Monday, April 27, 2009
The amount of money I will be able to invest is only a very insignificant amount if I am to work the jobs that I am qualified for (unskilled labor, restaurants, etc.).
So, first thing's first. I need a bigger salary. This way, I'll be able to live comfortably and also save/invest substantial amounts of money. Currently, I'm only able to live in a near-poverty like state and save/invest insignificant amounts. I will also never qualify for a mortgage loan off the salary I earn now, because I'll never be able to afford the monthly payments. So, to get a bigger salary, I can go to technical school and get a labor job, get a college degree and find a job, or the route I have decided on - acquiring a financial certification. I am studying for my ChFC license - it is the equivalent of the CFP but does not require a college degree.
I am taking these courses through the American College, and I have my first of eight examinations this Friday.
Rather than continuing to learn security analysis while I do this, I think it best to put it down for a while. I believe that focusing my efforts on one thing will lead me to success versus spreading my efforts out over a few things. We will go back to Security Analysis once I have a salary large enough to afford considerable stock investment.
Saturday, March 7, 2009
For cash items, the analyst should include everything equivalent to cash; the analyst should include all the cash equivalents the company lists and any equivalent which is not shown as current but could be if the company decided to. Cash-surrender value of life-insurance policies are generally shown as an intermediate item, but the analyst may include them as part of current assets for the purpose of certain calculations, such as finding the current asset value of the stock.
For inventories, valuation is the most important factor, especially pertaining to the FIFO and LIFO methods, as discussed in Chapter 11.
Receivables should be shown as current assets, even if the period of repayment extends well over a year. Some companies sell the receivables to finance companies or banks under the condition that the company is responsible for nonpayment. These amounts should be added to both receivables and current liabilities.
When receivables play a large part of the company's business, extra attention is needed to make sure that the reserve for losses and collection expense is enough; comparisons should be made with other companies in the same field.
Some companies set up reserves for income tax to be paid upon collection of the receivables, but the analyst should subtract these directly from the receivables to make a more accurate figure.
Any reserves which represent a fairly definite liability should be considered by the analyst as current liabilities. Current liabilities should be all liabilities due within a year.
Intermediate assets include non-current receivables, investments not treated as marketable securities, cash-surrender value of life insurance, and deferred assets. Most companies include claims for tax refunds, but some show this as a current receivable.
Fixed assets, also known as the plant account and property account, is carried usually at actual cost minus depreciation.
Prepaid Expenses and Deferred Charges are sometimes confused. A prepaid expense is an expense paid in advance which has actual value, like paying 12 months of rent at the beginning of the year. Each month, this prepaid expense will be deducted by 1/12th. A deferred charge is very similar, but has no substance. For instance, 100 thousand dollars may be spent to start a company, but, instead of charging the full 100 thousand at once, it could be called a deferred charge, and amortized over a period of time.
Large prepaid expenses/deferred charges must be examined closely, but, usually prepaid expenses/deferred charges are too small to matter and can be ignored.
Bond discounts are when a company sells a bond and receives less than par value for them. The discount can be charged off against surplus or carried as an asset and be amortized over the life of the bond. Usually, these items are too small to matter much.
Intangible assets include good-will, patents, copyrights, trade-marks, franchises and licenses, organization and development expenses, etc.
Leaseholds - the right to occupy a premises for a stated period of time subject to payment of rent. It may be considered an asset if the rent is well below current-rental value of the property, but it is intangible.
The analyst is concerned with two main things when dealing with liabilities: the treatment of reserve items and the proper valuation of the preferred-stock liability. We have already gone over the treatment of reserves.
Preferred-stock liabilities - preferred-stock's main value is the right to a fixed dividend above the common shares, and is similar to a bond in that it is a fixed security. To value the preferred-stock liability, an analyst can follow this simple rule:
value preferred-stock at the highest of: par value (plus dividends), call price (plus dividends), or average market price. Sometimes, it might be more useful to create a par value, such as "the equivalent of a 5% dividend rate."
Most companies list preferred stock on the balance sheet at par value, but sometimes that is misleading.
Book value per share of common stock is arrived at by adding up all the assets (not including intangibles), subtracting all liabilities and stock issues ahead of the common, and then dividing by the number of shares. When calculating book value of preferred stock, do it in exactly the same way as you would common, but leave the junior issues out.
There are two other values that are important: current-asset value and cash-asset value.
Current assets consist of current assets alone minus all liabilities and claims ahead of the issue. (this excludes intangibles, miscellaneous, and the fixed assets).
Cash asset value consists of cash assets alone, minus all liabilities and claims ahead of the issue.
Free cash asset value assumes that the other assets of a company are enough to meet the liabilities ahead of the common, then the cash will be deducted to meet the balance of the senior claims ahead of it.
The asset-value is not as important as people think, because it has no real relation to earnings power; earning power and dividends are much more important when valuing a stock. But, it should not be ignored; the wise analyst will follow these rules:
1 - a safe bond or preferred stock almost always requires an ample margin of tangible assets over the senior claim, together with adequate earning power.
2 - paying many times the asset value for a common stock may be hazardous. also, purchasing a common stock at only a small fraction of asset value carries with it certain speculative possibilities.
3 - valuing or appraising common stock is dependable when the earning power is not more than the book value. A good combination of factors for purchase of stock include: earning power value, book value, and average market quotations in the past.
4 - a market quotation well under current asset value has significance - either the price is too low or the management needs to change its policies in some way.
The current ratio (assets versus liabilities) should be at least 2 to 1 and should also be compared with others in the same field.
Another measure of financial strength is the acid test. The acid test is: current assets exclusive of inventories should be at least equal to current liabilities.
Bank debt is not a problem in and of itself, but it is frequently a sign of weakness and requires careful observation.
A better way to calculate true earnings than adding up reported profits is to add the increase in surplus (and surplus reserves) and dividends paid. This is advantageous because earned surplus generally includes all gains and losses, while some may have been excluded in the income statement. All voluntary reserves must be included in earned surplus. Be careful not to include the changes in owner's equity that are not caused by earnings and cash dividends, ie. repurchase of shares by the company, extraordinary write-ups/downs of assets. These cases are usually cleared through the capital and capital surplus accounts and do not affect the earned surplus account.
