The Zero Dollar Emergency Fund!

Last week I asked How many months do you have in your emergency fund?

Earlier, my blogging friend JD Roth at get Rich Slowly (GRS) asked the same question of his readers, and this is what he found:

How many months do you have in your emergency fund?
GRS 7m7y
less than 3 months 38% 29%
3-6 months 26% 24%
7-12 months 13% 24%
more than 12 months 14% 16%

This shows that more 7m7y readers have 3+ months living expenses in their ’emergency funds’ than GRS readers, which means …

I’ve done a terrible job 🙁

On the other hand, if you answered “what’s an emergency fund?” good for you, you’re already a step ahead of the pack … you see, not everybody – including me – thinks that you need to have an emergency fund at all!

[AJC: At least not until after you reach Your Number]

For instance, Liz Pulliam Weston writes at MSN Money that you should have a $0 emergency fund, replacing it with a concept that she calls ‘financial flexibility’:

The whole idea that everyone needs a big pile of cash, and needs it right now, should be rethought. In reality, the failure to have a fat emergency fund isn’t inevitably a crisis. At the same time, those who feel safe because they have three or even six months’ expenses saved up might be kidding themselves.

Let’s say your take-home pay is about $4,000 a month. Although you have been spending every dime, you make a concerted effort to trim your expenses by 10%. This not only frees up money for your emergency savings but lowers the total amount you need to save from $12,000 to $10,800.

Still, it will take you 27 months — more than two years — to scrape together your emergency fund. And that assumes nothing comes up that forces you to raid your cache.

Let’s explore this a litter further: JD Roth has $10,000 in his emergency fund, but that doesn’t just represent $10,000 today …

…. it represents the future value of $10,000:

Let’s say that you intend to retire in 20 years, if you earn 9% on your money (say, invested in Index Funds) then you are giving up, say, 2% bank interest (by having your emergency fund sit in an ordinary savings account for quick ’emergency’ access) to earn 9% – or, a net of 7%.

That extra 7% earned represents about $8k in extra interest/profit that you are giving up for the benefit of ‘peace of mind’ in an emergency. But, we aren’t investing our money in Index Funds, because we are on a mission: we want to reach $7 Million in just 7 Years!

To us – that is, those of us on a steep financial trajectory – this $10k pile of cash represents seed capital for your new business venture or next real-estate acquisition [AJC: and, don’t tell me that an extra $10k wouldn’t be a big help for either of these endeavors] …

… now, $10k ‘invested’ at:

  • 15% (stocks) grows to $35,000 after just 10 years
  • 30% (real-estate) grows to $106,000 after just 10 years
  • 50% (business) grows to $384,000 after just 10 years

… a slightly larger price to pay for peace of mind 🙂

The Instant IPO

Money AngelRecently, I pointed all of the difficulties of the Entrepreneur’s Holy Grail – the IPO [cue angels] …

… for all these reasons – and more – I didn’t IPO my businesses … but, I found something almost as good:

7million7years Patented Instant IPO

It works like this:

Step 1

Make sure that your company is profitable and has a reasonable track record of growing profits. This should value your company at 3 to 5 times earnings (i.e. annual net profit after tax)

Step 2

Find a Public Company in a related industry that is trading at least 12+ times its earnings after tax – the more the better, for you!

Step 3

Sell your company to that company and negotiate a mutually agreeable split of the difference between your ‘private value’ and their ‘public value’!

Basically, what you are doing is using the public company’s stock to “IPO” your own company:

You see, when you are on the outside, your company is worth only 3 to 5 times its profit to a buyer, but as soon as the other company buys you and ‘absorbs’ your profit into their profit stream, that profit is suddenly (well, after a relatively short ‘disruption’ period where the market has to get used to the sudden change in profitability of the public company) ‘worth’ 12+ times itself.

