ETF's as a hedging tool?

Posted on June 21, 2008 by Adrian

A while a go I wrote a post that discussed the difference between ETF’s and and Index Funds for diversification purposes … and, you know what I think about diversification.

But, for those who are just passing by the blog and thought you’d like to drop in [AJC: my regular readers will skip over this post because they wouldn’t be interested in diversification either 😉 ] here is an interesting article from the Tycoon Report:

If you haven’t already, you should start moving your money out of mutual funds and into ETFs (Exchange Traded Funds). In my opinion, they are tailor made for the “Average Joe” investor to get the benefits of a mutual fund without their crazy fees.

For a detailed listing of all of the fees, etc. that come with mutual funds, you can visit http://www.sec.gov/investor/pubs/inwsmf.htm#how.

In my opinion, the only downside (for some people) with respect to ETFs may be that you can buy and sell them as easily as you can. The reason that I say that this may be a downside for some people is because, if you are impatient or have an addictive personality,etc., then you may know yourself well enough to stay away from investments that you can easily get in and out of.

In other words, if your personality is such that you are tempted to trade without a logical reason to do so, then perhaps the difficulties (such as fees) that come with a mutual fund will prevent you from trading needlessly. An ETF, on the other hand, may (because of their ease) encourage certain types of people to trade. If you do not have this type of issue, then you should certainly choose ETFs over mutual funds.

I like ETFs personally because they are less risky than individual stocks. As you may know, you can never totally eliminate risk, but you can reduce it. You can reduce risk by hedging, diversification, and insurance. ETFs reduce risk through diversification, as you’re not assuming the risk that your investment will go to zero based on the demise of one single company.

Nice summary. Here’s where I sit … if you’re using the ETF for:

1. Speculation– Using an ETF (or any other ‘broad-based’ investment) as a hedge against short-term risk is fraught with danger … you are speculating. Yes, you are ‘hedging’ against the risk of any particular stock tanking (conversely, spiking) but you are really just betting with/against the whole market – if people knew where the market was going, they would be richer than Buffett. On the rare occasions that I do speculate (anything less than a 5 – 10 year outlook going in is speculating to me), I prefer to speculate with options and/or just a select handfull of the underlying stocks.

2. Investment– Now, if I am going to invest with a 5 – 10+ year outlook going in, then I am less likely to be speculating and more likely to be ‘saving’ or ‘investing’. It’s important to realize that I may not actually hold the investment for that long ( who knows what the future will bring?), but I certainly have the expectation of holding, going in. I don’t like to ‘invest’ in a broad-based ETF/Index because then I am truly ‘investing’ in paper, and market sentiment/emotions. I would not be investing with the understanding of the fundamentals of the underlying business, which is the only way that I expect to ‘beat the market’ in the long-term: buy under-valued businesses that I would be prepared to hold forever, and wait for the market to ‘catch up’ to my way of thinking … this is pretty much what Buffett does (actually, did … when he was a little smaller and could make smaller investments) with the stock investment part of his portfolio. If I get it wrong, but I llike the business and it makes good profits (else, I wouldn’t have bought it … then, I don’t mind holding. If I get it right, and the price spikes up to ‘fair market value’, I may end up selling early.

3. Saving– I don’t have ‘saving’ strategies – my speculation (20%) and investment (80%) strategies seem to cover me pretty well. But, if you just want to plonk your money away … either as a one-off (Uncle Harry left you some money) or on a more regular basis (you have a 401k or just want to regularly save) … AND you have a 20+ year outlook, then this is where ETF’s or Index Funds finally come into play! Plonking your money into a Spider ETF or broad-based Index Fund can be better options than CD’s or Bonds. Just don’t get fancy here … the good news is that Warren Buffett also recommends this strategy for the “know nothing investor” as he calls them … he also calls it “dumb money“, but he means that in a nice way 🙂

Now, as to selecting an ETF v a broad-based Index Fund, it’s a close call.

Finally, I was a little amused this little ‘teaser’ on the very same page as this very nice Tycoon Report article exhorting you to ‘invest’ in ETF’s; it said:

Most ETF Traders Will Lose … And Lose BIG

ETFs are the hottest new investment around, and for good reason. But many everyday investors who jump into ETFs without a proven system to guide them will lose their shirts.

Then [of course] it went on to the ‘solution’: On Thursday, June 12th, Teeka Tiwari will reveal the secrets of using ETFs to generate enormous wealth. But, there’s nothing wrong with a little good marketing …

My advice? Keep your shirt buttoned!

How to see through a job disguised as a business …

Posted on June 18, 2008 by Adrian

The best way to give up your ‘day job’ is to watch my Live Show this Thursday @ 8pm CST (9pm EST / 6pm PST) at http://ajcfeed.com ….

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Lots of people come up to me to proudly tell me about their wonderful, growing businesses … how do I look them in the eye and tell them that I really think that what they have is actually a job?

… and, no, I’m not just talking about the obvious: the accountant, doctor, attorney who earns an income from their own labor, whether individually or in a partnership.

Anthony asked me to post on this (I had said I might … so, I guess he was just encouraging me!), when I mentioned in a recent post that I would comment on this exact topic:

You should. I want to start my own business in an artistic field and every-time I think of having an employee create my vision, I shudder, just a little bit. That’s where modelling someone comes in. Model those who were able to export their vision to other people.

