sometimes it’s okay to accept risk as long as you go into the deal with your eyes open and you can get it for the right price.

To beat the market, you need to manage all market conditions

Most investors have a style that they stick to. Some are aggressive growth investors looking to maximize their returns. Others are defensive value investors, looking to make a reasonable return and minimize losses. Different investment styles are suited to different market conditions. The aggressive investor will do well in a bull market, while the defensive investor will perform better in a bear market, but these results don’t tell us anything about these investors’ skill. All too often, the aggressive investor loses more than the market in a recession and the defensive investor fails to achieve average market returns in a bull run. What ends up happening is the additional return these investors gain in their ideal market condition is canceled out by them underperforming the market in less suitable conditions. Ultimately, neither the aggressive investor nor the defensive investor is able to beat the market.

What really matters is asymmetry. Can the aggressive investor achieve superior returns during a bull run, and diminish losses during a bear market? Can the defensive investor effectively allocate capital in a bear market, and seize the market returns during a bull run? To beat the market, you must be able to keep more money than you give back, either by outperforming in a bull market or minimizing losses in a bear market.

What makes The Most Important Thing unique?

As previously mentioned, Howard Marks is himself a successful money manager who frequently wrote memos that are both widely read and highly regarded amongst the investing elite. The Most Important Thing is in many ways a structured presentation of these memos. Marks frequently references his own memos when explaining his points. Aside from borrowing from his past self, Marks also borrowed the wisdom of other writers to supplement his points, primarily from Benjamin Graham, Warren Buffett, and Nassim Nicholas Taleb, author of Fooled by Randomness. Thus The Most Important Thing is something of a compilation, a mash-up of correlating investing ideas into a single product. For this reason, The Most Important Thing is a remarkably holistic approach to investing. Unlike The Intelligent Investor, which is unfortunately outdated in terms of specific applicability, and The Psychology of Money, which is more concerned with understanding money than making it, Howard Marks’ book stands out as an effective investment philosophy applicable to the modern market.

Final thoughts:

At just under 200 pages, The Most Important Thing is not a long book. But it is a dense book. Howard Marks has done his best to fully explain his own position as an investor in as few words as he could manage, and it shows. There is, compared to other finance books at least, little repetition in The Most Important Thing. The ideas Marks presents aren’t exactly revolutionary, but he has a way of presenting them that makes it feel like you’re finally understanding how the market works for the first time.

Should you read The Most Important Thing?

Yes, definitely. It’s not very long and the various analogies Marks uses to illustrate his point can go a long way to clarifying a concept that is otherwise difficult to grasp.

I am not without criticism, however. In terms of investing philosophy, Marks leans more conservative, as is common for defensive value investors. While this is a perfectly legitimate investing approach, it doesn’t offer much leeway for those of us entering the stock market in midst of the longest bull market known to history (ahem). Marks emphasizes the importance of patience when the market is overheated, but as recent history proves, sometimes an overheated market can grow only more overheated as the years go on. It’s too much to expect individual investors to wait half a decade for the market to cool as their friends and family all make a fortune in the stock market. Although Marks has acknowledged that some allowances should be made with regard to investment standards during certain circumstances, he doesn’t offer any solid investment advice for new investors buying into a bull market. He also neglected to mention the importance of intangible assets (something Warren Buffet is known to value) and how it might be accounted for when evaluating a stock.

But looking past the flaws, The Most Important Thing provides a solid basis for investors of every stripe and creed. Just keep in mind that sometimes, especially during drawn out bull markets, you would be better served drawing your own conclusions about whether to invest in the stock market rather than unquestioningly following Marks’ recommendations.

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Reviewing Common Stocks and Uncommon Profits – The Lesser Known Foundation of Buffett’s Investment Philosophy

Jenny Xu — Sat, 13 Jul 2024 06:17:12 +0000

According to Warren Buffett, if The Intelligent Investor is the best book on investing, then Common Stocks and Uncommon Profits is the second best. Where Graham is the forefather of value investing, Philp Fisher is the founder of growth investing. This means that instead of focusing on minimizing loss of capital, Fisher wants to find stocks that will grow his capital as much as possible, with as little risk as possible. Seeing as Graham’s iteration of value investing is acknowledged to be outdated in many ways, has the same fate befallen Fisher’s concept of growth stocks as presented in Common Stocks and Uncommon Profits? Or is this a book that has withstood the test of time?

The long and short of it:

As far as investing techniques go, Fisher is unique in his advocacy for the “scuttlebutt” method and his insistence on the 15 points. As these two tactics consist of the foundation of Fisher’s investing methodology, we will begin by going over them in detail.

The “scuttlebutt” technique

Fisher’s scuttlebutt technique is easy enough to understand. In essence, it’s about getting off your butt and personally approaching every individual with a stake in the business you’re looking to invest in and asking them good questions that will net informative responses. This means getting an audience with the business’s important clients, competitors, suppliers, ex-employees, as well as research scientists (of a related field). Finally, after first approaching everyone else, Fisher would meet with the company’s executives to fill in the missing gaps in his knowledge. This process is so integral to Fisher’s methodology that if he is unable to get an audience with the necessary people, he will simply stop pursuing the stock and move on to something else.

The 15 points

The 15 points are the factors that make or break a bonanza stock. Not all the 15 points necessarily have to be present, but most of them should be, and the only way to find out if the company truly meets these high standards is by personally speaking with people who know the company. In other words, the whole point of the scuttlebutt is to attain reliable answers to the questions below:

Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?