[Hint: The smaller you are relative to the size of the acquiring company the smaller the disruption … on the other hand, the smaller you are, the less attractive your cashflow may be to them, so it helps if you also have some ‘secret sauce’ – i.e. Intellectual Property – to make you look that much more attractive to the ‘big end of town’]

The company that has acquired you has just made a huge windfall by using the difference between how private companies are valued and how they – the public company – are valued to their advantage … in fact, there are plenty of public companies that do this as a matter of course. Sometimes, it even need only be only an ideal coincidence that your company actually adds any other business synergy to theirs!

But, when you sell to them, you will find – if you are a smart negotiator – that they have gone to all the expense and trouble of the IPO process for you 🙂

Let’s look at an example: say that your company produces $1,000,000 net profit each year, and you have found a likely candidate public company. You have evaluated the market and believe that your business would sell for $4 million in the private sale market.

But, you realize that your widgets complement those of Acme Widgets Inc. very nicely. Acme’s stock is currently trading at a P/E of 12.

You approach the CEO of Acme Widgets Inc. [AJC: actually, if you’re VERY smart, you’ll engineer it so that he approaches YOU 😉 ], but play reasonably ‘hard to get’.

The CEO realizes that:

a) Your widgets do indeed fill a hole in his product range that will cost his capital (and, short term profits) to fill in house, and

b) Your $1 mill. profit adds $12 Mill. to his company’s value (i.e. his stock price will eventually go up by about $12 mill. when the value of all the stock out there is totaled), and

c) He happens to hold a nice bundle of stock and options set to vest in 18 months or so.

So, what is worth $4 million to you, is worth $12 million to him … how much would you sell for?

New Rule # 1 Group on Share Your Number

Rule 1The KC-inspired discussion on Rule # 1 Investing (thanks, KC!) has prompted me to create a new group on Share Your Number, the home of people who want to help others (and themselves) to reach their Number ,,, and, now also the only web-Community [webmunity?] partially devoted to all-things-Phil-Town – well, at least to his book: Rule # 1 Investing.

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

Join here:

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

Fundamentals Will Out!

[pro-player width=’530′ height=’253′ type=’video’]http://www.youtube.com/watch?v=HiW2-hygtzU[/pro-player]

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

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

Fundamentals Will Out

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

A fool’s game …

mordred foolsI’m hoping that after today, you’ll never look at stocks quite the same way again … first we need to go back to when Debbie asked how “the value of a company … translates to the price per share?”

Now this is REALLY key:

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

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

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

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

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

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

d) Liquidity: as Brandon said:

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

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

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

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

Read that again … before you buy your next stock 🙂

So, stocks have TWO values:

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

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

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

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

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

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

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

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

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

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

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

I want my share!

What is a stock? What is a share? Are they interchangeable, and who even cares?

Well, Debbie does … asking on the Share Your Number community forum:

I understand why you would need to have a good idea of the value of a company if you plan to buy stock in that company – But I don’t understand (and I’m sure this is stocks 101) how that translates to the price per share.

Even though this blog isn’t about Stocks 101 … there are plenty of other places on the web to find that sort of info … this does open up some interesting questions:

For example, even though I owned some of my businesses 100%, they were structured with lots of shares (usually between 100 and 1000).

Why?

Well, ‘just in case’ …

… it makes it easy for banks, partners, JV’s, partial sales, etc. to buy in – just transfer them a % of the shares: if you have 1,000 shares (or 100, it doesn’t matter … larger numbers just have more divisors and the ability to make finer and finer ‘cuts’ of the company value) and they are buying 40% of the company, you just give then 400 (or 40) shares.

Simple!

If you want to be sneaky, you create two classes of shares: A (say, 600 of the shares) and B (the rest), with the voting rights going to the A stock, which you – naturally – keep. You get to sell 40% of the company to some sucker and keep 100% of the control (actually, 60% still should give you majority control, so it’s not such a big deal, anyway)!

Unfortunately, for my New Zealand Joint Venture (fancy term for ‘partnership’), where I owned just 40% of the stock, that wasn’t possible … and, for my US JV, where I ‘controlled’ the company with 51% of the stock, there were so many “by unanimous agreement” clauses written into the shareholder’s agreement, I couldn’t blow my nose without seeking my partner’s approval, first 🙂

So, the first lesson we learn about stock is that numbers and/or percentages CAN matter less (or more) than you think … it’s all in the fine print 😉

Public companies are the same, except that they are usually (a) huge, and (b) divided into LOTS of small pieces (1,000,000+) so that people can buy very small chunks of the company, and trade them very easily i.e. for small sums of money.

