Needless to say, not all one-time charges should be charged against income. Some one-time charges such as mass layoffs may very well be valid. Other legitimate non-recurring expenses include damages caused by natural disasters, adverse legal, regulatory and tax rulings, changes in accounting principals and sales of discontinued operations. [2]

The Big Bath

But if the layoff charges kept showing up on the books every quarter for the past 12 quarters as in the case of Hewlett Packard [3], you ought to start questioning whether the restructuring cost should be considered an operating expense. Now, you can’t generalize and assume that any company that has recurring one-time charges every year is taking a “big-bath”; that is, frequent extraordinary charges. Although rare, annual one-time charges can be appropriate if they are for different things. For instance, a charge for discontinued operations in year one, followed by a material regulatory ruling in the second year and an investment gone south the next are reasonable.

Taking a “big-bath” can be an effective way to conceal management’s past mistakes. An overpriced acquisition that has gone south can be slipped under investors’ radar into a big pool of one-time charges, attributing the poor performance to the industry cyclic nature and economic downturn. Essentially, what management is doing is wiping the slate clean.

Shifting Future Expenses

During bad times as we are experiencing now, some companies opt to take huge restructuring charges that would reduce future depreciation charges. This in turn magnifies future income when compared to current performance. This accounting gimmick is also referred to as shifting future expenses to the current period.

IBM got especially creative in its 1999 10-K when it decided to boost its earnings by using a one-time gain on sale of its Global Network business to offset a one-time write-off of the huge losses from its DRAM business. But old habits are hard to break. In 2002, IBM reported earnings that beat analysts’ expectations by (hold your breath) one penny per share only because it included a one-time gain from the sale of its optical transceiver business.[4]

Be Skeptical

The line that separates legitimate from improper one-time expenses is anything but lucid. Every one-time charge has to be taken with a grain of salt. Discontinued operation charges at conglomorates whose primary operation is to trade businesses for profits should be treated as operating expenses instead of one-time charges. Even the occassional bad investments may need to be treated as operating expenses if management has a knack of making bad investment judgements.

Investors should always read the footnotes looking for more details about one-time charges. In the case of IBM, reading the footnotes would have uncovered a plethora of juicy tidbits that would have sufficed to deter any prudent investor. The gist of this is a one-time charge should be just that — a non-recurring expense. But if management keeps recording a similar charge year after year, it’s simply not a one-time charge. I’d err on the side of caution and find some other companies to invest in.

Think Independently

Remember, management shouldn’t be telling you what to include and what not to include in evaluating a company’s performance. As an investor, you need to decide on your own. A little known poet-cum-oracle in Omaha wrote this rhyme about pro forma earnings:

Don’t count this, don’t count that,
just count what makes earnings fat.

References

1. Investopedia Staff, Detecting Two Tricks Of The Trade, Investopedia.com, May 30, 2001.
2. Richard Loth, The One-Time Expense Warning, Investopedia.com, 2007.
3. Ashlee Vance, Hp Takes 12 ‘One-time’ Charges In a Row, The Regsiter, March 14, 2006.
4. Whitney Tilson, IBM’s Accounting Tricks, The Motley Fool, February 20, 2002.

Don’t Forget Your Homework

Sometimes, you see the projected price and just want to buy before it shoots up and you feel like you’ve missed an opportunity. Remember, research and reading up on a company is a huge part of successful investing. Don’t just rely on what others are saying, but don’t negate it either. Make sure that your decision to buy is informed and that the risk has been properly assessed before handing your money over.

History Often Repeats Itself

This phrase is used over and over in many aspects of life, and investing is no different. Another aspect of doing your homework is to get a clear picture of the company in question’s performance over time. How did they fare the last time their price dropped? Is there a pattern developing? Will the company be around a year from now? Think about K-Mart a few years back — the price kept dropping until it was utterly worthless. Even at less than a dollar a share, the stock continued to falter until it could fall no more.

What’s Your Timeframe?

Are you in this for the long haul, or do you want to make a quick buck to jumpstart your entrepreneurial goals? This is a very important consideration, and one that cannot be understated. If you are looking for a fast turnaround in this market, you have your work cut out for you. Sometimes it’s better to look at things long term and make sure you are fully diversified so you don’t lose your shirt if things continue to drop.

Great Deals - Too Good to be True?

Sometimes you will see a deal you think you can’t pass up, only to see the price continue to plummet. Bide your time; even the biggest and brightest stars can fall. Especially if you are looking into a large mainstay on the market, consider their longevity and their ability to adapt to the demands of the current consumer. Will they make it five more years, or are their days numbered? Sometimes you’ve got to realize that no matter how good the deal is you may end up wondering what you were thinking later on down the road.

Making sure that you are doing the right thing is difficult in the investing world. Risk is involved and is something that you will ultimately have to weigh against your expected returns. Don’t be dazzled by the low prices or bells and whistles; use the data to make an informed decision. Knowing whether you made the right decision or not is only something time will be able to tell.

Side note: My recent post Share Buybacks - Pros and Cons was featured on the Carnival of Personal Finance #177. There are enough articles in this week’s carnival to last you a month. Enjoy!

The hours we spent designing and redesigning were totally worth it. The only drawback with the cards is that they are heavy to carry around especially if you plan on carrying, say 50 cards. But I love the feel. It’s different from paper or plastic cards. Feels sturdy and hopefully stands out among other business cards. And, don’t tell anyone but if you stick this into an ATM, it will spit out money. I swear, cross my heart.