To me the difference between a ‘job disguised as a business’ and a ‘true business’ is:

1. Could it run 3 months without you?, and

2. Can you sell it?

The first point is self-evident: no employees/partners = no ability to run without you (unless, you can totally automate your business … in which case, call me … I want in!).

Therefore, no business!

The second point is a bit more subtle: if the business is not saleable (a) it probably also fails the first point (i.e. no employees), and (b) you are tied to the business and it is tied to you … when you stop, the business stops … when the business stops (market changes, product life-cycles end, etc.) … you (at least your income) stops.

To me, that’s a job; sure, it’s a flexible job with extra benefits … but, a job none-the-less, just like that ‘self-employed’ accountant/doctor/etc.

Now, how do you make a ‘glorified job’ into a true business?

First, you create Positions in your company!

Now, the business may be you, your Mom and your Dad (that’s a whole series of other posts right there!) … but, if you are going to morph into something that meets our two requirements (i.e. runs without you; and, is saleable), then you are going to need to create a simple Management Structure:

CEO (the gal who runs the show); CFO (the guy who runs the finances); Sales/Marketing Manager (the guy who brings in the business) … right on down to Mail Girl.

If there’s only one, two, or three of you … well, you’re each going to be wearing lots of hats for a while. The key is, though, that each ‘hat’ (i.e. position) has only ONE person who wears it! Only ONE of you gets to be CEO (now, I let me know when you have your first Owner’s Meeting … I sure want to be a fly-on-the-wall wall for that!).

Now, for small businesses it can be very difficult to understand this concept, so try this one one:

When the OWNERS walk in the door, they become EMPLOYEES … when they leave at the end of the day, they become OWNERS again. Simple … critical!

Next you create Systems!

You need to get down and document absolutely everything that you (and everybody else!) does in the business.

As Michael Gerber (whose ground-breaking book, The E-Myth Revisited, taught me everything that I know about business!) says, you should act as though your business is a prototype and that one day there will be 500 more just like it.

Even if your little store is ever going to be the only one, this step will allow you to easily grow and add staff, and sell the business … because the purchaser will see how well everything is documented.

Of course, if you’re like me, you could never believe that your business can run without you … here’s how I learned otherwise:

In the early days of one of my businesses, every file would come to me for approval … now, I had experts – trained in the field in which we were operating (compared to me: I was self-taught when I decided to get into that particular business!) – yet, I still checked every major file.

Eventually, my staff stopped bringing me every file … gradually, at first (they’d ‘forget’ to bring me one here and another one there).

When I didn’t notice – because I was so damn busy, running myself ragged doing ‘other stuff’ – they conveniently ‘forgot’ to bring more and more files to me until, they stopped bringing any to me for approval at all!

If I had noticed, would I have got so upset that I would have fired somebody? Probably. Ego does that.

Did the business run any worse after they stopped bringing me the files? Of course not … I said they were trained, and I wasn’t! I just needed a lesson in faith and trust.

So, that’s how I was gently pushed out of Operations and never again stepped a foot back in … in ANY of my businesses.

But, I was CEO … without me at the helm the business would hit the rocks and sink … or, so I thought:

A year or two later, I closed on an opportunity to acquire a business in the USA, requiring me to move countries. I decided to move to the USA (where we’ve been ever since) as this would be a much bigger business – but, at the time, I wasn’t selling any of my overseas interests.

So, I did the responsible thing: I hired a replacement CEO months ahead of my planned relocation …

… who decided to leave less than 6 weeks before my departure for the USA!

Luckily, after a frantic phase of executive search that consisted of me calling the only guy that I thought could do the job (even though he had no direct industry experience) and him saying ‘yes’ immediately (phew!), I found somebody who could start exactly 4 weeks before I was leaving … remember, this is a business that COULD NOT POSSIBLY run without me, and here I was putting in ‘New Guy’ with only 4 weeks ‘training’!

Needless to say, he took over seamlessly, didn’t miss a beat, never called me about ANYTHING (bruised ego on my side!) and, not only did he keep the business running, keep the staff happy, and keep the clients equally happy, he damn well GREW the business!

In his favor, he did have Positions all neatly laid out and filled before he joined, and he did have a whole Operating Manual full of Systems that worked …

… and, in my favor, I had a business not a job! How do I know for sure?

Not too long after, I found a buyer …

How about you? Do you have a business or a glorified job?

Millionaire by 30?

Posted on June 17, 2008 by Adrian

The best way to become a Millionaire by 30 is to watch my Live Show this Thursday @ 8pm CST (9pm EST / 6pm PST) at http://ajcfeed.com ….

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Recently I wrote a post that I consider to be one of the critical “you either get it or you don’t” pieces that will determine whether you will ‘make it’ or not …. if you haven’t seen it yet, fully understood it, or hotly debated it (with me, yourself, or your mother) then I highly recommend that you go and get to it!

Anyhow, Jim wrote a comment:

This video was suggested from one of my posts and I think it gives a pretty good example of your premise. This is Douglas Andrew, author of Missed Fortune…

I watched the video … and, set it aside presuming that because it was so short, the one or two glaring errors (did you spot them?) would have been addressed in the full video (or a Douglas Andrews seminar) …

… then I saw an article on My Money Blog:

The overall moral of this book review is that even though a book finds a publisher, it doesn’t mean the advice is accurate or applicable to you. The book Millionaire by Thirty: The Quickest Path to Early Financial Independence by Doug Andrews & Company appears to be very similar to the other Missed Fortune books by the same author. In fact, from reading the reviews all of these books seem to contain the exact same material.

