By Charles Osgood broadcasting The Osgood Files © 1986 WCBS Inc. Reproduced with permission. Ending edited by Edward Mendlowitz There once was a pretty good student Who sat in a pretty good class And was taught by a pretty good teacher Who always let pretty good pass. He wasn’t terrific at reading, He wasn’t a whiz-bang at math, But for him, education was leading Straight down a pretty good path. He didn’t find school too exciting, But he wanted to do pretty well, And he did have some trouble with writing Since nobody taught him to spell. When doing arithmetic problems, Pretty good was regarded as fine. 5+5 needn’t always add up to be 10; A pretty good answer was 9. The pretty good class that he sat in Was part of a pretty good school, And the student was not an exception: On the contrary, he was the rule. The pretty good school that he went to Was there in a pretty good town, And nobody there seemed to notice He could not tell a verb from a noun. The pretty good student in fact was Part of a pretty good mob. And the first time he knew what he lacked was When he looked for a pretty good job. It was then, when he sought a position, He discovered that life could be tough, And he soon had a sneaking suspicion Pretty good might not be good enough. The pretty good student, soon aspiring to be great Which learned much too late, If you want to be great, Pretty good is, in fact, pretty bad.
Continued from my previous blog…
We are all emotional and many investment decisions are made based on emotions and not just the facts. His advantage is that he makes fewer emotional investment decisions than most of us. Yes, he does make some emotional decisions – he is human! He also leans toward companies that make products he understands.
An example of the type of deal Buffett can do that most cannot is the acquisition of H.J. Heinz. BRK and a Brazilian partner, 3G, each invested $4.4 billion for equal 50% interests. BRK then invested $8 billion in preferred stock paying a 9% dividend. Therefore, BRK will receive, off the top, $720 million before either equity owner receives a cent of the profits. There is also debt financing from JP Morgan and Wells Fargo and assumption of present Company debt making the entire deal worth $28 billion. 3G are the owners of Anheuser Busch and are proven very capable managers of consumer products businesses so Buffett got a great partner (for very low cost) to oversee his investment.
Aversion to Loss
Buffett doesn’t like to lose and would rather pass on a deal than go into something without underlying value. If the value is there, the stock might not increase so quickly, but the way he sees it, downside is limited. He buys stocks that he feels will have low volatility, low risk, low leverage, that are safe, cheap, profitable, high quality and growing payout ratios. Strong brand recognition and possibly a secret process or patent or unique product is also a plus. He also looks for management with strong ethical values and that look to maximize shareholder value. Look at definition of value investing above.
Leverage is another way of defining debt. Many investors trade on margin in that they borrow against the stocks they own to buy more stocks. Doing this accelerates gains, but also accelerates losses. Also, interest payments are a drag on profits which must exceed the interest paid. Further, momentary drops in the stock the broker holds as collateral can cause the stock to be sold ending the ability to recover from those drops. Buffett does not use significant borrowed money to acquire his shares.
Plan an Investment Plan
Buffett has a well-disciplined plan, investing values, goals and criteria that he rarely deviates from. He also has the discipline to wait and not chase overpriced companies, often looking to acquire stock at what he sees as large discounts from his assessment of the Company’s “fair value.”
With a lone exception, BRK has never paid a dividend accumulating and compounding its earnings and investing in more and more situations. He also uses his cash hoard to rebuy some BRK stock when he believes BRK’s market value is too low. On some level, if he did not control BRK, it would not be a stock Buffett would invest in because it doesn’t pay any dividends. He created a company in the image and style that suits him and his personality.
Buy When Others Sell
When the market tanks, more people are selling than buying. The drop in stock prices has nothing to do with the intrinsic value of the company, and Buffett looks at this as a buying opportunity. Let’s face it, when you go to buy a car, do you secretly wish the price was higher? Well, people buy stocks after they’ve increased in price and hold off on their purchases when the price drops. Not Buffett.
Many people think they can time the market by frequent trading. Buffett is a “buy and hold” investor. He doesn’t believe in market timing as a strategy.
Investors’ Trading Costs
Individual investors have many costs of trading that reduce their returns. Brokerage commissions, the spread between bid and ask prices when trades are executed, taxes, operating and management costs of mutual funds or managed accounts and courses and subscriptions to investor publications and news services. Additionally, there is time opportunity cost where an investor spends time learning about trading and stock situations and analyzing and trading his portfolio. Warren Buffett does what he is doing as part of making his living and individual nonprofessional investors cannot come close to the time he spends. Also, his trades, as for most institutional investors, are at a reduced “wholesale” cost.