If you love them as much as we do, please vote us up at faveup.com.

I agree with his perspective somewhat. I don’t think it is possible to make an indiscriminate statement whether share buybacks are good or bad without examining the underlying motives behind each buyback decision.

As I’ve mentioned in my article Value Investing - Evaluating Management, it is important to always ask if management is acting on the best interests of the shareholders. Similarly, when evaluating whether a share repurchase is a good decision, we as investors need to decide if management made the right decision under the circumstances.

The Cons

As Andrew has pointed out, share buybacks may not be all good news. There are three motives we need to watch for when evaluating management’s decision of buying back shares with our money:

Mask Over-dilutive Stock Option Grants

One of the biggest crime management could legally commit is to grant themselves massive stock options at the cost of shareholders. Buffett has always said that if management wants a piece of the action they should pay. Nonetheless, stock options, when awarded reasonably based on certain performance metrics, can be an effective form of compensation to align management interests with shareholders.

Back in 1999, Microsoft issued about $60 billion worth of stock options to its employees.[1] At the time, Microsoft earned a net income of $7.8bln but issued options worth $9bln.[2] And none of these options were expensed, but that’s a story for another time. It wasn’t until 2003 when Microsoft announced it would stop issuing stock options, start granting restricted stock and start expensing stock awards.[3] One wonders if the $70bln stock buyback beginning in 2004 is merely to reduce the dilutive impact from the stock options it has issued throughout the years.

Earn Performance Bonuses

Carefully chosen metrics for performance-based compensation is essential to the success of a business. Management incented to increase share price could resort to gaming the numbers to prop up the stock price and ultimately earn their bonuses.

Buying back shares could achieve the same effect. By reducing the number of shares outstanding, management can almost immediately increase earnings per share, increase return on assets and reduce PE all at the same time. Best of all, management would have earned their bonuses at the cost of shareholders money!

Lack Capital Allocation Skills

Sometimes, buying back shares could mean management lacks the skills to find better use of excess capital. The question to ask here is can the business earn a better return investing elsewhere? A dollar retained should increase the value by at least a dollar. If not, the cash should be returned to the shareholders so they can divert the funds into other investments.

This is where understanding the business is important. Could the business earn a better return by acquiring a related business on sale? Should management invest in organic growth to sustain future revenues? Every case is different and need to be examined carefully.

The Pros

Needless to say, not all share buybacks are bad. Share buybacks can be beneficial in the following ways:

Catalyst to Narrow The Gap Between Price and Value

Substantial share buyback programs typically have an effect of helping the price converge on the intrinsic value sooner. This is, in fact, one of the weapons in the arsenal of activist investors to help realize the value of their investments.

When a share buyback is announced, management is usually sending a signal that the stock is undervalued and management is confident in the growth in future cash flows. Coupled with significant insider open market purchases, a share buyback could boost the share price in a meaningful manner. On the other hand, if after announcing the share buyback, management is quietly selling off their shares, you have to question the real motive behind the repurchase.

Tax Efficient Way to Return Money to Shareholders

Back in the days when capital gains tax is lower than dividend income tax, a share buyback is a more tax efficient way to return money to shareholders than paying a dividend. But since both capital gain and dividend income are taxed at the same rate now, the tax advantage has disappeared.

However, at the corporate level, there are still tax benefits to be had when buying back shares. A company that spends $100 million in cash to repurchase its shares will relieve itself of paying $9 million in taxes on the interest income it would have earned on the same amount had it kept the cash in a money market account earning 3% (assuming no growth in interest).[4] This tax saving in theory should translate into a $9 million increase in market price in a share buyback. In short, by returning the excess cash to shareholders, the business continues to generate the same cash flow but on less equity divided into lesser number of shares. Not a bad way to return money to shareholders and save on taxes.

Lower Cost of Capital

Buying back shares can be enhanced by utilizing cash from issuing debt. Remember, excess cash held at company is not free for company to use. After all, the cash belongs to the shareholders and the shareholders expect a decent return on the equity.

By issuing debt at an interest rate lower than cost of equity to buy back shares, the company has just increased leverage and lowered the cost of capital. This magnifies the return on invested capital to shareholders. What’s more, the interest expenses paid on the debt can be tax deducted. Again, the tax saving translates to an increase in share price.

Prevent Deworsification

When there are no other investments that could yield a better return than buying back shares, management should just return the money to shareholders. Spending the money on share repurchase also has the effect of preventing management from getting into silly acquisitions that would in the end cost huge losses to shareholders. Peter Lynch calls these deals deworsifications.

Dumb acquisitions could cost losses that run well into the future. Buffett calls buying Dexter Shoes with $433 million worth of Berkshire stock in 1993 the biggest mistake he has made. Although Dexter is no longer making shoes, Berkshire shareholders has lost $3.5 billion on the deal thus far and will continue to lose money as the shares increase in value.[5]

Conclusion

In summary, don’t be too quick to credit or discredit a buyback without first identifying the motive behind the decision. After all, if you were to draw a line here and consider all buybacks to be bad, you could be missing out on many, many great companies selling at a discount.

