Cash is an investment, too

Posted on May 19, 2008 by Adrian

Aspiring ‘investors’ tend to laugh at low-return strategies like keeping money in CD’s or paying down mortgages – and, as a long-term investing tool (now, that’s a tautology) they do suck.

But, as a short-term ‘money parking’ tool there’s nothing better … and there’s no time like the present to dust off those borin’ ol’ Ramseyesque strategies, as this article from the Tycoon Report suggests:

The most successful investors in the stock market aren’t always invested in stock. They’re only invested when the odds weigh heavily in their favor.

You must have the discipline to know when to stay out! For most people, this is one of the easiest concepts to grasp, yet the hardest to follow. This is something that comes with experience. It’s something that most people have to learn several times throughout their investment life.

People ask: “When do I know when it’s the right time to be in or out?” The answer is: If you’re asking that question, it’s time to stay out.

Otherwise, find an account or stable investment vehicle that offers you a nice interest rate. You can look at Treasuries, Certificates of Deposit, money market accounts or a bank or broker offering a relatively high-yielding interest rate.

The point is to sit in something safe while you wait for trades with a high probability of success to present themselves.

Savvy investors are willing to sit in a risk-free interest bearing account for years if need be, and you should get comfortable with taking the same stance. What’s likely tied for first place on the individual investor’s list of most common mistakes is the notion that if you’re not in the market, you’re not making money. Anxious and over-eager investors force trades at the wrong time, mainly because they’re afraid of missing the next big gain.

Fear of missing the next winner is a killer. Professional investors know that cash is a trade too.

I love that last line … that’s why I ripped it for the title to this post!

Right now, I am sitting in cash … and, I have been totally out of the market for a few weeks now even though there was a rally in between.

I am waiting for the right time – read: after the market starts climbing again (I’m happy to miss the absolute bottom) and I am sure that represents a longer-term trend OR until I find a stock that I feel won’t go much lower even if the market doesn’t rally for a while.

Same applies for real-estate, although I am actively looking for deals right now … residential isn’t my preference (I have plenty of exposure to that sector) as I am totally out of commercial right now and would like to get back in if the cash-on-cash returns improve a little (as they should as the recession takes hold, then eases a little).

Having said that I am in cash … it isn’t in your ordinary Mid-West Bank deposit account or CD … it’s legally earning 7.5% interest, hedged against the falling US dollar.

That’s why it’s often true that the rich get richer … because they have more investing options.

Still, the principle applies: sometimes, it’s OK to stay in cash or [AJC: perish the thought!] temporarily pay down a mortgage.

Oops … I just broke The 20% Rule!

Posted on May 17, 2008 by Adrian

Last days for ‘pre-applications’ to become one of my 7 millionaires … In Training! Click here to find out more …

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If you’ve been following this blog, you will know that I have a radically different approach to owning your own home than the Dave Ramsey’s of this world who advocate paying off your own home early:

To be fair, Dave and I are actually saying two different things:

1. Dave Ramsey is saying not to carry any personal debt at all – INCLUDING your own home, since it doesn’t generate an income. And, there are certainly many who advocate this approach.

2. I am simply saying that the EQUITY in your own home shouldn’t exceed 20% of your Net Worth.

Now, if your house is worth more than 20% of your Net Worth, and for most people it will, then by definition I am saying that not only is it OK to borrow the rest … you HAVE to borrow the rest!

When you are old and gray, then Dave Ramsey’s approach is fine … but, when you have a plan to retire wealthy, your home – and, your ability to borrow against it – become key.

So, when I told you in a recent post that my house was worth $2 Million … my wife and I actually met BOTH my criteria and Dave Ramey’s as we paid cash and the house fit well within the 20% Rule for us.

As it happens, I can’t stand to see a ‘dead asset’, so we agreed that I could take a substantial line of credit against the house (more than 50% of the current value of the house as a HELOC) and use it to fund some investments … I recommend this approach, even if you fit within the 20% Rule, because you should be maximising the amount that you have invested at any point in time …

… of course, as you get closer to retirement, you may choose to wind back again – as Dave Ramsey suggests – I haven’t, but that’s just me 😉

Now for a ‘small problem’ … a few days ago, we bought a house worth more than twice as much as our current house … at least, it had better be worth more than twice as much, because that’s what we paid.

This means that we have temporarily broken the 20% Rule … d’oh!

It’s not as bad as it sounds, but I wanted to share this story so that I could walk you through our thinking process, because it will be inevitable that you go through a similar process as you gradually step-up your lifestyle (the side-benefit for all of those who read this blog … we hope!):

1. We are taking a very conservative view of our Net Worth: I tend to discount the sale value of any businesses and similar risk-assets that we may have, when calculating our Net Worth, as they can be taken away.

