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Investing
101 - What Your Investment Advisor Doesn't Tell You
If you are looking for Sooty's Candidates Tables they are at:
Trusts,
Shippers,
US Stocks.
The Stock Market Value of a Company is Wrong
Stock markets are a place where you buy fractional parts of companies
called shares or stock. On investment sites you will see the stock
value of a company which is the number of outstanding shares times
the current share price. This is what people who are currently buying
and selling the shares have negotiated as the value of the company.
There are many other ways to estimate the value of a company but
stock market theory says the stock value (or market value) is the
best one. Sooty asserts that the market value is a trailing indicator
because it is usually the best estimate for the company as it existed
three to six months ago.
What you need is something tell you the value of the company today
or even better three to six months into the future. But more on
that later.
All Stocks Go To Zero
Stocks start at near zero, rise to a peak, and then fall back to
zero. How quickly they rise, how quickly they fall, and how long
it takes to go from birth to zero depends on what business they
are in and how smart the company is managed. Some companies complete
the round trip in months (like heavily promoted mining stocks) others
may take a 100 years to complete the cycle (like Bears Stearns born
1923, RIP 2008).
Of the 500 largest US companies in 1957 only 74 survived 40 years
later (1997) in the S&P 500. A tiny number were bought before they
actually hit zero but most went out of business and their shareholders
were left with nothing. The US stock indexes at the close of 2009
were lower than the close in 1999. A growth investor who was well diversified
would have earned nothing over those ten years.
You may be convinced your favorite stock will never go to zero but
are you willing to bet your life savings on that? It is best to
assume every stock you own will eventually go to zero so you must
have an "exit strategy" for each one.
Company Financial Reports are Lies
Okay that is a little harsh but the financial report a company provides
is a marketing document that tries to attract new stockholders or
keep the existing ones. Like a product brochure they will fudge
the truth or try to leave out embarrassing details. There are some
pretty harsh laws about out-right lies but like laws on advertising
there are ways to suggest the situation is better than the cold
hard facts would reveal.
As an investor you need to know where and how information can be
hidden. The best place to hide unpleasant things is in the notes.
The balance sheet will show a million dollar piece of equipment.
There will be a little number next to the amount. Find the number
in fine print below the table and you discover that the equipment
is actually "stuck in a swamp a thousand miles from any town
and cost to recover it has not been determined". I would probably
deduct that from the book value of the company.
The other major trick is to push bad news into the next quarter
or pull good news in from the next quarter.
AR fudge: get a customer to pay 50% of their bill in advance when the
actual work won't start for six months.
AP Fudge: pay late on a big bill even if it means interest charges or penalties.
GL Fudge: depreciate or write off equipment in the next quarter to
avoid the charge against this quarter.
HR Fudge: lay off a bunch of senior staff and hire much cheaper
junior staff to cut labor costs (also known as the Circuit City
maneuver).
Eventually the company will have to reverse out the fudges but they
can temporarily show a financial position that is better that the
real situation. These will often show up in Q1 and Q2 reports. By
Q3 they will start to worry because at Q4 (year end) they
will have to come clean. Now some fudges (like GL and HR) can be
floated over a year end but even those have to be corrected within
a couple of years.
There are many good companies that report their honest position
each quarter but it is hard to tell the honest ones by reading just
one quarterly report. The wise investor will read at least 3 years
of financial statements and follow "noted" items to see
how they are treated. If the company is less than 3 years old do
not buy it. If you detect any fudges assume you missed most
of them and do not buy the stock. Keep reading the reports for stocks
you own looking for any change in management behavior. Despite Sooty's
"buy and hold" approach if the management suddenly embraces
the dark side it is time to unload the stock.
"Buy Low and Sell High" is Gambling
It is intuitively obvious that if your buy a stock at its low point
and sell it at its high point you will make money. Sooty asserts
that it is impossible to tell when a stock has hit its high and
extremely difficult to tell when a stock is at its bottom.
There are many strategies to figure out the high and low points.
Most involve graphing the stock price and watching for it to "break
out" from its 50 or 200 day moving averages. There are other
patterns that suggest a stock establishes "support levels"
and if it crosses these something important is happening. So you
sell if it falls through a level or buy when it climbs through a
level. This allows you to buy low and sell high with some (Sooty
says "illusionary") statistical confidence.