Outsmarting Everyone Else
Most investors, and virtually all traders, are trying to outsmart every other person like themselves with similar thoughts that think they found a gem among the weeds. For every buy transaction, there is a seller that thinks the opposite. They cannot both be right.
Warren Buffett is Warren Buffett
Many times Buffett can make a better deal for himself than others can get is because of the value created by people knowing he invested in that deal. When the market was crashing the end of 2008 and beginning of 2009, knowing that Buffett was investing in certain companies created a reassurance to the markets. It also propped up the market and some people got back some confidence.
Recently, I presented my 34th annual financial program. This year’s topic was “How Warren Buffett Did It.” As part of my handout, I had a section with rules that Warren Buffett follows (or has, but does not follow) that might be interesting for others to know. Here they are.
This is investing based on the underlying strength of the company and not on the way the stock trades or is expected to trade (which is called technical analysis). Buffett uses fundamental analysis and doesn’t “bet” on the way the stock will trade
Access to information
When Warren Buffett wants to review a Company, he has access to all of the public information everyone else has. What he does differently is that he has a team of people that know where to look, what to look for, how to access it, how to use it and how to integrate the myriad data to form a clear opinion. Most people simply cannot do this
Value stock investors try to spot more mature companies paying reasonably good dividends that also appear underpriced. Buffett is a value investor. Growth investors look for underpriced companies whose stock price is expected to grow to provide them with gains while dividends are not as big of a concern. Value investors look at traditional valuation measures such as price/earnings ratios and dividend yields. They also look for stocks they expect to grow once the market either “corrects” or realizes their “mistake” of the lower stock prices. Meanwhile, they enjoy good dividends. They are not expecting dramatic growth, although, that sometimes occurs
This refers to the percentage of profits that a company pays in dividends. The ratio is derived by dividing the dividend by the profits. A stock that pays an $80.00 per share dividend and earns $100.00 per share has an 80% payout ratio. A stock that pays a $20.00 dividend and earns $100.00 has a 20% payout ratio. The lower the payout ratio is, the greater the possibility for increases in the dividend. Additionally, the greater the availability of funds to be used by the Company to expand operations, introduce innovations, enter new markets, or have excess cash to buy back shares that are trading below their intrinsic value. Buffett likes the lower payout ratio companies
Corporate tax rates
Corporations such as Berkshire Hathaway (“BRK”) only pay tax on 30% of the dividends they receive. At a top corporation tax rate of 35% this means BRK pays a 10.5% tax on its dividends. Some of BRK’s investments are in “convertible” preferred stock issues (rather than bonds) and are not usually available to other investors. What Buffett does is provide funds and then receives the preferred stock paying an above-market rate that he can convert into common shares at the stock price on the day he makes his investment. If the stock goes down, he keeps getting the high dividend. If stock goes up, he keeps getting the dividend until he decides to convert to common shares, or he has to convert because of a predetermined conversion time limit (or due date) when the preferred stock was issued to him. Bonds pay interest that is fully taxed to the recipient
Ability to Act
One of the great advantages Buffett has is his ability to make quick decisions and provide ready cash. BRK is set up that way with a small group of trusted advisors in his Company
A basic belief of investing is diversification which is a method of spreading and offsetting risk. This means that you do not have a high percentage of your total assets in only a few issues, or in one type of investment. Even though Buffett has a large portfolio, in four of the stocks, BRK own accounts for 60% of his public stock investments. This does not indicate adequate diversification for a typical investor. I am not criticizing him – I am just calling this to your attention
Understanding what the Company does
Buffett only invests in companies where he understands what the Company does to make money. I read a story where Buffett was asked if he wanted to take over, and save, Bear Stearns, he said he started looking at their financial statement and every time he came upon something he didn’t understand, he made a note on the cover. At one point he noticed his very many notes and decided it was too confusing and passed on it
Warran Buffett Risk
I give a basic financial planning speech where I’ve identified over 20 risk factors investors should consider. One of them I call the “Warren Buffett Risk.” This is a situation where Buffett decides to “buy” a company and makes an offer. He is not known to bid once his offer is made. Many people are disinclined to bid against him for fear of offending him. This can mean that the public shareholders could receive less than what they could have received if there was a “bidding war.” Buffett’s argument is that he did the work, identified the value and is making the best offer for the Company
To be continued in my next blog.