References

1. Rob Landley, Why Microsoft’s Stock Options Scare Me, The Motley Fool, February 17, 2000.
2. Bill Parish, Microsoft Financial Pyramid, Parish & Company, November 17, 1999.
3. Todd Bishop, Microsoft to End Stock Options For Employees, Seattle Post-Intelligencer, July 8, 2003.
4. Richard Dobbs & Werner Rehm, The Value of Share Buybacks, The McKinsey Quarterly - McKinsey & Co., September 20, 2005.
5. Jonathan Stempel, Buffett Calls Dexter Shoe His Worst Deal Ever, Thomson Reuters, February 29, 2008.
6. Justin Pettit, “Is a Share Buyback Right for Your Company?” Harvard Business Review, April 2001.

Evaluating management is not easy. The key here is to make sure management has integrity, intelligence and energy. “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.”, as Buffett pointed out. Remember, when you invest, you are entrusting your money to management. In The Intelligent Investor, Benjamin Graham tried to tell us that, in theory, the shareholders are the most powerful people at a company. We are capable of bending any management to our will. But he gave up after realizing that, in practice, many shareholders simply surrender their rights to management by voting according to management recommendations.

So unless you have the resources to secure a controlling interest at a company, you will have to rely on your ability to pick capable management you are willing to get in bed with. Here are four points to remember when evaluating management.

Take Management Communication with a Grain of Salt

Annual reports and company websites often have colorful photos of the executive team because someone must have figured out that putting a face next to a name makes the company more credible. That someone must have never read Leucadia annual reports. Try searching for photos of Ian Cumming and Joseph Steinberg and you’ll see what I mean.

When reading executive bios, always take it with a grain of salt. Guess who controls what goes into the bios? The executive backgrounds allow management to enhance their credibility by peppering names like Harvard and Yale. Not all information provided in the executive profiles is useless. For management who just took over the helm, the profiles hint at where management previously worked and how they fared. Also important here is how long has management been with the company. I tend to favor management who founded the company and stayed on.

Shareholder letters offer insights into how management communicates with investors. The tone of the letters are almost always positive and upbeat. The worst adjectives you could find in a letter are “challenging” and “difficult”. But they are commonly followed by a vote of confidence by management to calm the nerves of shareholders. This is understandable. But watch for management who draws attention to better looking but less important numbers to distract shareholders from focusing on the current problem.

Some investors advocate talking to management to get a better feel of their characters. I don’t think this is necessary. The danger here is management tend to have excellent oratory skills that might charm you into believing everything they say. In fact, some management thinks frequent communication with shareholders is all but a waste of time. Leucadia never holds quarterly conference calls.

The Juice Is In The Proxy Statement

Many investors tend to glean over proxy statements because annual and quarterly reports are already long enough. But what they don’t realize is the proxy statements contain crucial disclosures that could make or break an investment such as self-dealing. This is most evident in the Enron debacle. Had Enron investors read in the 1999 proxy about how CFO, Andrew Fastow, borrowed Enron funds to purchase energy related assets from Enron via his two partnerships, they would have balked.[3]

Another juicy tidbit offered in the proxy statement is management compensation including grants of stock options and restricted stock. It is important to pay attention to how management is compensated and how the pay compares to similar sized companies in the industry. Bonuses preferably in stock options or restricted stock should be awarded only if management hit a reasonable performance target.

Finally, the proxy statements also provide information about how much stock insiders own. Management should eat their own cooking. I expect management to have their substantial net worth invested in the company they run. Couple your analysis with the Form 4 filings to find out if management has been adding or reducing their stake. Recent significant open market purchases indicate a strong vote of confidence while significant selling by multiple executives and directors could be a sign of trouble.

Analyze Capital Allocation

To gauge the intelligence of management, observe how management act during tough times. Management that can keep the ship afloat when things go south will tend to do phenomenally well when the tide changes because weaker competitors would have faltered. Take AmeriCredit for example. Management has survived a credit crisis once back in 1998. Then CFO, Daniel Berce (currently CEO), made the right decision to reduce volume to conserve capital and came back roaring when the crisis subsided.[4]

Since the job of a CEO is to allocate capital wisely to maximize shareholder benefits, investors need to analyze deals made by management. The general rule of thumb as, Buffett always emphasized, is every dollar retained should produce a dollar or more in value. If not, the money must be returned to shareholders. Some CEOs, unfortunately, think they are paid to act. So in the interest of making themselves look busy they strive to make say five acquisitions a year. This is just plain stupid. If the deals are not going to produce a decent return for shareholders, the acquisitions are nothing but what Peter Lynch calls deworsification.

At some companies, the CEO is the key asset to the company. Study the deals the guy at the helm makes. We are all familiar with the dynamic duos Warren Buffet and Charlie Munger, and Ian Cumming and Joseph Steinberg. But there are some lesser known smart cookies such as Michael Ashner of Winthrop Realty who has consistently made some pretty amazing deals in real estate.

Apart from allocating capital, management is also responsible for maximizing efficiency. Days sales outstanding is a good measure of how quickly management can convert sales to cash. For financial companies, you would want to look at efficiency ratios, which is non-interest expense divided by net interest and fee income.

Don’t forget to look for signs of overspending in office buildings and unnecessary fringe benefits. Remember former Tyco CEO, Dennis Kozlowski’s $6,000 shower curtain and $2-million birthday party for his wife? Of course, these are hard to detect. But generally expenses should be in-line with same-size competitors.

