Time to hop back in?


Fortune Magazine publishes the above chart and says:

There should be a rational relationship between the total market value of U.S. stocks and the output of the U.S. economy – its GNP. [Warren Buffett] visualized a moment when purchases might make sense, saying, “If the percentage relationship falls to the 70% to 80% area, buying stocks is likely to work very well for you.”

Well, that’s where stocks were in late January, when the ratio was 75%. Nothing about that reversion to sanity surprises Buffett, who told Fortune that the shift in the ratio reminds him of investor Ben Graham’s statement about the stock market: “In the short run it’s a voting machine, but in the long run it’s a weighing machine.

Now, I don’t have a crystal ball, but it appears that most of the world’s greatest Value Investors (a technical term for ‘cheapskates’) are hopping back into the market, as this article – this time from Forbes – says:

Over the past several weeks, more and more of history’s most successful investors have turned bullish. Warren Buffett, John Neff and David Dreman–all of these gurus and others have said that they are now in full buying mode. Even Jeremy Grantham, a notorious bear, has said that stocks are cheap, as cheap as they’ve been in two decades, in fact.

I’m wondering: if you were prepared to buy when the market was high and people were beginning to speculate whether it would last, why wouldn’t you be prepared to buy (and hold for the long-haul) now, when the market is closer to the bottom than it was then?

I have some money that I can get an immediate 33% ‘kick’ by moving it from the US to Australia (due to favorable exchange rates), yet I am sorely tempted to keep it in the US and trade options with it, as I feel that there will be great volatility between a Dow of 8,000 and 9,000 … the time when traders make (and lose) fortunes.

Not suggesting that you do the same, but I am suggesting that if ever there were a time to buy (for the long-term), it might be right now … there might be deeper bottoms still to come, but there will be higher, highs as well … by buying and holding now, you will ride out those bottoms (if they come) and guarantee that you will reach the highs (when they come) … how can that be a bad thing?

… and, loving it!

Monday’s post set out to use a reasonably obscure study on the success of Warren Buffett [hint: it’s NOT due to luck] to ‘prove’ that the efficient market theorists are wrong …

… but, first, what is Efficient Market Theory, anyway?

Well, our trust Wikipedia entry says:

In finance, the efficient-market hypothesis (EMH) asserts that financial markets are “informationally efficient”, or that prices on traded assets, e.g., stocks, bonds, or property, already reflect all known information. The efficient-market hypothesis states that it is impossible to consistently outperform the market by using any information that the market already knows, except through luck. Information or newsin the EMH is defined as anything that may affect prices that is unknowable in the present and thus appears randomly in the future.

The principle is that there are thousands of stocks to choose from and each company is divided into millions of pieces (i.e. each piece of stock) with millions of individual buyers and sellers (from large institutions to small, individual buyers and sellers) all operating in a regulated, open market that ensures that all information that may affect the current or future share price is published.

Therefore, everybody should be factoring all of the same information to come up with a fair value for each stock, all of the time …

… or, so the theory goes.

But, there are some obvious ‘cracks’ in this theory:


When a company like Enron misreports its numbers and misrepresents its business prospects and business model, the price of the stock can be widely different to its real (or, intrinsic) value. We know the result of this one 🙂


When a person has access to special information about a company – that may affect its current or future price – through ‘inside’ contacts … and, that knowledge has not yet been published … then they can purchase (or sell) a stock a a price that may change dramatically once that information does reach the market. Of course, this is not legal; it’s called ‘Insider Trading … and, we know the result of this one, too 😉


The study that I mentioned yesterday clearly shows that Warren Buffett’s success is NOT the result of luck, or taking additional risks, but clearly and unequivocally due to his “superior stock picking skills” …

… but, how is this possible if Warren is acting legally, ethically, and with the SAME information available to everybody else?

It’s simple: efficient market theory is wrong … SOME of the time. In fact, often enough to allow investors like you and I – and, especially Warren Buffett – to make a killing … IF we are patient in both buying and selling:

Warren Buffett’s mentor, Benjamin Graham, discovered that some stocks were priced less than their current book value and he bought those stocks, typically looking to make a quick (< 2 year) killing and move on … he was successful enough at this that Warren, as his star pupil, took notice.