With these ACTIVE assets included, we are well within the 20% Rule, and very close to it even when only counting PASSIVE assets (a MUCH more conservative way to view Investment Net Worth that we will discuss in future Making Money 301 posts).

2. We paid cash for the house (well, we have only put down the deposit, so far, but will pay cash at closing).

The remedy?

Simple: as we did with our current house, we will take out a home equity line of credit and use that for investment purposes.

This means that we have effectively shifted the borrowed portion of the equity in the house from the personal side of our ‘ledger’ (bad) to the investment side of our ledger ‘good’ …

Used this way, borrowing is a positive tool to be used to advance your financial position, which is why I disagree with the Dave Ramsey approach for those who need to step up their lifestyle and have a solid reason for doing so [read: driving desire to achieve some Higher Purpose in their lives] …

… or, if you prefer the Dave Ramsey approach, simply wait before buying the house.

Financial choices abound!

BTW: to be ultra-conservative, we may instead simply use, say, 50% of the equity in this new house (perhaps more, certainly no less) to secure further income-producing real-estate investments (rather than stock purchases) that we intend to hold for a VERY LONG TIME.

As our Net Worth rises, will we pay down that loan (i.e. HELOC)?

We could … as we would again ‘fit into’ the 20% Rule. But, we probably won’t – because the 20% Rule is a minimum standard and there is nothing wrong with investing more, particularly in conservative, long-term buy-and-hold investments.

I see holding such investments, and borrowing a reasonable proportion to fund them, as less risky to my financial future than the typical ‘save and never borrow’ approaches … but, only because my financial future has to be reasonably BIG … certainly more than a simple savings approach could ever achieve.

That’s how we deal with upgrades to our living standards … perhaps, it’s a model that you can follow, too?

Contrary to popular opinion, paying off your mortgage is the dumbest move you can make …

Posted on May 13, 2008 by Adrian

I wrote a post a long while ago … actually, it was my 5th-ever post – some say that I should have stopped there 😉 – about the classic Rent or Buy dilemma for your own home … and, I just (!) received an interesting comment to that Post from Joy:

That’s the silliest thing I’ve ever heard – borrow against your house (aquire more debt) to invest??? Paying off your house early and being debt-free allows you to do whatever you want with your income, THAT’s truly the way to wealth.

Now, Joy is not alone: I recently read a post by Boston Gal on her blog that talks about Suze Orman’s advice which also is to pay off your home loan early:

Believe me, I have thought about trying to pay off my mortgage early. But since I have an investment condo which is mortgage free (yeah! paid that one off in 2007) I have been a bit hesitant to use my current excess cash to pay extra toward my primary home’s principal.

Now, this sparked a whole series of comments, including this comment from ‘Chris in Boston’ who said:

This is interesting. Usually you hear from personal finance people that its best to take on the longest fixed rate mortgage you can afford. This allows you to tie up as little cash in a non liquid asset as possible (slowly building equity). Also allows you to protect that pile of cash from the effects of inflation. The house is bought in today’s dollars and paid off over 30 years in today’s dollars.

Sure, when you own a property you have to compare it to owning any other investment – cost/benefit; risk/reward; all the usual stuff. You also need to compare the costs of holding it (including interest) against the costs of investing elsewhere.

But, this last piece in Chris’ comment is THE critical point: “the house is bought in today’s dollars and paid off over 30 years in today’s dollars”.

You see, the one thing that makes owing a property, even your own home, very different to any other investment is that it can be easily financed … almost completely (remember the sub-prime crisis?).

This leads to a whole swag of benefits that I don’t think that you can get anywhere else … benefits that simply cannot be ignored by the typical saver / investor.

Here’s why …

When you mortgage a house, you and the bank enter into a partnership (typically the bank is an 80% partner and you are a 20% partner going in), but you are not in the same position:

1. You have access to ALL of the upside … so as inflation and market conditions push the value of the property upward over time, you gain 100% of the increase, the bank gets none of it.

Let’s say you buy a property for $100,000 today; you put in $20,000 deposit and the bank puts in $80,000 as an interest-only loan (forget closing costs for now) … in 20 years, if it doubles to $200,000, your share of the ‘partnership’ is now $120,000 and the bank’s is still $80,000.

You are now 60/40 majority owner of the real-estate venture! In fact, even as 20% ‘owner’ you have total control over all the decisions related to the real-estate – as long as you pay the bank on time.