Trying to guess the highs and lows of a stock is much like trying
to guess the next lotto ticket number (Jees I haven't seen 17 or
27 show up for a long time - I'll try those). Most rising stock
volatility is based on herd mentality (everybody is buying so I
better get in before it's too late). Most falling stock volatility
is because something bad happened six months ago and stock is heading
to zero.
In any case if you bet on an outcome without having any real knowledge
about the underlying process you are by definition gambling.
Most gamblers understand that only the casino makes money in the
long run. In the stock market only the brokerage houses make money
because win or lose they always get their trading fees.
Pay Me Rent
While Sooty believes in buy low and never sell but he still wants to get
his money out of a stock before it hits zero. If the stock returns a
monthly or quarterly dividend the amount invested in the stock drops over
time. Stock volatility is less important because even the stock lows
are higher than the net amount invested. The risk to the investor drops
to zero as the accumulated income approaches the original purchase price.
Sooty does not have millions to invest (you probably don't either) so he
must select stocks that pay the highest rents and that means higher risk.
This requires more research but it means the net investment (the money at risk)
drops faster. Sooty takes risks but is not a gambler (more later).
Buy Low, Pay Me Rent, then Sell At Zero
Sooty's strategy for investing uses all the points you have seen
so far. If you have read the financial statement you have a pretty
good idea what a company is actually worth. This is hard to do and
takes a lot of reading but you can develop a reasonable estimate.
If the stock is trading below this estimate it is a "bargain" and
a good candidate for purchase. Find 3 or 4 candidates you like,
watch their stock prices to get a feel for the mood of the herd
and buy the best bargain price. This is the "buy low" part of the
process.
Pick stocks that pay reasonable dividends for their sector. For
banks it is about 5%, for income trusts and utilities it is about
12%, and for shippers it is about 15%. Since you are buying at a
"bargain" the rate you actually get should be higher. Based on the
price you paid and the amount of dividends calculate how long it
will take to get all you money back, that is, how long before your
ACB (Adjusted Cost Base) goes to zero. If you are getting 12% this
would be 8 years. This is the "pay me rent" part of the
process.
When your ACB goes to zero you own a "zero risk stock". You can
hold that stock forever while it keeps paying out dividends. At
some time the company will collapse and your dividends will stop.
As long as your ACB goes to zero before the stock value goes to
zero you come out ahead. In effect this means you expect to sell
your stock at zero. This is the "sell at zero" part of
the process.
Now this ignores a bunch of complexities such as; trading costs,
a non-zero ACBs because of company buyouts, the opportunity costs
based on the prime interest rate, the inflation rate, or the dividend
rates of competing investments. As you develop your portfolio models
you can certainly add these complexities. You will quickly discover
that they often affect all of your stock picks equally and rarely
help you decide what to buy.
Diversity Reduces Risk
If put your entire life savings in one stock and it does
you do well. . .but if it fails you are wiped out. This is a very high
risk strategy. It is best to assume one of your investments will fail and the
others will do as well as you expect. If your portfolio is paying
an average of 10% then you better hold at least 11 stocks so you
can lose one a year and still break even.
Oddly enough the lower your return the more different stocks you
need to hold in the portfolio to avoid a loss. At 5% you need at
least 21 stocks to break even if you lose one of them each year.
If you hold 21 different stocks paying 20% and you could lose three
of them a year and still make money.
As a rule of thumb you should probably plan on having at least a
dozen stocks in your portfolio. If you are concentrating on a sector
(like shippers) then you should have no more that 25% in that sector
and at least a dozen stocks in each sector portfolio.
Sooty's strategy is to have one cash portfolio (like GICs), one
diversified portfolio (like income trusts) then build sector portfolios
(like shippers or utilities). Once a sector portfolio is complete;
pick a new sector, become an expert in the stocks in that sector,
and build a portfolio of at least a dozen stocks from the income
generated by your other portfolios.
Do Not "Dividend Reinvest"
Dividend Reinvestment Plans (DRIPs) allow you to have your income
stream converted to stock so you increase your holdings. Companies often
provide discounts on the stock price (up to 20%) and charge no brokerage
fees.
This is a really bad idea. You have just converted your income stock
to a "growth stock" and as I said all stocks
go to zero. If you start with 10,000 shares paying a great
dividend and after ten years DRIP your investment into 30,000 shares only
to watch the stock go to zero you still lost your entire investment. Take your income
stream and buy a different investment. Building diversity out of income reduces
your risk. Adding to your position in a single stock (even "averaging down"
which Sooty is ashamed to say he has done) increases your risk.