My previous blog suggested buying very long-term bonds instead of shorter-term bonds and worked out numbers to show the reasons why. However, there is a lot of additional information you need to know about bonds before investing in them. Here is a checklist of some of what you need to be aware of. Also, I posted previous blogs on bonds on Feb 26, 2013, Sep 13, 2012, Aug 16, 2012, Aug 14, 2012, May 3, 2012 and Feb 24, 2012. If you email me, I’ll send these to you in one file. Also, before doing anything, consult with your investment advisor.
Basic reasons, facts and principles:
- Bonds are purchased to provide a fixed cash flow for a fixed period of time at the end of which you get back your investment
- The typical investor should not buy bonds to trade in or to get a profit on changes in market value. That should be restricted to sophisticated traders or those with managers experienced in such maneuvers
- Bonds should not be purchased for a long period or term if there is a distinct possibility that they might need to be sold before maturity. Then, there is a great possibility of loss when they are sold
- Longer-term bonds have a higher risk than shorter-term bonds and because of this, pay higher interest rate
- Every corporate and muni bond carries a default risk. Some are greater than others and rating services categorize these risks
- Irrespective of what bonds you buy (including default risk-free Treasuries), market values will continuously fluctuate. However, if your purpose in buying the bond is to hold it until maturity, the changing value will be meaningless. It will be a paper notation upward or downward that will eventually vanish on the maturity date at which time you will get the bond’s face value
- One way to reduce risk of default is to buy a range of individual bonds, and I suggest at least ten different companies spread over at least five sectors
- To increase overall yield, you might want to consider some lower rated bonds for about 20% of your bond portfolio
- Another way to reduce risk is to create a bond ladder. This is where you stagger maturities so a certain percentage of the bonds mature at fixed intervals – such as every two years for the next twenty years
- Bond funds are an easy way to buy bonds and spread risk, but they lack a key element of the reason for bonds – there is no fixed maturity date, ever. You are NEVER guaranteed to get your investment back. You can only get what the market says the funds are worth when you decide to cash out. In the case of funds, the fluctuations become reality! I do not recommend bond funds
Here are steps to follow:
- Decide on the percentage of bonds you want in your portfolio
- Decide on the type of default risk you want to assume
- Decide on yields you are willing to accept and for what terms you are willing to lock in those rates
- Buy the longest maturing bonds you are able to get to provide the cash flow you want
Here are my reasons:
- Bonds create a layer of safety to your portfolio, are an anchor that protects some of your assets and reduce overall portfolio risk
- Longer-term bonds provide a higher cash flow than shorter-term bonds
- No matter how you feel, at least some portion of your bond portfolio will be a locked in, a sunk investment, that will never be liquidated (baring terribly unimagined circumstances)
- Whatever that portion is, invest as long as you can to get the highest reasonable yield
- A frequent objection to longer-term bonds from older investors is that they don’t want to buy bonds that will outlive them. This is not a valid concern. The purpose of bonds is to provide cash flow. When the owners die, their heirs will have a choice whether to sell the bonds at a possible loss, or retain them for the cash flow. If the concern is the loss of value to the heirs, then buy life insurance to assure a legacy, but don’t use this excuse to buy lower yielding bonds
How to defending what I am suggesting:
- Show this blog to your investment manager and ask them to either do what I say or explain where I am crazy
- If they tell you I am wrong, get their reasons and compare what they say to what I wrote and decide who is making more sense. You can even ask them to prepare a little calculation for the “30 year” period
Other issues with bonds to consider or be aware of:
- There is more than one rating service and investors should be aware of the differences between them and how they base their ratings
- High yield or “junk” bonds should not be entirely ignored, but also need caution and understanding when considering them for a portion of your allocation
- 30 years is a long time to give up the opportunity for alternatives
- Bonds purchased at a premium, that are held to maturity, will see that premium vanish. They should be made up as an offset to the higher coupon payments
- Bonds purchased at discounts will receive the full face at maturity and will have a capital gain. The offset here is lower interest payments each year
- Many bond issues are callable even when specified as not being callable, have sinking fund or prefunding provisions, are subject to special provisions involving maturity date changes and step up or downs of rates
- Many times when buying bonds, the brokers’ markups are not disclosed and excessive mark ups would reduce the eventual yield
- Always find out the yield to maturity when buying a bond – that is what you will get, annually, assuming the bond is held to maturity
- If a bond has an earlier call date, also find out the yield to call
- People trade bonds with the same volume and frequency as stocks, but for much higher amounts and possibly greater risk. This is not covered here and is not recommended except for very highly knowledgeable investors who understand the full risks
- Those with larger size portfolios should consider an investment manager for their bonds, but, like any other financial endeavor, should determine the investment objectives, style, value and fees beforehand
Buying bonds is somewhat confusing and I tried to explain it as clearly as possible. If you question anything or want greater clarification, write a comment and I will respond to it. Or, email me directly and I’ll post your question anonymously with my response.