Housing Prices Always Go Up, Take Out Largest Mortgage Possible!

“Do you rent? Rent is like throwing money down a black hole. It doesn’t matter how much money you have saved or how long you plan on staying in the same place, you should always try to buy a home. If you aren’t going to stay very long you can simply get an adjustable-rate loan with no down payment. Housing prices always go up, so you can enjoy the low interest for a couple of years, and then sell and make a nice profit.

If you are really smart and disciplined, you can even get an interest-only or negative-amortization loan because then you won’t build up any equity at all. Accumulating home equity is bad. Anytime you have any, you should take out a loan on it and invest it somewhere else, like a second home.”

The above are all the dangerous generalizations about real estate contained in this book. Newsflash… Renting can be the best option for many people. Housing prices do not always go up. Thousands of people who bought a home and now have to sell after a few years will have lost tens of thousands of dollars compared to if they had rented.

Summary
Many of the books I read may not be brilliant, but they contain generally good ideas and target a specific type of reader. However, this book is one that could actually hurt more people than it helps. This book is just plain misleading. It would be wonderful if home prices always went up and there was an investment where I could never pay taxes, have no downside risk, and get stock-like returns, but unfortunately both are too good to be true. I’ve tried to lay out my arguments for this briefly, but if you want a better description read the detailed reviews here and here. Clever Dude also shared his thoughts here.

Short version: Don’t read it, don’t buy it, don’t even borrow it from the library

Firstly, I agree with My Money Blog on the home ownership issue to a degree … owning your own home is not always the smartest FINANCIAL option.

However, here is where I differ: for MOST people, it’s the only way that they will get financially free for lots of psychological/emotional reasons, more than strictly financial. Also, I do agree with the ‘forced saving’ and ‘forced appreciation’ that it can give you (provided that you do something with the appreciation … you don’t want to die ‘house rich / cash poor’!).

The ONLY time you shouldn’t invest in your own home, is to invest in income-producing property instead*.

And, while it’s true that real-estate doesn’t always go up, if you have a 20 – 30 year outlook and can lock in circa 6% interest for up to 30 years (another reason why your own home can be a good idea) … I think the future is exceedingly bright.

So, it is with a little surprise that I find myself actually siding with Doug – warts and all (!) – on this one …

But, I don’t agree with Doug that you shouldn’t have ANY equity in your own home (again, strictly financially speaking, he is probably correct), but I have proposed the 20% Rule that says that you should have no more than 20% of your Net Worth invested in your own home at any one time.

This rule, when understood and applied properly, accomplishes two key things:

1. Let’s you get/stay invested in your own home, but

2. Ensures that you maintain enough of your Net Worth in outside investments.

… without the screaming holes in the get-rich-quick schemes promoted by the ‘nothing down’ brigade!

So, go back and read all the posts that I have linked to … as I said at the very beginning, this could be the key to your wealth …

* or to invest in some other high-reward activity (e.g. buying/starting a business; leveraged
  investments; etc.) ... although, I would still prefer that you ALSO buy you own home 'just in case'
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Hitting Suze Orman out of the ball park …

Posted on June 16, 2008 by Adrian

… with a fly ball that even Dave Ramsey won’t be able to catch!

As expected, my recent post “Contrary to popular opinion, paying off your mortgage is the dumbest move you can make …” drew a number of comments – but, not as many deep criticisms as I was expecting (hoping for) … I would’ve liked some issues out in the open so that we can really bang them around.

After all, my view is diametrically opposite to the ‘pay off ALL debt INCLUDING your mortgage’ view espoused by the likes of Suze Orman and Dave Ramsey!

With some suitable flaming of the “you’re just another Make Millions In Real Estate Like I [wished] I Did guru” or “Robert Kiyosaki knows what he’s talking about compared to YOU” kind, I’d at least be able to dig in and show you why my view is correct for MOST people.

I’d also be able to explain why, perhaps counter-intuitively, it’s actually the more conservative option.

Instead, let me make do with the much more polite, and more thoughtful, comments that one reader – Chris – did leave on that post:

AJC – I completely understand and agree with your concept. I think the reason why you and Suze Orman differ is because you target a different group, or have a different approach.

You talk much more about leverage. Suze Orman wants to get people to stop buying frivolous things and instead pay down debt (because most people are buying junk and creating more of it).

While anybody can start a business, a rental, etc. There are people who don’t have the ambition or the stomach for it. The concept of leverage and more involved ways of wealth appreciation get lost on those people.

The point that needs to be made is, if you aren’t going to leverage that debt properly to grow wealth, then paying it off is better than buying useless things. Perhaps for some people we need to focus on getting them to be frugal spenders first, and then wealth builders later.

I would also note that I think paying off mortgage debt should rank much lower than other investments in reducing higher cost debt, a business (including rentals) or retirement accounts. But for some people, putting an extra $100 towards a mortgage is a great way for them to start being more financial considerate.

The assumption is that my approach is different to Suze’s and Dave’s because:

1. I aim at a different audience

2. Their approach is a more sure way to a comfortable retirement

3. They focus on ‘frugal living / debt free’ which comes before wealth building

It seems logical, safe, and conventional … and, I agree on one point, my approach isn’t for everybody …

… it’s just for anybody who doesn’t want to retire on the poverty line!

By that, I mean that I am targeting anybody who wants to retire with a nest-egg of MORE than $1 Million in LESS than 20 years.

