Wednesday, August 26, 2009

Readers' Questions

1. How do I determine the Discount Rate?

The best explanation on how to determine a discount rate can be found in Aswath Damodaran's book, The Dark Side of Valuation. But I don't get into too many details about the discount rate. I just use 10%. I simply want to get an idea of whether a stock is undervalued. I am not interested in being exact. I don't believe anyone can be exact.

2. What are some helpful websites for determining 5-year and 10-year projected earnings for a stock?

You can look at

3. How ofter is a discount to value greater than 40 percent? What is the track record of your valuation model?

The amount of discount varies based on the economy and particular securities. For example, during the current recession it is relatively easy to find companies trading at a 40% discount to value. But there are particular securities that enjoy even higher discounts.

As far as the track record, I don't think about it this way. The valuation model is no the answer to riches. It is just one of the tools to assist investors in valuing a stock. There are also other ways to value a company. For example, investors can look at the hard assets and estimate what they could be sold for if the company was liquidated. The valuation model works all the time. The question is whether investors are right about the assumptions. You can make any company be worth anything you want depending on the assumptions.

4. Will value investing become more popular as the economy moves into a prolong recession or mile depression?

I am not sure whether the popularity of value investing will increase, but what I know for sure is that when the economy deteriorates, investors are likely to oversell, sending stocks way below their values. This will provide opportunities to pick up good companies at great prices. Not every company will go out of business. I just watched a documentary about Coca-Cola and it showed that even during the Great Depression, the company was doing fine.

Tuesday, August 18, 2009

Why Are We So Clueless about the Stock Market?

I was inspired to write this book by the 2008-09 economic recession that started with the bust in the housing market. The Dow Jones Industrial Average fell from its high of approximately 14,000 in July 2007 to about 6,500 in March 2009. The majority of people who were invested in the stock market saw their 401(k)s, IRAs, or other investment accounts decline 50% or more.

During the same period, my investment portfolio lost nothing. As a matter of fact, it showed a gain of 5.81% in 2008 and 258% year-to-date. Why did I achieve this performance when everyone else experienced investment losses? Is the answer that I am some kind of a stock market genius or hold a PhD in economics? No, neither of these descriptions is the reason. The answer lies in the fact that I was almost 100% in cash before the market started collapsing. When analyzing stock in 2007 and early 2008, I was not able to find anything trading at reasonable prices. Staying in cash was the best alternative.

As I later realized, I was not the only one having this problem. Warren Buffett was not buying much during the same period but was just accumulating cash. He was criticized for doing so because some wanted him to invest it and others wanted him to return it to Berkshire Hathaway's shareholders in the form of dividends. Like Mr. Buffett, I patiently waited for opportunities.

When the stock market crashed, the opportunities to buy excellent companies were plentiful. The companies, such as American Express and Wells Fargo, which I had dreamed of owning for years, became available at prices well below their values.

So how come most mutual funds, financial advisors, and other money managers failed to see the lack of investment opportunities during the peak in 2007 and early 2008? Maybe some of them did, but even so, they would have failed to act because of the compensation system that was in place. The majority of money managers are paid a percentage of assets under management. For example, if the assets under management are $100 million and the management fee is 1.5%, the money manager will receive $1.5 million (1.5% x $100 million). Under this compensation system, generating above-average returns and protecting investors' money is secondary. The primary concern for these managers is to have as much assets under management as possible and to be fully invested at all times. How likely is it for a money manager making $1.5 million if fees to go 100% when he or she is supposed to be investing the money, not sitting on cash? If a money manager did go 100% cash, he or she would have been criticized as Warren Buffett was criticized for having too much cash. Going cash or returning the money to the investors would be equivalent to quitting a $1.5 million job.

So what could the individual investors have done to prevent themselves from seeing their portfolios lose half of their values within a matter of months? Since investment professionals and other so called experts may not always act in their clients' best interests, there is only one option left: do it yourself. But the problem is that the majority of the general public does not have enough knowledge to take it upon themselves. To illustrate my point, let me pose this question:

What did the general public do when the 2008-09 recession provided 1-in-a-100-years investment opportunities?

Many panicked and sold their holdings by cashing in their retirement plans or other investment accounts. The investors who did not sell kept sitting on the same stocks that had lost money. If an investor's portfolio went from $100,000 to $50,000, in order to break even the $50,000 portfolio would have to double. However, it might not be realistic to break even with the same set of stocks. An investor in this situation should ask himself or herself,

If I had $50,000 in cash would I still invest in the stocks that I currently hold?

If the answer is no, the funds should be placed somewhere else where there is a greater potential for growth. If on December 31, 2008, the above investor had invested this $50,000 in stocks that were in my portfolio, it would have growth to about $179,000 as of the date of this article.

The panicky and fearful behavior of many individual investors is indicative of how unprepared and uninformed we as a society are about investing. It has been my experience that most people lack basic investment knowledge, but because some of use are successful in our careers, we assume that we will be good at investing. Nothing can be further from the truth.

Why Are We So Clueless about the Stock Market?

Because we

* panic and run away when the stock market is serving us unbelievable deals,
* jump on the wagon or stay in the wagon when the market is overpriced,
* do not understand the difference between stocks and businesses,
* cannot differentiate between excellent and mediocre businesses,
* do not know how to value stocks,
* do not realized how over-diversification can destroy returns, and
* do not understand why investing in IPOs is not a good idea.

In this book readers will learn to identify the missing pieces of the puzzle in investment strategies and the way to arrange them in order to realize investment success. The fundamentals presented will decrease the chances of making investment mistakes, and most importantly, will make us think twice about whether we are investing or simply gambling and calling it investing.