In the days of falling stock prices, Board of Directors will often begin to pay dividends to help stabilize the company’s stock. Many investors consider these dividends as a sign of safety and financial conservatism (which they are in many cases). Dividends in and of themselves, however, do not necessarily make the company a better investment. Companies that earn high returns on equity, have little or no debt, and large room to expand in their current industry would best serve their shareholders by paying no dividends. Instead, they should opt to reinvest all of the company’s available resources into growing the value of the underlying business. The shareholders will be rewarded through appreciation in the stock price.
In other words, a company should only pay dividends if it is unable to reinvest its cash at a higher rate than the shareholders (owners) of the business would be able to if the money was in their hands. If company ABC is earning 25% on equity with no debt, management should retain all of the earnings because the average investor probably won't find another company or investment that is yielding that kind of return.
Why Do Stock Prices Fluctuate?
The stock market is essentially a giant auction - only instead of antiques and heirlooms, it's ownership in businesses that's up for grabs. Stocks are traded at places called exchanges. At these exchanges, traders buy and sell shares of companies. Generally, the price of a stock is determined by supply and demand. For example, if there are more people wanting to buy a stock than to sell it, the price will be driven up because those shares are rarer and people will pay a higher price for them. On the other hand, if there are a lot of shares for sale and no one is interested in buying them, the price will quickly fall.
Because of this, the market can appear to fluctuate widely. Even if there is nothing wrong with a company, a large shareholder who is trying to sell millions of shares at a time can drive the price of the stock down, simply because there are not enough people interested in buying the stock he is trying to sell. Because there is no real demand for the company he is selling, he is forced to accept a lower price.
Because of this, the market can appear to fluctuate widely. Even if there is nothing wrong with a company, a large shareholder who is trying to sell millions of shares at a time can drive the price of the stock down, simply because there are not enough people interested in buying the stock he is trying to sell. Because there is no real demand for the company he is selling, he is forced to accept a lower price.
Building a Stock Position by Writing Put Options
In the world of the small speculator, options are used, customarily, in an attempt to capture large gains with little capital investment. One way to use derivatives in an investment operation, however, is to write put options for an issue in which you want to build a position.
Writing Put Options
You want to buy shares of a fictional company, Acme Pharmaceuticals. After reading the annual report and analyzing the financial statements, you have come to the conclusion that, in order to earn your required rate of return, you can pay no more than $25 per share. Today, the stock trades at $30 per share.
Instead of sitting around and waiting for the stock to fall to your desired price, you could write put options for the shares at $25. In essence, you would sell a “promise” to another party (it could be a bank, mutual fund, corporation, or individual investor) that if the shares of Acme fall below the threshold during the life of the option, the purchaser will have the right to require you to purchase those shares at $25.
Why would you agree to do this? In exchange for this promise, the buyer of your put options will pay you an “insurance” premium. The amount of this premium depends on a number of factors but for our purposes, assume you are paid $1.12 per share to take on this risk. If you wrote ten puts (remember that options are for round lots of 100 shares), you would receive $1,120 (10 puts x 100 shares = 1,000 shares x $1.12 premium = $1,120). If the option expires and is never exercised, you keep this money free and clear.
If the option is exercised, it serves to effectively lower your cost basis. If, for example, the price of Acme fell to $15 per share, the buyer of your put options is going to exercise their right to require you to purchase the shares at $25. Your actual cost, however, would only be $23.88 ($25 cost of shares - $1.12 premium = $23.88 net cost.)
Writing Put Options
You want to buy shares of a fictional company, Acme Pharmaceuticals. After reading the annual report and analyzing the financial statements, you have come to the conclusion that, in order to earn your required rate of return, you can pay no more than $25 per share. Today, the stock trades at $30 per share.
Instead of sitting around and waiting for the stock to fall to your desired price, you could write put options for the shares at $25. In essence, you would sell a “promise” to another party (it could be a bank, mutual fund, corporation, or individual investor) that if the shares of Acme fall below the threshold during the life of the option, the purchaser will have the right to require you to purchase those shares at $25.