Alignment of Interest with Shareholders

Responsible management always act in the interest of the shareholders. Ask yourself “Is the action in the best interest of the shareholders?” If not, sell your shares and stay away. The reason is simple: As a shareholder, the management team works for you. If you don’t like them, why let them manage your hard-earned money?

Good management would pay dividends when they couldn’t find a better use for the cash generated by the business. After all, as a shareholder, the cash belongs to you. If the stock is trading at a discount, they would repurchase shares to maximize shareholder returns. Of course, not all share buybacks are equal. But that’s a topic for another day. As mentioned earlier, look for management who eat their own cooking. They are more inclined to take the side of the shareholders.

References

1. Whitney Tilson and John Heins, Buffett: Still The Best Jockey, Forbes excerpt from Value Investor Insight, April 28, 2006.
2. Joe Ponzio, Notes from the Pabrai Funds 2008 Annual Meeting, FWallStreet, October 1, 2008.
3. Benjamin Graham with commentary by Jason Zweig, The Intelligent Investor Revised Edition, HarperBusiness, 2003. p. 500 - 501.
4. Andrew Osterland, Less Business Wanted? It Worked for AmeriCredit, CFO.com, October 22, 2001.

Side note: My recent post Valuing a Business - Seth Klarman’s 3 Methods was featured on the Festival of Stocks #110 and the Investing Carnival #17. Both carnivals are my favorites. Be sure to check them out.

The truth is all of us can recognize a discount when we see one. When I shop for organic fuji apples, I know they are at a discount at $2.39/lb if they normally sell for $3.99/lb. Keeping an eye on the price tags is the key. But when it comes to recognizing a business selling on a discount, the share price does not always reflect the value of a business. This is because a business is made up of people. Hence, businesses evolve for better or for worse. When a business evolve into a more valuable business, the share price must at some point reflect this change.

The trouble is no one perceives the value of a business the same way. This is why even Ian Cumming and Joseph Steinberg couldn’t agree on the same intrinsic value for Leucadia. So when you throw the entire population of investors and speculators in the mix, you get a variable share price that changes by the second.

Business valuation is as much an art as a science. There is no one value that is the absolute right value for a company. Because of the imperfect knowledge of the future, we can only come up with a range of values for a company. Below are the three methods of business valuation that Seth Klarman postulates every value investor should have in his warchest.

Discounted Cash Flow / Net Present Value

In Theory of Investment Value, John Burr Williams was among the first to introduce the discounted cash flow (DCF) analysis. Seth Klarman categorizes this under the net present value (NPV) method. With a properly chosen discount rate and reasonably predictable future cash flows, the NPV method yields the closest to precise valuation of a profitable business.

DCF basically calculates the present value of all future cash flows by applying a discount rate. The discount rate is the interest that you would like to be compensated for incurring the opportunity cost of giving up alternative, less risky investments. The riskier the investment the higher the discount rate should be. Generally, the short term US Treasury securities are considered risk-free alternatives. In other words, if you are accepting a higher risk for an equity investment, you should expect to earn an interest higher than the current US Treasury yield. Don’t just apply a 10% discount rate on all analysis. A smaller, less liquid company probably deserves a higher discount rate, say 12% - 15%, than its blue chip counterpart.

Despite its proximity to accuracy, DCF has a flaw: it depends on predictable future cash flows which no one can reliably estimate given the massive number of variables. Unlike a bond, the earnings of a business are not fixed every year. A one percent difference in your growth assumption can have a huge impact on the NPV. Unfortunately, most investors are overly optimistic when it comes to estimating growth. The best defense here is to err on the side of caution and always pick the more conservative estimate.

Liquidation

The net present value analysis works great for determining the value of a profitable business with predictable future cash flows. But when it comes to valuing an unprofitable business, the NPV analysis falls apart. Since there is no future cash flow, you can’t calculate the NPV. [Note: This is an erroneous statement. Be sure to check out Tim Mayes' excellent explanation below for the reason.] Thus, most investors, unwilling to part with NPV, would simply pass on investing in unprofitable businesses. But this is precisely why investors who are willing to spend the time scouring the floors for cigar butts could find some wonderful bargains.

To value an unprofitable business, an investor needs to be extra conservative since many of these businesses are already troubled businesses headed for the dead pool. Typically, only tangible assets are considered. Intangibles such as brand names are assumed to be worthless. A good shortcut to evaluate the liquidation value of a business is to calculate the net-net working capital. Net-net working capital is calculated by subtracting current and long term liabilities from current assets. If the company trades below its net-net working capital and it is not depleting its net-net working capital nor does it have any off-balance sheet liabilities, the failing company could be a very successful investment.

However, there is a shortcoming with the net-net working capital analysis. Most of the time, in a liquidation, a company sells pieces of standalone operating entities too. These operating entities could very well be profitable going concerns despite its parent’s fallout. The net-net working capital analysis would have underestimated the worth of these subsidiaries. Often, in this situation, investors resort to a breakup analysis to evaluate the worth of the subsidiaries. Basically, you treat the subsidiaries just like you would any company when valuing a business; applying the proper analysis. Once you have the values of each of its subsidiaries you sum them up to arrive at the total value of the parent. This is also known as the sum-of-parts analysis.

