PHIL TOWN

TRADING BP COMPARED TO INVESTING IN BP

Garrett wrote a very thoughtful analysis on BP as a stock to trade.  I put his full analysis below but I'll comment on it here.  I wrote Rule #1 to be a book about using long-term investing strategies and then using short-term trading techniques to actually do the day to day investing.  It is, in the end, a book about trading.  Garrett is suggesting I eat my own cooking on BP and trade it.  That is a fair suggestion, no?  But then I wrote Payback Time as a prequel to Rule #1 and as a way to explain the more 'hand's off' investing style of 'stockpiling'.  Here's how they compare and when to use them each:

Rule #1 is about trading instead of doing the hard homework required by the 'stockpiling' strategy I described in Payback Time.  Stockpiling is much more 'hand's off' but much more 'head on'.  If I am trading a business, I don't have to be so accurate about its value, its long term prospects, the quality of the management team ... all I have to do is watch what the market movers and shakers are doing and get out when they get out.  While I'd like to be right about all of the above, I don't have to be right about any of it.  I can get it all wrong and still not get burned if I'm trading.  There is really only one problem with trading as I describe it in Rule #1: It does take some effort to stay on top of it.  You've got to check your positions every day.  Perhaps not so surprisingly, that problem prevents quite a large number of people from being interested.

Stockpiling, as I describe it in Payback Time, is the process of adding to my ownership whenever I have the money and the stock price is well below the value.  Its like dollar cost averaging with a brain.  Instead of buying regularly no matter what the price, we buy regularly when the price is low.  This, of course, requires knowing quite a lot about the industry and the business and, most importantly, the value.  In other words, it requires due diligence.  What it does not require is day to day management.  Once I know the value of the business, the value isn't very likely to suddenly change.  I can stay on top of this kind of an investment with a quarterly report and a news feed.  This is long-term investing at its most pure.  It is the type of investing most people are completely capable of within the boundaries of their area of understanding.  

What Garrett has done below is provide a reasonable evaluation of the two strategies side-by-side. This took some work and I very much appreciate the effort. The only major issue I'd have with the analysis is that it left out the impact of taxes.  This is not a minor issue.  By holding steady for a year, I've reduced my tax burden from 40% to 20%, a 50% reduction in taxes.  The tax on one short term gain of $10 is $4.  I get clipped for 40% right off the bat.  This leaves me with less capital to reinvest and the numbers begin to change.  I haven't done the analysis but I suspect I'll come out better waiting until I get the lower tax category.

Still, there is definitely a place for trading.  I use it to take a position before I'm sure I know enough about the business to really own it.  I bought LPHI at $20 last year for a few days and then, after digging deeply, decided it wasn't something I wanted to own and I traded out of it at $20.  Its now at $4.  Trading rocks.  We rarely get opportunities like BP.  When we get them I don't want to trade, I want to own more and more of it and forget about it.  I want a huge chunk of my portfolio on autopilot.  As much as possible.  I'd rather play than work and if I can make great returns without trading, I'm happy.  But the real world requires that most of us have to work hard to get high returns and trading is integral to that work when we can't find a really great company available at a really big discount.

Here's Garrett:

"...If you bought BP at a fantastic price and bought and sold using "The Tools", reinvesting your profits, then you could have made even more money on BP than just using the "Buy, Hold, and PRAY" strategy. There's quite a lot of volume on BP and the BUY and SELL signals are pretty consistent and accurate. I'm sure you put a pretty could investment in the company, but I doubt you bought more than 1% of the shares which could effect the price when you attempt to make a trade.

So here's a little back-testing to see how things could have panned out with a $10,000 investment based on using "The Tools" and reinvesting your profits to accumulate more shares:

BUY: $27.50 a share / $10,000 / own 363 Shares.
SELL: AUG 2010 at $37.50 a share

BUY: SEP 2010 at $37.50 a share /$13,612 / own 363 shares
SELL: OCT 2010 at $40.00 a share / $14,520

BUY: NOV 2010 at $40.00 a share
SELL: NOV 2010 at $41.00 a share / $14,883

BUY: DEC 2010 at $40.00 a share / own 372 shares
SELL: FEB 2011 at $45.00 a share $16,743

BUY: MAR 2011 at $46.00 a share / own 364 shares
SELL: APR 2011 at $45.00 a share / $16,380

BUY: MAY 2011 at $44.00 a share
SELL: JUN 2011 at $44.00 a share

We'll subtract $85.00 for the discount broker fees for an approximate profit of:
$16,380 - $85.00 - $10,000 initial investment = $6,295

VERSUS the "BUY and HOLD Strategy"
$10,000 investment at $27.50 ='s 363 shares
Today, 363 shares x's $42.83 at today's price ='s $15,547

$15,547 - $10,000 ='s $5,547 Profit

There's about a 5.3% profit difference buy using "The Tools"

Phil, doesn't it just makes sense to just use "FACs" and "The TOOLS" to maximize our profits of a wonderful company and buy more of it if/when it ever reaches our MOS/PBT price? Another way to look at it is, maybe you wanted to buy more at $27.50, but you thought...it might go even lower...which was entirely possible, but then it finally started to go up and you missed out on putting another $10,000 investment. Maybe using the "The TOOLS" could help you make money on the way up by trading it.