Now, that is almost everybody that I have ever known or met– and, I’ve known and worked with a LOT of people from call-center people to CEO’s – because $1 Mill. in 20 years (the typical target for the ‘save your way to wealth’ crowd) simply gives you the equivalent of $15k per year in today’s spending-dollars!

For every extra million dollars, you only get an additional $15k per year to live off … and, for every 10 years that you will retire sooner, you get another $7,500 per year ‘pay rise’.

So: how much do you need to live off now? How much do you need to live off when you ‘retire’ and by when?

I don’t know the answers to these questions, so you do the math …

I can tell you this: if all you do is live frugally and become debt free you will be poor, with a roof over your head … if you don’t, you will be poor without a roof over your head.

Neither seems like a great option … so, you can understand when I say that the Suze Orman / Dave Ramsey ‘save and pay off all debt’ approach still seems a tad ‘risky’ to me, and a sure approach to a fairly uncomfortable retirement.

Given that Door 1 and Door 2 pretty much suck [AJC: OK so one door sucks more than the other … are we here to measure degrees of ‘suckiness” or what?!] what’s left is Door 3 …

If you live on the same planet that I come from (Planet Save a Little, Spend a Little … Enjoy a Lot), then we simply have to aim for more … a lot more!

That’s where leverage comes in … and, it has to come in WHEN saving, WHEN learning to be frugal, WHEN paying off all debt (and, probably BEFORE paying off some debt) …

… and, if you are aiming to retire somewhere above the poverty-line, then you are simply going to have to find the ‘ambition or the stomach’ for something.

I never had the ambition or stomach for work … I simply had to do it or starve. Don’t you?

I never had the ambition or stomach for investing … I simply had to do it or figure on retiring near-broke. Won’t you?

If the government takes away your social security safety net … if your employer takes away your pension … if your rich relatives die and forget to leave you anything … it’s going to be that simple: do it or retire broke.

OK, if that hasn’t turned you on, then nothing I ever write will … otherwise, here are some options, in decreasing order of risk and difficulty – but, also decreasing order of financial outcome:

1. Start a business

2. Buy a business

3. Invest in real-estate

4. Buy your own home

5. Leverage into Stocks

6. Leverage into Index Funds

In every one of these cases, you borrow as much as the banks, convention, your gut, your advisers tell you to … then you hold – preferably for ever.

[AJC: Speculative ‘investment’s such as: rehabbing/flipping real-estate; trading stocks/options etc. all belong in Category 1. Start a business]

Now, go do it …

Play the match game …

Posted on June 14, 2008 by Adrian

Here’s an ‘investing match game’ for you to try … simply match the active investment actions in Column A with the investment vehicle of choice in Column B (you must use each word in Column A once, and once only … you may use any word/s in Column B as often as you like):

Investment Actions		Investment Choice

Rehab’ing / Flipping		Real-Estate

Mortgaging / Leveraging		Motor Vehicle

No Money Down		Business Assets

Now, is this a trick question? If you’re honest, you probably answered:

Investment Actions		Investment Choice

Rehab’ing / Flipping		Real-Estate

Mortgaging / Leveraging		Real-Estate

No Money Down		Real-Estate

… after all, these are all ways to make money with real-estate; so did you pass the little test?

Good, because here is how they might work:

1. Rehab’ing, then flipping (quickly on-selling) real-estate

You can purchase a run-down property in a good location (usually a small house, condo, duplex, triplex or perhaps a run-down apartment complex), provide some of your own labor (or try and find a general contractor willing to work cheap) to fix up the kitchen and bathroom/s, apply a little paint and some new carpet, and … voila … you get to re-list the property and resell it for a price that covers your purchase price + rehab + profit (both yours and the general contractor). At least that how it used to be done – and, will again, sooner or later. Rehab’ing and flipping can be a useful way to generate a small lump of cash (also known as ‘chunking‘).

2. Mortgaging real-estate

You can purchase some real-estate, perhaps putting in a deposit of 10% – 20% and then using the bank’s money to pay for the balance. You can either live in the property or rent it out to help cover the cost of the mortgage (which you should usually fix so that you can be certain of your future costs). Since the mortgage payments do NOT rise with inflation (if you were smart enough to fix them), but rents do … over the long run you will earn an income and an eventual capital gain as the property increases in value. Buying and holding is a simple strategy for long-term wealth.

3. No Money Down

This is where you find a creative way to avoid paying a deposit (perhaps you don’t have the cash?) and then work with one of the other two strategies. There are people who swear by this method and others who say that there is no ethical way to use this strategy in a repeatable fashion. In either case, you use tools, like assuming an existing loan, and/or seller carry-back financing and/or finding a partner to avoid the necessity for fronting the 20% deposit yourself.

Of course, this little primer on real-estate was just a little ruse to stop you from peeking ahead …

… you see, even though I have also invested in real-estate in many different ways, here’s how I would match up those columns a little differently, based upon some things that I have actually done over the years:

Investment Actions		Investment Choice

Rehab’ing / Flipping		Motor Vehicle

Mortgaging Leveraging		Business Assets

No Money Down		Business Assets

i) Rehab’ing, then flipping a motor vehicle

Just out of college, I landed a high-flying job in the hot IT sector (yes, we had computers in the 80’s … just bigger) … when all of my friends were buying their first new car, I was selling mine, to buy …

… a 10 year old Porsche 911 (the particularly ‘hot’ S-model) for just $13,000 (she was a beauty, but more exhaust fumes ended up inside the car than outside … helps to explain the loss of a few memory cells).