Fisher raises an excellent point about the nature of price-to-earnings ratios. Say for example that we have two companies, Company A and Company B, that each have enormous growth potential. The market is aware of this and thus both Company A and B are selling at a P/E ratio of 20, aka at 20X their earnings. Say 2 years pass and both the companies have doubled their earnings. However, now Company A is selling at only 10X its earnings because its current prospects are not nearly as attractive as it was 2 years ago. Meanwhile, Company B continues to sell at 20X its earnings because the market recognizes its continued propensity for growth. In this situation, although Company A and Company B appear identical from the onset, further investigation on the long-term growth prospects of both companies will reveal Company B to be the far superior investment vehicle.

Therefore, there needs to occur one of two developments for a company to be a proper growth investment. A) The company takes advantage of being in a new and lucrative industry or B) The company expands into a new and lucrative industry, potentially inventing entirely new products and markets that did not previously exist. These developments can only occur under a highly competent, and ingenious management, a factor that Warren Buffett also holds in high esteem.

Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?

Indeed, even the most capable management team can fall victim to complacency. This is why a constant drive for further growth and improvement on part of management is vital for the long-term prospects of the company. Beyond simply the day-to-day tasks of operating a corporation, executives should have in mind a long term plan for future growth and expansion.

How effective are the company’s research and development efforts in relation to its size?

The engine that drives prolonged growth is fundamentally the money and effort devoted to research and development, and the overall effectiveness of this effort. The results of a company’s research and development cannot be judged in the span of months or a single year. The investor must patiently wait through not-infrequent research failures, coordination of the development and market teams, and a lengthy shakedown period as the new invention is marketed and factories are fitted for production. The true effectiveness of a company’s R&D efforts can thus only be determined via the scuttlebutt technique, only by approaching experts who know the field of research and the company in question can you gain a true understanding of what’s happening beneath the hood.

It’s worth mentioning that Buffett’s 10th tenet “for every dollar retained, make sure the company has created at least one dollar of market value,” as discussed in The Warren Buffet Way, is a more general take on this point. What ultimately needs to happen is that the company is putting its own money to good use, ultimately generating more value for the shareholder.

Does the company have an above-average sales organization?

While R&D is important, it can only ever be as effective as the company’s sale’s department. If the product invented, no matter how brilliant, is too expensive to find a market or isn’t marketed properly, it can still be a terrible drain of resources. So what makes an above-average sales organization? Beyond good leadership and good workers, companies should strive to continually improve their quality of service. As R&D comes up with new innovations, the sales arm needs to be kept abreast of the developments, which means frequently updated training and education to make sure everyone is at the forefront of progress.

Does the company have a worthwhile profit margin?

Profit margin is in many ways the company’s margin of safety. Research and development, effective research and marketing campaigns, paying workers fair wages, these all take funding. Profit margin is especially important in the event of inflation. While companies can and do pass along the raised prices to the consumer, there is a period of time before the adjustment can be made when costs are high but the price of products are still low. A company with a higher profit margin for their industry, say 5%, is more likely to make it through this period intact where their competitor, who only has a profit margin of 3% might be severely impacted if inflation rises too far.

What is the company doing to maintain or improve profit margins?

In other words, what efforts are the company putting towards the task of cutting costs? Practically speaking, this manifests as efforts to streamline the production process, stimulate workers, and reduce transportation costs. Companies should not attempt to improve profit margins by cutting corners on product quality or worker’s compensation. While companies that do so may see a temporary spike in earnings, Fisher warns us that such arrangements are untenable and thus not suitable for long-term investors.

Does the company have outstanding labor and personnel relations?

Even with workers occupying the most basic entry level positions, it is vital to the long term health of the company to promote a communal and positive feeling among workers regarding the company. Workers who are self motivated, feel that they are treated with dignity, and are properly compensated are far more productive and result in far better quality of work for the company. Workers should feel that they can bring grievances to their superiors without repercussion and such grievances should be settled promptly and decisively.

The simplest way to determine the quality of labor and personnel relations would be to speak with a number of current workers from multiple sectors. Other indications include worker turnover statistics and the company’s relationship with unions – if worker turnover is abnormally high, or the company engages in union busting tactics, the company is likely not a good investment vehicle.

Does the company have outstanding executive relations?

The satisfaction of top-level workers are just as, if not more, vital points of consideration as that of the ground floor employee. Outstanding executive relations mean a general sense that merit determines promotions and that high level executives will be promoted internally, rather than brought in from other companies. A chief executive officer brought in externally is typically a very bad sign fir the company’s health. Salary increases should also be given on a performance-basis, and not something executives feel the need to request. Salary differences should also not be so dramatic as a single person taking the lionshare of the earnings. Among top executives, compensation should have a much gentler slope from the CEO on down.

Does the company have depth to its management?

Companies have different stages of development. First there is the young company, with potential both for outstanding success and devastating failure. In order for a young company to successfully scale up and transition into an established institutional company, there needs to be an increase in the depth of management. Young companies can be run by one or two massively talented executives but when the scale gets bigger, it quickly becomes too much for an individual to manage. Therefore it is vital for a company’s executive team to comprise a number of talents all working together as a team without undue micromanagement. An executive without the necessary authority to make decisions will never be able to contribute to the company to their full potential.

How good is the company’s cost analysis?

This point is included because proper accounting is absolutely vital to good business practice and healthy development but unfortunately, assessing the strength of a company’s cost analysis requires a bit of background in statistics. However, Fisher assures the readers that companies that fulfill the other 14 points on the list (or most of them), then you can be reasonably sure that the accounting has been done to a sufficiently high standard.

