Value Investing and Entrepreneurship Blog

Picking the right company to invest in is like trying to pick up a grain of sand in your rice with your chopsticks. To come out unscathed, one needs to avoid a lot of investment follies. But everyone makes mistakes. Fortunately, simply avoiding the biggest mistakes is sufficient for you to do well.

The following are the biggest sins I think we should strive to avoid.

1. Buying with little or no margin of safety.

“The three most important words in investing.” is how Buffett described margin of safety. Margin of safety allows room for errors in our assumptions about a business. Because the intrinsic value, the present value of all future expected cash flows, of a business is calculated based on assumptions derived from incomplete data, we are bound to make mistakes in our assumptions. A margin of safety will not guarantee a profitable investment. But it tips the scales and puts the odds in your favor. If the company turned out to be worth half what you projected, you would still be getting the shares for a fair price.

2. Insufficient due diligence.

Before placing your life savings in the hands of a CEO you’ve never met, it is important to do your homework. People often refer to this as doing your due diligence. But I think the term “due diligence” is too loosely defined and often played down. Due diligence is reading annual and quarterly reports word for word, proxy materials, and everything you could find about the company. Due diligence is understanding the market the company operates in. Due diligence is reading the competitors annual reports. What due diligence is not is listening to your friend’s overly optimistic projections of the 2009 Amazon’s (AMZN) Kindle sale. Lest you misplaced your hard-earned money in another Enron, make sure you understand what’s more important than margin of safety.

3. Following a guru blindly.

I’ll be the first to confess this sin. I’ve followed one of my favorite gurus, Mohnish Pabrai, into Delta Financial (DFCLQ). Yes, I can already hear your jeers of derision. For those of you who missed the story about Delta Financial, the company went from a promising multi-bagger to a worthless piece of crap. When asked about his bet on Delta Financial, Pabrai responded, “It was a good bet.” For Pabrai, maybe. For me, it was stupid. I followed Pabrai blindly. I didn’t understand that the ability to securitize loans is the key to survival for loan originators. And Delta couldn’t securitize. So it collapsed. I hate to end your schadenfreude so quickly, but I only held Delta in a mock portfolio. One great lesson learned nonetheless.

4. Buying on margin.

Buffett in his speech to Emory University students said, “Over the past 50-60 years, Charlie and I have never permanently lost more than 2% of our personal net worth on a position. We’ve suffered quotational loss, 50% movements. That’s why you should never borrow money. We don’t want to get into situations where anyone can pull the rug out from under our feet.” The biggest problem with buying on margin is your broker gets to sell your stock without any prior notice should the stock price fall below the broker’s maintenance requirement. You lose your chance to ride the potential rally and you’re stuck with losses plus interest owed.

5. Buying the hot stock.

If mentioning Apple (AAPL) in this paragraph is not going to flame my inbox, I’ve no idea what will. Admittedly, Apple has done magnificently well - rising 1500% in the past five years. My friends and relatives can’t stop whispering into my ear, “The new iPhone 3Gs are going to sell like hot cakes.” Frankly, I don’t know how Apple’s gonna perform in the next five years. But buying the stock simply because you own an iPhone is wrong. Buying the stock simply because your friend can’t stop talking about it is wrong. The only reason you should be buying the stock is if you have determined the stock is undervalued.

What other mistakes that you think we as investors should avoid?

Full disclosure: At time of writing, I do not have positions in any of the securities mentioned in this article.

Side note: My recent post How to Buy Stocks was featured on the 9th Investing Carnival. I highly recommend the carnival for some of the best tips on investing.

Buy low, sell high. It’s obviously good advice. In practice, it’s not as easy as it sounds. How do you know tomorrow the price will not drop another 10% or 30% for that matter? If you bought today with all the cash at hand and it drops another 50% tomorrow, no amount of self-kicking would relief the pain inflicted.

Take Leucadia for example. It first revealed its stake in AmeriCredit (NYSE: ACF) early in January 2008. By May, it has acquired approximately 26% of outstanding shares at an average price of $13/share. When Fitch affirmed AmeriCredit’s negative outlook, its shares promptly went into a free fall and didn’t stop until it lost about 37% of its market cap. All the while, Leucadia stayed on the sidelines. Recently, Leucadia finally bought the last 4% of the outstanding shares (at an average of $7.63/share), hitting the maximum of outstanding shares it can own based on its agreement with AmeriCredit.

No one could have anticipated that significant a drop. So that begs the question, “How do you know if you are buying at the bottom?”