The trouble is that she was that horrible bright/lime green that the German engineers thought was oh so appealing … yuk. I hired a compressor and bought some paint and materials … and, a friend who (said that he) had some experience spray painting, helped me to strip and sand the car’s exterior to bare metal then we spray painted it (in his backyard garage) a beautiful red … acrylic. We used over-the-counter enamel spray cans in a matching red to change the color of the interior of the doors, cabin, and engine/trunk because those areas were too hard to sand smooth and polish to a shine.

When we were finished the car ‘looked’ a million dollars …. needless to say I flipped it pretty quicky … selling it for $26,000. That was a decent profit for a not-long-out-of-college kid in the early 1980’s!

2. Mortgaging business assets

I mentioned in a previous post that I left my high-flying job just shy of 10 years to join my father in a very small finance business (just me, my father, and one administrative clerk); it didn’t perform very well, not even covering salaries. However, when my father got sick, I decided to buy out the family, leaving me $30k in debt.

The only problem was, that being a finance company, the business needed funding – bank funding, and a lot of it. The best solution that I could come up with was to find a bank who would treat the business assets (the ‘paper’ that we were funding) just like real-estate: I had no trouble finding a major bank willing to lend me 75% against those assets at a middling-to-high interest rate (leaving me to find the 25% deposit … by way of a partner whom I found then later bought out). The bank took no other security other than my personal guarantee … now, I have banks lining up to fund millions at up to 95% of those same assets (sub-prime or no sub-prime!) with no additional security and, now at an excellent rate.

3. No Money Down

Obviously, finding a partner for that business was a ‘no money down’ technique as applied to business, rather than real-estate. However, I came to the USA to sell some software to a related business. What I found was a business that had been family-owned for 50 years, allowed to run down, then been purchased by a large multinational for a ridiculous sum.

Naturally, the part of the business that I was interested in was not operating profitably, so instead of selling them my software and services to help them ‘fix’ the business themselves, I provided a cost-benefit that showed that they should give me majority share – for nothing – in return for taking over, and re-engineering its operations.

My team and I turned that business around in just a few, short months, and I sold my share to another public company for a huge gain (what’s the return on ‘no money down’? Infinite!) just 2 years later.

The point here is that money can be made anywhere, in any manner … all you need to apply is the NEED to achieve a certain level of financial result, the VISION to see a way to get there, and the PERSISTENCE to see it through …

… failure to do so will NEVER be for a lack of opportunity!

What are the pro's and con's of value investing?

Posted on June 13, 2008 by Adrian

I answered a great question at TickerHound posted by the staff (as they do from time to time to stimulate discussion) that I thought I should simply repeat here:

What are the pro’s and con’s of value investing? Do you think it’s a worthwhile strategy or are you more of a “efficient market” proponent?

Well, I consider myself a Value Investor in everything that I do … stocks, real-estate, etc. The only exception is in the case of businesses, I’m generally a Growth Investor or a Value Investor.

Value Investing simply means “buying something worth $2 for $1” … well, not exactly, but you get my point: buying something for less than it is WORTH.

Now, this is a critical distinction: just because something was selling for $2 last week, and is selling for $1 this week, doesn’t mean that it is a VALUE Stock … it may only be ‘worth’ $0.50 and the market may simply be driving the price down to that … and, beyond!

In fact, that same stock (really ‘worth’ only $0.50) may BECOME a Value Stock if/when the market overshoots and sends the price down to $0.25.

The problem with Value Stocks is then one of KNOWING what they are truly worth at any point in time, and only buying when they are selling for a price less than that (preferably, with a large Margin of Safety … which simply means, buying it for MUCH LESS than what you THINK it is worth “just in case” …).

Now that we have covered the basics, what is the PRO of Value Investing?

Exactly that … being able to buy something ‘worth’ $2 for only $1. I can’t think of a better, more sure way of making money than that!

Then, what is the CON of value Investing … after all, there must be some or we’d ALL be doing it?

Simple: as I said before, it’s all about KNOWING which stock that is currently selling for $1 is actually worth $2 (and, avoiding the ones that are only worth $0.50!!). And, that takes some knowledge and skill. Warren Buffett has that knowledge and skill … so do many others, to a greater or lesser extent.

One other CON – one that is, ironically enough, addressed by another TickerHound question: “Is technical analysis still applicable in a “news driven” market like the one we’re in now?”:

If a stock that you KNOW is worth $2 is currently selling for $1, is it an automatic BUY?

Well NO … you see, you KNOW it is worth $2, but the rest of the market may not!

Or, it may have BEEN worth $2 but there is something happening (maybe a pending lawsuit around a key patent, or the loss of a major contract, or … ) that YOU don’t know about because it hasn’t hit the “news” (or TickerHound) yet, but those ‘in the know’ are selling off the stock by the truckload.

So, that’s where technical analysis is not just applicable in a “news driven” market like the one we’re in now, but absolutely CRITICAL for buying Value Stocks …

… it will tell you WHEN to buy (or sell off) that stock holding, based upon what the “insiders” are doing.

If you want to learn more about Value Investing, and using Technical Analysis to know when to get in/out of a Value position, I recommend picking up a copy of Phil Town’s excellent primer: Rule 1 Investing …

… and, Good Luck!

The $7million Real-Estate Rule

Posted on June 11, 2008 by Adrian

Yesterday’s post, The $7million Real-Estate Question(s), was aimed at the first-time investor, perhaps stuck on making their first real-estate investment (not home) purchase decision by the – perhaps too many – factors that they would need to consider.