Why would you agree to do this? In exchange for this promise, the buyer of your put options will pay you an “insurance” premium. The amount of this premium depends on a number of factors but for our purposes, assume you are paid $1.12 per share to take on this risk. If you wrote ten puts (remember that options are for round lots of 100 shares), you would receive $1,120 (10 puts x 100 shares = 1,000 shares x $1.12 premium = $1,120). If the option expires and is never exercised, you keep this money free and clear.
If the option is exercised, it serves to effectively lower your cost basis. If, for example, the price of Acme fell to $15 per share, the buyer of your put options is going to exercise their right to require you to purchase the shares at $25. Your actual cost, however, would only be $23.88 ($25 cost of shares - $1.12 premium = $23.88 net cost.)
What are the sources of the company’s cash flows?
The value of any asset is the net present value of its discounted cash flows. Before the investor can even begin to value a business, he has to know what is generating the cash. It is important to be specific and avoid making assumptions.
Take Coca-Cola, for example. Billions of people across the world are familiar with Coke’s products. When you see it on the shelf of your local grocery store, you may have concluded that it was the Coca-Cola Company that sold the bottled goods to the grocer. In reality, a look at the most recent 10K reveals that, although the company does sell some finished beverages, almost all of its revenue is derived from the sale of “beverage concentrates and syrups” to “bottling and canning operations, distributors, fountain wholesalers and some fountain retailers.” In other words, it sells the concentrate to bottlers, the largest being Coca-Cola Enterprises (a separately traded public company). These bottlers create the finished product, shipping it to your local store. It may seem like a small distinction seeing that Coke’s ultimate success depends upon the products sold in stores and restaurants; approached from another angle, however, and the investor can quickly surmise how vitally important the relationship between Coke and it’s bottlers is to the bottom line.
Take Coca-Cola, for example. Billions of people across the world are familiar with Coke’s products. When you see it on the shelf of your local grocery store, you may have concluded that it was the Coca-Cola Company that sold the bottled goods to the grocer. In reality, a look at the most recent 10K reveals that, although the company does sell some finished beverages, almost all of its revenue is derived from the sale of “beverage concentrates and syrups” to “bottling and canning operations, distributors, fountain wholesalers and some fountain retailers.” In other words, it sells the concentrate to bottlers, the largest being Coca-Cola Enterprises (a separately traded public company). These bottlers create the finished product, shipping it to your local store. It may seem like a small distinction seeing that Coke’s ultimate success depends upon the products sold in stores and restaurants; approached from another angle, however, and the investor can quickly surmise how vitally important the relationship between Coke and it’s bottlers is to the bottom line.
What Are the Best Investment Stocks
In light of the recent volatility on Wall Street, many investors seem concerned about their portfolios. Although, as a dyed-in-the-wool value investor, I view these events opportunities to pick up more shares of my favorite companies at bargain prices, it’s understandable for those who aren’t professional investors to get nervous. After the correction, a friend of mine asked me what kind of portfolio I would construct for someone who wanted to own equities (stocks) but wanted to enjoy some insulation from price gyrations. As we had a conversation over coffee, I started thinking that the information might be useful to some of my readers.
Stocks with Dividend Yields Greater than Long Term Treasury Yields
The first, and perhaps most powerful, defense is a stock that has healthy earnings and a relatively high dividend payout ratio and dividend yield, especially when compared to the yield that is available on the risk-free United States Treasury bond. The reason is actually pretty simple: Investors are always comparing everything to this so-called “risk” free rate. The reason? When you buy a debt obligation of the United States, you can be certain that you are going to get paid. As the wealthiest nation in the world, all the government has to do is raise taxes or sell off assets to pay its debt.
When the dividend yield of a stock is the same as the Treasury bond, many investors would prefer to own the former. Not only do you get more cash from the dividend yield because of favorable tax treatment (dividends are subject to a maximum 15% Federal tax rate while Treasury bonds, although exempt from state and local taxes, can run as high as the 35% tax bracket) but, perhaps more importantly, you get the capital gains generated from an increasing stock price. After all, what reasonable person wouldn’t want to have their cake and eat it too?