Warren soon found that he could simply buy and hold such stocks – and, look for ANY stock trading below it’s ‘intrinsic value’ (the discounted value of its future cashflows, as compared to treasury bonds + a suitable ‘risk’ margin).

Needless to say, student eventually outperformed teacher … but, BOTH outperformed the Efficient Market Theorists.

Here’s how YOU can do the same:

Pick up a book such as Rule #1 Investingby Phil Town (which, despite the title, is NOT Warren Buffett’s OR Benjamin Graham’s methods) or any other credible book on Value Investing (which simply means to buy a stock at less than its ‘true’ value).

Use that book to help you find stocks that some Efficient Market Fool is willing to sell to you for current market price, which HE believes is also fair market price (after all, if its that price, efficient market theory says it MUST be fair), but YOU know is a helluva bargain, and …

… wait until time and circumstance reprices that stock dramatically upwards, so that its market price and your estimate of its true/intrinsic value pretty much match.

What should you do then? Simple.

Sell it back to the same (or some other) Efficient Market Fool!

You see, you rely on these few facts:

1. Efficient Market Theory IS correct MOST of the time,

2. But, it is wrong SOME of the time,

3. And, when it is wrong – as long as the business of the underlying stock is sound – the Market will (eventually) correct its mistake!

The trick is simply to have the time and energy – and, the simple tools – to find such stocks, and the patience and discipline to wait for the correction …

… it makes Warren 21% a year; it should make you at least 15%

House or Home? 7 Case Studies …

The real advantage of my 7 Millionaires …. In Training! ‘grand experiment’ for the rest of us is that it provides some great ‘real life’ case studies of the topics that we talk about on this site.

For example, we talk a lot about your house, as – for most people – it’s your largest single purchase  …. assuming that you don’t intend to actually get rich and go off and buy yourself some REAL investments 😉

Here is where each of the 7MITs are at with their current housing; if any of these case studies interest you, click on the link to read their full post and be sure to scroll down and read all the comments:

Scott talks about both his current home (he has kept his previous home as a rental) and compares his current dual income to the 25% Income Rule – although, there is a question about his wife’s income to be answered.

Ryan isn’t sure whether he bought the ‘bargain’ home that he thought he was getting; should he pay down the mortgage to compensate? Read the post – and the comments – then let us know (either here or there) what you think?

Jeff is a Navy Pilot, so it should come as no surprise that he: (a) moves a lot, and (b) gets some housing assistance. Jeff is seeking to capitalize on his unique situation by flipping his current home … why don’t you add your comments to those that are already on his post?

Mark has a home that he wants to keep as a rental. Is he making the right move … and, is he using the right metrics to help him make the right decision? Also, in the comments, we examine whether Jeff’s (yep, back to the Navy Pilot) house is a home or an investment.

Josh is the ‘free accommodation at home’ guy … sigh! I (slightly) remember those days. But, does Josh have a housing decision to make (he has been give the task of managing his grannie’s flat)? Read his post (and the comments … feel free to add one of your own) and YOU decide!

Lee asks the critical question: house or home? We also have (read my comment) a totally new version of the Old Age Pension to offer Lee …

Diane lays an interesting ‘life situation’ on us: when do Life Partners combine assets and liabilities and when don’t they? Also, if finances are separated, how do you calculate where you are REALLY at financially? It can (and should) be done, but how? Diane has taken the same ‘live at home with parents’ path as Josh (for now) … what advice can you add?

If you are still deciding how much house YOU can afford – and, want to learn more about the 25% Income Rule and the 20% Equity Rule – start with this post, and work backwards through the links.

Tempting deal … bad deal!

picture-1My last (not ever, but for a while) Reader Poll showed that most of you thought that my hypothetical real-estate transaction was a good deal, provided that it didn’t tie up your money for too long.

Thomas, who has all the hallmarks of becoming a great real-estate investor, liked the strong returns on cash invested:

I don’t have to invest the full 100k. I can finance most of it, secured by the real estate. So, let’s say I can finance 80% of it, which means I “only” need to come up with 20k myself. If I can finance it at 5%, the interest on the 80k would be $4k a year, which would leave me with $3500 left over each year. $3.5k annually for an investment of 20k is a return of 17.5% per year. In addition, any appreciation is also yours, so unless you need to average a very high annual compound rate, this sounds like a great deal.