In essence, what I said is: in a commodity market, buy the commodity at commodity prices … and wait!

Wait for what?

Ideally, forever … but, at least until the values have improved.

But, what kind of real-estate are commodities?

Houses and apartments in most areas are commodities; small multi-units (duplex / triplex / quadraplex) can be, too. Anywhere where there are lots of them near each other …

… preferably lots for sale, and fewer vacant [AJC: Too many vacancies can show an area that’s declining in population and/or jobs (with job growth being, by far, the most important of the two) … we don’t want that!].

Also, for residential property (that you don’t intend to live in) you really need to go for an area that will/can appreciate as it can be very difficult – if not impossible – to get them to cashflow-positive on a reasonable deposit (say, 10% – $20%).

Even so, my first two $7million Questions showed you the right type of market to buy in … which is, right now!

But, when evaluating more complex real-estate transactions, such as: commercial apartments (6 and above); offices and factories of all sizes … surely the The $7million Real-Estate Questions are not enough?

And, surely you are right …

These types of properties are sold as ‘businesses’ in that they have:

a. Income (or rent)

b. Expenses (or outgoings)

c. Taxes (unfortunately)

d. Profit/Loss (or Net Operating Income)

I will run you through how to analyse some of these types of property in future posts; for now, I want to tell you one way to assess these types of Investors’ Real-Estate that is NOT as important as you may be lead to believe, and another way that is MUCH MORE IMPORTANT.

Because commercial property runs at a profit (or loss) and has an Income Statement, people tend to buy (and sell) these types of rel-estate on the basis of their financial statements alone …

… and, not on the sale of comparable buildings around!

This is critical to understand – as it is totally opposite for the types of residential real-estate that most of us are used to.

The second thing to realize is that these buildings sell on a variety of bases, but usually the ‘expert’ real-estate acquirer will assess the Net Operating Income during Due Diligence and buy for a multiple of that … there is usually a multiplier [AJC: that the real-estate books that you read will all say is around 10 … but, these days in many of the hotter markets in the US and overseas, it will be as high as 12 to 16 – or even more when things get crazy].

This is called a Capitalization Rate or simply Cap. Rate.

Yippee!

This is just another way of saying that when you buy the building, it will return 10% of the Purchase Price (for a cap. rate of 10) by way of Net Operating Income (which should improve as you increase rents).

A larger Cap. Rate when you talk “times” (or smaller when you express it as a %) is BAD for purchasing (but, great for selling if you can increase the rents a lot!); here’s why:

A 12 times Cap. Rate means that a $1,000,000 property will only return (NOI or Profit) a little over 8%

A 16 times Cap. Rate means that a $1,000,000 property will only return (NOI or Profit) a little over 6%

So, a serious investor will pull out all the numbers, take a look at the Cap. Rate and make a decision whether to buy (obviously, there will be a lot of other factors … this will drive the financial decision).

How will they typically make that decision?

Well, they’ll compare the % return to what the cost of funds are … if they can make enough to cover the mortgage … then they’re in. So, with a Cap. Rate of 8% and Mortgage Interest rates at, say, 7%, it’s slim … but, they’re in front!

Cap. Rates are really useful, when you can a property for, say, $1,000,000 – add $50,000 of renovations that allow you to increase rents by 10% … all of a sudden, your property is now worth $1,100,000 – a 100% Return on your $50k rehab. investment!

But the Cap. Rate alone doesn’t give you the true picture for the original purchase decision … there’s a MUCH better way to look at the financial decision … first, here’s why:

A. Your investment in real-estate is only the deposit – typically 25% (plus Closing Costs) on commercial

B. The Bank’s investment in real-estate is the mortgage – typically 75%

But, you get the ‘return’ or the Net Operating Income on the entire building …

Because of this wonderful benefit of buy-and-hold, income-producing real-estate, the ‘right’way to value an investment is by it’s return on what YOU put in: it’s called your Cash-on-Cash Return.

So if you put in 25% deposit on a $1,000,000 building with a Cap. Rate that’s returning 1% over the mortgage rate, then you are getting:

1. 8% return for the 25% that you put in, plus

2. A ‘free’ 1% for each matching 25% that the Bank puts in – since they put in the other 75% that’s another 3% effective return.

All of a sudden that ‘small’ 8% return that seems only a little above the bank’s interest rate of 7% swells into a real 11% Return on your money [AJC: most investors will look for a return on their money (in real-estate) in the 10% – 20% range; this requirement will increase as Mortgage Interest Rates increase] … and, we haven’t even counted on any appreciation, yet (!):

i) As Rents increase, so does your return because YOU don’t have to put in any more money … inflation does all the work for you!

Example: if interest rates remain the same (and, they will because you DID fix them, right?), but the rents go up a mere 4% per year over costs (and, they will because you DID put a ratchet clause in the lease, right?), in just three years the building’s 8% return will swell to 9% …

… and your cash-on-cash return will jump to 9% + (3 x 2%) = 15% – try getting thatin CD’s, Bonds or Stock Funds!

ii) As the building appreciates, so does your future return, even though you can’t cash on this right now (unless you refinance, of course).

Example: If cap rates don’t change (that, unfortunately, is up to the market), the 4% increase in rents will ALSO increase the value of the property by 4%. Which sounds great, until you realize that you only put up 25% of that …

… so, YOUR return increases by 16% – try doing that with Stocks!

