… and, is still sharp enough to describe himself as an opportunist.

Wealthy Matters shares Ed’s financial success with his readers (you should read the whole article to learn more about Ed’s ‘EZ’ investing system):

Stick with stocks, says investor Edward Zajac. He should know. The 94-year-old has been trading for 72 years and said he’s made about $2.5 million.

So, should we all aspire – strictly from an investing standpoint (after all, who doesn’t want live to 94 and still be so ‘with it’) – to be like Ed?

Absolutely!

According to my calculations, Ed (assuming he started on or around the average salary for college educated technicians “installing computer systems” of $1,900 in 1939) would had to save 50% of his salary until he retired young (at the age of 51) and receive Warren Buffett level stock investing returns (21% compounded) for the entire period!

What I can’t model, because the numbers simply fall short, is how Ed managed to draw enough salary to “travel the US in a recreational vehicle with his wife” after he retired in 1968, yet still manage to double his portfolio again in the 42 years since he retired.

Good on you, Ed, we have a lot to learn from you

The relatively recent gyrations of the stock market from all-time highs to many year lows and back again, and so on, have scared many into pulling their money out of the market … and, keeping it out.

This is a mistake …

Unless you have solid plans (and, expertise) in investing elsewhere, the stock market is a pretty good place to try and build up your warchest.

I would like to see you make major forays into businesses and/or real-estate, as these offer the best opportunity to make money that can be counted in the millions, but the stock market is a pretty good alternative.

And, certainly better than sticking your money in the bank!

The problem is that most people panic during a crash …

What they don’t realize is that crashes will occur around every 10 to 20 years, and recessionary downturns occur every 10 years – more or less – as well.

The question is: which one leads to the other? The answer is not always clear-cut. But, it doesn’t really matter.

You see the market always recovers.

Unless there’s a ‘fundamental change to life as we know it’ (such as the fall of the Roman Empire) the market comes back to life.

Here’s why:

The stock market wasn’t developed as a means to speculate on some random ticker prices, as it has become to many professional traders and certainly to most lay-investors (that’s you and me, bud).

It was developed as a means to share partial ownership (i.e. to raise capital for expansion, etc.) of real, live companies.

Real, live businesses make stuff, sell stuff, and (usually) make a profit in doing so. Their ability to make a profit is more closely related to market forces (i.e. customers, competition, etc.) than it is to economics.

And, their ability to make a profit has virtually zero correlation to stock market sentiment.

Yet here’s what occurs [hypothetical chart]:

The yellow line represents some hypothetical economic indicator (e.g. growth in GDP), and does its thing.

The blue line represents the stock price of a company we are tracking and it rises and falls as prices (both the prices its customers are willing to pay and prices its suppliers feel that they are able to charge) and labor costs and so on rise and fall.

Interestingly, company profits (hence earnings per share) are somewhat related to the economy, but not always obviously: in a down economy, a huge new contract with upfront payments could help to improve company profits; so could a new plant being completed (it was probably commissioned when the economy was looking good!).

However, the red line – which represents the share price of our company – reflects market sentiment: there’s a rumor going around that the ceo is about to be indicted on a racketeering charge, so it goes south very sharply. The ceo, of course, steps aside pending the investigation and in a week or two, there will be an announcement that no charges were made.

Notice that the company still commissions its plant and production goes up; some customers hold off on new purchases because of the rumors (catching up after the ceo steps aside amidst the rumors, and certainly after the charges are eventually dropped) but most contracts were signed weeks/months ago and business generally improves.

The share price, of course, will rebound making some traders very rich.

So, here’s the crux: if you’re a stock trader, you will live by these market sentiment issues; they will misprice the market and/or individual stock prices over and over again and you will make or lose a fortune depending on how well you read things.

But, if you are a stock market investor, you will look to buy future company profits, not future market sentiment.

Investing in market sentiment is gambling, and you can see where that might lead.

