Saturday, November 23, 2013

The Way of The Value Investor (Part III Conclusion)

The first rule of making money is, “Don’t lose what you already have.” Keep an age appropriate percentage of your money in a wide variety of relatively safe stable investments. Don’t put too much at risk at one time. This is particularly true after retirement. When you are no longer a part of the workforce, it becomes very difficult to recover from financial disasters. When you are young you can take more risks, but only after you pay off those credit cards and build up an emergency fund. “Safe” includes investment grade bonds, Treasury Bills, Government National Mortgage Association (Ginnie Mae) funds, cash (insured money market funds and the like).

For new readers, your age in bonds, cash, and CD was the old rule of thumb. Hence, at age 30 one would hold 30% in safe investments and have 70% of their holdings in stocks and stock mutual funds. The new rule of thumb is based on the fear of inflation. It recommends your age less 15% in safe holdings. Hence, at age 30 one would hold 15% in safe investments and 85% in stocks. Even the young who are playing with relatively large amounts of time and relatively small amounts of money need to keep some powder dry. When the market tanks, and it will, that money will allow you to purchase once in a decade bargains.

Value stocks with a low beta are all good bets for capital preservation. Beta is a measure of volatility that can be found on quote pages on sites like Google Finance. A beta of 1.00 means a stock is as volatile as the market. Less than 1.00 means it is more likely to be safe and boring. Greater than 1.00 means the stock moves faster than the market, both on the way up and on the way down.

The Price Earnings Growth Ratio, commonly called the PEG ratio, is the PE ratio divided by the company’s growth percentage. Let’s say a company has a PE ratio of 20 and it has been growing at 10% per year and you expect it to continue to grow at that rate. The company has a PEG of 2. The lower the PEG ratio the more likely the stock is a bargain. A PEG ratio of 1.0 is considered neutral.

Peter Lynch, the genius who managed the mighty Magellan Fund during its glory days, put a slightly different spin on this measure. He suggested adding the growth rate to the dividend payout, then dividing the result by the P/E ratio. Hence a stock with a growth rate of 7% plus a dividend of 3% divided by a P/E ratio of 15 would be 0.67. This would be pretty typical in today’s market. Peter Lynch considered under 1.0 poor, 1.5 neutral, and over 2.0 good.

As an engineer and an embittered old cynic, I have a problem with the PEG ratio as well as the more sophisticated number suggested by Peter Lynch. I am very comfortable with interpolation, the art of taking two know points on a graph and estimating the value of an unknown point between the two known points. I am not so happy with extrapolation. A trend is a trend until it is no longer a trend. The line on a graph may be linear up to some point and then take a wicked curve in the opposite direction. When I plug a number into the denominator of the PEG ratio, do I use history and extrapolate, or do I just make a guess after looking into my crystal ball? Neither option appeals to me.

Buy what you love. One of the first and best places to begin your research would be your favorite companies. What companies do you love? My wife loved Yankee Candles. I thought that scented candles were a pretty stupid idea. Any fool with a stove, a pot, some wax, and some scent could make the things. My wife assured me that Yankee Candles were different. When the company went private a couple of years later we came close to a three banger. We almost tripled our investment!

Don’t buy what you don’t understand.

One of the most successful investors of the 20th century, John Templeton observed, “If you don’t understand what you’re investing in – don’t invest!” This advice will save you from an enormous amount of pain. I consider it the prime directive of investment. Yes, you will miss a few opportunities, but sometimes the certainty of not losing money is more important than the chance to make money. The art of investing, unlike the game of baseball allows you to wait for your pitch; you are never out on called strikes in investing. Warren Buffett observed, “The problem when you’re a money manager is that your fans keep yelling, “Swing you bum.”

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