I, too, think it’s a pretty tempting deal, but NOT for the reasons that many of you gave for liking it in the first place …

… to summarize; here’s what I like about the deal:

– very well-established commercial strip-mall in a great area

– fully rented, with long leases

– currently returning 9%, less contingencies … so, estimated yearly distribution is $7,500

So, on an investment of $100k, I get a 7.5% – 9% return each year … presumably, there’s some sort of ‘ratchet clause’ in the lease to ensure that rents at least keep pace with CPI and/or market. I would NOT invest until I knew the answer to this question, but it’s a reasonable assumption to give an ‘in principle’ OK to the deal … with the cost of funds at sub-6% these days (and, I can lock in for 5 to 10 years on a commercial loan), this is beginning to look quite good. The capital appreciation almost becomes a ‘bonus’ …

So, here’s what I don’t like about the deal:

– It’s a general partnership … luckily I am the general Partner and get to control the property, but the rest of you don’t 🙂

– There is a rental/return guarantee

Whoa … I DON’T like a guarantee??!! … what’s up with that?!

To me, the guarantee is  a risk – not an opportunity – because the real returns should meet or exceed the guarantee at all stages, anyway, except in two cases:

1. The value of market-place rents decline (a recession can cause deflation; tenants may leave or go broke and we may need to cut rents to retain new tenants),

2. Costs can go over budget (vacancies could cause protracted loss of income; hidden structural issues could cause major repair costs; etc.)

3. Both could happen at the same time

Rick agrees, sounding the following warning:

It really sounds too good to be true- if a lot of these businesses go out of business can the $9K/year really be guaranteed? Could you really find another buyer in the current economic environment?

If only one of these things happen, we may be able to dig into our contingency fund to ‘ride it out’ (remember, we retain roughly 1.5% on net income each year as a ‘contingency’), but if a number of things happen at once, such as in the current economic and real-estate ‘perfect storm’, then the fund may run ‘dry’ …

… if this were our only investment, we would simply not take much/any rent out of the deal until we covered these costs and rebuilt our fund (if the situation becomes dire, we may need to put more money in or even sell out … but, this should be extreme).

However, because this is a partnership with a guarantee, the General Partner (me) has to maintain a minimum 7.5% return to the partners (you); which only leaves me a few choices:

1. Dig even further into the contingency fund, or

2. Ask you ALL to agree to vary the contract and take less money this year OR sell the project (are you ALL going to agree?), or

3. Borrow more money to pay the guarantee and/or cover the costs (increasing the expenses on the project even more), or

4. Wait for the bank, a supplier, or an investor to foreclose (because we pay you and slow down the bank and/or suppliers, or we pay the bank and one of you initiates proceedings because we fail to pay you as ‘guaranteed’).

In all of these cases, the flaw is that the ‘guarantee’ is funded by the project itself and forces the General Partner to make decisions that he would NOT make if ‘the project’ didn’t have to pay the guarantee

I like to think that the ‘managers’ on any project or business that I am involved in are always making the best commercial decisions, not acting artificially to enforce some sort of ‘forced distribution’ …

…. kind of like the board of directors of a business focusing on maintaining a certain level of dividend for investors, rather than growing the business’ long-term earnings (a.k.a. profits).

Can you now see that dividends and profits (businesses) or guarantees and net income (real-estate) are NOT the same thing?

So, for this project, if I were an outside investor, I would make a decision on the project and insist that there were NO guarantees … simple. Unfortunately, most investors don’t think past their noses (“what’s my return?”), hence the ‘guarantee’.

As to me, unless I was the General Partner and there was no guarantee, I would NOT invest …

What do you think?

Real Cashflow, Fake Cashflow


This is the first installment of a four part series on what I describe as the three types of cashflow (as it relates to Real-Estate) … feel free to weigh in!


I think, by now, most of our readers no longer subscribe to the “buy property for the tax deductions and future appreciation” scams of the 90’s and 2,000’s that resulted in one of the biggest property busts that the USA has ever seen.

But, I fear a new mantra – not quite as dangerous, but one that can squash your future returns (hence, financial dreams) like a kink in a fireman’s hose [AJC: that’s probably the worst simile that I have ever written] …

… it’s the ‘positive cashflow’ mantra.