In summary, when analyzing a balance sheet:
- all companies should state the value of their fixed assets for insurance purposes, or supply some other guide to their present value.
- companies on a LIFO basis should also give the replacement value of their inventory
- the statement of capital and surplus should clearly show the real claim of prefereed shares, for principal and back dividends, as against the total fund.
Thursday, March 5, 2009
Wednesday, March 4, 2009
We have learned how to do this process to the income statement by doing the following steps:
1 - eliminate nonrecurrent items from single year analysis, but include them in long term analysis.
2 - exclude deductions or credits arising from the use of contingency and other arbitrary reserves
3 - place the depreciation (or amortization) allowance and the inventory valuation on a basis suitable for comparative study
4 - adjust the earnings for the operations of subsidiaries and affiliates to the extent they are not shown
5 - as a check, reconcile the allowance for Federal income tax with the reported earnings
Now, it is time to put this into practice. We cannot effectively perform these tasks without practice, so, to begin practicing, you can order company reports free of charge from http://mreports.ar.wilink.com/
Now we will move on to the balance sheet...
$0 - 50,000: 15%
$50,000 - 75,000: 25%
$75,000 - 100,000: 34%
$100,000 - 335,000: 39%
$335,000 - 10,000,000: 34%
$10,000,000 - 15,000,000: 35%
$15,000,000 - 18,333,333: 38%
Personal Service CorporationsPersonal service corporations are subject to a flat tax of 35% regardless of their income.
Personal Holding CompanyPersonal holding companies are subject to an additional tax on any undistributed personal holding company income. (Code Sec. 541)
2000 and prior years 39.6%
Accumulated Earnings Tax - In addition to the regular tax, a corporation may be liable for an additional tax on accumulated taxable income in excess of $250,000 ($150,000 for personal service corporations). (Code Sec. 531)
2000 and prior years 39.6%
Monday, March 2, 2009
Now we will learn the final step of income statement adjustment: comparing the reported earnings to the income tax deduction.
This is necessary because many reports vary significantly - if the results are significantly different, the analyst can question the dependability of the published income.
There are many different reasons why the income accepted for tax purposes has charged to it less than the standard percentage rate of corporate tax:
- net income below a certain amount
- carry-forward or carry-back of losses
- income received on state or municipal bonds is tax free (rarely of importance)
- dividends from domestic corporation have a lower tax rate
- gains realized on the sale of capital assets
- mining and oil companies can use "percentage depletion", insstead of acounting depletion based on the book cost of the properties
- most investment companies or funds are allowed to save paying taxes if income is distributed to stockholders
The management of the company may do any of the following, which cause the reported income to differ from the taxable income:
- charging depreciation at a different rate in the income statement than the tax return
- by use of voluntary reserves
- by placing certain debits or credits into the surplus account, but including the tax result in the income account
The analyst should decide whether depreciation is correct or not compared to the tax deduction; if not, he should change it to fit accordingly.
On the subject of reserves and taxable income, Graham says,"When inventory is valued at LIFO for tax purposes ther are no resulting inventory reserves and no related difference between reported and taxable income. But when the LIFO result is obtained by setting up reserves, not recognized for tax purposes, a difference will, of course, be created."
One will find discrepancies from reserves in cases of:
- amortization of past-service pension payments
- operating reserves
- contingency reserves
Charges and credits through surplus accounts, where the income tax charges or credits are reflected in the income account, can distort earnings in various ways:
-losses or gains on property sales cleared through surplus
-bond discount charged off and redemption premium paid
-interest during construction
So, an analyst should determine why the reported profits and those indicated by the tax deduction differ. In the case of dividends or tax-free interest, no action is needed. If it is due to capital-gains, the anlyst should separate these from ordinary profits. In oil and mining companies he will expect a smaller tax allowance.
In the case of a carry-forward from a past-loss, the analyst should restate the earnings with a normal tax deduction for the profits.
If the reported earnings differ because of reserve entries, the analyst should exclude them and re-calculate the results.
If he finds a significant discrepancy which he is unable to explain, he should contact the company's treasurer.
Companies' treatment towards the reporting of the results of subsidiaries and affiliates varies:
includes all subsidiaries
consolidated statements with exceptions:
similar to above but may lack things such as partially owned or foreign companies
largely unconsolidated statements:
lack most information about subsidiaries
affiliates as distinguished from subsidiaries
Next, we learn that some companies draw upon their unconsolidated subsidiaries in the form of special dividends to boost profits during a poor year. An analyst should include all important profits and losses pertaining to the company - adjustments are not necessary if they are, in total, less than 10%.
How do we deal with the question of "do losses in a subsidiary necessarily reflect the quality of the parent company being studied?" Perhaps, if the company could be run the same without the subsidiary, then they could be segregated and the loss of the subsidiary shown as a temporary loss, but if the company relies on its subsidiary as an important part of its operations, then it should obviously be included in the analysis, and the loss should be deducted from normal earnings.
Thursday, February 26, 2009
While the cost of a company's assets serves as the appropriate basis for computing depreciation, this is not the case for the investor, because the investor is buying these assets at a different price than they cost the company.
The book value of an oil company is $35 million, but the stock was priced so that the investor would be paying $88 million, then the investor would be paying $53 million more than the book value. The oil company receives revenue from oil royalties, but it also has oil holdings still underground. The company carried the holdings at no value on its balance sheet, so it did not amortize them. The investor, however, in actuality, is paying $53 million for the holdings, so he should properly amortize the oil holdings.
Another oil company carries producing leases, and the company is earning $3.44 per share. An investor would be paying $34 million more than the book value of the company. It is possible that the company's nonproducing royalties and undeveloped leases, which cost $2.6 million, are worth much more than that, enough to make up the difference. However, this is a very speculative operation, so the investor should mark up the depletion charge to include the $34 million, which reduces the earnings to practically nothing.