 

DON'T CHANGE THE RULE ONE MARR FOR INFLATION

This is an important question from Alex in the Ukraine about how to value a business in a business environment where government bonds are at 20%.  

"I live in Ukraine. Our stock market is an emerging market. And the issue. If a savings deposit yields 15% per year and bonds yield 16-24% should I increase my MARR - not 15% as well, such as 20%. And is it right?"

The MARR in Rule One investing is our Minimum Acceptable Rate of Return.  Its the amount we expect to make each year compounded over the life of the investment.  I use 15%.  

The rate of return on government bonds reflects the risk of the government defaulting and/or inflation. If Ukrainian government bonds are yielding 16% to 24%, that means there is either a high risk of default or massive inflation or both.

High yields of Ukrainian bonds for any reason do not mean we should increase the MARR to get the value right on a Ukrainian company. The correct MARR is 10%-12% over the 'risk-free' rate of return - typically over the US Treasuries rate of return.  It should be that rate for any company in the world.  If you are investing in Ukrainian businesses, you should still use Rule One criteria and not invest if the business does not meet the criteria.  This must be a business you know is going to be a good business 20 years from now. If you are buying businesses that don't meet that criteria, you are not doing Rule One investing.

A wonderful business in the Ukraine will have the same basic criteria of a wonderful business in the US. One of the most important features of a wonderful business is its ability to raise its prices with inflation. The reason you don't have to increase the MARR is to get the right value in an inflationary environment is that your estimated growth rate for earnings will take care of the inflation issue by including the inflation rate in the growth rate.  A company that would grow 10% a year in the US might grow its Ukrainian earnings at 25% a year.  The MARR stays the same.  The growth rate changes.

But what about the risk of Ukrainian default?  The default of the Ukrainian government on its bonds should not effect a wonderful business in the long run.  If it would, don't buy that business. It is not, by definition, 'wonderful'.

It is a world market. You can invest anywhere in anything. Pick only those things that meet the 4Ms regardless of what country the business is in.

That said, there is a benefit in raising the MARR. It makes the value of the business go down and that makes you pay less for the business. But that doesn't make the investment better. It just makes it cheaper. Sometimes that is enough to make the investment successful but usually if you are buying a bad business, paying less for it only means you lose less money.

Now go play

THE NLRB CUTS OFF RULE ONE INVESTING IN BOEING

Boeing has a big NLRB issue. Consider the latest problems they've gotten themselves into:

Boeing decided to expand their construction capacity in South Carolina - a 'right to work' state - and put the construction of a new aircraft there.  A few years ago, workers at the plant in South Carolina voted to kick out the International Association of Machinists (IAM) union hierarchy.  Now, at the request of IAM union bosses in Washington State, the NLRB's Acting General Counsel is attempting to force Boeing to take away the jobs of the South Carolina workers and give those jobs to new union workers in Washington State.

This issue isn't even over a choice between existing union workers being replaced by non-union workers. No one in Washington state is being laid off.  

American Federation of Labor founder Samuel Gompers once wrote of workers who choose to refrain from union membership, "It is his legal right and no one can dare question his exercise of that legal right."

Craig Becker, NLRB board member and former lawyer to the SEIU and AFL-CIO, has questioned whether employees should have "the choice to remain unrepresented." In his radical worldview, workers could only choose which union to join.

Obviously, a company that allows a trade union in, is simply committing long-term suicide.  

As we saw in the case of GM and Chrysler, trade unions are willing to kill the goose that lays the golden egg. A trade union strategy is to ask for more than the company can possibly give them and survive.  But if they get what they ask for and then the company fails, they blame management for being spineless.  

What public company manager is going to be strong enough to withstand the criticism of mutual fund manager screaming in his ear to get the earnings going again and end the crippling strike?  If the fund managers sell off, the stock goes down, the manager gets fired by the board and everyone learns the lesson: stock investors are short term investors and will not abide a shock to short term earnings.  The unions get it.  The managers get it.  And so it goes.  

If I decide to invest in a company that has trade unions representing the workers, I can not invest in it for the long term.  If I do, I may live to regret my partnership with a trade union.  The union leaders are likely to burn my investment to the ground no matter the cost to their members.  But then again, GM set another precedent.  