Are there other aspects of the business somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?

This is a catch-all category that depends on the industry you happen to be investigating. This mostly means a company performing better in context in its competitors. One particular measure of this might be seen in the company’s insurance costs. If the company has an insurance cost that is 35% less than its competitors, this demonstrates a greater “overall skill in handling people, inventory, and fixed property so as to reduce the overall amount of accident, damage, and waste and thereby make these lower costs possible.” Additionally, Fisher urges readers not to hyperfocus on patents, as patents are less important in the long term for the well-being of the company than other more sustainable factors.

Does the company have a short-range or long-range outlook in regard to profits?

When the time comes to report quarterly earnings, executives frequently feel pressured to maximize their profits in order to make a good showing for the report. These efforts are ultimately detrimental to the long term profits of the company, as prioritizing future growth and future profit frequently means sinking huge amounts of capital into research projects that may very well fail for the chance of achieving fantastic returns for the future. It also means building good-will among suppliers and clients by absorbing short-term costs because it creates mutually beneficial relationships for all future transactions.

In the foreseeable future will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders’ benefit from this anticipated growth?

Fisher specifies that the purely financial aspects of a company is unimportant if all other points on the list are met. However, one element does require special consideration, and that is one which may directly affect the value of the company’s shares. The investor needs to evaluate the company’s current funds, earning power, and further borrowing ability is enough to sustain the cost of future growth. The company should not be forced to issue new shares to raise funds, as doing so will dilute the value of the stocks in your possession. If the company needs to issue new stocks, then the potential growth these funds will bring should more than offset the diluting of value for the stockholder.

Does the management talk freely to investors about its affairs when things are going well but “clam up” when troubles and disappointment occur?

To be clear, the unavoidable truth of success and averages means that companies which achieve the best growth will inevitably suffer through costly failures before realizing its potential. The executive team should be open about its poor showings and mistakes, and offer up reasons for why this has brought them closer to greater profitability and plans for implementing what they have learned from the mistakes in their process.

Does the company have a management of unquestionable integrity?

As the company’s management will always have a better understanding of the company affairs and operations than the stock holder, their integrity is of vital importance to the overall value of the company. A dishonest executive team can easily squander invested capital by unduly rewarding their family and close associates through higher-than-appropriate salaries, by assigning them preferred stocks, or renting/selling properties to the corporation at above-market prices. The only way an investor can guard against this form of risk is by developing a knack for character judgment and thereby ascertaining that the team of executives are fully beyond reproach. Of course, in this endeavor, scuttlebutt is the best and only method.

A few words about market timing

While Phil Fisher agrees wholeheartedly that shares should not be purchased at too high a price, the companies he truly feel to be worth investing in are frequently not cheap. Fisher’s experience has taught him that it’s ultimately pointless to quibble over eighths and quarters. If a company made it through Fisher’s highly exacting standards, then it’s an outstanding company with the potential to not just double in price but grow to by hundreds, and sometimes thousands, of percentage points. Therefore, Fisher concludes, it’s not worth trying to save $500 in purchasing the shares and as a consequence missing out on tens of thousands in profits. Additionally, while it’s valuable to maintain a contrarian attitude, provided you are right, sometimes a stock that is judged to have growth prospects does in fact have growth prospects. A high P/E ratio does not necessarily mean the stock is overpriced and vice versa, sometimes a low P/E ratio indicates genuine issues in the company and the share price is depressed for a good reason.

So having spoken on how Fisher approaches the matter of buying stocks, then is a good time to sell them? Ideally, never. Excellent growth companies will continue their excellent performance not just for you but your offspring also. However, sometimes it can happen that a company has fully exhausted the growth potential of its market and this is the time to sell. And just as other investors also recommend, if the company’s fundamentals, the management most fundamentally, has deteriorated, it would also be a time to sell. Finally, it could simply be that the investor has made a mistake in their assessment. If this is so, the stock should be sold as soon as the error is realized, and not a moment later. Attempts to hold out in hopes of the stock “breaking even” not only runs the risk of seeing your capital devolve even further, but also ties up your funds when you should be reinvesting it in more profitable holdings.

What makes Common Stocks and Uncommon Profits unique?

Among the investors who use fundamental analysis, virtually all adhere to Graham’s theory of value investing and invest primarily with the aim of minimizing risk and finding bargains. Meanwhile, Fisher is an adamant growth investor, in fact the first of his breed. While he still values bargains, he feels that the stocks with true growth potential aren’t given away as obvious a discount. The true bargain, he believes, lies in knowledge gained by proper research via “scuttlebutt” which has not yet occurred to the investing public. Fisher is also among the first to push back against diversification for the sake of risk management. The true way to minimize risk, Fisher maintains, is to have a thorough in-depth understanding of your holdings, something that becomes quickly impossible when one holds any more than 12 different stocks. Putting all your eggs in one basket may not be advisable, but having your eggs in so many different baskets that you can’t keep them all in your sight is not advisable either.

Final thoughts:

Although Fisher makes a strong case for the necessity of the careful and thorough research in a company before committing a significant percentage of your wealth to it’s stock, practically speaking very few people have the connections or the time outside their jobs to put this method into effect. To these people, Fisher suggested finding a competent financial advisor to do the legwork, which would be great, except even financial advisors who can be trusted to go this far for individual stocks are few and far between. So where does this leave the retail investor? Is there actual value in Fisher’s writings?

Yes, I believe there is.