The truth is nobody knows. To quote the Fidelity Magellan Fund phenom, Peter Lynch, “When stocks are attractive, you buy them. Sure, they can go lower. I’ve bought stocks at $12 that went to $2, but then they later went to $30. You just don’t know when you can find the bottom.”

The best defense against such devastating drops is to ensure you have a big margin of safety. Sure, even with a big margin of safety you might still face a huge drop after the purchase. However, if you are confident about your analysis, you can take comfort in the fact that the drop is nothing but a temporary paper loss.

Given that we don’t know the bottom, how much should we invest when we have sufficient margin of safety? Should we go all out? Should we hold back some just in case it drops further? Looking at Leucadia’s transactions, it doesn’t seem like there’s a formula to determine how much to invest when you hit a certain price point. I’m sure Ian Cumming wished he could have bought all the shares at a 37% discount. Clearly, he didn’t expect the price to drop that much. Had he known, he would have waited.

Institutional investors like Leucadia and Berkshire usually buy shares in chunks instead of all at once. The sheer volume of shares being bought would cause the price to jump. When you are buying a $50 million stake, an increase of 1% in price will cost you an extra $500k. Not exactly chump change.

For us individual investors, the lack of such buying power is in fact a blessing in disguise. The volume we deal with is so small it barely affects the price. So, we don’t have to buy in chunks. But, could buying in chunks help reduce the average cost?

Buying in chunks is a double-edged sword. It can only reduce the average cost if the price is falling. If the price moves in the other direction, it ends up increasing the average cost. Also, don’t forget the frictional cost of commissions. The greatest risk of buying in chunk is you may not realize the price is already at its bottom. When the tide rises, it may continue to rise and never return to that lowest price point. And 25 years from now, you would spend the rest of your life lamenting to your friend how you could have been a billionaire had you bought that stock with all $10,000 you had.

Buying stocks is really a tough decision. Spend all your cash and you risk not having cash to spend if the price drops further. Spend too little and you risk missing the chance to dethrone Warren Buffett on the Forbes 400 Richest.

Looking at both sides of the coin, the risks may seem well balanced. The truth is the former is less painful should it materialize. In fact, Buffett has made the mistake of the latter and considers it one of his biggest mistakes in his investment career. He admitted sucking on his thumb when Wal-Mart was selling on a discount back in 1999. He estimated the error cost him $8 billion. If you miss the ride, the inflicted pain could get worse as the price rises. On the other hand, if you bought as much as you could, there is a floor for how much the price could fall.

So, to avoid future heartaches, I would rather buy with all the cash at hand when the opportunity presents itself. When the price falls further (Yes, this has happened to me numerous times.), I usually find that I have some cash at hand because like everyone else, my income produces some incoming cash flow. So I buy more.

Am I completely off base here? What is your strategy in buying stocks?

Side note: My recent post More Important Than Margin of Safety was featured on the 102nd Festival of Stocks and the 8th Investing Carnival. Check out both carnivals for some of the best articles I’ve read.

After laboring 18-hour days for two months in a row to get your next Google-killer application out the door, nothing is more depressing than watching your site traffic continue to hover around the 8-visitor-per-day line on the day you launch your product. And worse, your mom, your dad, your little brother and sister and your best friend make up the first five visitors. You scratch your head and wonder “What the hell is wrong with everyone? This is bigger than iPhone. I should be worrying about whether my server will hold up with all the traffic I’ll be getting. F#$@!”

It hurts. Believe me, I know. Have you heard of our product IncBaby? Exactly.

Instead of crying over spilled milk, I’ve decided to get my act together and figure out how to market properly. If you are a geek like me, you’d think the word “marketing” is as evil as Microsoft. It reminds us of greed, power and ruthlessness that lead to the corrupt corporate empires. But the sad truth is, to get your product into the hands of your customers, you have to first market your organic, wholesome product to the world.

Marketing does not yield effects overnight. It is a long term commitment. You need to think about marketing every day. Someone once said, “Running a startup is 50% coding and 50% marketing.” Because it takes time to build a following, it is important that you begin marketing way before you plan to launch your product. This way by the time you launch you already have a steady following, thus increasing your chance of a successful launch. Because blogging is the cheapest and one of the most effective form of marketing, this is where I’ll be focusing my discussion.