Here’s how it protects you during a down market: As the stock price falls, the dividend yield goes up because the cash dividend is a larger percentage of the purchase price of each share. For example, a $100 stock with a $2 dividend would have a 2% dividend yield; if the stock fell to $50 per share, however, the dividend yield would be 4% ($2 divided by $50 = 4%.) In the midst of a market crash, at some point the dividend yield becomes so high that investors with excess liquidity often sweep into the market, buying up the shares and driving up the price. That’s why you typically see less damage to high dividend paying stocks during down markets. Combined with the research done by Jeremy Siegel, this is yet another reason investors may want to consider these cash generators for their personal portfolio.
Consumer Staple Companies and other Blue Chip Stocks with Conservative Balance Sheets and Durable Competitive Advantages
True investors are interested in one thing and one thing only: Buying companies with the most earnings at the most attractive price possible. In strained economic times, the stability of profits is extremely important. Often, the most successful stocks are those that have durable competitive advantages. These consumer staples often sell things such as mouthwash, toilet paper, toothpaste, laundry soap, breakfast cereal, and soda. No matter how bad the economy gets, it’s doubtful that anyone is going to stop brushing their teeth or washing their clothes.
Finding these companies isn’t hard. They are often known as Blue Chip stocks and make up the Dow Jones Industrial Average. They include household names such as 3M, Altria, American Express, AIG, Coca-Cola, Exxon Mobile, General Electric, Home Depot, Johnson & Johnson, McDonald’s, Procter & Gamble, and Wal-Mart. They often have extremely large market capitalizations.
Good Companies with Large Share Repurchase Programs
Some companies, such as AutoZone and Coca-Cola, regularly repurchase enormous amounts of their own shares. In a falling market, this can help reduce pressure because as the stock is sold, the company itself is often standing by with its checkbook open. There is a double benefit here in that if the stock does become undervalued, long-term shareholders benefits from these repurchases as the company is able to reduce the total shares outstanding far more quickly as a result of a lower stock price, increasing future earnings per share and cash dividends for the remaining stock. This is especially beneficial when things turn around the stock recovers because the shares that remain get a higher boost.
Value Stocks
Of course, if you only buy stocks that traditionally have characteristics associated with value investing such as low price to earnings ratios, low price to book ratios, low price to sales ratios, diversified operations, conservative balance sheets, etc., the odds are good that you will emerge from the wreckage unscathed over the long-term. This is why value based money management shops such as Tweedy Browne & Company have managed to return such impressive results to their fund holders and private investors over the decades.
A Few Other Thoughts
If you don’t have the ability to analyze financial statements and calculate a conservative estimate of intrinsic value for the assets in your portfolio, it is a wise policy to maintain widespread diversification.
Consider keeping a portion of your portfolio in international investments by investing in a highly rated, low risk global mutual fund.
Never invest any capital into equities that you might need within the next two to three years.
If you can’t handle price volatility, consider reducing the overall gyrations of your portfolio by including a substantial bond or fixed income component. Although this might lower your long-term returns over subsequent decades, if it reduces the chances of you selling everything in a panic, it can provide a workable compromise.
Stocks with Dividend Yields Greater than Long Term Treasury Yields
The first, and perhaps most powerful, defense is a stock that has healthy earnings and a relatively high dividend payout ratio and dividend yield, especially when compared to the yield that is available on the risk-free United States Treasury bond. The reason is actually pretty simple: Investors are always comparing everything to this so-called “risk” free rate. The reason? When you buy a debt obligation of the United States, you can be certain that you are going to get paid. As the wealthiest nation in the world, all the government has to do is raise taxes or sell off assets to pay its debt.
When the dividend yield of a stock is the same as the Treasury bond, many investors would prefer to own the former. Not only do you get more cash from the dividend yield because of favorable tax treatment (dividends are subject to a maximum 15% Federal tax rate while Treasury bonds, although exempt from state and local taxes, can run as high as the 35% tax bracket) but, perhaps more importantly, you get the capital gains generated from an increasing stock price. After all, what reasonable person wouldn’t want to have their cake and eat it too?
Here’s how it protects you during a down market: As the stock price falls, the dividend yield goes up because the cash dividend is a larger percentage of the purchase price of each share. For example, a $100 stock with a $2 dividend would have a 2% dividend yield; if the stock fell to $50 per share, however, the dividend yield would be 4% ($2 divided by $50 = 4%.) In the midst of a market crash, at some point the dividend yield becomes so high that investors with excess liquidity often sweep into the market, buying up the shares and driving up the price. That’s why you typically see less damage to high dividend paying stocks during down markets. Combined with the research done by Jeremy Siegel, this is yet another reason investors may want to consider these cash generators for their personal portfolio.