A counterexample: A coal company's stock was $9.30 per share, but the net current assets were $20.50 per share. An investor would be getting the plant account for free, so he need not be concerned with the amortization.
It appears that the company's own amortization charges are irrelevant, and the investor should always do his own calculations. While this is true in a strict sense, in most cases the earnings would not be affected this significantly by any changes to the company's amortization charges; the company's charges are usually close enough that an investor need not make his own calculations.
An investor should always pay attention to the value of the fixed assets - the company's amortization charges should be looked at in relation to the value of the fixed assets implied by the stock's current price. If the stock's price is considerably above book value, then the investor can assume he is paying for the present replacement value of the fixed assets, in which case, he would calculate depreciation based on this present-day value instead of the lower original cost.
Of course, the present-day replacement value should replace book value, but no more. If the stock's price is still higher than the value of the fixed assets after the present-day adjustments, then the balance can be ascribed to goodwill or some intangible asset.
Like stated earlier, if a stock's price is less than the working-capital alone, then the investor would not use any depreciation. But, he must not ignore it and count it as additional earnings, because the company may use this for replacing fixed assets or expansion over the years.
Expended depreciation is just this - when the investor reduces depreciation to a figure approximating the replacement/expansion costs, over about ten to fifteen years in the difference would then go into surplus earnings, to benefit the stockholders. To find the expended depreciation, the investor should subtract the decrease in the net plant account from the total depreciation charges for the period. Be sure to include any substantial sales of property or write-downs charged to surplus (added back in to the plant account) before making this calculation.
An example would be a company who's depreciation charges ate up all the reported earnings, but the stock price was at a level where the investor was paying nothing for the plant accounts. He would reduce the depreciation figure to the cost of replacement/expansion, and the balance he would realize is accruing to the stockholders.
Obsolescence is a type of depreciation, but it is more properly thought of as an adverse business development which affects the earnings potential of the company.
Companies have a trick, where they devalue an asset to a low price, say $1, in order for them to save the depreciation charges against income. This leads then to companies with high value assets being worth less than an identical company but with low value assets, because the depreciation charges are higher for the high value assets. This is absurd, but makes sense on Wall Street. This can lead to radically different earnings reports, which will affect dividends (if a company "doesn't make any money" then it cannot pay dividends). A businessman would determine the reasonable value of the companies by examining their assets and charging only necessary depreciation.
Monday, February 23, 2009
- deprecitation (and obsolescence), replacements, renewals, or retirements
- depletion or exhaustion
- amortization of leaseholds, leasehold improvements, licenses, etc.
- amortization of patents
There is a controversy about whether to allow depreciation based on the original purchase price or the current replacement cost. Many companies that argue for replacement cost depreciation fail to mark up the replacement value for the item being depreciated, which they should. These companies vary in the way they introduce depreciation into the income account (both are designed for increasing the depreciation allowance)
over-all depreciation on replacement cost
This method is the practice of charging depreciation to the estimated increase of fixed assets to their future replacement cost.
immediate write-downs of new plant facilities
This method is the practice of charging depreciation to newly constructed fixed assets to offset the cost - this method is the polar opposite of the one above. The former writes the fixed assets up to a future value, while the latter writes down the fixed assets to a past value.
Next, we will discuss the rate of depreciation; there are several types
standard straight-line method
where a fixed annual percentage of the cost of each type of facility is deducted.
rates arbitrarily different from those tax-allowed
companies either charge less depreciation than allowed for income tax purposes, or they charge more. When less is charged, profits are boosted. When more is charged, the profits are lowered in a conservative fashion. The security analyst will need to adjust the earnings accordingly in these scenarios.
rates varying with use
This is sometimes designed for above-normal use of the facilities, but often times it is not.
Rules of thumb for dealing with the different depreciation practices
1 - amounts should not be adjusted when minor
2 - do the same for each company in the same industry
3 - strongly favor the income tax figure over a significantly different allowance adopted by the management in its reports to stockholders
4 - the security analyst should accept or develop figures differing from the income tax figure in exceptional cases where the figure will supply a better clue to the stockholder's position. Be sure that it corresponds to the value of the fixed asset.
In oil and mining companies, there are two different methods of depreciation calculating authorized, percentage depletion and discovery depletion.
In percentage depletion, the company may deduct a specific percentage of gross income for the property or 50% of the net income, whichever is lower.
In discovery depletion, the cost is marked up to a higher value established by the discovery of minerals in the property after the purchase was made, and then amortizes such value in lieu of the cost.
Oil companies can use either method, whichever makes the lower tax, but mining companies can only use the percentage depletion method.
Mining companies sometimes disclose depletion in both the income account and the balance sheet, sometimes only in the balance sheet, and sometimes in neither the income account nor the balance sheet. The stockholder should be aware of which companies deduct their depletion charges in their reported earnings and those that do not.
Oil companies depletion charges are more representative of the cost of doing business than in mining companies; mining companies will write off the cost over a number of years, but because a new oil well may use up to 80% of its total output its first year, oil companies depletion charges are more respresentative of finding new leases and new wells.
Companies are allowed to amortize the intangible assets of patents and leasehold interest; the charges can be made against surplus to avoid reducing earnings. Good-will, however, amy not be amortized for tax purposes, but is often contained in published statements; this is to show hte "purchased good-will," or the amount paid for a business in excess of its net tangible assets.
Depreciation and inventory valuation go hand in hand in corporate income analysis as they both affect the income of the company. The standard method for evaluating inventory is to carry the items at cost or at market, whichever is lower. For depreciation, the practice is to write down each item from cost to salvage value by regular charges against the income extended over its expected life.
When examining inventory and depreciation, the security analyst must decide how to treat both in order to calculate correctly the normal earnings for the company, and he must also be sure to apply the same treatment to other companies in the same industry so that he can compare accurately.
The two standard methods for calculating inventory are FIFO (first-in, first-out) and LIFO (last-in, first-out). The methods vary considerably, and both often show different earnings for the same transactions. LIFO is more stable, as normally it will show the true profits for each year, when FIFO can be confusing. However, if the current price of the items drops below original cost, LIFO will be subject to irregularities as well.