2. Sure you pay the bank interest on their $80,000 share … but this is fixed (you did take out a fixed interest rate, didn’t you?!).

At 8% interest rate that’s approximately $6,400 per year … this year.

Why only this year? Because the same inflation that is increasing the value of the house (and you get to keep 100% of that increase) also decreases the effective amount that you pay to the bank; as each year goes by, the bank gets less and less in real dollars and your salary goes up.

The price of bread, milk and gas may go up, but the bank’s interest rate never will because it’s fixed!

3. You either get 100% of the value for the payments that you make to the bank (call it ‘rent avoidance’ if you live in the property) or you take 100% of the income if you decide to rent it out … all as 20% minority ‘partner’ going in. The bank on the other hand, gets their $6,400 and ONLY their $6,400.

4. The government gives you tax breaks and incentives to do all of this!

Here is my advice …

Look at everything that you own as a business: if it’s your own home, separate the ownership of the property in your mind from it’s use …

… for example, even if it’s your own home, treat yourself as your own tenant and figure the rent that you would otherwise had to pay when doing the sums.

Then evaluate the investment against any other investment or ‘business’ … and ask yourself:

– What ‘business’ gives you pretty damn close to 100% control for only 20% initial investment?

– What ‘business’ lets you in for only 20% initial investment, but then gives you all of the upside?

– What ‘business’ gives you only one-time multiplier on your initial investment on the downside but a five-time multiplier on the upside?

– What ‘business’ grows in your favor (and not your “partner’s” favor) merely by the effects of inflation?

By all means, pay off you mortgage and your lines of credit as you reach your financial goals and are set to retire …. you have plenty of money and just don’t need the stress, right?

But, if you’re still trying to get rich(er) quick(er)?

If you own a home, don’t pay it off … use the upside to help you buy more and more of these wonderful, one-of-a-kind, almost-too-good-to-be-true ‘businesses’ …

If you have other sources of income (businesses, investments) don’t spend it or reinvest all of it … use some of the spare cash to help you buy more and more of these wonderful, one-of-a-kind, almost-too-good-to-be-true ‘businesses’ …

That’s my advice to you, and to Joy, but only take it if you want to be rich!

The optimism of the young …

Posted on May 12, 2008 by Adrian

When you are just starting your working career – or perhaps you are still studying for your career – it can be hard to think of anything more exciting and fun than working at a job that you love.

So, when I talk about retirement – as I do from time to time – I can imagine that a large chunk of my audience is looking for the ‘close window’ button?

Well, don’t!

[AJC: Also, keep reading this particular post even if you AREN’T young … I have included a lot of back-links, because I want you to review some of the ground that we have covered so far, with this blog .. the idea of Future Vision is THAT important to your financial success!]

Recently, I suggested that most people fail financially, not because their dreams are too big, but because their dreams are TOO SMALL!

Now, this seems counter-intuitive, therefore some of the comments were interesting … the one that I felt expressed the counterpoint the best was from Alex, who said:

I don’t plan on quitting working anytime soon. My “retirement” is to retire from working 9-5 and work for myself. I wouldn’t call that work since I know I will enjoy it, if not, I can always pick a new thing to work on. Life is simple and fun if you have more choices right?

I responded:

It’s my thesis that one day working will no longer be fun, for any of us … if you agree that it’s possible that you will one day feel the same way, then it’s your job NOW to decide WHEN that will be, WHAT you’ll be doing instead of working, and HOW MUCH it will cost to do it – and, if you’re no longer earning money, WHERE will it come from?

The younger that you are when you get this, the more chance that you have of either:

1. Achieving a larger goal, given enough time, than your friends and peers, or

2. Achieving a more modest goal, but much earlier than your friends or peers.

Simply applying Making Money 101 principles as outlined in this blog will, given enough time, compound your savings to a large’ish sum. Not anywhere near large enough for me – but, that’s another story – if that provides enough for you … great … you’ll have a reasonably stress free (but, long-working) life.

But, if you aspire to an unconventionally wealthy and rewarding lifestyle, where you have replaced work with even more rewarding activities, while you are still young enough to enjoy them (e.g. 29, 39, or – hope YOU don’t need to wait THIS long – 49 years old!) then you will need to sit down and dream your large dreams NOW …

… then wake up, splash some cold water on your face and get straight to work applying my Making Money 201 principles!

If you do, you will soon be keeping your very large nest-egg safe with my Making Money 301 principles – and, at a much earlier age than me or most others.

I’m 49 y.o. – officially retired – and I think that’s WAY TOO OLD!

So will you, if you just sit back and wait because you are still young, and still excited about your work or your business or your whatever … if you follow my advice, these will still be your fun and exciting means to a much more valuable end, so …

… start now!