Consumer Staple Companies and other Blue Chip Stocks with Conservative Balance Sheets and Durable Competitive Advantages
True investors are interested in one thing and one thing only: Buying companies with the most earnings at the most attractive price possible. In strained economic times, the stability of profits is extremely important. Often, the most successful stocks are those that have durable competitive advantages. These consumer staples often sell things such as mouthwash, toilet paper, toothpaste, laundry soap, breakfast cereal, and soda. No matter how bad the economy gets, it’s doubtful that anyone is going to stop brushing their teeth or washing their clothes.
Finding these companies isn’t hard. They are often known as Blue Chip stocks and make up the Dow Jones Industrial Average. They include household names such as 3M, Altria, American Express, AIG, Coca-Cola, Exxon Mobile, General Electric, Home Depot, Johnson & Johnson, McDonald’s, Procter & Gamble, and Wal-Mart. They often have extremely large market capitalizations.
Good Companies with Large Share Repurchase Programs
Some companies, such as AutoZone and Coca-Cola, regularly repurchase enormous amounts of their own shares. In a falling market, this can help reduce pressure because as the stock is sold, the company itself is often standing by with its checkbook open. There is a double benefit here in that if the stock does become undervalued, long-term shareholders benefits from these repurchases as the company is able to reduce the total shares outstanding far more quickly as a result of a lower stock price, increasing future earnings per share and cash dividends for the remaining stock. This is especially beneficial when things turn around the stock recovers because the shares that remain get a higher boost.
Value Stocks
Of course, if you only buy stocks that traditionally have characteristics associated with value investing such as low price to earnings ratios, low price to book ratios, low price to sales ratios, diversified operations, conservative balance sheets, etc., the odds are good that you will emerge from the wreckage unscathed over the long-term. This is why value based money management shops such as Tweedy Browne & Company have managed to return such impressive results to their fund holders and private investors over the decades.
A Few Other Thoughts
If you don’t have the ability to analyze financial statements and calculate a conservative estimate of intrinsic value for the assets in your portfolio, it is a wise policy to maintain widespread diversification.
Consider keeping a portion of your portfolio in international investments by investing in a highly rated, low risk global mutual fund.
Never invest any capital into equities that you might need within the next two to three years.
If you can’t handle price volatility, consider reducing the overall gyrations of your portfolio by including a substantial bond or fixed income component. Although this might lower your long-term returns over subsequent decades, if it reduces the chances of you selling everything in a panic, it can provide a workable compromise.
An Introduction to a Stock's Annual Report
Many investors know that they are supposed to request a company’s annual report to understand the business but they don’t really know what it is or why it is important.
What is the annual report?
The annual report is a document prepared by a company’s management to the shareholders explaining what happened in the business for the year. There are no real rules for what an annual report contains. Some companies don’t even prepare one.
How is the annual report different from the 10K? Do I need to read both?
If the 10K is regular Coca-Cola, the annual report is Diet Coke. It is a softer, more accessible, easier-to-understand version of the company’s finances, business, and management philosophy. The 10K is often hundreds of pages of text, financial statements, and legal disclosures. The annual report, on the other hand, is sort of a PR document with lots of pictures, colorful graphs, and images of smiling employees.
Some companies don’t prepare an annual report at all, instead releasing everything in the 10K. Others combine a short annual report with the 10K. Still others have a very, very lengthy annual report and their 10K statement consists of nothing but the saying, “incorporated by reference from the company’s annual report.”
The bottom line is that you need to read both the 10K and annual report to get a full understanding of a company. You wouldn’t buy a car without knowing the background of the company that made the automobile and due to the power of compounding, there is much more at stake when you choose a stock to buy.
What is the annual report?
The annual report is a document prepared by a company’s management to the shareholders explaining what happened in the business for the year. There are no real rules for what an annual report contains. Some companies don’t even prepare one.
How is the annual report different from the 10K? Do I need to read both?