Market Value

The market value analysis is the best and only sensible valuation method for closed-end funds. Closed-end funds are funds that are closed to new capital after launch and their shares can be traded at any time in open market. Unlike a mutual fund, a closed-end fund usually trades at a premium or a discount to its net asset value (NAV). The NAV of a closed-end fund is the sum of all its securities. Since the value of the securities are realized when sold to the market, only a market value analysis of the securities makes sense.

Some investors make the mistake of extending the market value analysis to valuing companies. The reasoning behind this is simple, but irrational; if a similar company in the same industry trades at 12 times pretax cash flow, this company should trade at the same multiple. This is what Seth Klarman calls “circular reasoning”. What if all the companies in the industry are overvalued?

A more appropriate relative valuation method for companies is the private market value analysis. The assumption here is that in a private transaction where sophisticated businessmen are involved, businesses are often bought at fair prices or at reasonable premiums. Often times, this is true. But when considering a leveraged buyout transaction for comparison, an investor has to be cautious about whether the buyer overpaid.

Conclusion

All three valuation methods are not without flaws. Therefore, it is sometimes necessary to use several methods simultaneously to arrive at a more comfortable estimate. It is important to pick the right tool for the right job lest you contract the man-with-a-hammer syndrome. As Munger would say, “To a man with a hammer, every problem looks like a nail.”

References

1. Seth A. Klarman, Margin of Safety, HarperBusiness, 1991, p. 121 - 135.

Side note: My recent post Value Investing - 6 Key Principals was featured on the Carnival of Personal Finance #173. As always, the carnival has some of the best articles I’ve read. Be sure to check it out.

A value pretender may not realize he is a pretender. He understands the difference between price and value. He understands that Mr. Market is here to serve him. He knows he should demand a margin of safety. He admires the value investing gurus so to the point of thinking they are always right. But he does not grasp the principals of value investing.

To become a true value investor, we need to first understand the principals of value investing. Below are six principals I think are crucial for an investor to truly understand value investing:

Risk, not profit

Often, when you read a stock analyst’s report, you find the target price prominently displayed on the report. This gives investors the information he needs at a glance. The danger here is once the investor sees the target price higher than the current trade price, he skips the rest of the report and completely forgets about the risk. This is akin to lending your hammer to your neighbor because he promised to return two hammers when he still hasn’t returned the hammer you lent him two years ago.

Unlike a value pretender, a value investor does not target a specific return. Risk is what a value investor targets first. Understanding risk helps you avoid losses. Only after you understand the risks of an investment can you then calculate the rewards. An investment that promise a 50% return in one year is a lousy investment if there’s a 50% chance of the business going under in three months. But an investment promising a 20% return in one year with an 80% chance of surviving the downturn can be a wonderful investment. The rules of investing laid down by Buffett are simple — Rule No. 1: Don’t lose money. Rule No. 2: Don’t forget rule no. 1.

Do your homework, but not too much

Understanding the businesses behind your investments is what separates value investing from other investing approaches. To get to know your companies well, you need to do your homework and study the fundamentals of the businesses. Doing due diligence is a pain in the butt. In Investing Mistakes - 5 Deadly Sins, I talked about the hundreds of pages of annual and quarterly reports to read, not to mention the 8-Ks and proxy statements.

But investing is one activity where you don’t get paid by the hour. Here the general 80/20 rule applies; the first 80% of the most useful information is gathered within the first 20% of the time spent.[1] Don’t strive to find the perfect information about a company. Knowing the secret recipe of Coca Cola does not guarantee a profitable investment. At some point when gathering information, you will hit the point of diminishing returns. Embrace the uncertainty and imperfect knowledge about a company that make the company a bargain. Besides, if it’s too much work, you can always pass.

Maintain discipline and patience

A value investor knows to take advantage of Mr. Market when he is being irrational. Timing the market is futile. No one can reliably predict the direction of the market let alone when the direction will change. To overcome the uncertainties, a value investor must insist on a huge discount to allow himself a sufficient margin of safety.

A riskier investment warrants a bigger margin of safety and a higher discount rate to arrive at a more conservative value. A discount rate is the rate used to calculate the current value of future cash flows generated by a business. If the stock doesn’t trade at or below your margin of safety, just don’t buy. Yes, you may miss the opportunity of a ten-bagger, but don’t forget you may as well have saved yourself from a company headed for bankruptcy. If you are patient, eventually, the price will drop to your buy price. Then, you would have made a killing. Remember, the profit is determined the moment you buy the stock. If you buy at a bargain price, you are almost certain of success.

Bottom up, not top down

Many investors continue to worry about the state of the current economy as they read about the soaring bankruptcies, the rising oil prices, the growing unemployment and the worsening housing slump. In this environment, value pretenders will predict and identify sectors that will outperform the market and begin searching for bargains there. The problem with this top down approach is you are buying based on a trend, almost to the point of speculating. You’ve decided a sector will outperform before you can perform value analysis.

A value investor understands that a company that is fundamentally strong and run by competent management will ultimately survive the downturn. Searching for a bargain begins from the bottom; you find a company and learn about the company first, not the industry. Nevertheless, there are some industries like the airline industry that are just not worth investing in. Still, if you focus on the fundamentals of a company, you don’t need to worry about the economy and market direction. In the long run, the price always converges on the value.