Now, how does a 30% return (half now, half when you sell) sound to you? And, what happens if you hold for a little longer?

You do the math!

The $7million Real-Estate Question

Posted on June 10, 2008 by Adrian

I’ve posted recently on the importance of real-estate to your portfolio …

… only ‘important’ of course, if you intend to retire on more than the Pauper’s Million 😉 Well, at least important enough that you probably need to find a good reason NOT to invest in it (e.g. can’t stand the stuff; market is too crappy; can’t find a deposit; etc.)

So, how do you tell a good real-estate investment from a bad one? There are so many variables:

1. Purchase Price – This varies by type of property and area

2. Deposit Required – This varies by type of property and Lender

3. Mortgage Repayments – This varies by type of property and Lender

4. Comparable Returns – What would other investments produce?

5. Comparable Risks – How risky is this investment v. other uses that you put your money to?

For the new real-estate investor, these factors are almost impossible to accurately assess, so investing in real-estate usually comes down to:

(i) What kind of real-estate appeals to me as an investor? Residential – Houses; Residential – Condos; Residential – Multifamily; Commercial – Apartments; Commercial – Offices; Commercial – Retail; Vacant Land; and the list goes on

(ii) What area/s am I interested in? For most real-estate ‘noobs’, that means their local neighbourhood, town, city, or possibly state.

(iii) What price range can I invest in? For most this is dictated by Type of Property, Deposit Available, Income available to service the loan, and the Lender’s Rules

Which is all well and good, but here is how most real-estate investors ACTUALLY invest:

They see something that they like and can afford, and:

a) They buy if they are not too chicken, or

b) They pass if they are … well, you know … cluck, cluck cluck.

Since, I am usually scratching in the yard myself, please don’t consider this an insult 🙂 I actually think that this is a perfectly reasonable way to buy real-estate IF you first (more bullet-points!) ask the $7million Questions:

A. Is the market off its high?

B. Do you at least understand the type of property that you are looking at – and, the area – and consider it a reasonable buy (i.e. you don’t think you are paying ‘top dollar’ to get in)?

C. Are Interest rates off their highs?

D. Can you can afford the payments?

E. Ideally: Will the property be cash-flow positive (or very close to it)?

F. Can you (will you!) hold on to the property for a very, very long time?

Here is the basic principle:

Certain types of real-estate (certainly the entry-level types that most beginners would look at) are virtual commodities … you can pretty easily assess their value (and, potential rents) by looking up a few databases (Zillow, RealtyTrac, Loopnet, Rent.com) and/or newspapers.

There are more intelligent people than you and I out there who actually know how to assess this type of stuff … just trust a ‘commodity market’ to price reasonably accurately and you can’t buy too wrong.

One of my first acquisitions was a simple little condo … the market had been low but was starting to appreciate (how did I know, my 20 year-old nephews told me … they had just bought two condo’s in the same area!).

I didn’t know very much about the values, but I found a condo that was going to auction (actually, the most common way that condo’s were sold in this particular location) and the real-estate agency was from out of town, so I figured that they would attract fewer buyers than an well-advertised local agent would.

The only other keen buyer appeared to be a young builder: I could tell by his overalls, ass sticking out, and his trusty tape measure in hand.

So, what did I do? I just bid at the auction until it came down to just him and I … and, I kept bidding slightly more than him, until he stopped bidding!

I figured that HE knew how to do his sums and HE would not overpay … so, the max. I could overpay is by the amount over his bid that I would have to bid. Risky: you betch’a! Did it work: you betch’a!

His advantage: any rehab would be ‘at builder’s cost’ (I at least knew this would relatively minor … kitchen / bathroom / carpet / paint / lights / knobs). My advantage: Time … I could afford to hold.

In fact, we still own this condo and it has done very nicely thanks … it’s the only single condo left in our portfolio.

But, you could do even better: if you are prepared to do what most other (lazy) people won’t do – which is turn over a lot of rocks and put in a lot of low-ball offers before one is accepted – then you might actually out-smart the so-called ‘smart investors’.

So, how and when to get started?

For those who are following along, you will realize that the current market satisfies $7m Questions A. and C. … a bit of work will help you decide on $7m Question B. … and, your Lender will pretty quickly sort you out on $7m Question D.

$7m Question E. is the one that will give you the most difficulty … as you may not know how to estimate the costs (loss of rental; utilities; Repairs and Maintenance; etc. etc. … if that’s the case, don’t worry TOO much:

TIME (which is why you hold for a long, long time) will cure most ills … and, my $7m Questions … will protect you from disaster.

Oh, and do JUST ONE ONE MORE THING:

Lock in the current low interest rate for as long as the lender will let you!

That will help TIME help the MARKET do its thing … which is get the property/s to appreciate and the rents to rise 🙂

Now, if you can do the analysis that a ‘seasoned’ real-estate investor can do … well, go do it … you will make more money / faster, if you do.

But don’t let fear and ‘paralysis by analysis’ stop you … just use the $7 Million Dollar Questions, and …

Good luck!

The lesser of two evils?

Posted on June 9, 2008 by Adrian

Ramit Seth of I Will Teach You To Be Rich recently arose from his bunker – where he has been holed up, busy polishing the manuscript to his latest book [publishers please!] to pose the question:

“Should I invest in CDs or a Roth IRA?”

The post was brief, and to the point:

Sherene writes:

“I am a recent college graduate and I want to put the little money I have saved (approx $3,000) into something that will give me good returns over the years. Would you suggest I get CDs or a Roth IRA?”