As the company approached bankruptcy, it issued bonds to many pension funds to get the capital to survive.  The bonds had risk and therefore carried two qualities to offset that risk: 1. A higher interest rate to attract capital and 2) the loan was secured with all the net assets of GM. What that is supposed to mean is that if GM went bankrupt, all the shareholders would lose all of their investment but all the bond holders would get their money back from the sale of the GM assets - things like the Chevy brand, fabrication plants and so on.  That is not, however, what happened.  GM did go bankrupt but instead of the bankruptcy court ordering the sale of the GM assets to pay the bondholders, President Obama ordered the court to simply discard the bondholder claims, get rid of the debt owed to the bondholders and allow the company to survive.  This, of course, saved the union jobs.  The bondholders got screwed, plain and simple.  And interestingly, the biggest bond holders were pension funds like the Minnesota Fire Fighters pension fund.  They lost $16 million of firefighter retirement money to protect the jobs of union workers in Michigan thanks to the President of the United States.  

So now, I can't in good faith, put my money in a bond of a US corporation with any expectation that the assets of the company are there to secure the bond.  If the King (Obama or the next President from whichever party) of the US decides it, those assets won't be available to me no matter what the contract says.  The 100 year old rule of law that encouraged and protected loans to corporations has just been nullified and once that happens, it can never be said that it can't happen again.  Once that horse left the barn, there is no getting it back.

That's sad and all but it is what it is and investors will do what they've always done - adjust for it.  Now you don't lend to a corporation unless the interest rate is so high it covers your downside risk.  Therefore expect borrowing costs to eventually rise to meet the new reality.

The combination of trade unions, NLRB union support and Obama's disregard for established business law means there is no place in my portfolio for Boeing until I see that it is getting itself out of Seattle and the union demands there.  

Now go play.

 

 

 

 

MEDIFAST IS A VALUE TRAP FOR RULE ONE INVESTORS

Michael Beals asked about Medifast (MED).  I'm not a fan.  

(You guys know that when I put a title like "Medifast Is A Value Trap For Rule One Investors", its my opinion, right?  It's not advice or a recommendation.  The purpose of this blog is to have a rational discussion about stocks and investing that starts with my opinion.  You can have a different opinion and we can discuss it amongst our little Rule One community of rational investors.  That discussion should help you make better investing decisions.)

That said, my opinion on Medifast is that its growing itself by pushing its multi-level sales program. I'm not much of a fan of multi-level.  Too many of them are about selling the business, not the product and that, , in my opinion, makes them a pyramid scheme.  

There are a few multis that are good.  Buffett recently bought Pampered Chef. Pampered Chef is distinguished by the ability of its sales people to make a living by selling the Pampered Chef product line at Pampered Chef parties.  

Here's how you tell if its a bad-guy kind of MLM.  You do not see a significant percentage of its distributors making a living just selling the product.

(By the way, if you have not had the pleasure of someone befriending you with the secret purpose of selling you on becoming part of their MLM downline, you must not be getting out much.  The MLMs are everywhere selling everything from nutrients to cosmetics to legal insurance.  Almost any product that has very high profit margins can be made into a multilevel product.  You need the big margins because you have all these levels that get paid when someone sells something.  The pitch is that multilevel distributors eliminate advertising costs but the actual cost of all those distributors in the middle massively outweighs advertising.  Its the effectiveness of the MLM program that moves the product.  Distributors have to buy product in order to participate.  Often, that's the only product buying going on.)  

Here's the thing that bothers me about the Medifast MLM plan - it only pays a 10-15% commission to its sales people when they sell the product sans the business.  Do you think you could drum up sales and incur the costs of doing business and make a profit with a 10% margin?  Melissa and I were recently offered a regular distributorship for a wonderful horse feed that we buy for our competition horses.  The company offered to pay us 10% to set up a little distribution business to sell this premium feed around the area.  It doesn't take a genius to figure out that there isn't enough in it to win it and we turned them down. If they'd offered 30% we might have gotten busy and put some friends to work on it.  But 10? No way.

Same problem here with MED.  Which means this thing probably doesn't have a sincere percentage of its distributors actually selling the product.  And that means it doesn't fit into my value system.

The MEANING of the business can take you into a business or out of it.  It takes me out in this case. That's important.  Its why I do 4Ms, not 3.  If I liked the Meaning in this case, it would be hard to say 'No' to MED. Check out these Moat and Management numbers:

And the valuation numbers are just as good.  The RuleOneTools show a 6.5 year Payback Time at the current price of $23 with an MOS of $80.  If you don't mind the values, its way on sale.  

The problem is that we reap what we sow.  

You put money into places with bad values, you are going to reap those values some day.  How you vote with your money is the most powerful vote you will have.  Always try to put your money where your values are.  You'll be more interested in what you own and that will make you a better investor.  If you have good values, what you invest in will, like a good seed, sprout into good things for your family and for the world. And if your values are bad, you'll get burned and change your values.  Its a win - win.