These shares/stocks are traded on public stock exchanges, which are heavily regulated to make up for the fact that ‘idiots’ like me buy small pieces of businesses without the effort or forethought that they would put into buying the WHOLE business: we take all the risks without any of the business controls.

Stupid!

And, that’s why the stock market is more akin to a casino than to ‘real’ business or investing … we have no control, and only limited understanding of the underlying business that we are – in effect – buying into.

Now, here’s Josh to answer the second part of Debbie’s question (“how that translates to the price per share”):

If you think a company is worth 1 billion and there are 100 million shares outstanding, the price you think the shares are worth are 10 dollars each. Of course you want to wait until you have the opportunity to pay less then this.

So, if you would be willing – that is, if you were Warren Buffett instead of Jane Doe – to buy the whole company for $100,000,000 and it had 1,000,000 shares, then you should be willing to buy one (or each) share for $100. Except, Warren reads the financial reports and calls the shots, while we read Money Magazine and wait patiently (what other choice do we have?!) for our dividend check 😉

This leads to some other key numbers:

In a private company, we have sales and profits.

In a public company (i.e. traded on a stock exchange), we also have sales (or ‘revenue’) and profits (or ‘earnings’), but we can now also divide each of those by the number of shares available to come up with numbers like Revenue per Share and (more importantly) Earnings Per Share.

Also, if we COULD buy the whole company for $100,000,000 and it had a 25% profit margin, then for each $100 share we buy, we would expect $25 in company profits … which means the company is now selling for a Price/Earnings Ratio of 4.

Which leads me to the Grand Mystery of the Stock Market:

If a P/E of 4 is right on the money for a private company (they typically sell for 3 to 5 times annual profit/earnings) why is a P/E of, say, 15 for a publicly traded stock the ‘norm’ and a P/E of 8 to 12 times earnings so damn cheap that even Warren Buffett might buy the stock by the truckloads?!

[AJC: I know the answer … but ‘knowing’ doesn’t make it right 😉 … do you know the answer?]

So, Debbie – in case you’re worried about asking a 101 question – please remember: there’s no such thing as a bad question, only a bad answer 😛

Does technical analysis even work?

Rick is skeptical about the value of technical analysis:

I would be very skeptical that technical analysis works- here is a link discussing the controversy:
http://en.wikipedia.org/wiki/Technical_analysis#Empirical_evidence
I’ve never heard of anyone getting very rich from technical analysis. Plus neither Peter Lynch nor Warren Buffett believes in it.
A web site that tells you when to buy/sell stocks strikes me as too good to be true. Let’s say that you had a stock purchasing system that WORKED- would you
A Make it available to the world on a website/write a book and make $1M
B Keep it secret, start your own hedge fund and make $1B.
I’m guessing A wouldn’t be too likely… Also if you did have a system that really worked then making it widely known will cause the system to be useless. Why? For every transaction there must be a buyer and seller. If many potential sellers see a “buy” signal at the current prince they will demand a higher price to sell driving the price up. Similarly, if many potential buyers see a “sell” signal at the current prince they will demand a lower price to buy forcing the price down. The final result is that the pool of believers in the system will force the actual price to agree with the system’s prediction of a fair price.

Rick might be a little surprised to know – given my recent posts, apparently condoning technical analysis a lá Phil Town – that I tend to agree with him!

Firstly, keep in mind that I am on record as stating that I am not the ‘go to’ guy on any specific form of investment (perhaps some on business, less on real-estate, even less on stocks, and so on) … my ‘expertise’ (more like ‘passion’) is in the overall strategy of wealth-building, and showing how these individual pieces fall into place.