Change your mind

One of the most essential virtue a value investor needs is humility. Everyone makes mistakes. No one can make the right decisions all the time, not even Buffett when he sold Anheuser-Busch too early and left a big chunk of change on the table. Buffett willingly admitted he made this mistake and that is why people admire the man.

More importantly, once we learned that we have made a mistake, we must be willing to take action even if it results in a loss. The obvious case here is to sell when you realized you made a mistake in your analysis of a company. Too, when hunting for a bargain, a value investor must not get too attached to his first love. Unlike a marriage, infidelity isn’t a bad thing in investment. He may find a better bargain as he continues his search. And when he does and he has no cash available, he needs to trade his first love, even if it’s at a loss, for the better bargain. This is very, very tough to do. This is what baffles many people when gurus switch from one position to another, even though there is nothing wrong with the former position.

Absolute performance, not relative performance

Setting the right goal and focus could mean the difference between devastating losses and reasonable successes. The trouble with focusing on beating the index is we are too competitive. It is too easy to succumb to the temptation of trading just to beat the index every quarter. Ironically, this is the very reason many mutual funds underperform the index. The mutual fund managers are not entirely at fault here because if the fund underperforms the index in a quarter money starts flowing out to better performing mutual funds. The general public demand for short term performance will continue to ensure mutual fund underperformance.

On the contrary, a value investor focusing on absolute performance should do quite well in the long run. By setting aside the need to beat the index every quarter, you are forced to focus on minimizing risk while earning a decent return. If you do this well, you won’t be too far off from the index performance. Buffett uses an internal score card to gauge how he does in life. He posits, “Would you rather be the world’s greatest lover and let everyone think you are the world’s lousiest lover or be the world’s lousiest lover and let everyone think you are the world’s greatest lover?”

References

1. Seth A. Klarman, Margin of Safety, HarperBusiness, 1991, p. 102 - 115.

Side note: My recent post Index Funds - What You Don’t Know was featured on the Carnival of Personal Finance #171. This week’s Carnival of Personal Finance will be hosted by Girls Just Wanna Have Funds. Be sure to check it out on Monday.

John Bogle, the founder of Vanguard Group, started the first index fund in 1975 after Burton Malkiel popularized the efficient market theory (EMT) and commented “It is time the public can [buy an index].” The EMT basically says the stock price reflects all the best information currently available (even though it may be incorrect) about the company. Now that you know what EMT is, you can skip all 522 pages of Burton Malkiel’s A Random Walk Down Wall Street.

Because most mutual fund managers fail to beat the index, it makes perfect sense for the uninitiated investor to simply buy the index. But there are a few things you need to understand about indexing.

You will never outperform the market.

With indexing, you will at best earn a market matching return. In fact, when buying an index fund one of the most important factors to consider is the cost. The lower the cost the closer your performance to the index. By indexing, you are subscribing to the notion that the market is efficient. To put it bluntly, you are not willing to try to beat the market.

Warren Buffett wrote “in any sort of a contest — financial, mental or physical — it’s an enormous advantage to have opponents who have been taught that it’s useless to even try.”^[1] If you crave a market beating return, you will have to either pick your own stocks or invest in a mutual fund run by a guru.

You are not investing, but speculating.

Investing by definition is making buy sell decisions based on the difference between current price and perceived value. When you buy an index fund, you are not investing because you have no idea what you own. Yes, you know the tickers that belong in the index but you don’t know the companies the tickers represent. Since you don’t understand what you own, you will not be able to estimate its value.

In other words, you are buying in the hopes that the prices will go up not because the underlying of the securities will go up, but because you think the next buyer will pay a higher price. This is speculating. Don’t get me wrong. Speculating is not a bad way to make money if you loathe investing.

You are buying high and selling low.

As an index investor, you are inevitably buying high and selling low. When a stock is added to the index the price spikes. Similarly, when a stock is removed the price sinks. Two days after GameStop was added to the S & P 500 replacing Dow Jones, the shares surged 6%. This is because index fund managers were rushing in to buy the stock to match the index. With so many parties vying for a piece of the pie, it is only reasonable to expect to pay a higher price.

As a value investor, you just can’t help but wonder: Did GameStop just become more valuable overnight because it was added to an index? Did it really increase its future cash flow overnight?

You are forfeiting your shareholder rights.

At a typical stock corporation, shareholders get to vote on matters that are important to the company and themselves. It is also one way (albeit not the most effective way) of keeping tabs on management. Sometimes winning a proxy fight against management (think Yahoo!) could be quite lucrative for the shareholders.

However, when you buy an index fund, you are waiving your rights to vote as a shareholder. You are leaving the voting decision up to the index fund manager. The index fund manager’s only goal is to track the index closely. As a matter of fact, because the manager has no fundamental knowledge of the company, he is incapable of making an informed decision.

Prevalent indexing leads to poor returns.

This may sound counterintuitive: the more investors index, the more inefficient the market. Because everyone assumes the price correctly reflects the value of the security, no one will try to correct the price even if it significantly deviates from the underlying value.

Barron’s observed, “A self-reinforcing feedback loop has been created, where the success of indexing has bolstered the performance of the index itself, which, in turn promotes more indexing.” As I pointed out earlier, an indexed stock typically trades higher than its non-indexed counterpart. But, when the market goes south, matching the index return seems silly when the non-indexed stocks perform better. Thus, indexers rush for the exits, promptly dumping shares as we saw recently with Lehman Brothers.