We must not neglect the magnificent technologies available to us today that were no so in Fisher’s time, primarily the internet. While it would still be a far cry from conducting the thorough in person research Fisher insists is mandatory, it’s still a big improvement from only reading financial statements and looking at price averages. By highlighting the main elements that he watches out for when researching companies, Fisher draws our attention to the areas we need to direct our attention in our foray into the interwebs.

At 317 pages, Common Stocks and Uncommon Profits is not long, nor is it short. It’s fairly dense and may take you a fair amount of time to get through. For those who are pressed for time, the most important chapters are Chapter 2 What “Scuttlebutt” Can Do, and Chapter 3 What to Buy. Don’t get me wrong, there is a lot to be learned from every chapter of Fisher’s book but the true value of Fisher’s philosophy is concentrated in these chapters.

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Reviewing The Snowball: Warren Buffett and the Business of Life – What Can We Learn?

Jenny Xu — Sat, 13 Jul 2024 05:36:32 +0000

Warren Buffett is a man who needs no introduction. Since appearing in Forbes’ “World’s Billionaires Ranking” in 1993 as the ninth richest man in the world with a net worth of $6.6 billion, Buffett became a mainstay second only to Bill Gates. In 2023, Buffett is the sixth richest man in the world and worth a whopping $106 billion USD (source). Unlike the likes of Gates, Musk, and Bezos, Buffett did not achieve outrageous wealth by starting companies but by buying them. However, Warren Buffett did not write The Snowball: Warren Buffett and the Business of Life nor is the book focused on Buffett’s investments. So is Alice Schroeder’s biography a useful read for those of us on the journey to Financial Independence? Or is this biography an ultimately uninstructive recount of Warren Buffett’s personal life?

The long and short of it:

Over the course of Warren Buffett’s long and colorful life, he had many experiences that are of great didactic value, not only for the money-makers of the world, but also for anyone looking to live a good life. For the most part, Schroeder organizes the book chronologically, moving through Buffett’s various notable experiences and the notable people who enter and leave his life. Thus the money/general life lessons are scattered throughout the book in a disorganized but realistic fashion. For the purpose of expediency, I opted to gather up the money lessons which I feel are most pertinent to you, the average investor, and leave the equally important, but unfortunately less relevant, life lessons for another discussion.

Compounding

Buffett first came across the concept of compounding in Frances Minaker’s One Thousand Ways to make $1000. Minaker presents the following idea for a business venture: say you saved up $10 and bought a weighing machine. You charge people a dime to use it. It would take 100 people using your weighing machine before you have enough money to buy a second machine. However, with two weighing machines, you can now make money at double the speed. This means only 50 people per machine, and you can purchase a third machine in half the time. With the addition of a third machine, money comes faster and so on and so forth. Buffett did this with a pinball machine he and his friend put in a barber shop. Soon enough there were pinball machines set up in barber shops all around town.

Because of Buffett’s understanding of compounding, he saw money in the present and money in the future as directly linked. His legendary frugal ways have its roots here. Why spend a dollar today when it will grow to be a thousand dollars in five years? Why spend a thousand dollars when it will grow to be a million dollars in twenty years?

Lessons from Graham

In the investing community, it’s well known that Warren Buffett was a student of Benjamin Graham’s. From Graham, he learned a number of valuable lessons:

1. The market prices are cyclical but for the most part, the economy is growing and businesses are becoming more profitable. Therefore, by buying during recessions and selling during bull markets, you stand to earn a reliable profit.

As Buffet said once in a conference: “In the short run, the market is a voting machine. In the long run, it’s a weighing machine. Weight counts eventually. But votes count in the short term.” The long-term upward progression of the market is the weight, the short term fluctuation is the vote.

1. Have a margin of safety to protect your investments from unexpected market forces, and to buy good companies at cheap prices (bargains frequently emerge during recessions and company lawsuits). Minimize the downside.

1. Mr. Market is often unreasonable, so don’t take the market valuation of your share to be the actual value. Only buy from and sell to Mr. Market when it is profitable to you.

For more on Graham’s teachings, check out my review of The Intelligent Investor.

Intangible assets are valuable

There are some differences between Buffett’s investing ideology and Graham’s. The first difference lies in Buffett’s recognition of intangible assets. For Graham, a company’s tangible assets make up the bulk of its value — how many factories they own, the value of the machines therein, and the company’s own investments in bonds and shares. Buffett accounts for these assets, but he also pays attention to things like a company’s reputation (how trustworthy is it? Is there a strong brand recognition?), management, and patented ideas (coca-cola’s syrup recipe, apple’s computer interface).

When American Express ran into a lawsuit and the stock price plummeted, Buffett first ascertained that the public still trusted in the brand (intangible asset) before investing heavily in the company. His decision paid off handsomely when the lawsuit was settled and American Express’s stock price rose to reflect its value. In a similar case with a different company, Buffett and Munger purchased See’s Candy for $25 million. The company only had $2 million in post-tax earnings and $8 million in tangible assets, but See’s Candy had a loyal customer base and an excellent reputation backed up by excellent products. To this day, See’s Candy remains one of Buffett’s favorite investments.

Diversification up to a point (if it’s a good company, then buy more of it)

Another way that Buffett differs from Graham is in his approach to diversification. It is an oft repeated truism that you should diversify your holdings in a variety of industries for a margin of safety. The idea is that if a company or industry falls out of favor with the public, you won’t be forced to sell otherwise strong positions. When you have other dependable options, it’s easier for you to remain resilient in a fluctuating market. Buffett agrees up to a point. For the average investor who isn’t attuned to the market’s ongoings, it would be a fair decision to choose 10-30 strong companies from different industries, or to invest in an index fund and leave it at that. For investors who are confident in their stock analysis and have a history of successful stock picks (Buffett being an exceptional example), it would be more beneficial to concentrate their wealth in the companies best positioned to grow and increase their own earnings.