AJC.

PS If you are a ‘young adult’, Ryan at Bounteo has a great series specifically focussed on investing for young adults … why don’t you check it out, and let me know what you think?

What's the probability that you'll even read this post?

Posted on May 10, 2008 by Adrian

Well, if we look at all the billions of people on this planet [AJC: is it 6 billion or 8 billion now … damn, I lost count] … the chances are minuscule.

If we take all the people who use the Internet daily … still microscopic.

If we take all the people who read Personal Finance blog … not much chance.

If we pick all people who read the self-prophesying headline to this post …. bloody great! You see, it WAS a trick question of sorts …

… all to lead me on to the subject of Probability … as in “it’s probable that your eyes will glaze over just about now, and you’ll click back to Pamela Anderson’s home page” … brought to my attention by a recent post from an excellent blog by All Financial Matters, appropriately titled Probability 101.

Even if you hated math [AJC: in other countries, known as: maths] and statistics, stick with me past this excerpt:

I’m in the process of reading Peter Bevelin’s awesome book, Seeking Wisdom – From Darwin to Munger (Not an Affiliate Link). I HIGHLY recommend this book for anyone interested in investing and behavioral finance. As boring as that sounds, this book is a page-turner. One of the sections of the book that I found most interesting was this illustration of probability on page 151:

A lottery has 100 tickets. Each ticket costs $10. The cash prize is $500. Is it worthwhile for Mary to buy a lottery ticket?

The expected value of this game is the probability of winning (1 in 100) multiplied with the prize ($500) less the probability of losing (99 our of 100) multiplied with the cost of playing ($10). For each outcome we take the probability and multiply the consequence (a reward or a cost) and then add the figures. This means that Mary’s expected value of buying a lottery ticket is a loss of about $5 (0.01 × $500 – 0.99 × $10).

The first comment that I would make is that whilst you need to understand the basics of a ‘good decision’ against a ‘bad decision’ in probability/statistical terms, simply running your eye over the key line “A lottery has 100 tickets. Each ticket costs $10. The cash prize is $500” should do the trick:

If you bought all 100 tickets, at $10 each, you would spend $1,000. But you would only win the cash prize of $500 … are YOU smarter than a 3rd Grader?

But, as one of the comments on that post pointed, out not all decision that SEEM to be mathematical ARE simply mathematical:

Unfortunately, probability doesn’t always translate directly into real-life situations.

Let’s take your example of the lottery, except we’ll change things up a little.

Mary is 50 years old and approaching retirement. She’s been financially savvy for her entire life and has accumulated $1M in cash.

Donald Trump decides to hold a lottery for only Mary. One ticket costs $1M, and she has a 50% chance of winning $10M.
If you looked at just probability, her EV is -(0.5 x $1M) + (0.5 X $10M), or +$4.5M. Does that mean she should buy the ticket? Obviously, no.

I think what this comment is saying is that EVEN THOUGH you have a 50/50 chance of winning 10 times your money, you shouldn’t invest your entire life savings into it … because you have an equal chance of ending up flat broke!

The concept is good, but I take issue with the “obviously no” bit …

The numbers in this example are ridiculously skewed for most people, so I tried to give some ‘closer to home’ examples in my post centred on that popular game show, Deal or No Deal.

It all boils down to this:

When a decision is potentially Life Changing … the numbers count less … the possible result counts more.

In practice:

1. You should understand basic probability because it is so important in life,

BUT

2. You should first make the Life Decision then look at the odds …

Deal or No Deal?!

What is the best way for a newcomer to get started in investing in stocks?

Posted on May 7, 2008 by Adrian

I just got back from Omaha, where I attended the Annual General Meeting for Berkshire Hathaway – Warren Buffett’s company – so, it’s timely that I remind you there are only a TWO sensible ways to INVEST in stocks – BOTH recommended by Warren Buffet – plus one Speculative way:

1. Buy and Hold low cost, diverse Index Funds (check out Vanguard’s web-site, and others) – this is a long-term, low risk (if your holding periods are 30 years) strategy that can help you fund a normal retirement.

2. Invest in a FEW stocks in companies that are:

(a) undervalued,

(b) have a large margin of safety,

(d) are prepared to HOLD …

… until the rest of the market decides that they love them, too, at which point you cash out and go back to (a).

Anything else is SPECULATING – lots of people have made a ton in trading stocks and options (e.g. George Soros, but he was smart enough to know to quit gambling when you are ahead) – or UNDERACHIEVING such as following the herd and/or buying high-cost Mutual Funds.