Before you cringe, marketing your site is really as simple as the five steps listed below. Just add a pinch of creativity and a whole lot of persistence and you will do fine. Without further ado, here are the things I’ve found effective via trial and error:

Step 1: Catchy Title Like This One

This is why you are reading this. The most important thing about blogging to promote your site is to come up with a catchy title for your article. When you do a search in Google for a topic, you first see the big bold blue links. If your article title doesn’t stand out among the ten titles listed on the page, you will lose quite a bit of potential traffic. No matter where your article is going to appear, the title is always the first line that people read. So, make sure your title grabs the attention of the reader within the first few seconds. Erica Douglass, a millionaire entrepreneur, found out that positive headlines do better than negative headlines. Chip and Dan, of the Made to Stick bestseller fame, came up with a simple formula known as SUCCESS to come up with ideas that stick. Some of them can be applied to headlines. Write unexpected headlines. “Google Search Is No Longer The Best” is more likely to garner attention than “Better Search Results with XYZSearch”. Be specific. “Get a Raise By Asking” is not as interesting as “Get a 20% Raise In Three Minutes”.

Step 2: Content, content, content.

A great title must be paired with great content. Great content is content that is useful to your readers. Tell a story. A story is easy to remember and makes good entertainment. Be controversial. A little bit of controversy as long as you can back up your opinions can pique curiosity and challenge the conventional wisdom. Be personal. Don’t be afraid to show who you are. To paraphrase Steve Pavlina, your life experience is unique. So that makes your content unique when you tell a personal story. Create a list. Most popular articles are lists that are insightful. In fact, marketing guru, Seth Godin, lists this as the first item on his list of suggestions to grow your traffic. A list allows the casual reader to quickly scan an article and get the message right away.

Step 3: Make Your Site Viralable.

Now that you have created something of value for the world, it’s time to make sure your site is, what I’d call, “viralable”. A site that is viralable is a site that is capable of being spread easily. The best way to achieve viralability is to add something like an Add / Share This button. An Add / Share This button allows a user to submit your article to popular content aggregators such as Digg, Reddit, Delicious, and StumbleUpon. These aggregators could drive thousands of visitors to your site.

Step 4: Optimize for Search Engine.

A great website is nothing but a great waste if no one could find it. There are a lot of Search Engine Optimization (SEO) experts out there who charge hundreds to optimize your site for search engines. You don’t need them. If they are so good at SEO, they won’t need to sell you their services. They can get rich selling ads. Just do the basics and you’ll do fine. Use the free Website Grader to guide you. Focus on writing great content for your visitors and the rest will follow. One more word on content… Don’t touch on every topic under the sun. Try to focus on a niche. Be an expert on a narrow topic. For example, if you like to talk about safe, organic cosmetics, then talk about that and nothing more. As you write more, you are building credibility that supports your expertise. You may not be the first in the search results for “cosmetics”, but you are likely going to be the first in “safe cosmetics”.

Step 5: Tell the world.

Great! You have made all the preparations for the finale. It is time to announce to the world the birth of your shiny new website. Here are a few ways to make your entrance:

a) Submit your best articles to related blog carnivals.

Blog carnivals are basically quality link exchanges. The host of a blog carnival gets to choose the best articles from all submissions and list them on his website. Most often the host website has decent traffic, so you get a fair share of the traffic. You can also volunteer to host a carnival as well. Blog carnivals work well for websites just starting out. I’ve tried them with wonderful results.

b) Comment on popular blogs.

Erica Douglass suggested commenting on popular blogs. This is also known as networking in the blogosphere. When you comment on someone’s blog, you can link back to related articles on your blog. You get some decent traffic from this. I’ve tried this with mixed results. So I wouldn’t place too much emphasis on this. But your mileage may vary.

c) Submit guest posts to popular blogs.

Contributing your articles to popular blogs for free is a great way to promote your blog. This is one of my favorite. Remember to include a link back to your blog in the footer of your guest post. Make sure you have some content other than your guest post on your blog first. Otherwise, there’s nothing else for your visitors to come back for.

d) Linkbaiting.

I picked this up from reading Problogger Darren Rowse’s 20 Linkbaiting Techniques. Some of the techniques recommended include writing a controversial piece that challenges the point made by the blogger. I’ve tried this with 150 Stocks - The Secret to Proper Diversification? and found it to be quite effective.

e) Participate in publicity stunts.

Another linkbaiting technique involves hosting a contest. HubSpot recently announced a 50k viral marketing contest offering $100 for published articles and $5k if the article made the Digg front page. To tell you the truth, I submitted a trimmed down version of this article to the HubSpot contest but didn’t get selected. I didn’t care too much about the prize money although winning the 5k wouldn’t be bad at all. I was more interested in the potential traffic I might get from being published on their blog. Anyway, I figured, what the hell, I’m going to write this anyway so I can share my worldly wisdom with the world. Hmm… Now I think about kicking myself when I imagine how I’d miss winning the $5k if this article did make it to Digg front page.