Next, we learn of the normal-stock method. Using the normal stock-method, one will write-down all items to a very low price, so low that the market-value of the item should never fall below the marked price. The usual normal-stock method allocates a large portion of the total inventory to this normal-stock pricing, with the remainder kept under FIFO or a current-replacement-cost method. When part of a normal-stock inventory is sold, it is necessary to charge earnings with a reserve for the replacement of the deficiency; thus, it cancels out the large profit made on the sale.
Next we will look at contingency reserves.
Contingency reserves are reservations made to protect against future events, either being charged to earnings or surplus, or charging it to profit and loss after the payment of dividends.
Basically, a company, during a good year, would take out a reserve on the earnings, thereby showing smaller earnings for that year. Afterwards, during a bad year, they would charge the shrinkage to the reserve instead of current earnings, making the earnings appear higher.
Some companies execute a different strategy - taking reserves out during a good year, but they charge it to accumulated surplus instead of current earnings; this way, the current earnings are still high. During a bad year, they can charge the shrinkage to this reserve; thus, the losses will not be reflected in the income account in any year.
Some companies apply a different strategy; they will take out a similar reserve during a year when they have a deficit, and then they will boost their profits the next good year. The reason for this is that stock prices are indeed affected by a deficit, but the amount of the deficit isn't very important. A $4 deficit isn't much better than a $6 deficit (in the market's mind). Profits also influence the stock's price; however, the amount does make a big difference. A $6 profit is much better than a $4 profit. So, the company will take out the reserve during a year where they are already negative anyway, because not much will change. Then, the next good year, they can boost profits. In a sense, they are boosting profits for free.
An idea held by some is that the reserves should only be connected with the surplus accounts and never the income. This way, the earnings will never be affected. The reserves instead will serve more like a warning or a good omen. When the security analyst examines these reserves, he should adjust them to follow this method, so that the company's operating results are more reflective of the true earnings. He can make an exception for LIFO inventory reserves, however, to adjust for the differences in market values of the inventory items.
In conclusion, we see that the "real" purpose of reserves is to skew earnings to make them appear more favorable, except in the case of inventory reserves for LIFO calculations, where it serves to absorb the rise and fall of market values of the inventory items.
There are three prominent types of reserves:
These serve to mark down assets against
- receivables (for doubtful accounts)
- against fixed assets (depreciation/amortization)
- mark down marketable securities to current price
- mark down inventories to a figure below cost and market value
These serve to reflect liabilities arising from the past, such as
- taxes (when nonrecurrent or amount is uncertain)
- workers' comp/benefits
- profit sharing/bonuses
- claims in litigation/similar liabilities
- losses, unearned premiums, policy reserves (for insurance companies only)
- injuries/damage (for transportation companies only)
- recapture of subsidy (for shipping companies only)
- unexpired subscriptions (for publishing companies only)
Reserves Against Future Developments:
These serve to account for possible future losses.
When reserves appear on the balance sheet, they appear explicitly or by reference by charges to the income account, a surplus account, or the capital account (this is rare, except in public utilities).
The readers will notice that the rules for the treatment of reserves in corporate income accounts are similar to the rules for the treatment of nonrecurrent items:
1 - small items are to be accepted as reported (all together they should total less than 10%)
2- reserve appropriation allowed for income tax purposes should be considered ordinary deductions from current income, unless they relate clearly to a nonrecurrent item
3 - reserve appropriations not allowed for income tax purposes should be ordinarily excluded from the income account (added back to) The use of such reserves will likely benefit the income account of future years, which makes a single year's analysis less reflective of the actual conditions prevailing in that year.
Sunday, February 22, 2009
We start with the 3 major divisions of the analysis of a corporate issue: the company's business and properties (to include historical data and management), financial material (capitalization, record of earnings and dividends for a number of years, a recent balance sheet), and the prospects of the enterprise and the merits of the security.
We learn of the different types of analytical studies.
The prospectus includes a discussion of factors that may make for large or small profits in the future, but it lacks any industry comparison, and it lacks a recommendation on buying the issue for investment or speculation.
Brokerage-house releases usually have a conclusion, and that is to buy the issue. It can be argued that they are not analytical studies at all, but a disguised sales pitch.
Reports by investment services, such as Fitch, Moody's, and Standard & Poor's, are analytical reports and usually include a recommendation on the attractiveness of the issue.
The study of corporate income accounts can be classified under three headings:
1 - the accounting aspect - what are the true earnings for the period studied?
2 - the business aspect - what indications does the earnings record carry to the future earning power of the company?
3 - the aspect of security valuation - what elements in the earnings exhibit must be taken into account, and what standards followed in endeavoring to arrive at a reasonable valuation of the shares?
Next, we learn how to adjust the income statement to bring about the true operating results:
1 - eliminate nonrecurrent items from a single year analysis, but include them in a long term
2 - exclude deductions or credits arising form the use of contingency and other arbitrary
3 - add in depreciation (or amortization) and the inventory valuation on a basis suitable for
4 - adjust earning for operations of subsidiaries and affiliates if not shown
5 -reconcile allowance for federal tax with reported earnings
There are two types of nonrecurrent items:
events from past years
- payments of back taxes/refunds not previously provided for, and applicable interest
- results of litigations and other claims from prior years (renegotiations, damage suits, utility
events in the present
- profit/loss on sale of fixed assets or investments in a non-investment company
- adjustments of investments to market value; write-down of non-marketable investments
in a non-investment company
- write downs and recovery of foreign assets
- proceeds of life insurance policies collected
- charge-offs in conection with bond retirement and new financing
The mark-ups and mark-downs are not considered real, neither are the profits and losses from the sale of major fixed assets. However, if there is repeated sales of fixed assets, then they are considered real and should be included. Because of non-recurrent items, the earning power and intrinsic value of a company cannot be determined from a single year.