You may be one of the few that can succeed in either of these alternative methods … but, please don’t offend the World’s Greatest Investor by calling it INVESTING …

We believe that according the name ‘investors’ to [people or] institutions that trade actively is like calling someone who repeatedly engages in one-night stands a ‘romantic.’ [Warren Buffett]

So, there are only two methods that Warren Buffet would recommend (and one that he clearly would not) – one for the wise and the other for the even wiser – which one would you choose?

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Well, the ‘news’ of my 7 Millionaires … In Training! ‘experiment’ is finally out … check out my friend, Bill’s post on Money Hacks, then click here to find out more …

The Great Debt Repayment Fallacy … don't fall for it!

Posted on May 5, 2008 by Adrian

Everybody knows about ‘good debt’ and ‘bad debt’, right? And, we all know – and have committed to memory – Personal Finance Prime Directive # 1:

Eliminate All Bad Debt Now … Before Doing Anything Else!!!

This may be the current Personal Finance mantra, but, if you happen to subscribe to the same view, then read on because this post could be the most important piece of wealth-building advice that you will ever read!

But, first …

That simple and clear ‘PF Directive’ was the assumed premise behind a recent (and very good, I might add) post on The Simple Dollar that I want to delve into a little more deeply than usual because it brings out a critical wealth-building point that may not be obvious to all. In that post Trent said:

A reader wrote in recently:

I have kind of a weird situation with our 2 credit cards, and wanted to see what you thought. We have one card (Citi) with a total balance of $4,800. $3,800 of this is a balance transfer that is at 2.99% until paid off. The remaining $1,000 is at 13.49%. Of course, all principal payments are applied to the lower rate debt first. Our other card (Chase) has a balance of $5,700, and is at 0% until September 08, when it goes to 8.99%. Which card do you think is best to “attack” first?

After reading this email, I thought it would be a good time to take a more general look at comparing the debts you owe as well as how to construct a healthy debt repayment plan.

Trent then proceeded to outline a very good and pragmatic approach to dealing with these, and any other, debts … a plan that involved:

A few sheets of paper and a pen; the latest statement for every single debt; making the first list; ordering all of the debts by their current interest rate; looking for ways to reduce the rates, focusing most strongly on the highest current one; when you’ve reduced rates, making a new list reflecting the changes; dealing debts that are set to adjust in the future; directing all of your extra payments towards the top debt on the list; when a debt vanishes, crossing it off and feeling good about it; updating the list when you acquire a new debt; and, updating the list when one of your debts adjusts to a new rate

Before I weigh in on this, let me ask you a Very Important Question:

Do you really just want to be debt free or do you want to be rich?

I know that sounds self-evident, but stick with me … if you just want to be in the top 5% of the US population and retire on $1,000,000 in, say, 15 years then by all means, do the Dave Ramsey, Suze Orman, and/or Oprah ‘debt diets’:

That is, save and be debt free (including your own home) … whoohee! … by the time you ‘retire’ [read: work part-time in Costco handing out free food-samples until you’re 75], you’ll be living on the equivalent of $15,000 today and hoping to hell that the government can still afford to pay you social security!

It’s OK if you slavishly follow this thinking: it’s the Conventional Wisdom …

It’s just that if you want … nay, need … to be rich(er) and retire soon(er) then you’re going to need unconventionally large amounts of money in an unconventionally rapid timespan, and that’s going to take some Unconventional Wisdom!

You see, I believe that being debt free and being rich are [almost] mutually-exclusive!

This is a pretty controversial view, I should think … but, I will even go so far as to say that it is [almost] impossible to become rich without using debt: debt to fund your business (working capital finance and/or leases on equipment and/or leases on vehicles, etc.); debt to fund your real-estate investments (fixed interest mortgages and/or interest-only funding); debt to fund your stock purchases (margin lending); etc.

Hold on, all the Personal Finance writers/bloggers out there say:

We can put all of the above examples in the ‘good debt’ category and we already agree that they are OK …

Great!

But, then they always add:

… but, ‘bad debt’ is ‘consumer debt’ (credit cards, student loans, car loans, etc.) and we all know that our Number One Personal Finance Objective is to wipe Bad Debt out, right? After all, it’s not called ‘Bad’ for nothing! Right??!!

Well, not necessarily … sure you shouldn’t get yourself INTO any of this Bad Debt … but, once you have some (you naughty, failed human being, you), you need to mix it with your Good Debt and revisit Trent’s Plan with ALL of your debts in hand … both ‘Good’ and ‘Bad’.