Go for companies with a wide moat

As something of an addendum to the point on “intangible assets,” Buffett also stresses the value of companies with a wide moat. These are companies with qualities that are very difficult to replicate. This might be economy of scale, such as with AT&T and Walmart, or companies with an excellent reputation such as See’s Candy and Apple. Companies with a wide moat are excellent vehicles to hold long-term capital because of the stability that results from its competitive edge.

Invest in what you know (circle of competence)

As Schroeder writes, “[Warren Buffett] believed in what he called the Circle of Competence, he drew a line around himself, and stayed within the three subjects on which he would be recognized as absolutely expert: money, business, and his own life.” On this point, Buffett and Graham are in perfect agreement: stay in your circle of competence and invest in what you know.

On one hand, this makes perfect sense, it wouldn’t be right for someone who cornered the market on Shoe Buttons to assume themselves qualified to speak about zookeeping. But on the other hand, the average person is not born a competent investor. Buffett is not saying that you should stay firmly in your comfort zone, but you should recognize when you have exited your circle of competence. With the understanding that you are out of your depth, you must decide. Do you have the energy and capacity to properly research and understand a new subject and expand your circle of competence? Or would it be better for you to leave it alone and focus on something you’re already familiar with?

When Warren Buffett wrote in one of his letters to shareholders, “We will not go into businesses where technology is way over my head is crucial to the investment decision. I know about as much about semiconductors or integrated circuits as I do about the mating habits of the chrzaszcz,” he is recognizing the limitations of his knowledge, assessing his own interest and energy, and making a tactical retreat. For those of us who have the energy and resources to learn about semiconductors, integrated circuits, and the mating habits of the chrzaszcz, we can certainly invest in such companies, but only after obtaining the necessary knowledge.

Pass up riches if you couldn’t limit the risk

This is related to the idea of the Circle of Competence. Not having a solid grasp of a company’s operations drastically increases the risk of the investment. Other factors that play into risk would be the length of time a bull run goes on for (with stocks trading at ever higher P/E ratios), offerings in a complicated or poorly regulated industry (biotech as an example of the former, crypto for the latter), and potential worker strikes resulting from poor management.

Such was the case in the dot-com bubble from 1995 — 2001 during which the mesmerizing potential of the internet drove the share price of untested internet start-ups to eye-watering heights. During this time, Buffett sat by, unmoved and unwilling to invest. Buffett was unfamiliar with the world of computing, superconductors, and software, he knew the new technology lied beyond his circle of competence. Even as people around him became rich and berated him for “losing his touch” and “past his prime,” Buffett remained steadfast. Of course, with the benefit of hindsight, the ill-begotten wealth of internet speculators soon vanished and Buffett’s judgment proved superior. If the risk can’t be managed, it’s not worth it, no matter how high the potential return.

There’s no such thing as a new paradigm

Returning to the rise of the dot com bubble, there was a belief that a new paradigm was upon the world of business and investing. New tech start ups and young entrepreneurs entered the scene with swagger befitting of new money and snake oil salesmen. The stock market soared to new heights with stocks trading at prices 50, 60, 70 times their earnings. There was enormous optimism that the internet will not only revolutionize communication, but the very fundamentals of investment and business. Of course, hindsight is 20/20 and no one can deny now that Buffett’s stoicism in the face of such investment fervor was a wise decision. There is no such thing as a new paradigm, investors buy shares of a company, the company’s value goes up when the company’s earnings go up. So goes the popular German proverb: leaves will fall sooner or later, trees won’t grow to the sky. The foundational core of investing has remained the same from the Dutch tulip craze through to today’s tech giants.

What makes The Snowball: Warren Buffett and the Business of Life unique?

Although I haven’t addressed this in favor of brevity, Alice Schroeder’s The Snowball: Warren Buffett and the Business of Life stands out among the many books on Warren Buffett as one that puts the most emphasis on the many friends and influences in his life. It takes the perspective of Warren Buffett as a person, rather than Warren Buffet as a legendary investor. Schroeder demonstrates how Buffett’s investment philosophy reverberates through every aspect of his life, from his opinion on politics to the way he interacts with his family. Aside from delving into Warren Buffett’s personal history, this book also unearths the personal histories of his associates, and the people he did business with. Schroeder also took the liberty of contextualizing the social events occurring throughout Buffett’s lifetime, from the Civil Rights movement to Nixon’s impeachment to the Housing Market crisis. It’s an unprecedented and personal look at the entirety of Warren Buffett’s lived experience told mainly from his perspective.

In devoting such attention to detailing Warren Buffett’s life, Schroeder shows readers that Buffett is not a coldly rational investing superhuman. He too has made mistakes and had moments of doubt and uncertainty. He too is driven by subjective beliefs and experiences. Where Buffett differs is his willingness to sacrifice family time, all non-investment-related hobbies, and short-term profits all in the name of making consistently good long-term investments. In reading The Snowball, readers implicitly understand that Warren Buffett is not just a highly unusual investor, but indeed a highly unusual person.