The two are very different.

A Roth IRA is an investment account, but once you get it, you have to put money in it and invest. You can read all about it on my article The World’s Easiest Guide to Retirement Accounts.

A CD is a type of investment, which you can buy inside (or outside) of any investment account. And if you’re wondering what I think about CDs/bonds…

It was the last line that triggered the most comments … and, of course those comments were split into four camps:

1. Pro-CD’s

2. Pro-Bonds

3. A little of both

4. Ramit, why don’t you write more 😉

But, these miss the point …

Are you an ACTIVE investor or a PASSIVE investor?

Active Investor

You will have realized that you can’t retire on $1,000,000 in 15 to 20 years. And, inflation will serve to ensure that investing greatly in either Bonds or CD’s will keep you poor.

Therefore, you will be looking for direct (maybe leveraged through margin borrowing, if you have the ‘appetite’) investments in a very few stocks that you understand and love, a business here or there if you have the aptitude and interest, and/or a few well-chosen real-estate investments.

You will manage these for growth and hold until they no longer make sense to keep, or you retire (and, want to adjust your investment strategy).

I don’t see any room in this portfolio for either CD’s or Bonds, except as short-term vehicles for parking cash while you gear up for the ‘next big thing’ do you?

Passive Investor

OK, so we don’t all want to be rich … and some of you are just window-shopping this blog (or, seeing how the ‘other half’ lives?).

Let’s say that you DO subscribe to the $1,000,000 (or even $2,000,000) in 15 – 20 year philosophy (yes, I even had some applicants for my 7 Millionaires … In Training! ‘experiment’ with that outlook … they don’t need my training; they just need Valium!) … what then?

Firstly, you will be looking to max out your 401k/ROTH certainly enough for the full employer-match; this will probably mean selecting from the list of funds available … unlikely to include Bonds (although, there may be a Bond Fund in there, somewhere) and certainly CD’s won’t be an option. So, it’s a moot point.

Secondly, you will probably be looking to invest in buying a home … saving a deposit, making payments, etc. then trading up as soon as the sun starts to shine (now, there’s a financial treadmill for you!). So, it’s a moot point.

But, Uncle Harry might die and leave you with $20,000 and you are suddenly faced with the decision: CD’s or Bonds …

…. hah, you think you got me? No way!

I would be immediately looking at becoming an Active Investor ($20k might just be enough for a deposit on that nice little rental ‘fixer upper’ down the street).

But, let’s say that you still are determined to retire late and poor … but, don’t want to be quite so poor … where would I go for advice on conservatively investing that nice little chunk of change?

Hmmm … when I look for investing advice, I usually look to the best in the business. That’s why I went to Warren Buffett’s Annual General Meeting in Omaha a few weeks ago.

At the meeting, Warren suggested that IF you don’t really know what you’re doing, you should dollar-cost average (that means put a little bit over time) into little pieces of all of “American Business” … he later clarified that to mean a low-cost Index Fund (in fact, he named Vanguard).

Why?

Well inflation will keep your CD’s and Bonds worthless … by buying and holding Index Funds (LOW-COST ones) for a VERY LONG time, the market will go up (there hasn’t been a SINGLE 30-year period where the market hasn’t averaged an 8% return) and you will stand a better chance to beat inflation …

Of course, none of these PASSIVE investment strategies will make you rich (or even financially free at a young age), but Warren’s strategy at least has a better chance of keeping you out of the poor house, and giving you a chance of retiring at 55 or 65 … IF you start young enough, and maintain the course for 20+ years!

But, what if you don’t want to invest in stocks at all … even via an ultra-low-cost Index Fund? Is it thenOK to invest in Bonds or CD’s?

Maybe, but I would much rather plonk that $20k into my mortgage!

I know that I said that it’s a dumb strategy, but it’s sure better than the CD/Bond alternative (better after-tax returns, but check with your financial adviser before doing anything!).

In fact, the only time that I would invest in:

1. CD’s – when I need to ‘park’ some money for a while … waiting for the next ideal investment to come along.

2. Bonds – when I am already rich and retired: Bonds can play an important part in maintaining wealth as part of a Making Money 301 strategy. As Ramit mentions in his comments, Bonds can be laddered (that means bought with a variety of expiry/cash-out dates).

For two great Bonds-in-Retirement strategies, read: Worry Free Investing by Zvi Bodie and The Grangaard Strategy by Paul Grangaard.

Now, let’s go and get rich!

PS For more Personal Finance articles visit: http://ptmoney.com/2008/06/09/the-156th-carnival-of-personal-finance-songs-of-summer/

Hi Dad, I'm going to win $1 Million!

Posted on June 8, 2008 by Adrian

For this week’s video, I thought that I would choose one that has no apparent financial lesson behind it …

… but, I might be wrong! Also, watch for the ‘phone a friend’; it’s a doozy (doozie?):

http://youtube.com/watch?v=hr3tsMCrQgo

Here’s the ‘lesson’:

There’s a fine line between arrogance and confidence … arrogance is a sure way to lose everything because it’s an anti-people skill, and people skills are critical to your success.

But, the confidence to put it ‘all in’ when you are certain – in your gut – that what you are doing is right, is the stuff that millionaires are made of.

Just be sure to have a buffer and a margin of safety, when you do go ‘all in’ … because there’s an equally fine line between bravery and stupidity 😉

AJC.

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