Look at it this way, once you find yourself with a mix of both Good (appreciating and/or income-producing assets) and Bad (depreciating, consumer goods) Debts, the only things that matter are:

1. Paying off the Dollar Value of the Bad Debt as quickly as possible, and

[AJC: Here is the key … its in the “AND“]

2. Paying off the highest after-tax interest rate loan off first.

So here was my advice to the person who asked the question on Trent’s post:

Interestingly, in the reader’s case (if I read correctly) his ‘consolidated’ card is at a Combined Effective Rate of only 5.2% … because he can’t attack the 13% portion until he pays off the 2.99% portion I would do the following:

1. Pay off the other card first, then

2. Buy an investment using the money that he would have paid the 5.2% debt off with …

… after all 5.2% is a very low rate of interest!

To clarify: I would not pay either card when interest rates are under the standard variable mortgage rate … I would be financing new real-estate, or paying down the mortgage on my existing (IF I’m not breaking the 20% Rule). The plan I outlined above starts when the 0% period ends … until then, pay off NEITHER card IF you have a more productive use for the money!

What does this mean for the rest of us?

i) Don’t get INTO Bad/Consumer Debt … save and pay cash for any ‘stuff’ (cars, vacations, furniture, ipods, computers, etc.) that you want.

ii) Once you do get INTO Bad/Consumer Debt … don’t be in such a hurry to get out of it; compare the cost of your Student Loans; Ultra-Low-Honeymood-Rate credit-cards; Super-Low-Suck-You-Into-Buying-More-Car-Than-You-Can-Afford Interest Rate car loans; etc. against the after-tax cost of the mortgage that you have on your house and/or investment properties (or the interest rate on your Margin Loans for your Stocks; or your Working Capital Finance for your Business; etc.).

iii) Work out a repayment plan as though you were going to pay INTO that Bad/Consumer Debt … instead, pay an equivalent amount off against your highest after-tax interest rate loan across your entire Good/Bad Debt portfolio.

iv) Reevaluate at the earlier of Quarterly (i.e. every 3 months) OR when one of the interest rates on ANY of your loans changes OR [yay!] when you have paid one of your loans off.

v) If you don’t want to (or can’t) get out of a higher-interest loan early using (iii) then compare the cost of the lowest-interest loans that you have (regardless of whether they are Good/Bad) against the current FIXED interest rates for new loan on a new investment … if LESS, buy new instead of pay off old.

Remember: The Object of Personal Finance is to end up with MORE money … the object isn’t to SAVE money, PAY off debt, BUY a house, START a business … they are all just all steps along the way.

If you want to get Rich(er) Soon(er) never, ever confuse A Means To An End with The End …

… now, let the flames begin!

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Last days for ‘pre-applications’ to become one of my 7 Millionaires … In Training! Click here to find out more …

Business for sale?

Posted on April 28, 2008 by Adrian

As you know, I’m a member of Networth IQ – and quite an active member, at that! I love reading and answering questions …

[AJC: you’ve probably already seen that from the detailed responses that I try and give commenters on my posts on this blog … try me, if you have a question … I just won’t give direct personal advice, because I am not a qualified professional, but I will give general advice if I think it will benefit all of our readers]

… and this unique site provides a great platform (as does Tickerhound, which provides a great Q&A forum on everything from stocks to real-estate).

For those of you who aren’t members of Networth IQ, here is an exerpt of a great question:

I found a business for sale that has generated the following free cash flows since 1998.

1998 – $3,426.0 Mil
1999 – $3,949.0 Mil
2000 – $4,917.0 Mil
2001 – $7,133.0 Mil
2002 – $6,077.0 Mil
2003 – $8,333.0 Mil
2004 – $8,956.0 Mil
2005 – $9,245.0 Mil
2006 – $11,582.0 Mil
2007 – $12,307.0 Mil

The current owners are asking $183.49 Bil, …. I don’t have $183.49 Bil, but they said that they would sell me a smaller portion of the business if I wanted … Should I buy?

I like this question on two levels:

1. It’s a neat reminder that when we buy stocks, we’re not just buying ‘bits of paper’ … we’re buying a small piece of a real, live business!

And,

2. It gives me an opportunity to show you the sorts of questions that I would ask – and the types of information that I would be looking at before buying into this – or any – business.

According to Warren Buffet (or sources who purport to know how he works) the intrinsic value of a business is in its discounted cashflow.

That is, a business is – or should be – a cash machine … what’s the reason for owning it, if not to get some cash out?

So, in the above example, we should be able to decide if the business is worth $183.49 Billion (not knowing the company in the above excerpt, I am assuming that this number represents the entire current market capitalization of the business) by discounting the cash-flows shown above …

… a quick look at the most recent cash-flow figure shows that it is currently producing $12 Bill. cash per year (probably growing, if history is any guide); that would mean about 15 years to get our money back … yuk.