Buying bonds requites the effort to understand bond ownership. Also, do not lose sight of the purpose of bonds which is to be part of a cohesive plan to provide for you and your family’s long-term financial security.
With today’s low interest rates, looking for reasonable yields from fixed income investments is not easy. Many investment and fund managers and advisors are recommending relatively shorter-term bonds – with maturities up to five years. I disagree. I believe that for many situations, longer-term bonds should be purchased.
For discussion purposes, I will use representative corporate rates, but the principles refer equally to tax-free or Treasury bonds.
The reasoning for using terms not exceeding five years is that “rates will soon rise” and 1) you won’t be locked into today’s low rates and 2) there will be less loss in market values as rates increase.
The “locked in” argument is only valid if rates increase and the investor will then buy longer-term bonds when the shorter-term bonds mature. From my experience, investors that buy shorter-term bonds never switch to longer-term since they always feel they do not want to be locked in while waiting for higher rates. Further, the loss in market value argument is a spurious claim since most of the people I know that are not traders and buy bonds to hold to maturity. Accordingly, the fluctuations in market values create meaningless temporary paper entries.
Most of my clients that buy bonds want the stability of the interest payments, either to spend or accumulate, and safety of principal. By buying the shorter-term bonds, they are giving up cash they could be collecting. Those that use investment managers end up barely getting what they could with two to three year bank CDs. How do these shorter-term bonds make any sense?
My suggested alternative is to buy very long-term bonds, say 30 years. YIKES? Am I serious? Yes. Let’s look at the numbers. For our discussion, we will assume 30 -ear corporate bonds yield 5.25% while 5-year corporates yield 2.25%. You can make similar calculations with any current yields.
If you are willing to buy a 5-year bond and get 2.25% but buy the 30-year bond instead, you will receive 3% extra for each of the first five years. That is 15% extra. Dividing this 15% by the remaining 25 years comes up with .6% extra per year meaning that you will “earn” 5.85% for each of the remaining 25 years. I have a question to ask you. If you decide to buy a 25-year bond when the 5-year bond matures, how likely is it to expect 5.85% for that 25 year period? You don’t know, but I suggest that you will probably not buy a 25-year bond, but will buy another 5-year bond (continuing to wait for rates to rise). If rates stay exactly the same, then you will get another 2.25% also instead of the 5.25% you would have locked in with the original 30-year purchase. This results in another cumulative 15% greater than you would have received. So, now, you banked 30% additional interest that can be spread out over the remaining 20 years. That works out to 1.5% extra for years 11 through 30 or 6.75% for that remaining “20 year” bond. We are getting into an area that would be hard to match unless rates really start shooting up and then all the stars have to be perfectly aligned for you to catch it exactly when your five-year bonds mature and you have the cash to reinvest.
The point I want to make is that those intending to hold bonds until maturity should consider very long-term bonds rather than shorter-term. There are other issues and I refer you to my next blog for more information. There are many arguments on every which way of buying bonds – mine is presented here.
Work out the numbers! Compare the cash flow. Figure out how you are richer.
Financial and investment planning is a skill that is never mastered. People can get good at it – very good in fact, but you are always working against a moving target. The economy, government policies, global demand for capital, commodities and labor and personal goals that keep changing all make it hard to have a concrete agenda. However, those that plan are much better off than those that do not. Here is a 13 step tool kit to use to plan your own finances.