You see, there are three types of positive cashflow, when it comes to Real Estate … and, I’m not sure that you will read about this anywhere else, but here it comes:

1. Tax Cashflow

2. Fake Cashflow

3. Real Cashflow

… only one of which we are really looking for, although, any great property purchase will probably exhibit characteristics of all three.

First, though, let’s review the typical property; the one that doesn’t produce any cashflow at all and loses you money … it’s negatively geared!

Negative Cashflow

A property produces rents – hey, even your home produces a ‘rent’ … it’s just that you don’t bother to pay it to yourself, but you should 😉 – and those rents are offset by costs: e.g.

– Mortgage Interest

– Repairs and Maintenance

– Vacancies

– Provisions

And, there are many others …

… interestingly, the last two aren’t strictly a ‘cost’ but a lost opportunity to earn rent – it amounts to the same thing: more cash going out than going in.

If the property has more expenses going out than money coming in from rents it is said to be Negatively Geared; this simply means that you are losing money!

So, why do you do this? Well, the promoters of such property – and, there are many such ‘promoters’ (e.g. builders, developers, real-estate agents, etc.) – will say that you do it for the FUTURE APPRECIATION …

… definitely lose a little bit of money today for the chance to make a LOT of money in the future.

There’s a word for that: gambling. I prefer poker; you may prefer lotteries; let others gamble on this kind of real-estate.

In the next installment in this special 4-part series on real-estate, I will cover the first kind of ‘positive cashflow’ real-estate: Tax Cashflow.

Playing the Efficient Market Theorist for a fool …

I love it when a scientific study – that cost goodness-knows-how-much – produces a result that is, well, kind’a stating the obvious …

Take this paper as an example; it finds that Warren Buffett’s success with stocks is not due to luck or taking higher risks, rather – surprise, surprise (!) – it’s due to superior stock picking skills:

The stock portfolio of Berkshire Hathaway, comprising primarily of stocks of large-cap companies, has beaten the S&P 500 index in 20 out of 24 years for the time period 1980-2003. In addition, the average annual return of Berkshire Hathaway’s stock portfolio exceeds the average annual return of the S&P 500 by 12.24% over this time period.

We examined various potential explanations for Berkshire Hathaway’s investment performance. We first explored the explanation that Berkshire Hathaway’s performance may be due to pure luck. We find that while beating the market in 20 out of 24 years is possible due to luck at a 5% significance level, incorporating the magnitude by which Berkshire beats the market makes the “luck” explanation unlikely.

After employing sophisticated adjustments for risk, we find that Berkshire’s high returns can not be explained by high risk.

Ruling out the major alternate explanations to Berkshire’s investment performance leaves us with the potential explanation that Warren Buffett is an investor with superior stock-picking skills that allows him to identify undervalued securities and thus obtain risk-adjusted positive abnormal returns.

Well, d’ah …

So, let me tell you – and, I’ll accept a $1 Mill. federal government grant to write the obvious up as a paper, if you like – that Warren Buffett makes his money essentially in two ways:

As Businesses

Contrary to popular belief that Warren Buffett is a vulture who swoops in when there is carnage all around to pick up businesses at bargain prices, Warren actually patiently waits to buy sound businesses at fair prices.

These are usually private/family businesses that need to be sold for reasons other than the soundness of the business itself … for example, the largest family business in Australia was split up to avoid squabbling by the ‘next generation’ … succession is usually the major issue facing such private/family businesses. Warren did not buy this Aussie business, but you get my point …

Warren, to the best of my knowledge, rarely bargains on the price of a business and has even been known to overpay; for example, when the Sees family wanted $30 Million for the Sees Candy business, Warren nearly walked away, thinking it was worth only $25 Million …

… Warren is glad that he bought it anyway, as the business returned Warren’s $30 Million in only a few, short years and is worth over $1 billion today.

You see, a business grows and produces continuing cashflows – even if you never sell (and, Warren NEVER sells!), so the price you pay is secondary, IF the business produces outstanding returns. That’s why Warren says:

It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

In Defiance

So, Warren Buffett wears two hats, with his first hat (surprisingly) being business owner … but, it’s his second hat as the World’s Greatest Stock Investor seems to be the most fascinating to most people.

Well, I’ll let you in on a ‘secret’ … there is no great secret here, at all: Warren simply makes a ton of money by proving that the so-called Efficient Market Theorists are fools … time and time again!