But, investing in future company profits is a pretty good game, if you choose good, solid companies and simply close your eyes when the market plays its little games.

Just ask Warren Buffett

The first is that I have reduced my posting schedule to (generally) twice a week; I’m trying for a Mon./Thur. posting schedule, but – if you enjoy reading this blog (near-future multi-millionaires need only apply!) – your best bet is to sign up for the RSS/e-mail feed on my home page because I’m fickle … if I get the urge, I’ll post daily, or simply shift days to suit my increasingly challenged schedule

The second is that I’m posting more business-related posts (e.g. my Anatomy Of A Startup occasional series) … I am funding a series of startups with the ultimate aim of a Y-Combinator style of early stage entrepreneurship mentoring / funding program and what I am sharing in this series is real ‘special sauce’ stuff … like everything that I do, it’s usually simple but works!

Back to the first change: if I write less frequently, I’m hoping to challenge myself and my readers even more. To whit, my last post (inspired by Canadian Couch Potato’s brilliant post on the same subject) inspired a one week long comment-debate … one of the best that I have seen on this blog.

The main thrust was the debate around income v capital growth.

Jeff stated the ‘for’ argument best when he said:

The reasons why people desire rental income from real estate are the same reasons why people desire dividends from stocks…you get a cash flow without having to sell the asset at an inopportune time.

But, there’s a key difference between so-called ‘Income Real-Estate’ and its stock market equivalent – Dividend Stocks: Income RE produces REAL cashflow, Dividend Stocks produce FAKE cashflow!

To illustrate, let’s take a look, first, at income-producing real-estate:

Tenants pay rent; you pay costs; what’s left (if any) is real, spendable, excess income/cashflow that generally increases with inflation. Bad RE doesn’t produce an income. Period.

Now, let’s take a look at so-called Dividend Stocks (i.e. Company stocks that you buy specifically because they produce a nice, steady dividend stream):

Dividend-paying company sells stuff; they pay their suppliers and other costs; Good company produces profits / Bad company produces losses.

In either case, the Board meets and says “we gotta pay some dividends”.

The CFO says “But, we got bills to pay!”; CTO says “I got R&D to do!”; COO says “I got warehouses to build!”; CEO just wants to keep his job (he is hired/fired by the Board, remember) and says nothing …

The Board says: “Too bad. If we don’t look after our shareholders they’ll crucify us … even worse, they’ll vote us off our nice cushy board positions and we’ll even have to buy our own lunches!”

“Let the CEO deal with poor cashflow and working capital, insufficient warehouses space, outmoded products and technology, lack of marketing, and so on … heck, we’ll even borrow money from our provisioning funds or the open market, if we have to. No matter what, those Dividends must be paid … after all, we are a Dividend Stock!”

So, they say “no” to the CFO, COO, CTO, CMO … and, every other shmo’

Do you want your board fussing over distributing cash that it may or may not be able to spare? Or, would you rather that your Board focussed on building a GREAT company, with GREAT long-term growth and profitability prospects?

In order to answer that question, there’s one more feature of dividend stocks that we still need to examine; Kevin @ Invest It Wisely says:

The pro-dividend guys do have a compelling case that dividends grow more smoothly than the ups/downs of the markets.

To which I say, “so what?”

As we have already seen, the apparent  ’smoothness’ of the dividend stream can be illusory.

And, what are you going to do with any dividends that you have received pre-retirement?

I presume that you are going to reinvest them so that you, too, can get to $7 Million in 7 Years (or, at least to your own relatively large Number by your own relatively soon Date).

In other words, you’ll just take that relatively nice, smooth dividend stream and throw it right back into the choppy market [AJC: Next, you'll be telling me that you're Dollar Cost Averaging ... somebody, grab me a Tylenol, please!].

If you’re going to be fully invested in the stock market, for a number of years, then why don’t you at least buy some stocks in great companies that are going to grow, grow, grow … profits?!