Graham has developed three rules to follow for dealing with non-recurrent items
1 - small items will be accepted as reported (all together they should not exceed 10%)
2 - after excluding a large item, one must make an adjustment for the income tax deduction
3 - most nonrecurrent items will be excluded from a short term analysis but included in a long
When analyzing financial companies, results in a single year are unimportant, because of fluctuations in the general market. When looking at the long term, you should look at two years that have approximately equal market conditions. This way, a fair comparison can be made.
Why must we learn accounting, if we don't want to be an accountant? It is because accounting is the language of money. This is best explained by an analogy:
As a child, we learned our ABC's. After you learned them, you could open a book, and you could say the name of every letter in it. While you may think you understand the book, but you really can only recognize the letters. An older child has learned how to put letters together to make words, and he can point out and say each word in the book. But, he still does not understand the story in the book. Only after much practice can people read and understand the stories in books.
The same principle applies to accounting. Most people can recognize the numbers, but that's it; this is like the child who can recognize the letters. Others have learned some basic accounting, and can recognize the different statements and what each mean; this is like the child who can recognize words. But, some people can read and understand the stories behind the financial statements. These people are who we strive to be.
Accounting really is a foreign language. Fluency in accounting gives one x-ray vision into a company. A medical doctor does not see the human body as just a human body - he sees the body as a collection of interconnected systems: the circulatory, the skeletal, the muscular, the nervous, etc. When we are fluent in accounting, we see a company as a collection of interconnected systems. We can look and see which parts are good and which parts are bad, and we can see clearly if it is a good company or a bad company.
This skill is critical. We must become financially literate.
This is the nightmarish portion of the book, but this part is critical to our studies. If you find that you are really having too much trouble understanding this part, then please discontinue your studies until you have a better grasp on accounting. Do not be discouraged by how dense and dull this part is, because this part will make us rich.
In most minds, bonds are considered safe, and preferred and common stock are grouped together. These opinions are probably due to the names of the securities.
Graham objects to this classification. He instead proposes a new one:
I - Investment bonds
II - speculative bonds
speculative preferred stock
- low grade senior issues
III -common stock
These items are not to be taken as is; we use the names of each security because of the behavior of each security. Therefore, if you have a common stock, but it acts like a bond, it falls under category I. Category I is safe and stable. Category II is more speculative and fluctuable. Category III is anything that fluctuates greatly and is not safe or stable.
Preferred stock is better grouped with bonds because they behave more like bonds than they do common stock. Preferred bonds are a claim on a fixed amount with a definite dividend; therefore, they fall into the same category as bonds. Readers should keep in mind that in each of the categories of bonds, preferred stock, and common stock, there is a huge number of variations. So, when deciding which category the security belongs in, do not categorize it based on its name, but its behavior.
-nature of the business
-relative position in the industry
-physical, geographical, and operating characteristics
-character of the management
-outlook for the unit, industry, and business in general
while quantitative factors include:
-earnings and dividends
-assets and liabilities
It should be noted that many companies are overvalued because of the character of the management. It is listed separately from high earnings, when, in reality, high earnings means the management was good. This is "counting the same trick twice."
We also learn about trends. While most people think it is quantitative, because it has numbers, it is really qualitative, because it is uncertain. Trends are not useful for qualitative analysis, either, because it defines a definite prediction; as investors, we avoid predicting definitively.
Before, we mentioned that, as investors, we try to guard against the future. Three ways that Graham suggests to offset a hazardous future are:
-to require a large margin of safety
-inherent stability in the company
*this is not a deciding factor, it is only to be used as a supplementary reason, and only when using sober judgement
In a nutshell, we the quantitative analysis is necessary to arrive at a conclusion whether we should buy a particular stock or not, but qualitative factors must also check out well.
Companies that are required to file with the SEC will have a:
-annual report (10K)
-interim figures (10Q)
You can also find information in trade journals or other official documents. Or, you can request information from the company.
This chapter emphasises that you as a stockholder are an owner of the company - you are the employer of the company's officers. Therefore, you have the right to have your questions answered.
Instituions that invest fall under three main groups, the first having the most amount of government control, the second having partial government control, and the third having no government control.
- life-insurance companies
- mutual savings banks
- "restricted" trust funds
- commercial banks (including trust companies)
- fire and casualty insurance companies
- unrestricted trust funds
- most philanthropic and educational institutions
- regulated investment companies (investment funds, mutual funds, investment trusts)
For individuals, there are two types of investors: defensive and enterprising.
The defensive investor is one who wants to invest passively - this is not us. He should place part of his funds in treasury bonds or similar, safe investments, and the other part into a diversified list of common stocks of big companies bought at a reasonable price. For the average person, we think this is the way to go.
The enterprising investor wants to invest actively, to put a lot of effort in to his investing - this is us. The enterprising investor follow no strict guidelines - he may employ part of his funds into something like the two-part plan of the defensive investor while employing the rest in more aggressive operations, or he may do something else.
We learn about tax considerations. For example, when choosing between a taxable and tax-free bond it is best to calculate to see which will give the higher return in the long haul.
We learn about formula timing plans, which is basically the idea of selling some shares when the market goes up and selling some when the market goes down. This is a good technique for the average person because it allows him or her to sell when the prices go up and buy when the prices go down.
Lastly, we are also introduced to dollar-cost averaging, which is the practice of regularly putting a certain amount of money into a stock or group of stocks, which is a good technique with proven results.
Many people believe that investment is:
-for permanent holding
-in safe securities
and speculation is:
-purchases on margin
-for a "quick turn"
-in risky issues
but, he shows examples of investment that fall under all the speculative criteria listed above. So, these are not good guidelines. He arrives at the proper definition of:
An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory rate of return. Operations not meeting these requirements are speculative.
We agree with this definition.
Next, we learn that an investment must be justified on both qualitative and quantitative terms.
We then take a look at speculation and how it is affected by analysis - the value of analysis is lessened as the factor of chance increases. There is intelligent and unintelligent speculation, but we will study neither of these. We are investors.