Given that luck and all the other explanations have been rigorously and scientifically ruled out, what the study has ‘proved’ – at great expense, I might add – is not that Warren Buffett is right …

… but, that Efficient Market Theory is wrong!

Now, THAT is a breakthrough of gargantuan proportions, and tomorrow, I’ll tell you how you can exploit it 😉

How not to be a dull boy …

When I worked I was dull and when I retired I became insufferable … it’s official!

But, there is a way out: it’s called the Work/Life Balance and we all want it, but none of us really have any idea how to get it 🙂

Which brings me back to a conversation I had with a friend of mine after showing him our new house a few nights ago (extensive renovations will be underway, soon):

My friend, a doctor – an internist, family doctor, or general practitioner as he would variously be called depending on which country you are in – confided that he originally wanted to become a surgeon.

But, he stopped his studies – after many years of trying, failing, then retrying to make the ‘cut’ when his wife suggested that he draw a pie chart of how he was spending his time.

Here’s his chart:


Typical working student; most of his day taken up with work, then study with very little left for sleep and virtually no R&R (rest and recreation: that’s where ‘family’ comes in) …

… she then asked him to draw a similar chart of how he would LIKE his typical day to look, and this is what he drew:


It doesn’t take a genius – or a budding surgeon – to realize that what he really wanted was a BALANCED LIFE: work, sleep, family.

My friend almost immediately gave up his surgery aspirations with absolutely NO REGRETS and now runs a successful suburban practice that gives him a life where he can help people, his family, and himself in almost equal quantities.

This leads me to think: why do we live the first pie chart, if not to get to the second? Perhaps, money is not really the object, after all …

… or, maybe you need to live the first for a defined period (your Date) in order to achieve a preset amount (your Number) so that you can live the life you really need (your Life’s Purpose)?

Now I better go and take some of my own advice … 😉 [AJC: Really, I just added this sentence: I have to go for a walk to the letterbox with my wife … whoo hoo!]

If you can manage risk, don't you deserve a better return?

Diversification is an example of a risk management tool … I take exception with it because the financial services industry promotes diversification as an ‘end’ rather than as the simple ‘means to an end’ that it really is …

Andee talks about a way to turn the concept of ‘risk v return’ on it’s head! Here’s his comment:

On the question of diversification, do you think it has something to do with risk?

I was thinking about the old phrase of Risk and Return. i.e. the higher the risk the greater the return. This has been used in the past to steer people away from high return. How about taking the opposite view which is; If you can manage the risk better than anyone else then you deserve to get the high return.

However, there’s only a limited number of risks that you can manage well and this often leads to LESS diversification and sticking to your knitting.

One of our clients said to me that he knew everything that could go wrong in his business and therefore wanted to pull money out and diversify. My question of him was this: Why would you take money out of something where you know the risk and can manage it and put the money into something different where you don’t understand the risk and therefore can’t manage it!!

If you can manage the risk better than anyone else, do you then deserve to get the high return?

Not sure about ‘deserve’, but I agree: you have to pick the return that you NEED to get then manage the risks accordingly.

If you have no particular goal in mind … other than: work until you reach retirement age, then see what you have in your 401k and live accordingly … then, you probably need to at least diversify (a low-cost Index Fund should do the trick – I wouldn’t even bother rebalancing into bonds etc.) and WAIT (at least 20 years-to-40-years) …

… but, if you do have a Number – a financial goal that is clearly set in your mind, to be achieved by a certain date –  then you have to take Andee’s tack:

1. Choose your Number and Date

2. Compare that to your current Net Worth

3. Calculate your required Annual Compound Growth Rate (i.e. to take you from 2. to 1.)

4. Choose your required investment vehicle (i.e. to achieve 3. or better)

5. Mitigate the risks

Mitigating your risks means learning all there is to know about the investment vehicle/s that you chose (4.); also, choose the ‘least risky’ investment vehicle that can get you there, rather than choosing a ‘more risky’ investment that could have helped you ‘overshoot’ your Number.

What if there is no investment that you feel comfortable with that CAN get you to your Number?


a) Lower your Number by a few million, or

b) Extend your Date by a few years, or

c) Do a mixture of both …

… in other words: opt out of your dreams!