Despite the gloomy picture I painted for index investors, it is important to recognize that index funds still kicked the pants off the majority of the mutual funds. But at the same time, it is also crucial to understand the implications of investing in index funds. At least you know what to look out for.

For those who abhor everything to do with investing, index fund is still the best way to go. In the end, what matters most is you get to enjoy collecting wine corks if that suits your fancy while earning a decent return on your investment.

References

1. Berkshire Hathaway, Inc., annual report for 1988, p. 18.
2. Seth A. Klarman, Margin of Safety, HarperBusiness, 1991, p. 50 - 54.

Side note: My recent post Finding Stock Ideas - Best Places to Look was featured on the Carnival of Personal Finance #170. Be sure to check out the abundant quality reading at this week’s carnival.

I am proud to host the following selection of the best entries to the Festival of Stocks. This edition is arguably the most insightful I’ve ever seen. Thanks to all the authors for sharing your articles with everyone. Please keep ‘em coming.

Stock Analysis

Frank Lara Jr presents Friday Mailbag: “What to Buy?” (GE, AUY, BA, ZOLT, POT) posted at The StockMasters - Wall Street News and Commentary for the Savvy Investor
Getting back into the market after last week, what’s safe for the week ahead, a few stock picks and reasoning about financial blogs

Contrarian Profits presents 5 Fat-Dividend Paying Pharmacuetical Stocks posted at Contrarian Profits
Given the gut-wrenching financial turmoil of the last year, many investors are looking for more secure ways of investing. Floyd Brown says one way of doing this is to rethink the “boring” image of dividend-paying stocks. These stocks can offer great returns and a steady cash flow.

Bootstrap presents Boeing Boo-Boo? posted at Bootstrap Investing
Literally weeks after my post on the virtues of Boeing, the Machinists union refuses Boeing’s contract offer and threaten to strike. Great timing, right?

Michael Cintolo presents Lehman, Apple and Canaries posted at The Iconoclast Investor.
Back on May 29, I wrote an issue of Cabot Wealth Advisory that mentioned Lehman Brothers (LEH) as the canary in the financial coalmine. One thing for you to watch: Financial stocks … and Lehman Brothers (LEH) in particular.

Dividends4Life presents Stock Analysis: Nucor Corp (NUE) posted at Dividends 4 Life
Nucor Corporation is engaged in the manufacture and sale of steel and steel products. As the largest minimill steelmaker in the U.S., Nucor has one of the most diverse product lines of any steelmaker in the Americas. Linked here is a detailed stock analysis and commentary.

Steve Alexander presents Magic Formula Stock Review: ValueClick (VCLK) posted at MagicDiligence - Optimizing Joel Greenblatts Value Stock Strategy
ValueClick has a great business model and an attractive price. Only competition and the lack of a built-in moat prevent it from being a Top Buy.

Dividend Growth Investor presents UDR Dividend Stock Analysis posted at Create Rising Passive Income From Dividend Paying Stocks
UDR is a dividend champion as well as a component of the S&P 1500 index. It has been increasing its stock dividends for the past 31 consecutive years. Is this REIT a buy, sell or hold?

George presents Winners and Losers of the Fannie Mae, Freddie Mac Bailout posted at Fat Pitch Financials
Remember the Monday market madness after the Fannie Mae and Freddie Mac bailouts? If not, this post lists the most active stock winners and losers after that major market event.

Super Saver presents 9/8/08 Stock Position Update - It’s Ugly posted at My Wealth Builder.
As with last week, I continue to take no further action based on my buy list and short list of 7/7/08. So far I have taken four long and one short position, which has been closed. Given the volatility of the market, I continue to be cautious for both purchases and selling short.

Commentary

Robert D Flach presents THE FEELING IS DEMUTUAL posted at THE WANDERING TAX PRO.
Over the past few years many of the nation’s oldest and largest life insurance companies - including Prudential, John Hancock, MetLife, Principal, Mutual of New York – which began as mutual insurance companies have “demutualized”.

Jim presents Index Funds Are Only Part of Your Investment Plan posted at Blueprint for Financial Prosperity.
There isn’t a single reason why you shouldn’t like index funds. They’re cheap, they offer market rates of return without fail, and they are simple to buy. So why not put all your money into an S&P 500 Index fund like the Fidelity Spartan 500 Index or the Vanguard 500 Index, call it a day and enjoy more time with the family?

Pinyo Bhulipongsanon presents 5 Surefire Ways To Improve Your Investment Performance posted at Moolanomy.
Investing in the stock market is a risky business if you don’t know what you’re doing. Even if you do, it’s possible to lose a lot of money — e.g., Bear Stearns, Fannie Mae, Freddie Mac, etc.

Babak presents Richard Russell: Sage of The Dow Also Confused posted at Trader’s Narrative.
Far be it from me to criticize a luminary of technical analysis but it certainly appears that Richard Russell is confused. For those who are unfamiliar with him, Richard Russell is known as the Sage of the Dow for his expertise in Dow Theory.

Leon Gettler presents Volatility rules posted at Sox First
The US market has taken a hammering. Volatile times, perfect for for a trader with the agility of Spider-Man and the mathematical chops of Steven Hawking, but for everyone else, it’s just frustrating. Get used to it! Volatility is significantly greater in down markets than boom markets. The reason? Traders, like gamblers, chase losses. If they’ve lost lots of money, it’s tempting to make big bets to try and get it back.