He gives us an analogy of speculation versus investment. In the game of Monte Carlo, the odds are 19 to 18 in favor of the proprietor. In an speculative operation, the analysis would allow somebody to win MORE if his number turns up on the roulette table, but it only helps if the element of chance is on his side. In an investment operation, the investor would reverse the odds to 19 to 18 in his favor, so, whichever number turns up, he is certain to win a moderate amount.
Next, we learn of what is perhaps the most distinguishing factor in our investment strategy, the margin of safety concept. This is gives us room for error. For bonds and preferred stock, the margin of safety is determined by the excess of earning power over dividen and interest requirements, or, rephrased, the value of the enterprise above the senior claims against it. For common stock we find the margin of safety by the excess of calculated intrinsic value over the price of the stock. This approach does not usually work with the biggest companies, so, for them, there is another margin of safety: the excess of expected earnings and dividends for a period of years above a normal interest return.
Finally, we learn of the concept of diversification. By diversifying, you reduce your chances of loss - if you make a mistake, it won't affect your whole portfolio. While this is taught in the book, I personally do not believe in diversification. Money works best when concentrated. Warren Buffett touts Security Analysis as the greatest book on stock investing, but he himself said that diversification is a valuable tool against ignorance. When he was studying under Graham, he invested almost all of his funds into GEICO, even though Graham was telling him to diversify the whole time. So, for our purposes, we will study Graham's principle of diversification, but we will not adopt it into our investment strategy.
We learn about second-grade senior securities, which are subject to large fluctuations, and are below the rating of high-grade senior securities. There is a maximum price, which is the amount the bond or stock is worth.
We learn that there are many factors that influence the price of common stock, both quantitative and qualitative. Also, people's opinion of the stock influences the price. There is a central value, which is the average of what the stock is worth on its particular trend. We learn that the stock's intrinsic value and market value converge over time. We learn that, when the general market is very high, one should be wary of buying even good deals. Finally, we learn that marketability is always secondary to value.
The information in this chapter is pretty basic, feel free to make test materials for yourself if you are having trouble remembering what was said.
While Mr. Reed has many good points about the truthfulness and usefulness of Kiyosaki's book, I must say that I have to respectfully disagree that Rich Dad, Poor Dad is a bad book.
Sure, Rich Dad is probably a made-up character. Sure, Kiyosaki's claims may be incorrect. But, he does enlighten people who know nothing about money to what is financially possible. He did for me. Rich Dad, Poor Dad was the first book I ever read about money. Before then, I never knew that you could buy things that paid you. I never heard that your money can "work for you." Sure, this may be a very basic principle to many people out there, but, to a lot of us, we've not heard of some of these basic principles. I was not raised rich. My parents are not rich. I never knew that I could buy things that paid me. What a concept!
This book changed my life. I have recommended it to many people, and it has changed their lives as well. Sure, Rich Dad, Poor Dad doesn't teach anything specific on how to make money, and many of his examples are wrong. But, what he does do is open up a whole new way of thinking for those of us who didn't know this way before.
I do not expect this book to help me with specific investment strategies or to provide me with quality information; for that, I read more serious books that have substance. Still, Rich Dad, Poor Dad holds a special place in my heart; I still recommend it to those who are starting from scratch and who do not come from wealthy families. It is not an answer-all, but it sure is a great book to begin with.
Saturday, February 21, 2009
In selecting securities to buy, you must first describe them, you do this by taking standard calculations provided by investment services, adjust them to find true operating results, and then compare them to others in the industry. (for those who do not know, securities include stocks and bonds)
In selecting senior securities, one will be sure that the company issuing the security has ample money to pay it back.
With common stock, there are two approaches. Some people believe that the market always prices stock correctly, while the approach we will be studying is different. We believe that the market is not always accurate, and that companies have an intrinsic value, separate from their current price.
I have created a worksheet and answers below for your studies.
1 - The three functions of security analysis are the descriptive, selective, and critical functions. When analyzing, one will follow this order. Explain the different levels one may use the descriptive function.
The descriptive function, at its surface level, consists of standard calculations usually given by the company to investment services. One can do a deeper analysis, which is the adjustment of these figures to reflect true operating results. At the deepest level, one ranks favorable and unfavorable factors of the issue, such as changes in position over the years, comparison to others in the industry, and future earnings assumptions.
2 - Explain the selective function, how senior securities are valued, and how common stocks are valued.
The selective function serves as a tool to select issues. For senior securities, the difference in valuation among analysts is not large. The usual method is to require an ample margin of safety in the past, which should protect against a bad future.
The difference in common stock is large. The anticipation approach is outdated. The value approach consists of finding an intrinsic value of the company and buying when significantly low. The usual method is to take the indicated average future earning power and multiply it by a capitalization factor. It is most useful in cases of extreme disparity between market price and value, and also when comparing with others in the industry.
3 -When the interest rate of a bond goes up, the price generally _____.
a) goes up
b) goes down
c) is unaffected
d) spikes up, then goes down.
4 - What are second-grade senior securities? Are the prices steady? Is there a cap on how high their price is? If so, how is that cap determined?
Second-grade senior securities are bonds and preferred stock below that of high-grade senior securities. Their prices are subject to large fluctuations, and they can rise only as high as their maximum price, which is determined by their interest, dividend rate, and call provisions.
5 - What is the central-market value? How do stock prices differ in relation to their CMV in leading issues versus secondary issues?
Central market value is the average of ups and downs in stock’s price. It is generally accurate among leading issues, but secondary issues are usually below CMV.
- civil obligations
- stocks and bonds of corporations
Basically, this means that the securities are either issued from the government or from private companies.
Below I have devised a sample test with answers to help in your studies.
1. What are the objectives of security analysis?
a – to present facts regarding a stock or bond in an informative and useful way to a prospective buyer
b – used to reach dependable conclusions based on facts as to the safety and attractiveness of something at a current price
2. What are the 5 problems that concern every investor? Explain them.
The General Price Level – the general prices of everything in an economy (goods, services, etc) due to the effects of inflation and deflation.