Finally, once you have achieved stardom, never forget your readers. They got you here. Continue to write great articles for your readers to keep them engaged and build loyalty.

By now, you might be thinking, “Gee, all this kinda make sense. I wonder how his blog is doing relative to the sites he mentioned?” Well, I’d tell you “It’s literally off the chart”. But a picture paints a thousand words. So, here’s a snapshot of this site’s traffic as of this writing in relation to sites mentioned above. Enjoy.

How do you market your website?

As I mentioned in my earlier post The Best Kept Secret to Successful Investing, the most important rule to remember in investing is never lose money.

In The Intelligent Investor, Benjamin Graham introduced the concept of “margin of safety”. Buffett calls “margin of safety” the three most important words in investing. The concept is simple. But before I get to that, an understanding of the difference between price and value is crucial.

The underlying value of a company is not always reflected in the stock price. The true value of a business is what’s known as the intrinsic value. Buffett couldn’t have summarized it better, “Price is what you pay, value is what you get.”

Because no one, not even Buffett, can determine the exact intrinsic value of a business, it would be wise to allow some margin for errors in our assumptions. This margin is what Ben Graham calls margin of safety. Graham and Buffett both advocated allocating at least a 40% margin of safety.

The above concept is best illustrated with an example. Assuming you valued Tom’s Great Company at $10/share, you are not to buy until the price drops to $6/share. What this translates to is if your assumptions were wrong, and the company turned out to be worth $6/share, you would still be getting your money’s worth. You didn’t make any profit, but you didn’t lose any capital either. Put another way, even if the company loses 40% of its value, you might still haven’t lost any money. Clearly, this lends itself pretty well to never losing money.

However, there is one assumption that could throw all your assumptions off course, even with a wide margin of safety - fraudulent accounting. With the SEC and auditors watching the financial reporting like hawks, it is only reasonable for us to expect that the statements are a fair representation of the business. Unfortunately, having lived through the Enron and Worldcom debacles no one dare vouch for the truth anymore. After all, Arthur Andersen, one of the world’s largest accounting firm that promptly went bankrupt, knew about Enron’s fraudulent accounting all along. How can we as individual investors, without the help of an army of competent accountants, detect even the slightest signs of fraudulent accounting?

Well, it’s safe to say it’s very difficult. But it’s not impossible. There are some simple tests that we can apply to help us identify some form of potential deceptive accounting. I must preface with the following… Like everything else in investing, never rely on a single factor to make a decision.

One of the most common chicanery in accounting is inflating revenues. Revenue, as the first line item in an income statement, is quite important. Comparison of past period revenues tells whether the company is growing or stagnant at a glance. Growing revenues also paints a pretty picture that can sometimes distract investors from the weaker aspects of the business.

According to the Generally Accepted Accounting Principles (GAAP), revenue should be recorded once the product has been delivered or, in the case of a service company, the service has been rendered. In other words, the customer is now obliged to pay.

In double-entry bookkeeping, a sale of merchandise is recorded in the general journal as a debit to cash or accounts receivable and a credit to the sales account.^[1] In laymen terms, you should see an increase in cash or money owed to you when you make a sale.

A sale, as it is normally intended, would result in higher net income and therefore higher operating cash flow. But when revenues are inflated, there is usually not enough cash to back up the revenue growth. You can pump up the numbers, but you still won’t get the money out of thin air. The money has to come from somewhere. In an honest-to-God operation, the cash would have come from your customers. But if the sales were only on paper, you will have to get pretty creative to come up with the cash.

Hence, one of the first things to look for in identifying potential inflated revenue is the operating cash flow to net income ratio. Here’s an illustration for Tom’s Great Company:

A significant drop of CFFO to net income ratio indicates a possible accounting trick. Also, be careful when CFFO materially lags behind net income.^[2] This means sales are not converted into cash as fast as sales growth. Since the business needs to spend more cash to generate higher sales but it’s not getting more cash coming back in, eventually it will face a cash flow shortage leading to potential bankruptcy. Now, management may be able to cook up some pretty good explanation for this. But it is a warning sign to clear up before you invest in the company.

Of course, with a contrived example, I can even prove I am Superman. In reality, as we have witnessed in Adelphia, management could go above and beyond to cook up the books. “In looking for someone to hire, you look for three qualities: integrity, intelligence and energy,” said Buffett. “But the most important is integrity, because if they don’t have that, the other two qualities, intelligence and energy, are going to kill you.”