Final thoughts:

Having lived as long and colorful a life as Warren Buffet, it’s perhaps unsurprising that his biography is nearly a thousand pages long (or 640 pages, depending on which edition you happen to have). It’s also very much a biography, not a finance book. Can nuggets of financial wisdom be gleaned from this behemoth of a book? Yes. Should you read it just to find them? Probably not. It’s for this reason that I took the trouble to pick out the most valuable of these nuggets. For a more in-depth exploration of Buffett’s investment principles and not his life story, The Warren Buffett Way by Robert G. Hagstrom would better serve your purposes than The Snowball.

However, if I were to judge the book as a book rather than a resource for potential investing tips, The Snowball: Warren Buffett and the Business of Life is an interesting read and about as close as most of us could get to knowing Buffett on a personal level. It’s well written, first and foremost, detailed without being overly so, and additionally possesses some historical value. All in all, The Snowball is an enjoyable way to spend your spare time, provided you have a good amount of spare time.

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Reviewing A Random Walk Down Wall Street – Is It Worth A Read?

Jenny Xu — Mon, 08 Jul 2024 08:34:51 +0000

Among the intellectual behemoths responsible for classic investment books, the author of A Random Walk Down Wall Street, Burton G. Malkiel, stands out as both a Wall Street financial advisor and a bona fide academic. Due to his unique background, Malkiel brings a fresh and valuable perspective into the time-honored debate between professional investors and academics about The Efficient Market Hypothesis. What is The Efficient Market Hypothesis and why should you care? Why is there so much discourse over whether or not it’s a legitimate way to approach the stock market?

The long and short of it:

On the Efficient Market Hypothesis

An important aspect of Malkiel’s philosophy is the Efficient Market Hypothesis. As the theory goes, the market will tend towards efficiency because due to the collective rational behavior of all market participants, all publicly available information will always be fully priced in. For this reason, if it is known that the stock price for a company will rise 20% tomorrow, it will rise 20% today. This is known in academic circles as the Efficient Market Hypothesis.

Due to this tendency, even incredibly insightful investors struggle to consistently beat the market. Even Graham’s legendary method of assessing stock value yields inconsistent results today. In an interview in 1976, shortly before his death, Graham was quoted in saying,

I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when Graham and Dodd was first published; but the situation has changed… [Today] I doubt whether such extensive efforts will generate sufficiently superior selections to justify their cost… I’m on the side of the “efficient market” school of thought.

Malkiel doesn’t fully ascribe to the Efficient Market Hypothesis, but he is more on the side of Efficient Market than most other personal finance writers. When it comes to most investors in the short term, the market is fully priced in and it is functionally efficient. However, there are definitely notable exceptions to the Efficient Market Hypothesis, many of which Malkeil does acknowledge.

Exceptions to the Efficient Market Hypothesis

1. Some people do consistently beat the market

Investors who are truly capable of beating the market long term, the likes of Warren Buffett, Peter Lynch, and Howard Marks, don’t use short-term market-timing techniques. In trying to take advantage of pockets of market inefficiency, other observant investors will inevitably cotton on and render the technique ineffective. Investors who consistently beat the market are innovative and long-term thinkers. Because the vast majority of investors are unwittingly caught in the cycle of valuing short term gains over long-term profit (encouraged by the quarterly evaluation of professional money managers), there is a great deal of market inefficiency in long-term investments, the type of which Warren Buffett specializes in.

1. Bubbles

Bubbles are a type of market inefficiency that arises when people don’t know what they’re investing in. The moment that FOMO and hype overcomes research and caution is when stock prices soar to untenable levels. The moment the majority of investors stop paying attention to the solid foundational aspects of a business is the moment the market stops being efficient.

1. Commission free trading apps

This is not a point from Malkiel’s books but I would like to briefly address it nonetheless. Recently, commission free trading apps like Robinhood, WeBull, and Wealthsimple have been gaining in popularity. Without commission fees, active trading will undoubtedly become a far more viable method of investing than it used to be. New market inefficiencies may be introduced as uninformed decisions combine with overreactions to make massive price swings that don’t correspond to the stock’s actual value. However, this new method of trading is still in its infancy and thus far, no one truly knows the full ramifications of this new technology.

1. Retail investors > mutual fund managers

It used to be that regular people don’t have enough money saved up to buy stocks on their own. Therefore, the only way they could invest was by pooling their money together in a mutual fund for a professional to manage.

There are, however, many downsides to mutual funds.

- Mutual funds frequently make trades on behalf of the investors and the cost of these trades really add up, eating into the investor’s profits

- Mutual funds are expensive, there are management fees and frequently also loading fees, this can add up to a full 1% of earnings

- The size of a mutual fund means managers frequently have to put money in subpar companies so they’re fully invested. It’s much easier to invest $500 million in excellent companies than $50 billion – there just aren’t enough investment opportunities

- The size of investments also means investments will change the stock price. Mutual funds are forced to sell at a discount and buy at a premium

Today we have the ability to purchase fractional shares so we can invest on our own. Most trading apps support this, whether commission free or otherwise. No longer is investing prohibitively expensive for the new investor, anyone who wants to invest can now purchase fractional shares, buying a half or a quarter of a share when they lack funds. Due to all the downsides of mutual funds, fund managers actually have to beat the market by 2-3% just to match the market return. This is why most money managers fail to beat the market, despite being professionals. As an individual retail investor, you don’t have to contend with any of the additional fees or investing difficulties of large mutual funds, which means the extra 2-3% is fully yours to keep.

Although Malkiel remains adamant that the wisest investment is always in index funds, he does allow that many people are insatiably drawn to the idea of stockpicking and beating the market. To that end, Malkiel offers a series of rules and steps to help the average investor manage risk and maximize returns.