Interest Rates – usually increase with government spending (deficit) due to inflation, but can be held artificially low. An investor is concerned with interest rates because, in the case of bonds, it will determine which types of securities he should invest in. If safer bonds have similar yields, then he should pick them. It is thought that there is correlation between bond yields and dividend yields on preferred and common stock, but in fact, only preferred stock had followed this trend.
There are two possibilities:
- Dividend yields should be compared with the return on Series E savings bond yields.
- They should also be compared with tax-free municipal bonds.
Business Conditions and Business Profits – the cycle of businesses (used to be
generally upward, but post 1929 had wide fluctuations)
Dividends – generally follow earnings
Security Prices – have followed a pattern since the civil war, except between 1927-1933, which were the result of mass speculative orgy like the South Sea Bubble and the Mississippi Bubble. There is no longer evidence that stock prices move upwards continuously, but it is shown that buying bear and selling bull is a good strategy.
1 – World War I caused ______.
a) sharp inflation, followed by severe deflation, then recovery at 50% above 1913
b) severe deflation, followed by sharp inflation, then stability at 50% above 1913
c) sharp inflation, followed by severe deflation, then recovery at a level just above that
d) severe deflation, followed by sharp inflation, then recovery at a level just above that of 1913
2 – During the Great Depression, the general price level _______.
a) prices declined, then recovered to a level 50% above pre-1914
b) prices declined, and stayed depressed at a level slightly below pre-1914 until
c) prices declined, then recovered to a level only slightly above that of pre-1914
d) prices declined, then recovered to the level they were previously at
3 – During World War II ______.
a) prices immediately inflated, like what happened in WWI
b) prices were artificially controlled and were kept low throughout the war
c) prices were artificially controlled, but eventually gave way to sharp inflation
d) prices immediately inflated, but were later brought down by artificial price controls
4 – During World War I ______.
a) the interest rates were high due to government involvement and financing brought about by the war
b) interest rates were low because of the governmental involvement through financing the war
c) the interest rates stayed the same – government financing affects only the general price levels d) interest rates remained the same due to artificial controls placed on them
5 – In the late 1930s interest rates ______.
a) rose due to New Deal controls
b) dropped because of irregular business, despite the government going into debt from New Deal programs
c) business was returning to normal, so the interest rates dropped. The government debt from the New Deal should have caused an increase, but the New Deal also included interest rate controls
d) irregular business coupled with heavy government debt from the New Deal caused interest rates to rise sharply
6 – Interest rates in World War II ______.
a) Effects from the New Deal coupled with the war financing caused interest rates to rise.
b) Heavy war financing caused the interest rates to rise, despite governmental attempts to artificially keep the interest rate low
c) Heavy war financing caused no effect due to governmental controls
d) Interest rates dropped because of governmental controls
7 – Stock prices during the World Wars ____.
a) rose each time.
b) Were not affected
c) Fell each time
d) Rose during WWI but fell during WWII due to interest rate controls
The first book we are going to read on stock investment is Security Analysis, 1951 Edition by Benjamin Graham. This book is largely renowned as the bible of stock investment. Pick up a copy of this book as soon as you can. At first glance, it looks like a nightmare. This book is, in some sense, a nightmare. It is thick, long, and dense. But, this book will be our most valuable source when it comes to picking stocks.
We will master this book.
In between chapters, I will continue to post on a variety of topics.
These posts are written from those who are starting from nothing, not for those who are starting in debt, who have even less than nothing.
However, I feel that I must include a section on getting out of debt, especially credit card. Some of us may have messed up our finances in the past, but now have the discipline to control our money, and it is for these people that I am writing this post.
All the savings in my previous post on budgeting will be going towards paying off your credit card debt. Pay the minimum on all, and put all the rest on to the card with the smallest balance owed. Do not worry about interest rates. Get rid of the smallest one first, and, once it is paid off, redirect all the money that went to it to the next smallest card. This applies to everything, not just credit cards. Get the small out of the way, then the next smallest, then the next smallest. It will go much faster than you think.
If your debt is credit card, you should do a balance transfer to a zero percent APR for a year credit card, but continue making the same payments. For example, if you normally pay $100 on your card bill each month, sign up with a new credit card that has zero percent APR for an introductory period, transfer the balance to it, and continue paying $100. You will pay it off much quicker.
Do not worry about spending, emergency, or investment savings. You have your credit cards for emergencies - it will be far more advantegous to you to use the money to pay off your debt.
Continue with this strategy until all debt is paid off (large debts, such as a car or mortgage, are separate, you do not need to pay them off before beginning the saving and budgeting phase).
Once everything is paid off, pat yourself on the back. Congratulations! You no longer have a negative net-worth, you are worth zero, which is certainly better than being negative. At this point, all the money you were using to pay off the debt will become the savings that I mentioned in the previous post on budgeting. Now you can building up into the positive, creating your seed.
The best book to buy for budgeting is How to Make A Fortune Today Starting From Scratch by William Nickerson. The first three chapters focus on saving money. I highly recommend this book to all readers. It might be difficult to find, because it has been out of print for so long, but it is worth the search. In it, he talks, in detail, about how to save money on food, shelter, clothing, insurance, transportation, and entertainment. Read these chapters and follow his suggestions.
We will not make a typical budget. Strict spending limits are impossible to follow, and they become very frustrating. The only definite thing in our budget will be our savings. Saving is a priority above all else - we are not working for free. We make our bosses or clients rich when we work, but we need to make sure that we are making ourselves rich too, until we can afford to focus only on ourselves.
So, have automatically a portion set aside for savings. Some of it will be saving for spending, some will be saving for investment. Say, 50% of your savings goes into a bank account that you never touch, unless it is to buy stock or real estate. 25% goes into your savings account, which will be cash that accumulates for emergencies (you also have your credit cards for emergencies). the last 25% goes into another account - this is your fun money for vacations and expensive goods. Setting up automatic transfers and direct deposits will aid you in saving this way.
Never, ever touch your emergency or investment savings. Don't even look at them. Ever. We will use them later, but, for now, consider that they are non-existent accounts.