If they happen to pay dividends, well great [AJC: you're going to give it straight back to them, anyway, aren't you?], and if they don’t, well who cares?

I mean, would you rather own “this dividend stock [that] has delivered an annualized total return of 3.10% to its loyal shareholders”? Or, would you rather own this never-ever-paid-a-dividend stock that has delivered an annualized total return of 20+% to its loyal shareholders for over 40 years?!

However, there is one special case (i.e what if you are already retired?) that I want to examine next time …

The graph shows the promise of dividend-investing, but Canadian Couch Potato states the reality – the case AGAINST dividends – far more eloquently than me:

Why do shareholders believe so strongly that a $1 dividend is preferable to a $1 capital gain? Meir Statman looked at this question in a 1984 article called “Explaining Investor Preference for Cash Dividends,” coauthored by Hersh Sheffrin. He also reviews the idea in his new book, What Investors Really Want, pointing out that receiving $1,000 in dividends is no different from selling $1,000 worth of stock to create a “homemade dividend.”

Even when this idea is explained to people, most refuse to accept it. Statman suggests that it comes down to a cognitive bias called mental accounting. Investors categorize $1,000 in dividends as income that they will happily spend, but the idea of selling $1,000 worth of stock is “dipping into capital,” which causes them great anxiety. This idea is deeply ingrained in many investors, but it is an illusion, because a company that pays a dividend to shareholders is depleting its own capital.

If you want to understand the arguments – both for and against – investing in so-called ‘dividend stocks’ for the sake of the dividends, you would do well to read Canadian Couch Potato’s whole blog post AND the comments … all for/against arguments are well thought out.

Here is my argument against dividends in a nutshell:

Since you can create a dividend stream yourself (“ignoring taxes and transactions costs, a stock that pays no dividend but increases in price by 6% provides precisely the same return as one whose share price rises 4% and pays a 2% dividend”), it boils down to what could the company do v what can you do with the ‘spare cash’ that the company plans to issue (or not issue) as a dividend:

1. If the company keeps the dividend:

- They could buy more inventory: if their business is a volume business, more inventory = more profits. Consumer products companies such as Kraft and Unilever are great examples.

- They could do more R&D: investing in R&D is necessary gambling on the future; often it will be money wasted (in which case it’s better off in your pocket as a dividend), but sometimes it will provide a huge payback, such as when a pharmaceutical company develops a breakthrough medication, or a venture capital firm finds the next FaceBook.

- They could invest in marketing: more marketing = more sales; pretty simply, huh? Consumer products and technology companies are classic examples; the more often they put their products in front of the consumer, the more sales they seem to get.

- They could invest in more infrastructure: more factories, more locations = more revenue and more profits. Manufacturing companies, high tech businesses, and retailers are all tied to physical infrastructure.

- They could invest the cash – Many companies (think Microsoft, Apple, the tobacco companies, and the brewers) are sitting on a ton of cash. Heck, Berkshire Hathaway is sitting on so much of it, even Warren toys from time to time with giving it back to the shareholders (i.e. by issuing a dividend); after all, if they can only get 3% while it’s sitting in the bank and you can get …? Inevitably, though, they use this cash to make a spectacular purchase that transforms the company: think Google’s $6.5 billion offer for Groupon, or Berkshire Hathaway’s $44 billion purchase of BNSF Railway.

2. If you take the dividend:

- You could buy more stock in the same company: this is the basis of the automatic ’dividend reinvestment policy’ that most companies now offer. So, let me see … you invest in company ABC because it issues a dividend, and you use it to, what? Oh, buy more stock in company ABC?!

- You could buy more stock in another company: why invest in another company? Oh, because it provides a better return. So, why not pull ALL of your money from the worse-performing dividend paying stock, and put it all in this company?