Malkiel’s Rules of Thumb

Keep up-to-date with the market. Malkiel recommends the following sources:

- The New York Times and Wall Street Journal for general news

- Barron’s, an American weekly business newspaper/magazine published by Dow Jones & Company

- BusinessWeek, Fortune, and Forbes for investment ideas

- Investment advisory services like Standard & Poor’s Outlook and the Value Line Investment Survey

Of these sources, only Value Line Investment places all its content behind a pay-wall. Most other services offer free videos, articles, and analysis in addition to subscriber-only services. Other good sources for business news that Malkiel did not mention include:

- MarketWatch, also a subsidiary of Dow Jones & Company

- BusinessInsider, a New York based international news outlet founded in 2007

- CNBC, a TV news program specializing in business, politics, investing, and finance

***Rule 1: “*Confine stock purchases to companies that appear able to sustain above-average earnings growth for at least five years**”

Here Malkiel straddles the line between growth investing and value investing. This advice is a double-edged sword, because while it avoids the potential of buying a value stock that never goes up (value trap), it also runs a greater risk of being overpriced than sticking purely to the fundamentals. Thus it’s important to follow all of Malkiel’s rules, not just this one in isolation.

***Rule 2: “*Never pay more for a stock than can reasonably be justified by a firm foundation of value**”

Malkiel mentioned previously that ascertaining the precise intrinsic value of a stock is akin to trying to catch a wil’o’wasp. This is because a key part of value assessment is projecting future earnings. Unfortunately any effort to forecast the future is more subject to randomness than analysis. Due to the unshakeable opacity, Malkiel suggests erring on the side of caution, to always go with the more modest estimate and not get carried away by faith and enthusiasm.

***Rule 3: “*It helps to buy stocks with the kinds of stories of anticipated growth on which investors can build castles in the air**”

Malkiel makes a good suggestion here to combine Graham’s emphasis of cheapness with the vast growth potential of stocks with good stories. According to Malkiel, it’s not enough to find a cheap unloved stock. It must be a cheap unloved stock with the potential to become well loved. This is a criteria few stocks are able to satisfy, so this rule is more suggestive than mandatory. Of course it certainly helps to find an attractive stock selling at a fair price before the public finds it, but it’s a very infrequent occurrence and requires a degree of dedicated research most retail investors are not ready to commit to.

Rule 4: “Trade as little as possible”

Malkiel recommends this for a variety of reasons; more trading means more commission fees, more tax you have to pay for realized gains, and diminished the long term benefits of compounding. For some, the first two points are non-issues, due to using a commissions free trading app and being in a lower tax bracket. However, the last point applies to us all. Compounding works wonders for the patient and it’s always a good idea to hold companies with strong fundamentals for a long term.

Rule 5: Diversify in industries with negative covariance

Diversification is the common rule of thumb familiar to almost every investor worth their salt, but diversify how? And in what industries? Here Malkiel introduces the concept of positive and negative covariance.

Say for example there are 2 companies. Company A sells sunscreen. Company B sells raincoats. When it rains, the stock price of Company A goes down -25% and the stock price of Company B goes up 50%. However, sometimes it’s sunny, and in that case, Company A gains 50% while Company B loses -25%.

Because one company makes money while another loses money, this is a negative covariance. Why is this important for investors? Well, let’s look at Josh and Mary, who each decided to invest $1,000 on Monday.

Josh invests his entire $1,000 in Company B on Monday because he thinks it will rain. Over the week, it rains on Monday, Tuesday, Thursday, and Saturday. By the end of the week, Josh will have a total of $1,067.87. That’s a profit of $67.87 or 6.7%.

Meanwhile, Mary invests $500 in Company B and $500 in Company A because she doesn’t know if it will rain or not. By the end of that same week, Mary will have a total of $2,565.78, for a profit of $1,565.78, or 156.578%.

How is it possible that Mary made so much money while Josh made so little?

The reason is compounding. While Josh lost money whenever it didn’t rain, Mary was able to make money on both sunny and rainy days. Over the course of the week, Mary was able to gain a steady 12.5% every day, which allowed compounding to take effect and lead to massive profits. Josh on the other hand, had to essentially start over his compounding every time it was sunny. Additionally, losing 25% took an enormous bite out of not just his accumulated profits, but also his principle. Of course, this is an unrealistic situation, no company’s stock price would be so volatile or so predictable. However, if we expand our example out to months and years (stock price of Company A increases by 50% in April, May, June, July, and August, then goes down by -25% every other month of the year), we can see that there is merit in accounting for negative covariance in stock selection.

Through this example, Malkiel demonstrates the importance of diversifying in industries with negative covariance. Of course, no industry will be 100% negatively covariant. If there were a recession, the stock price of both the sunscreen sellers and raincoat sellers would go down. However, even then, it’s wise to make preparations for what you can control instead of bemoaning what you can’t.

For such diversification, Malkiel recommends the following sectors in addition to a standard diversified common stock portfolio:

- REITs (real estate investment trusts) that allow you to buy a share of real estate. Pays historically high dividends, which can supplement income for those who need it

- International Index Funds, as a bad run in the US economy doesn’t automatically translate to a global recession (usually)

- Gold/Art Pieces/Collections, although these holdings are not productive assets and therefore can’t generate additional fundamental value the way stocks, bonds, and real estate can and often costs money to maintain, they are excellent hedging for times of economic crisis and rampant inflation. Malkiel recommends no more than 5% of your portfolio be invested in gold and similar holdings

What makes A Random Walk unique?