Also, I am a ‘value guy’ … I love to sniff out a bargain – be it a business, property, or stock – and pounce, and am a fan of Phil Town’s valuation methods (although, I will point out my ‘issues’ with his methodology in a future post).

And, I agree in principle that if you COULD:

a) Identify a stock that was under-priced, and

b) Avoid the market dips by selling out (then rebuying)

… you would increase your returns and – MUCH more importantly – avoid holding onto an under-priced ENRON … one that you thought was cheap but some disaster strikes that the ‘big Boys’ get wind of early.

In principle, that is 😉

Look:

1. There have been successful traders, but none that I know of with longevity; it’s a speculation / business … so, if you are prepared to take the chance on the big run up – then sell off – PERHAPS, just perhaps, you can make it big? Jesse Livermore did it 4 times (before putting a gun to his own head when he crashed for the 4th time).

2. Phil Town suggests that the ‘big guys’ (the huge mutual funds) put so much money in/out of the market that they have to make their move over a number of weeks to avoid the sudden price movement that you suggest. IF this is true and IF you can use technical signals to tell you when the run up/down is occurring, then Phil says that the smaller investor can use these signals to move instantly (in 8 seconds, v the ‘big guys’ 6 weeks).

… and, I have certainly used Phil’s methods to suffer ‘only’ a 15% loss when the rest of the market soured by 50+% (and, you need to remember that I have been actively trading since the crash UNTIL it bottomed and have been in cash since for reasons unrelated to the market), so my personal experience is that the ‘3 indicators’ ARE useful.

The catch is, I don’t know why, because they are all PRICE indicators, not VOLUME … in fact, volume only tells you of an increase in activity, there can be no net buying/selling because there are two parties in every trade (the ‘hint’, I guess, is in the price … it goes up/down according to market sentiment).

So, I am a fan of ‘value investing’ (if you can find the right way to reliably value a stock and can then find one that is way under priced … I believe that this happens often enough to make it useful) and am experimenting with the technical indicators to get in/out, but am – like you – skeptical, but not complaining while I am getting positive results …

… but, please DON’T read this post, I am planning to start my own hedge fund 😉

This week’s Carnival of Personal Finance is out; we’re buried in their list somewhere ….

The mythical stock market guarantee …

In a recent post I spoke about various products that purport to ‘guarantee’ your returns in the stock market … in the current environment, it’s totally understandable that investors would be looking for such guarantees. But, you pay for them …

… instead, I suggested:

You can provide yourself a similar – or better – result at far less cost: buy a low-cost Index Fund and wait 30 years to cash it out; I can virtually ‘guarantee‘ an 8.5% minimum return :)

Rufus, though, took me to task, citing the Japanese stock market:

Here’s a prediction for you….In about 5 years the NIKKEI index will show you to be completely full of it even at your 30 year timeframe. If you had picked up the NIKKEI 225 in 1990 you’d now be down 75% just on your principal. Fun! If you had picked it up in 1985, you’d be about even today, which is still an absolutely massive loss against inflation. Your entire premise has a market survivor bias built into it to which you are blind. There simply are no guarantees.

Firstly, Rufus is right … there are NO GUARANTEES in life .. especially when it comes to the stock market.

BUT, what I offered was a ‘virtual guarantee’:

It is simply based upon the fact that the past 75 years of the Dow Jones have seen NO 30 year periods (including buying in the day before the biggest stock market crash in history) of returns less than 8.5%.

I’m not sure whether Japan could claim anything remotely approaching the same track record, nor are/were its fundamentals the same as the USA.

From a practical standpoint, I can only tell you this:

1. I invest using history as a guide to setting my benchmarks, but I always buy on value: i.e. do the stocks, RE, businesses look cheap at the moment, and

2. I invest in markets where, if things turn drastically sour, then everybody else is likely to be in the same boat … and, by everybody, that means the whole world.

If I’m going to be peeling potatoes, then so is everybody else … hence my major stock market investments are always in the USA.

Rufus, of course, ONE DAY, there will be a 30 year period where this does not hold true for the USA either, but by then I’ll be learning to speak Mandarin Chinese ;)