- You could buy more stock in a bunch of companies: diversification is often seen as a good thing [AJC: by many reading "how I became rich" blogs; rarely by those writing them]. The more you diversify, the more you tend towards average market returns. Why would you want to take your cash out of a company that produces spectacular returns [AJC: that's why you invested in the 'dividend stock' in the first place, isn't it?!] in order to put your money into something that produces average returns?

- You could keep your cash in the bank: strangely enough, this one makes sense; if the company can’t do anything better with their ‘spare cash’ than give it to you, wouldn’t you rather have it sitting in your bank account rather than theirs, so that you can at least have the flexibility to make the decision what to do next, eg leave it in the bank, buy some index funds, pay down debt, or even buy back into the company stock when they get out of the ‘sit on a ton of cash with no vision for the future’ doldrums.

… but, if any of these things are better than leaving the money in the company, wouldn’t you be better off taking all of your money out of the company all in one go (i.e. sell the stock) rather than in dribs and drabs (i.e. taking small dividends)?

Let me finish off with a story:

Warren Buffett got started by purchasing a textile company and immediately canceling it’s dividends!

Why?

So that he would have more money to invest in growing the company.

Potential investors who wanted dividends invested elsewhere … those who didn’t invested in Berkshire Hathaway and became multi-millionaires!

Berkshire Hathaway still operates on the same principle: why pull money out of BH when Warren can grow your money faster?!

Phil’s a great speaker and this is a great story; it tells you where Rule # 1 comes from.

BTW: if you’ve read / got / intend to buy the book, this spreadsheet will help you apply the ‘rules’:

Rule 1 Investing – Worksheets – 90518

Don’t be high when you are buying or selling stocks

… you can take that advice to the bank!

To kick things off, I am sharing some resources (including my very own Rule # 1 spreadsheet!) … so, why don’t you join today?!

Join here:

http://shareyournumber.ning.com/group/rule1investing

I’m not being rude when I say this guy is one-eyed about stock … apparently, his Canadian ‘friends’ call him “The Pirate”

He gives a nice explanation that stocks follow interest rates, more so than the general economy (as measured by GDP growth) … but, in his next video he gives 5 rules, the only one of which really makes practical sense to me: FWO

Fundamentals Will Out

This means, that no matter what crazy gyrations the market may undertake in the short-term, over the long-term the fundamentals will ultimately decide which way stock prices go: buy on value!

There are three main ways to make money in the stock market:

Value

Last week we spoke about the disparity between private companies (that sell for 3 to 5 times their earnings) and public companies (that can easily sell for 15+ times their earnings):

‘Value investors’ like Warren Buffett look at what a business is really worth, and buy it when it’s at that price LESS a margin of safety (they usually try and buy when the current stock price values the company at 50% – 80% of the ’sticker price’ i.e. what their discounted future cashflow analysis tells them the company is really worth).

This is the long-but-true road to financial success in the stock market (after all, do you know ANYBODY who has made more from the stock market than Warren Buffett?).

Explosion

This is what Brandon was referring to when he said:

That’s why the holy grail for private equity firms is the IPO. Buy a company at 5-10x earnings and take it public for a valuation of 15-30x.

You ‘explode’ a company into lots of tiny pieces and, magically, the parts add up to many times the original value … nice.

Flow

If the ‘big money’ is made by the great ‘Value Investors’ and the venture capitalists and private equity firms that ‘explode’ companies via IPO’s and capital raisings, where is the SMALL money made and the BIG money lost?

Well, the SMALL money is made by trading the ‘flow’: once the company has been carved up and it’s stock is worth, say, between 15 and 3o times its earnings as Brandon suggests, there is no concensus as to what a stock is really worth … so money is made by trading the ‘flow’ of a stock’s price between the upper and lower estimates of what the ‘market’ thinks the stock is worth.

Now, don’t give me the ‘market is perfect’ spiel because the whole point is that money is made (and lost) by trading stocks between those who BELIEVE the market is perfect and those who don’t!