If the 10K is regular Coca-Cola, the annual report is Diet Coke. It is a softer, more accessible, easier-to-understand version of the company’s finances, business, and management philosophy. The 10K is often hundreds of pages of text, financial statements, and legal disclosures. The annual report, on the other hand, is sort of a PR document with lots of pictures, colorful graphs, and images of smiling employees.
Some companies don’t prepare an annual report at all, instead releasing everything in the 10K. Others combine a short annual report with the 10K. Still others have a very, very lengthy annual report and their 10K statement consists of nothing but the saying, “incorporated by reference from the company’s annual report.”
The bottom line is that you need to read both the 10K and annual report to get a full understanding of a company. You wouldn’t buy a car without knowing the background of the company that made the automobile and due to the power of compounding, there is much more at stake when you choose a stock to buy.
How Scrooge McDuck Taught Me to Be Rich
Hanging on the wall near the desk in one of my offices is a beautiful limited edition work called “Embarrassment of Riches” by famed comic book artist Carl Barks. In it, Scrooge McDuck, his nephew Donald, and his grand nephews Huey, Dewey, and Lewy are measuring the depths of the gold and treasurers in the money bin. As I glance up from whichever investment report happens to be in front of me at the time, I often think of the lessons that Uncle Scrooge has taught me; things that are very much a part of the enterprise that I’m building now and the way my investments are handled.
It may seem unconventional to those who don’t know me well, but it’s natural that McDuck was one of my childhood heroes. As someone born into a middle-class family, I knew that it fell to me to build a fortune if I were to ever have one; even winning the lottery had little appeal because it wouldn’t have felt earned or deserved (my parents worked extraordinarily hard and that was instilled in each of the kids). As I studied Peter Lynch, Warren Buffett, Charlie Munger, Ben Graham, and the rest of the greats, Scrooge inevitably made his way into the integrated framework that became my investment style. It was partly the lessons I learned from him that allowed me to go from an upstart with no capital and little experience working from a library cubicle with Value Line reports, a Bic ballpoint and a pad of paper to my current situation with gold-rimmed china, fine fountain pens, and an on-demand research system that lets me monitor my commitments from the comfort of an art-filled sanctuary.
Here are some of the lessons that I learned from the Richest Duck in the World. I’m hoping they will help you build your wealth, just as they have assisted me.
Harness the Power of Trickle Back Economics
Scrooge believed in a modified form of Reagan’s “trickle down” economics called “trickle back” economics. As one website explains the theory, “When (Scrooge) pays his nephews their wages of thirty cents an hour he knows they will use the money to buy tall, fizzy sodas at the nearest soda fountain. Then the soda fountain people will use the money to buy more fizzy ingredients at the chemical factories, and the chemical factory people will buy their ingredients from the coal tar factories - and who owns the coal tar factories? Uncle Scrooge! By the time those thirty cents have trickled back to Uncle Scrooge they have grown to sixty cents.”
In my own life, this was harnessed by creating a specialty e-commerce site that sold personalized apparel. My family owned the wholesale factory that served as one of the company’s main vendors so when we placed orders and paid for the cost of goods sold, the money was sent from the e-commerce group, which we owned, to the factory, a separate business that we also owned! To prove the value of this theory, we put aside the funds at the factory into a brokerage account where it was used to buy stocks, bonds, and mutual funds. Think of it as a company such as Berkshire Hathaway having the Nebraska Furniture Mart buy its car insurance from GEICO and selling See’s Candies inside of the store, albeit on a much smaller scale.
Study, and then Exploit, Supply and Demand Discrepancies
In one classic story, a disaster caused Uncle Scrooge’s money bin to blast wide open and shower money down on the citizens of Duckburg. Suddenly finding themselves fantastically rich, the ordinary folks gave up their day jobs and instead piled up as much treasurer as possible. The restaurants closed, the police abandoned their posts, the teachers went on vacation, and the office buildings were deserted.
Unflustered, McDuck took his now-panicked nephews (who wisely realized that the town was blowing their inheritance) to a farm on the outskirts of the city. Not understanding why Scrooge wasn’t emotional or distraught, they kept trying to impress upon their uncle the nature of the emergency. Not paying them any attention, he ordered them to help him pick up some tools and the four began sewing seeds. As time passed, the harvest began to grow and the now seemingly poor family lived on the farm.