Perhaps it’s because Malkiel is an academic, perhaps it’s because he had a history in Vanguard, the mutual fund provider that brought us index funds, regardless of the reason, A Random Walk is perhaps the most thorough book on capital allocation I have read thus far. Although I disagree with Malkiel’s assessment that beating the market is impossible for the average investor, he is able to clearly lay out actionable steps, backed up by a wealth of historical and statistical evidence, the reader can take to become a competent personal wealth manager. He also offers a formulaic way for passive investors to reliably achieve average market returns.

I have only the highest respect for the legendary investors who are able to consistently beat the market, but I also deeply appreciate Malkiel’s more grounded approach, especially as an average (okay, below average) retail investor. Beating the stock market is not easy, yet investors like Graham, Buffett, Lynch, and Marks make it sound (and look) so simple that the rest of us are left scratching our heads. Malkiel is not a genius investor, but he does have a deep understanding of the economy and Wall Street, so he takes a more realistic stance and clearly says, “Look, the market is inefficient in some ways, but don’t underestimate the forces that do in fact make it efficient. You must first understand what makes the market efficient before you can take advantage of the times it is inefficient.”

Final thoughts:

As I said, A Random Walk differs from most other finance books not in the uniqueness of its ideas, but in the depth Malkiel goes to explore these ideas. A Random Walk is like a textbook in this way, taking a generally objective stance in the world of investing, recounting past events and present theories from a birds-eye-view Also unlike many other writers of investment books, Malkiel is not a value investor. He has far greater respect for fundamental analysis than technical analysis, but he’s ultimately of the opinion that neither method will let you beat the market consistently (although fundamental analysis paired with a growth mindset will get you much closer).

Should you read A Random Walk Down Wall Street?

Maybe.

Malkiel goes in depth in his assessments on various investment approaches but his analysis is the sort you’ll get if you took an economics course at your local college or university. It’s very well-documented and academic, and therefore unlikely to make you much money. Perhaps the most useful concept I got out of the book is a newfound understanding of negative covariance, something that I previously only had very vague knowledge of. Aside from that, A Random Walk was mostly good for solidifying things that I already kind of knew with clear explanation and a deluge of facts and figures.

I personally enjoyed A Random Walk, but it’s fairly lengthy (456 pages), and at times over explained. For those who enjoy reading finance books, A Random Walk is very enlightening. For those who don’t feel the need, they will be well served by a condensed overview.

The post Reviewing A Random Walk Down Wall Street – Is It Worth A Read? appeared first on TheWeFIRE.

Growth investing Archives - TheWeFIRE

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C. The Cumulative Lifetime Benefits May be Lower:

Delayed Retirement Increases Benefits

Calculate How Much You’ll Get from Social Security

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Survivor Benefits:

What If I Want to Work in Retirement?

Decision-Making Factors

A. Financial Need:

B. Longevity and Health Factors:

C. Other Income Sources:

D. Balancing Income and Benefits:

E. Balancing Immediate Needs with Future Security:

Conclusion

Reviewing The Warren Buffett Way – Is This A Path Average Investor Can Follow?

The long and short of it:

Warren Buffett as a synthesis of thinkers

The 12 tenets and how to apply them

Business Tenets

Management Tenets

Financial Tenets

Market Tenets

Market psychology – what to weary of

Overconfidence

Overreaction Bias and Loss Aversion

The Lemming factor

What makes The Warren Buffett Way unique?

Final thoughts:

Reviewing The Most Important Thing – How Do People Beat the Market?

The long and short of it:

To beat the market, you can’t be average

To beat the market, you need superior insight

To beat the market, you need superior fortitude

To beat the market, you need to give up on the short term

To beat the market, you must control risk

To beat the market, you need to manage all market conditions

What makes The Most Important Thing unique?

Final thoughts:

Reviewing Common Stocks and Uncommon Profits – The Lesser Known Foundation of Buffett’s Investment Philosophy

The long and short of it:

The “scuttlebutt” technique

The 15 points

A few words about market timing

What makes Common Stocks and Uncommon Profits unique?

Final thoughts:

Reviewing The Snowball: Warren Buffett and the Business of Life – What Can We Learn?

The long and short of it:

Compounding

Lessons from Graham

Intangible assets are valuable

Diversification up to a point (if it’s a good company, then buy more of it)

Go for companies with a wide moat

Invest in what you know (circle of competence)

Pass up riches if you couldn’t limit the risk

There’s no such thing as a new paradigm

What makes The Snowball: Warren Buffett and the Business of Life unique?

Final thoughts:

Reviewing A Random Walk Down Wall Street – Is It Worth A Read?

The long and short of it:

On the Efficient Market Hypothesis

Exceptions to the Efficient Market Hypothesis

Malkiel’s Rules of Thumb

Keep up-to-date with the market. Malkiel recommends the following sources:

Rule 1: “Confine stock purchases to companies that appear able to sustain above-average earnings growth for at least five years”

Rule 2: “Never pay more for a stock than can reasonably be justified by a firm foundation of value”

Rule 3: “It helps to buy stocks with the kinds of stories of anticipated growth on which investors can build castles in the air”

Rule 4: “Trade as little as possible”

Rule 5: Diversify in industries with negative covariance

What makes A Random Walk unique?

Final thoughts:

***Rule 1: “*Confine stock purchases to companies that appear able to sustain above-average earnings growth for at least five years**”

***Rule 2: “*Never pay more for a stock than can reasonably be justified by a firm foundation of value**”

***Rule 3: “*It helps to buy stocks with the kinds of stories of anticipated growth on which investors can build castles in the air**”