- Purpose of Planning: Write down the purpose of why you want to plan. Review it to see if it is realistic and addresses for overall big picture concerns
- How much you spend: Determine how much you are currently spending a year, and how much you will be planning on spending at later intervals in your life
- Short-Term Goals: Write down what you want to accomplish over the next few years
- Long-Term Goals: Write down longer-term goals. Based on your age and situation, this could be five years from now, or twenty-five years
- Risk profile: Write down what you understand risk to be about and how you feel about stocks, bonds, commodities, real estate and if you have one, your business. How do you view inflation as a risk factor? Did you already win your “personal lottery?” See my prior blog dated June 20, 2013
- Cash flow: What is your annual cash flow and what do you expect it to be at various stages later in your life
- Net worth: Tally up your assets and debt. What is your financial net worth? Do you have a sensible way to pay down your debt, or get it under control? Determine likelihood of your net worth growing and how
- Asset allocation: Based upon your goals, determine how much of your net liquid assets should be allocated to rainy day funds, stocks, fixed income and other broad investment categories and at what levels of risk
- Relook at your asset allocation: Take another look at what you did. Does it make sense? Do your rainy day funds reflect immediate and possible emergency needs? Make sure you are reasonably comfortable with the allocation categories
- Number crunching: Work out potential cash flow from your asset allocation. Estimate expected interest, dividend and stock appreciation rates. Include income from your job or business, Social Security and pensions. Be realistic on the low side. If your income estimate is too low, you won’t get hurt; if it is too high, you could be hurt! Overestimate expenses for same reasons
- Whether goals are attainable: Match the cash flow against how much you spend and plan on spending. If there is a short fall between your cash flow and spending, you should consider adjusting your spending, increasing risk, working longer, or even getting another or a part time job. What many people do not realize is that financial goals are behavioral. Spending can be controlled or curtailed to accumulate funds that will enable future goals to be attained, or goals can be altered. For instance, a 52 year old might want to retire at age 60 but because of the funds they presently have and are expected to accumulate, they will not be able to retire until age 64. By curtailing certain spending and investing a little more aggressively, they can cut two years off and retire at age 62. It is then their choice to change present spending or their retirement goals
- How to attain goals: Write out a clear plan based on everything done in the first 11 steps that shows how you will attain your goals. That will become your big picture plan that you should now follow
- Plans are road maps: Road maps point you in the direction you want to travel, but lots of time there are unplanned for turns, tie ups or unexpected roads. The plan and goals will help you better maneuver those bumps and forced changes
Warren Buffett’s biography by Alice Schroeder describes Buffett winning the “Ovarian Lottery.” He was blessed to be born in America and able to take advantage of the opportunities that came his way and those he created.
He talks about people in third world countries that might have the same genes and able to take advantage of opportunities that he and people like Bill Gates had, but they were relegated to menial jobs such as tugging boats by the Three Gorges Dam Project in China. They lost the Ovarian Lottery.
I just finished an excellent book by Jill Lepore about Benjamin Franklin’s younger sister, Jane Mecom, entitled Book of Ages. Jane obviously had similar genes, above average intelligence, an interest in reading, writing and current affairs, as her brother but because she was a woman, was relegated to caring for a family (she had 12 children), fighting battles for fiscally irresponsible sons-in-law and living life on the sidelines. She never had a chance to fulfill any non-domestic accomplishments because opportunities for women were nonexistent.
The book is a page-turner about a remarkable sister of one of the most remarkable people of all time and, likely, the most famous man of his time in Europe and America. The most letters Benjamin wrote to anyone was to his younger sister. He was his father’s youngest son and she was the youngest daughter and they were the last surviving of 17 children. He died at age 84 and she at age 82. Jane was six years younger.
The book is well researched and while I started reading the book on loan from my local library, I purchased a copy so I could reread parts whenever I wanted and to use the large notes section as future reference sources.
The author describes what Warren Buffett calls the Ovarian Lottery. Because of the time she grew up in, his sister never had a chance to do more than she did. I don’t want to disparage her family activities, but we can imagine what could have come out of a sometime collaboration of this brother and sister.
One of the amazing things that struck me, and shows the love, pride and admiration of the sister for her older brother was retaining her entire life a note that Benjamin sent her when he was 21 and she 15 with his now famous epitaph. For 67 years, through war, displacement, sometimes poverty, children’s deaths, caring for a house, children, grandchildren and great grandchildren, she held on to this cherished scrap of her brother’s words. It was discovered on her after her death. The surviving letters she also held on to are pitiable tokens of what might have been.
In her regard, Jane, and probably us, lost the Ovarian Lottery!