You may feel differently or you may think I'm way off base about MED.  But until I hear different, MED is a business that may be doing well on the backs of the little guys and that makes me not a fan in spite of its awesome numbers.

Now go play.

WHY I DON'T PUBLISH MY ROI

A reader recently asked me to publish my ROI (Return on Investment) for the last 5 years so he can have more confidence in what I'm saying on the blog.  I think its a request that deserves a good response.  

Many people do not ‘get’ Rule One investing. I’ve found it either makes sense to you or it doesn't.  I can explain it until I'm blue in the face but people either get it right away or they don't ever get it.  If they don’t get it, they ask for an ROI - as if that will help them understand Rule One Investing better or believe in it more firmly.  It won’t.

It either makes sense to you to buy a wonderful business as it gets cheaper and cheaper or it doesn't.  It makes sense to buy on fear and sell on greed or it doesn't.  It makes sense that Mr. Market is commonly irrational or it doesn't.  It makes sense that value and price are different things or it doesn't.  If it doesn’t, you ask for an ROI.

But watch out what you ask for.  You just might get it.  The guys who ran Long Term Capital in the 1990's were Efficient Market Theorists and had the Nobel Prizes to prove it.  Their fund had astonishing 5-year results.  And then it went bankrupt in about ten minutes. People who decided to invest with them instead of Buffett did so because of ROI.  They put lots of money into Long Term Capital.  Lots.  And they lost all of it.

My point is that 5-year results don't mean much on their own.  But even if they did, my job here isn't to be your guru, to have you follow me slavishly or to provide you with the crystal ball to the future of specific stocks.  I will publish my opinions here and show you why I hold those opinions.  I will be as rational as I can.  I expect push back and discussion and conflicting opinions.  And I'll keep urging you to try not to get get caught up in short term ROI.  Doing Rule One investing requires the conviction to stay steady, if necessary, in the face of years of negative ROI.  

If I buy a stock at, say, $30 with the conviction that its worth $45 and it goes down for the next five years, am I a bad investor or a good investor if it is actually worth $45?  Am I nuts if I buy more as it goes down to $20?  If I am certain as I can be that it’s worth $45, I think I'd be nuts not to be buying all the way down, yet the ROI will be negative for all that time.

Most investors who have to worry about their public ROI are too afraid of the impact of short-term decisions on ROI to do what they know works - Rule One Investing.  For example, many fund managers knew BNI was on sale at $80.  But they also believed that it was not going to go up for a long time and they didn't want the short-term hit to their ROI if it went to $50.  That’s precisely why mutual fund guys don’t do Rule One investing.  They can’t stomach the short-term pain from investors who invest based on ROI. (Ironically, BNI doubled in less than a year when Buffett bought it.)

In addition, Rule One investing applies to every sort of investing including real estate, bonds, tax liens, private equity and venture capital.  When your portfolio includes these sorts of things, as most Rule One investor's portfolios do, an ROI will require an Internal Rate of Return (IRR) analysis based on mark-to-market values on non-traded assets.  But that's a problem, isn't it?  For example, what's the value of a derivative on commercial real estate right this minute?  I took such a position a couple of years ago. What's it worth now?  Darned if I know and darned if I'm going to pay some appraiser to give me his opinion so I can mark it to a market price that doesn’t mean anything over the long run.  And doesn't the same problem exist for public stocks?  If the true equity value of BP is $50 a share, how can I create an ROI based on a price today of $44 or last year of $27?  Mark to Market has its value but it can also make for a truly messed up ROI, so much so that Buffett simply uses the rising equity value of Berkshire to calculate his short and long-term ROI rather than the current price of Berkshire stock.

And really, what’s the point keeping score based on current prices?  If you aren't selling, current prices are irrelevant unless they're far below the current value.  At that point they matter because you want to buy. What really matters is that my family is financially better off in the future than it was in the past.  That’s what should matter to you, too.

For all these reasons, I will continue to urge all of you readers to do your own work, make up your own mind about the investments you are interested in and use this blog only as an educational resource, not some kind of stock advisory service cum guru blog.  I'm neither smart enough nor educated enough to have any clue what you should be investing in and I, too, am fully capable of having years of poor ROI.  

What I'm doing with this blog is to give you my opinion is about what I like and don't like.  You'll have to make up your own mind sans ROI about whether that opinion and the discussions that ensue are worth bothering with or participating in.

As to why I do this – well, Melissa keeps asking me the same thing.  Like right now.  It’s a beautiful day in The Hole.  She wants to go for a hike.  And I'm sitting here writing this for some guy who could be a professor at the University of Efficient Market Theory, for all I know.  How do I explain that?

Now go play.