In fact, come up with ANY theory of how to value a stock and as soon as you buy or sell it, you are betting against the person on the other side of the transaction … you are both betting on FLOW.

Except for one of you it is an ‘ebb’ (they lose) and for the other it is a ‘flow’ (you win) …

…  of course, the flow does have a preferred overall direction … fortunately for us, that is UP.

Over the long run, company earnings (profits) increase due to inflation … and, where the profits go, so does the share price (sooner or later … but, fortunes have been made and lost on the exceptions); but, it is a SLOW increase.

So, how is the BIG money LOST in the stock market?

Simple, look where the BIG money is MADE …

… it’s lost as soon as the FLOW investor buys their stock from either the Value investor or the guy who triggered the initial Explosion, and that loss is passed on – plus or minus the ensuing ebbs and flows – from ‘flow investor’ to ‘flow investor’ until the value dribbles back out of the stock [enter the Value Investor, again].

Now this is REALLY key:

IF private companies (from your neighborhood hairdresser to the engineering firm in your local industrial estate) sell for 3 to 5 times their annual net profit (i.e. a P/E of 3 to 5), then

WHY do public companies (those traded on stock exchanges around the world) sell for P/E’s of 15+?

There are a number of reasons, but if you had to pick four they would be:

a) Convenience: you can simply buy/sell as much/little of the company as you like,

b) Regulation: by necessity, these companies are well-regulated by the various government overseeing authorities (e.g. in the USA it’s the SEC, amongst others),

c) Transparency: by law, companies are required to disclose everything about their companies so, in theory, the guy holding one share of the company knows as much about it as the majority shareholders [AJC: enter Martha Stewart!],

d) Liquidity: as Brandon said:

P/E ratios are all about liquidity. I can sell my stock in 30 seconds but good luck selling a business in under 6-12 months.

If I had to boil it down to just one factor, I would say that Brandon is right: it’s all really about allowing people who don’t know what they are doing to get in and out really quickly.

Now, think about this: even though, I have never seen this explained quite this way [AJC: so, perhaps I'm the idiot here?!], to me, it explains why (i) Warren Buffett is the richest man in the world, (ii) the best fund managers around can’t ‘beat the market’, and (iii) why the typical investor averages less than 4% return from the stock market and would be better off just leaving their money in cash:

People pay FOUR TIMES WHAT A COMPANY IS REALLY WORTH just for the privilege of not having to worry about getting in and out!

Read that again … before you buy your next stock

So, stocks have TWO values:

1. Their ‘intrinsic value’ i.e. what the underlying business is really worth, and

2. Their ‘market value’ i.e. what people are willing to pay for the privilege of throwing them around like casino chips.

Traders and speculators (and, aren’t we all?!) buy on the second … but, true investors (e.g. Warren Buffett) buy on the first.

Warren Buffett, and a relatively few investors like him, don’t care about the advantage of getting out quickly … they deal with that by avoiding selling! Sneaky, huh?

So, ‘value investors’ like Warren Buffett look at what a business is really worth, and buy it when it’s at that price LESS a margin of safety (they usually try and buy when the current stock price values the company at 50% – 80% of the ‘sticker price’ i.e. what their discounted future cashflow analysis tells them the company is really worth).

[Hint: because of some of the other advantages that we mentioned, it's usually when the P/E is around 8]

So, think about it: Warren buys when the stock is valued at much closer to what he thinks the underlying business would be valued at if it were a private company (like that hairdresser) … then, he sells it – if he sells at all – to all of those other suckers out there when the stock gets up to normal valuations: for ‘normal’ read ‘sucker’

That’s why Brandon also is right on the money -literally – when he says:

That’s why the holy grail for private equity firms is the IPO. Buy a company at 5-10x earnings and take it public for a valuation of 15-30x.

Now, THAT’S a way to make a quick buck …

… but, hang on: if they are MAKING a quick buck selling at 15x – 30x valuations, what are WE doing when we are BUYING AT THAT PRICE?!