Now you know why the stock market is generally a fool’s game … I would by far prefer to invest in my own business, or buy a private one at ‘only’ 3 to 5 years free cash-flow (better yet, Net Income), and grow it … then float it myself!

Or, at least sell it to a public company who can immediately ‘claim’ 15 times my Net Profit (hence, give me 7 to 12 times my Net Profit).

But, if we are going to play ‘the stock market’ game, what would we need to know before we can make an informed decision about ‘investing’ in this stock?

Hmmm …

As I pointed out, the free cash-flows on their own say nothing …

For example, I recently sold two similar businesses: one had been going for many years and generated ‘free cash flows’ [now that’s an oxymoron!] of $1 mill. and the other was less than 2 years old and had yet to make a dime.

Yet, I sold them both (separately) for about the same price! So, there must be more to the valuation of a business than Free Cash-flows, right? Absolutely!Let’s start with Return on Invested Capital:

I’d like to know what it has been for this company (and, the industry) over the past 5 years? I’d like to see an improving trend in excess of 15%, please.

Then, is the company growing?

Cash Flow is just one measure (but, what about operating cash-flow … have they made any strategic purchases / major capital expenditures /etc.), so what about the 10 years trends in: Earnings? Book Value? And, what about plain, old Sales?

I’d like to see a history of growth (min. 10%) in all of these …Now, how is there debt situation?

How long will it take them to cover their long-term liabilities from ‘Free Cash Flow’?

I’d like to see no more than 2 to 3 years.

Do the people who run the company own stock? Are they buying or selling?

Tell me about the company: do they have a ‘sustainable competitive advantage’ (what Warren Buffet calls a ‘Moat’ … but, that’s too much water for me!).

Do I believe this company will be around for the next 100 years … do I really want to buy THIS business in THIS industry?

Lastly, if I like the answers to all of the above (unlikely … so far I’ve only liked the answers to similar questions for 7 companies out of the 5,000+ that I can currently buy a ‘piece’ of) …

…. then how CHEAP can I get this thing!?

PS I made the ‘other’ category … waaaayyyyyy down at the bottom of the 150th Carnival of Personal Finance … whoo hoo!

… 7million7years doesn't even know how much is in his Retirement Accounts!

Posted on April 17, 2008 by Adrian

[continued from yesterday]

Now, I’m not particularly proud of this … but, it is true … I have no idea how much is in my retirement accounts; and, I didn’t even bother opening my own 401k account as CEO of my last company!

Why?

Yesterday, I wrote about the costs that can build up in the ‘food chain’ of the investing world, showing that merely accounting for the cost-differential between a typical mutual fund and a typical low-cost index fund can account for 20% of the performance of your entire investment portfolio after just 10 years.

I also, mentioned that I don’t like any of these products (even low-cost index funds, even though I will recommend them to lay-investors), primarily because of lack of control and too much diversification (who ever got rich from diversifying?!) …

So, the second part of this post will, hopefully, tell you why I don’t worry about 401k’s and Roth IRA’s as well as address a question that I recently received from a reader who asked:

Any suggestions on a strategy to use for retirement accounts if you earn beyond the limit for a 401k and Roth Ira? I have no company match for a 401k … get hit hard in taxes and have discovered that there is an income limit to a 401k and Roth IRA. Any suggestions?

Well my simple suggestion is: don’t …

The only time that I invest in a retirement account is when my accountant says:

“AJC, you have too much income flowing in, we had better plonk some into your [401k; Roth IRA, Superannuation Plan, whatever]”.

Yet, using a tax shelter is saving money, and as yesterday’s post showed, even a small difference in cost can add to a big difference in outcome … so, what do I really recommend and why?

If you still have plenty of working years left, I don’t recommend that anybody invests inside their company 401k except to get the ‘company match’ (who can argue with ‘free money’… yee hah!)

I also don’t recommend that anybody – who still has 10+ years of working/investing ‘life’ left – invests inside any tax-vehicles (such as a Roth IRA) etc. UNLESS they can:

(a) Choose their investments, and

(b) leverage those investments.

By choosing, I mean the whole gamut of what we want to be investing in: e.g. businesses, stocks, real-estate, and ???.

Now, in practice, these 401k/IRA’s are limited, so if you don’t intend to invest in some/all of these classes of investment or you have so little money to invest that you can ‘fit’ the whole or part of your intended, say, stock purchase strategy into one of these vehicles then, absolutely … knock yourself out!