Then, you have to pay your bills.
Whatever is left is for your spending on anything you want. Usually, people with spending problems feel guilty in that they spend everything they make. Now, you will continue to have the same habit, drying up everything you have, but you no longer need to feel guilty, because you are also saving.
The hardest part of getting rich will be us saving our seed. We will have to live frugally and save like this for 3-5 years before we can buy our first rental property. This is by far the hardest part of our plan - if we can get past this, we will no doubt succeed in the rest of our plan.
Create a budget, and follow it. Save, save, save.
We will not take part in any risky "no money down" deals; we will not take part in any real estate speculation. We will conservatively save money for a down payment, and we will only buy property when we have sufficient cash reserves saved for emergencies in the property; we will never, under any circumstance, include appreciation of property value into our formula for becoming wealthy. It is not guaranteed, and we do not have a crystal ball. We are not speculators. If it comes, so much the better, and we will utilize it, but if it does not, our plan works still.
This website is for those of us who are becoming wealthy starting from scratch; it is for those of us who have less than $10,000, or even less than $100. For us, we will make a budget first, we will save money, and we will invest in the stock market. Stocks are cheap enough that we can purchase them now - real estate will have to wait. So, to wisely invest in stock, we must adopt certain principles:
We will never try to "guess" a company's future based off of opinions of "experts" - we will buy based on facts. We will not try to predict the future - we are not speculators. We will not buy and sell - we are not traders; we are investors. We understand that the market prices things inaccurately sometimes, and we will buy when we get a good deal. We will be sure that we have plenty of room for error; in the case that we are wrong, we will have a cushion to absorb the impact, protecting us from loss.
To do this, we will study stock investment. But before we do that, we must attend to the first step in our plan: creating a budget.........
Wednesday, February 18, 2009
- Security Analysis by Benjamin Graham
- The Intelligent Investor by Benjamin Graham
- Common Stocks and Uncommon Profits by Phil Fisher
- The Theory of Investment Value by John Burr Williams
Real Estate Investment:
- How I Turned $1,000 into Five Million in Real Estate in My Spare Time by William Nickerson
- Landlording by Leigh Robinson
- Real Estate Exchange and Acquisition Techniques by William Tappan
- Streetwise Investing in Rental Housing by H. Roger Neal
These books are all of substance, and all teach what we consider to be sound investment strategies.
There is, in popular financial culture, a risk-reward curve. The more risk one takes, the more reward one can hope to gain. One might hear "there is always risk" or "you have to take risks."
Conservative investment goes along with meager returns in most people's minds.
We believe this is nothing but gambling, except, unlike gambling, you can choose your odds. While many may call this investment, we do not believe it is so. This is speculating; this is gambling. We believe it is possible to achieve high rewards with little to no risk. Readers must be aware that our opinion is not widely accepted in the financial world; still, we believe we are correct.
The key difference is that we do not try to predict the future. People buy stock because they believe it will go up; people buy houses because of the incredible appreciation of property value they hope to achieve; people buy commodities because they hope it will go up. For most, this is gambling. For some, it is sophisticated gambling, or intelligent gambling. Even those who do plenty of research will find themselves in this realm which we call sophisticated gambling. In fact, most so-called research is only of others opinions of what the future may hold.
The problem with this method is that nobody has a crystal ball; nobody can predict the future. You can read 1,000 "expert" opinions about what will go up in value, but you still really have nothing substantial to base your decision on. So, do we hope value goes up? Of course we do. Everybody wants their investments to be worth more than they paid for. The difference though is that we do not rely on it. We assure ourselves of a profit regardless of appreciation or not.
Does this mean we are not concerned with the future? Absolutely not. We are very concerned. We are concerned that our investment might go down! So, we make sure we have sufficient safeguards and buffers to protect our investment should it go down in value. We follow the maxim "hope for the best, plan for the worst." When the worst still protects our investment and assures us an adequate profit, then and only then do we consider it an investment.
Tuesday, February 17, 2009
Our philosophy is best explained by an analogy. Surrounded by us everywhere are advertisements on how to lose weight. The magical answer to weight loss could be a pill, a special diet, a surgical operation, or any number of various things. These things all sell because everyone wants the easy way out; however, everyone knows deep down that there is no easy way. The only way is to eat less and exercise more. That means you will have to resist food often, have to work out when you do not want to, and that you will be uncomfortable and hungry most of the time.
We view building wealth as a process similar to the one above. There is no seminar which can show you "the way." There is no easy trick. There are no shortcuts. The only way to attain wealth is to be frugal, study, invest conservatively, and be patient. This means we will have to forego eating at restaurants many times, or we have to sit at home, bored, with nothing to do, so we can save money. This means we will appear to others as poor and incompetent, for we do not partake in many pleasures that others do, because we cannot afford it. We will not be able to take vacations as often as others, and if we are single, we will not be able to impress others with fun, costly activities. We will appear to be poor.
But, we will be rich thereafter. We will be free from work, and we will be free to do what we wish, when we wish, and how we wish.
This means we have a common mindset. We know that delaying our gratification will result in reward beyond what we imagined possible. We know that we are doing the right thing. We know that we will become capable and independent, and we know that we will not worry about our finances. We know that, if we are to have a family, we will be able to take care of them. We will be able to spend time with them, for we are not owned by our boss.
Our time will be ours. Our life will be ours. We will not be pawns in somebody else's game. We will not be a gear in a machine cranking out cash for somebody else. We will be building our own cash machines. We are money-makers.
Here we are honest. We have no shame in talking about how much money we have, or how much we are saving. If we have under $100 dollars, we will be open about it. This website is for others like us, and we will not judge each other. Most of us have had nothing once before, so we understand. This is a place for people with unquestionable integrity. Together we will create money, and together we will achieve freedom.
If you find yourself with a mindset similar to that described above, then this website is for you. This community is starting small, but we will grow into a large one. This is a place where others like us can come to learn, network, and find refuge from a world full of get-rich-quick con artists.