At precisely the moment the crops were ready, the town had run out of food. Scrooge turned to his nephews and explained that he now owned the only supply of fruits, vegetables, and other foodstuffs in the area, allowing him a monopoly on goods that were necessary for survival. Able to name his price, in no time, McDuck had managed to recapture his entire fortune, while teaching the boys a priceless lesson in hard work and the exploitation of the supply and demand curve.
Warren Buffett once did this very thing in his personal portfolio by acquiring copper when the supply and demand relationships got out of balance. Later, he had Berkshire Hathaway repeat the investment when it acquired a massive portion of the world’s silver inventories.
It may seem unconventional to those who don’t know me well, but it’s natural that McDuck was one of my childhood heroes. As someone born into a middle-class family, I knew that it fell to me to build a fortune if I were to ever have one; even winning the lottery had little appeal because it wouldn’t have felt earned or deserved (my parents worked extraordinarily hard and that was instilled in each of the kids). As I studied Peter Lynch, Warren Buffett, Charlie Munger, Ben Graham, and the rest of the greats, Scrooge inevitably made his way into the integrated framework that became my investment style. It was partly the lessons I learned from him that allowed me to go from an upstart with no capital and little experience working from a library cubicle with Value Line reports, a Bic ballpoint and a pad of paper to my current situation with gold-rimmed china, fine fountain pens, and an on-demand research system that lets me monitor my commitments from the comfort of an art-filled sanctuary.
Here are some of the lessons that I learned from the Richest Duck in the World. I’m hoping they will help you build your wealth, just as they have assisted me.
Harness the Power of Trickle Back Economics
Scrooge believed in a modified form of Reagan’s “trickle down” economics called “trickle back” economics. As one website explains the theory, “When (Scrooge) pays his nephews their wages of thirty cents an hour he knows they will use the money to buy tall, fizzy sodas at the nearest soda fountain. Then the soda fountain people will use the money to buy more fizzy ingredients at the chemical factories, and the chemical factory people will buy their ingredients from the coal tar factories - and who owns the coal tar factories? Uncle Scrooge! By the time those thirty cents have trickled back to Uncle Scrooge they have grown to sixty cents.”
In my own life, this was harnessed by creating a specialty e-commerce site that sold personalized apparel. My family owned the wholesale factory that served as one of the company’s main vendors so when we placed orders and paid for the cost of goods sold, the money was sent from the e-commerce group, which we owned, to the factory, a separate business that we also owned! To prove the value of this theory, we put aside the funds at the factory into a brokerage account where it was used to buy stocks, bonds, and mutual funds. Think of it as a company such as Berkshire Hathaway having the Nebraska Furniture Mart buy its car insurance from GEICO and selling See’s Candies inside of the store, albeit on a much smaller scale.
Study, and then Exploit, Supply and Demand Discrepancies
In one classic story, a disaster caused Uncle Scrooge’s money bin to blast wide open and shower money down on the citizens of Duckburg. Suddenly finding themselves fantastically rich, the ordinary folks gave up their day jobs and instead piled up as much treasurer as possible. The restaurants closed, the police abandoned their posts, the teachers went on vacation, and the office buildings were deserted.
Unflustered, McDuck took his now-panicked nephews (who wisely realized that the town was blowing their inheritance) to a farm on the outskirts of the city. Not understanding why Scrooge wasn’t emotional or distraught, they kept trying to impress upon their uncle the nature of the emergency. Not paying them any attention, he ordered them to help him pick up some tools and the four began sewing seeds. As time passed, the harvest began to grow and the now seemingly poor family lived on the farm.
At precisely the moment the crops were ready, the town had run out of food. Scrooge turned to his nephews and explained that he now owned the only supply of fruits, vegetables, and other foodstuffs in the area, allowing him a monopoly on goods that were necessary for survival. Able to name his price, in no time, McDuck had managed to recapture his entire fortune, while teaching the boys a priceless lesson in hard work and the exploitation of the supply and demand curve.
Warren Buffett once did this very thing in his personal portfolio by acquiring copper when the supply and demand relationships got out of balance. Later, he had Berkshire Hathaway repeat the investment when it acquired a massive portion of the world’s silver inventories.
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