Therefore, for most people, it’s still possible that a 401k or Roth IRA can provide an important place in their investing strategy … simply because the amount that they have to invest is so small …

… even so, they should go ahead only if it doesn’t limit the scope of their overall investing strategy, hence returns!

And, we should all know by now that primary importance of your investing strategy should be set on maximizing growth unless:

i) You are within a few years of retirement, when you no longer have time to take risks and recover from mistakes), or

ii) Have such a long-term, low-value outlook that simply saving in a 401k will do the trick (in which case, invest to the max.).

Just remember, this blog and my advice isn’t for everyone … it’s only for those who need to become rich …

… which usually means getting into investments that:

1. You understand and love, and

2. You can grow over time, and

3. You can leverage through borrowings.

If it doesn’t meet all three of these criteria, I simply don’t invest!

Direct investments in businesses and real-estate are the investment choices of the rich because of these three criteria… stocks to a lesser degree (you can only ‘margin borrow’ up to 100% of these, so the amount of ‘leverage’ that you can apply is lower than for, say, real-estate) … and, Managed Funds even less so (you can margin-borrow only on some of these, and only from limited sources).

For me, the limits that tax-effective vehicles place on me, and the maximums that I am allowed to invest in them, automatically reduce these typical ‘tax shelters’ to a very minor position in my portfolio … so minor, that I allow my accountant to manage them for me, totally.

Remember, though, that they only became a minor portion of my portfolio because I followed the advice that I am giving you here when I was still early into my working/investing career!

Now, I hope that (eventually) you, too, will have so much money OUTSIDE your 401K that whatever is INSIDE will be insignificant for you … in the meantime, at least invest for the full company match.

Pretty controversial? Let me know what you think?

Why 7million7years doesn't buy 'packaged' products …

Posted on April 16, 2008 by Adrian

I left a somewhat tongue-in-cheek footnote to a recent post on the differences between Index Funds and ETFs (if you didn’t read it, I favor the former over the latter for neophyte investors, and neither for serious investors):

Important Note: 7million7dollars does NOT currently invest in any Index Funds, Mutual Funds, or other “Packaged Investment Products” … apparently, he is just a (rich) product of the Stone Age

It seems to me that the wave of packaged products has increased over the past 20 years.

No longer do you tend to hear those stories of people like the reclusive and grumpy Old Man Miller who fell off a ladder and died leaving no heirs and a box of dusty old stock-certificates that now just happens to be worth $900,000 (not to mention a pile of gold just sitting under some lumber in the old wood-yard)!

It’s not just stocks … it seems that you can’t buy L’il Jon a toy without taking out your industrial grade laser to burn through 15 layers of impossible-to-open plastic ‘bubble’ packaging.

Think about the cost-differential between a typical consumer product at manufacture (the price it cost the guy who made it in: raw materials, labor, tooling, bulk packaging, and bulk shipping) and the eventual end consumer who buys it at retail: the price can inflate by 5 to 7 times … or even more.

The more hands, the more cost … simple.

Similarly, with ‘investment products’ …

… in my perhaps archaic way of looking at things, the further removed that I am from the investment, the less control I have, the more people who want to add cost (including their profit) into it, and less I like it.

That’s one of the reasons that businesses (my own) are my favorite form of investment … followed by direct investment in real-estate … followed by direct investments in company stock.

Now, if you do decide to invest in a fund, why would you choose a Low Cost Index Fund over the typical well-diversified Mutual Fund?

Unless, you can guarantee to find me a Mutual Fund that will outperform the market over the next 10 years (considering that 85% of fund managers don’t beat the market, that’s an easy bet for me to take), I would choose the lower cost option, simply because of cost.

If the Index Fund charged you only 0.25% of your total investment amount to enter the fund and another 0.25% a year to manage it for you, but the mutual fund charged you 1.0% and 1.0% [BTW: in this example, the Index Fund fees are too high and the Mutual Fund fees are too low] …

… over just 10 years (assuming an average 8% return for each), you would have paid the Index Fund just over $43,000 in fees … but, the Mutual Fund $157,000.

Why so much?

Because, you also need to factor in the foregone earnings on the amount that you could have had invested, if those fees weren’t there …

On the other hand, if you invested directly in some stocks and just managed to meet the market, with little to no fees (it costs just $7 to buy, say, $25,000 of stock using an on-line broker) …

… now you know why I don’t like packaged products!

I encourage you to run some numbers for yourself …

[To be Continued]

7million7years

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… 7million7years doesn't even know how much is in his Retirement Accounts!

Why 7million7years doesn't buy 'packaged' products …