References:

1. Pinson, Linda and Jerry Jinnett. Keeping the Books, Second Edition Upstart Publishing Company, Inc., 1993. p. 15.
2. Howard Mark Schilit. Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud in Financial Reports, Second Edition, McGraw-Hill Professional, 2002. p. 67

Welcome to the hundred-and-first edition of Festival of Stocks. The Festival of Stocks is a blog carnival dedicated to highlighting bloggers’ best articles on stock market related topics. This will include research and commentary on specific stocks, industry analysis, ETFs, REITs, stock derivatives, and other related topics.

I am proud to host the following selection of the best entries to the Festival of Stocks. This edition also includes a post on diversification because it’s the best of them all I wrote it. Enjoy!

Stock Analysis

Bank of America (BAC) Dividend Analysis posted at Create Rising Passive Income From Dividend Paying Stocks
BAC offers an above average yield, coupled with a low P/E ratio. The dividend payout is unsustainably large at this moment for me however in order to initiate a position. In addition to that, the whole uncertainty over the financial sector definitely makes it wiser to simply wait on the sidelines before jumping in.

Stock Analysis: Kimberly-Clark Corporation (KMB) posted at Dividends 4 Life
Stock Analysis of Kimberly-Clark Corporation (KMB). Leading global consumer products company produces tissue, personal care and health care brands include Huggies, Pull-Ups, Kotex, Depend, Kleenex, Scott and Kimberly-Clark.

Primus Guaranty (PRS) Earnings and Conference Call Notes posted at College Analysts.
Maybe I’m being soft on them because they’ve made me so much money the last few weeks, but I was highly impressed by what I heard on the Primus Guaranty (PRS) conference call earlier today.

Commentary

5 Disadvantages of Mechanical Investing posted at MagicDiligence - Optimizing Joel Greenblatts Value Stock Strategy
Although attractive for many reasons, mechanical investing strategies also have some inherent disadvantages over traditional research based investing. Here are 5 of the main ones.

Understanding Moving Averages Can Make You Big Bucks posted at Contrarian Profits
How can a chart tell you if we’re in a bull or a bear market. The secret is understanding moving averages, says Dominic Frisby in British finance magazine MoneyWeek. Dominic says moving averages “are a gloriously simple trading tool that can help clarify where you are in the grand scheme of things.”^[1]

150 Stocks - The Secret to Proper Diversification? posted at Value Investing and Entrepreneurship by Qovax, a Software Startup
Anurag Gupta, an average Joe retail investor, buys 150 stocks and he’s the poster child of diversification. Who’s Anurag? Doesn’t matter. What’s important is he managed to beat the broad market. That’s something. Or is it?

Oil & Natural Gas – Worried About Demand Destruction? Think Long Term posted at Traders Corner
In my article titled Oil Prices Gone Wild posted June 9th, I spoke about how oil prices seemed to have gotten ahead of themselves. Prices defied gravity when they soared from $100 per barrel to just over $138 per barrel (when I wrote the article) over the course of only a few days.

We Are Living In Interesting Times… posted at Blueprint for Financial Prosperity
In the Summer 2008 issue of In The Vanguard, a newsletter The Vanguard Group sends out to its customers, the newsletter interviews two outgoing managers of their Wellesley Income Fund: Earl McEvoy and Jack Ryan. Both have years and years of experience in investing, managing several other funds, and the interview was enlightening.

Come on U.S. Dollar, Come on PowerShares US Dollar (UUP) posted at The StockMasters - Investing News and Analysis, Hot Stock Tips, Stock Market commentary for the Savvy Investor
Our U.S. dollar has fallen 30% and should it start turning around, buy PowerShares DB U.S. Dollar Index Bullish (AMEX:UUP), as Biggy once said “Only, to hell I send thee, all about the benjis, What?”

Economic Data That Influence the Market | Stock Trading Ideas posted at Stock Trading Ideas
In this post, I explain some of the commonly used economic indicators that can influence the general direction of the market. If you are new to investing, these indicators will enhance your knowledge and affect your investments.

The Stock Market Bear Has Claimed Our Investment Portfolio posted at The Digerati Life
I haven’t discussed our portfolio for some time now — the last time I reported on it was many many months ago, and I’ve got an excuse. I was simply not excited about letting you all know how much money we’ve lost since my last formal portfolio report.

Why Technology Companies are so Tricky… Thoughts on Creative Destruction posted at Bootstrap Investing
I was reading CNN Money recently, and the concept of Creative Destruction came back to me in a very vivid way. This isn’t a concept invented here at Bootstrap, but one which most investors should be aware of.

Sources:
[1] How to make money from markets you know nothing about, Money Week, July 30, 2008 by Dominic Frisby