16% Income is Unsustainable"
The Dutch East India Company founded in 1602 paid over 16% dividend every
year for 200 years (until the stock went to zero). There are lots of great
companies that pay high dividends long after your ACB has gone to zero.
Even Bernie Madoff's Ponzi scheme (not an example of a great company)
paid 11% for nearly 40 years so if you bought his shares (once) and took your
dividend every year (did not DRIP) even his scam would be a "Sooty safe"
investment after 9 years. If a Ponzi can be made risk free then investing
real companies is a much safer gamble.
To repeat: the calculation is "how many years before my ACB = zero" (stock price/dividend)
and "how long before this stock goes to zero". If the first is shorter you will
make money. More important the faster your ACB goes to zero the less accurate
you have to be on your estimate of how long the company will stay in business.
The wise investor is skeptical and assumes any company could
be fiddling their books and works to safeguard against that risk. The wise investor
also knows that the vast majority of companies are honest and diversification
is the best way to build income based on that honesty.
Financial Escape Velocity
Most financial planners assume you want to run out of money a few
days after you die. This means you save more than you earn early
in your career then spend more than you earn after you retire. The
problem is that medical research advances could cause you to outlive
your retirement savings and end up at the mercy of your government
pension plan. Living longer than you expect could mean living many
years on mac'n'cheese and cat food.
To ensure you don't outlive your retirement savings you should plan
to live forever (Sooty suggests you might actually have to deal with
living forever. Read about it
here).
This introduces the concept of a "financial escape
velocity" an income level from your investments that will always
exceed your standard of living. The worst case is that you die early
and your greedy relatives and your ungrateful children spend years
in court trying to get their hands on your estate.
Your escape velocity is different from mine. If you live a simple
life in a rented one bedroom walkup in a small South American town
your escape velocity could be $5K per year. If you live in a New
York penthouse and insist on a new SUV each year you might find
you would have to watch your budget on $500K per year. So your first
task is to figure out your personal financial escape velocity.
You next task is getting off the launch pad. For that you have to
live below your income and invest every spare dollar. Compound interest
will increase your income and after some years you will get to your
escape velocity. How quickly you reach escape velocity depends on
how much income you can spare and how good you are as an investor.
You should be able to sustain 12% per year on your investments (yes
that is 12%).
Get an Excel spreadsheet plug in your starting cash position. Compound
it at 12% per year and see how many years it will take to reach
you escape velocity income. You will be very disappointed at first
because it will almost certainly take more money than you have for
investing and it will take many, many years. From this you will
learn two things; "I need more money for investing" and "I need
to spend less on stuff".
When you reach your escape velocity you have a couple of choices.
You could maintain you income level but move to safer (lower return)
investments. You could increase your appetite for stuff to match
your increasing income. You could play your portfolios as some kind
of video game in the massively multiple online player game (MMOPG)
called "stock market". Ah to dream - back in reality - Sooty is
still trying to get off the launch pad but he is doing better than
12% and will probably reach a comfortable escape velocity within
ten years.
Still interested? Then given you understand Sooty's investment principles
you can move on to specific investments. Sooty has completed two
portfolios; Income Trusts and Shippers. If you are starting out
you should read the Income Trusts section first and construct your
"base portfolio" of diversified income stocks. Once you
have your base completed you can pick a sector for your first "sector
portfolio". Sooty chose shippers partly because they pay large
dividends and partly because he could understand the business
model. You may choose a different sector but understanding shippers
should help to ask the right questions when building your first
sector portfolio.
Currently the Income
Trusts section is dated. It is unchanged from when Sooty was
first building the portfolio. (This note will be removed after the
section is rewritten.)
Currently the Shippers
section is under constant revision as shipping company stocks are
delivering new surprises every week and the portfolio has not yet
stabilized.
Sometime during 2010 a Utilities section
will be available as Sooty starts to build a new sector portfolio
around companies that provide power, water, and other city services (or
perhaps this will end up being a bond portfolio depending on interest rates).
Start with the more diversified Income Trusts sections and watch
the Trusts
page until you become familiar with their patterns. Then move to
the less diversified Shippers
section to understand what a sector portfolio looks like. If you want to
build your base portfolio from NASDAQ or NYSE based stocks go to the
US Stocks page.
Your base portfolio should follow the advice
in the Trust section and only after you have a diversified base
should you start building a sector portfolio.
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Income Trusts