Silicon Valley Blogger presents 14 Effective Strategies To Leverage A Weak Stock Market posted at The Digerati Life
There’s stuff you can do, even when the market is weak.

Raymond presents List Of the Best Online Discount Brokers posted at Money Blue Book.
So, you are finally sold on the idea of signing up for an investment brokerage account so you can start making money by investing in the stock market. Or, perhaps you are already an experienced trader but at times still wonder what other brokerage options are out there?

Based on my limited experience, I’ve found the following to be the most effective ways to find new stock ideas.

Steal from The Gurus

Investing is the only game where an amateur can beat the master at its own game simply by copying the master. I consider myself fortunate to be an amateur. The nice thing about being an amateur is you get to copy the masters like Bruce Berkowitz, Seth Klarman and Joel Greenblatt. Sometimes, you get really lucky and you get the opportunity to buy below the entry prices of the masters. In this case, you might just beat the master. To help us steal ideas from the investing gurus, the US Securities and Exchange Commission (SEC) requires investors holding more than 5% of a company to file a Form 13D. And a 10% investor to file Form 13G. Once the ownership crosses the 10% mark, the investor is required to report all additional trades on forms 3, 4 and 5. That’s a lot of forms to remember. Luckily for us lazy bums, GuruFocus keeps track of the gurus’ trades by scouring the forms filed with the SEC. So stealing ideas from Tom Gayner is now just a mouse click away.

Even though stealing ideas from gurus is both enriching and noble, sometimes gurus have ideas that don’t work out too. I fell into this trap once when I followed Mohnish Pabrai into Delta Financial. Despite losing quite a bit of money, Pabrai at least knew what he was doing. Me? I was clueless. But I was lucky to have invested with just play money. Lesson learned: Skipping homework was fun only when we were back in school.

Study Ideas From Value Investors Club

Another place to look for well researched stock ideas is the Value Investors Club (VIC), the brainchild of Joel Greenblatt of Gotham Capital. Greenblatt created the website to help him and peers discover high quality stock ideas. Message boards such as that on Yahoo! Finance contain more noise than facts. By creating an exclusive club of outstanding investors, Greenblatt and the members of the club get to cherry pick ideas from the smartest investors in the industry.

Since I can barely pass a Math exam, I was overjoyed to find VIC also offer guest accounts with a 45-day delay. So I don’t get to see the latest ideas and some comments are only viewable by members. But I still get to read the full analysis of the ideas. Be very careful here. Some ideas may read like great ideas. They don’t necessary turn out as promised. Make sure you read the annual reports and form your own opinion about the company before you invest. Even if you don’t find ideas that you act upon, you can still learn a whole lot from reading the analysis on the stocks.

Scour Insider Trades at Form 4 Oracle

Both Peter Lynch and Seth Klarman have emphasized the importance of observing the signals from insider trading. There are many reasons insiders would sell a stock, but there is only one reason they would buy a stock - they believe it would go up. Form4Oracle allows you to search for companies with the biggest insider open market purchases. This is a strong signal of insiders’ confidence in the company. But pay careful attention to the type of purchases. Open market purchases send the clearest signal because they require insiders to pay with cash out of their pockets. Exercising stock options, on the other hand, will only dilute existing shareholders.

Once you have found a company with high insider buying, dig deeper to understand the company and insider motives. Sometimes the best catalyst to narrow the price-value gap is to sell the company. But if the company is majority owned by insiders who have no intention of selling, you as a minority shareholder is left holding the bag.

Find Hidden Gems in 52-week Lows

Pabrai constantly scans the 52-week lows list to find stars that have faltered. You can find 52-week lows list on most financial websites such as Nasdaq. But finding a gem amongst stocks that have lost significant value is like navigating a minefield. Most companies trade at low prices for valid reasons. Only a handful may turn out to be deeply undervalued companies.

A good way to narrow down the list of stocks you need to scan through is to look for stocks trading at 52-week lows that are also owned by investing gurus. Again, GuruFocus offers a convenient way to track down these bargain stocks. The stocks you find here could be quite rewarding.

Listen to Randolph McDuff

This last method of finding stock ideas is a little unconventional. Randolph McDuff is the investment guru you’ve never heard of. His two model portfolios on Marketocracy earned annualized returns of 22% and 30% respectively since inception in 2001 compared to S & P 500 annualized return of -0.22% over the same period. You can invest in one of his Marketocracy mFolio portfolios for a fee.

Alternatively, you can follow Randy and his trades via his blog. Randy doesn’t write very often. This is actually good because someone once said, “If you find every stock a good idea, you are in big trouble.” Good stock ideas don’t come by easily. Otherwise, they won’t be good. I always wonder how publishers of investment newsletters come up with 10 new ideas every month. Randy discusses his reasoning behind picking the stocks for his model portfolio on his blog in gory detail. You can also ask him questions about his picks on his blog. An indisposable learning resource!

There you have it, my five best places to look for stock ideas. How do you find your stock ideas?

Side note: My recent post Are IPOs Smart Investments? was featured on the 105th Festival of Stocks and the 11th Investing Carnival. I will be hosting the 106th Festival of Stocks next week. If you haven’t submitted your articles, you still have some time. Don’t forget to check back on Monday morning for the best posts yet.