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Month: September 2016

Lesson 004 – EPS. What can be easier?

Lesson 004 – EPS. What can be easier?

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This is our investing lesson #4 and the first true fundamental investing lesson.

Many investors should admit: “All what I know about investments I know due to Warren Buffett”. Me too. A lot of things I picked up from Oracle Of Omaha is simple but powerful stuff. Today we are going to talk about probably the most important thing you should know about company’s fundamentals.

Let’s get started!

EPS – The most Fundamental Criterion

If you were allowed to look at just one kind of the company’s statistics and right after that to make a decision whether it is good or bad fundamentally, you should prefer to use the company’s EPS. This is probably the most fundamental one of all the fundamental criteria.

EPS Criterion

EPS should consistently grow with the passage of time.

The idea is very simple: the company is good if its future profits are predictable. Provided, of course, that they are positive and growing. And EPS growth reflects the growth of the profits. Sounds simple? Don’t rush to answer. The following discussion is about the niggles and caveats about it.

Not All Earnings Are Equal

Just an example, a company X has sold one of its businesses. The money they get from this deal will increase profits of the company for this year. This is an example of non-recurring event which boosts net income. But only for one year with a possible negative impact on the future earnings (since the company got rid of the business, the business will not generate profits in future anymore). As opposed to that, a company Y has re-invested retained earnings into the core business, which resulted in 10% growth of profits this year. And highly likely this growth is here to stay in future. You as an investor, which company you would prefer – X or Y?

Detrimental Buybacks

There are some cases when the management wants to mask the fact the business is actually getting worse and worse. They know that investors look at earnings per share. So, even though net profits are lower and lower, smart management starts repurchasing company’s shares. Less shares outstanding – the higher EPS. I.e. if they buy back enough stock, the EPS will still look okay. Beware of smart management!

In one of the following lessons we are going to cover this in more details.

EPS Growth Rate

If a company satisfies the criterion regarding EPS, you can calculate an annual EPS Growth Rate. There are couple of things to know about it:

  1. Its normal average value varies significantly depending on sector and industry;
  2. If you have two companies from the same industry, you should choose the one with higher EPS growth rate, all else being equal;
  3. It is very difficult for any business to maintain annual growth of more than 20%. If you see a higher value, it is recommended to cap it at 20% in your calculations.

And one more thing – as in any standard disclaimer: remember, past performance does not guarantee anything in future.

You need 10 years of statistics

This heading speaks for itself. To make any more or less reliable conclusions regarding any fundamental ratio (EPS in particular), you need a decade of statistics. I would not recommend you to use statistics for less that 7 and more than 10 years – your calculations and conclusions in both cases tend to be inadequate.

A Practical Problem

The problem is very simple: how to practically use this criterion? Yes, of course, anybody can glance at 10 financial statements of a company, skimming just earnings per share values and then apply this criterion, right? But in practice such thing is way harder: if you go to Google Finance, Yahoo Finance, MSN or any other free source, you will find the data for just 4 years. By the way, MSN used to have it, but after they redesigned the UI couple of years ago, it is gone…

As of now, I can recommend just couple of sources of such information – both are paid services – Morningstar and Black Belt Investments.

Outliers

Above we already spoke about non-recurring (one-time) events. They are not limited to just a sale of assets, they also include accidents, natural disasters, any kind of one-time abnormal situation around business. They tend to generate abnormally low or high value of EPS – outliers. There are different techniques how to cope with them (for example, you can get rid of maximum and minimum values or you can straighten it by spline functions – in further lessons we may touch this). The only important thing here is: you cannot ignore outliers.

Baby Buffett Portfolio

Named after Warren Buffett, it is just a set of his best long-term investments. We will need it, because we will refer to them quite often in our problems. Here is the Baby Buffett Portfolio:

  • Nike Inc
  • ConocoPhillips
  • Costco
  • The Coca-Cola Company
  • Procter & Gamble

Problem #5: There was one more company in Baby Buffett Portfolio: Burlington Northern Santa Fe Corp. Please find out what has happened to this company.

Problem #6: Please apply the EPS Criterion to all the companies in the Baby Buffett Portfolio.

Lesson 003 – 3 Rules Each Investor Should Know

Lesson 003 – 3 Rules Each Investor Should Know

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This is the third lesson regarding investments. And here we are going to learn something what can be practically used immediately. Plus, 3 rules we are going to talk about – they belong to a “gentlemen set” of any more or less knowledgeable investor.

Rule of 72

I learnt the Rule of 72 many years ago from the books of a prominent German couch, motivational speaker and entrepreneur Bodo Schaefer.

Let’s illustrate this rule at the example below:

Bodo Schaefer

You want to deposit $100 to bank. Interest rate is 6%. How long does it take to double the investment? Assuming, of course, that all interest generated on monthly basis is re-invested (stays in the same deposit account and generates more interest – aka compounding interest).

Rule of 72 will help us to answer this question quite precisely and very quickly. The timespan to double the investment equals 72 divided by the interest rate:

Years to double = 72 / Interest Rate.

In our case it will be 12 years (72 / 6 = 12).

Some more caveats on this rule:

  • It is also know as Formula of 72;
  • It is an important condition to have a monthly compounding. The rule will not work if payments are less frequent;
  • The same formula is applicable if you answering the questions how long will it take for the money to loose half of its value (buying power) if you know the inflation rate.

Problem #1: Use either an excel sheet or your bank savings account statement to see that the Rule of 72 works.

Problem #2: When you open up a savings account, you are told that it will pay 0.5% interest annually. How many generations of you family it will take to notice that your initial deposit doubled? Provided, of course, that you will not add more money later, that this account will not be amended by bank and that one generation is 30 years.

Problem #3: Provided that an inflation rate is 2%, how long it will take to for your money to loose 3/4 of its current buying power?

Rule of 150

Another great rule from the same author – Rule of 150:

In order to cover your monthly expenses you need to invest 150 times your monthly expenses at 8%.

Problem #4: Apply the rule of 150 to your own (or your household’s) expenses.

3-6-3 Rule

This rule is not very official and it refers to a very simplistic model of how banking system works. Later when we are going to cover the banking system, we will discuss what it has “under the hood” in more details. 3-6-3 Rule states:

A banker would borrow money, giving 3% interest on depositors’ accounts, lend the money at 6% interest and then  at 3pm the banker should be playing golf (constants and time may vary, but 3-6-3 is classic).

This means: the only form of business of a bank is lending out money at a higher rate than the rate paid out to its depositors.

Answers to problems will be added later on, so in one of the upcoming articles I will give an update on that.

Braking Badly, or Some Important Lessons of one MotoTrip

Braking Badly, or Some Important Lessons of one MotoTrip

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Last week my wife and I returned back from our first long motorcycle trip. We left Toronto, went to Kingston, crossed the border of US, then went through New York, Vermont, New Hampshire and Main to Portland, then took ferry to Nova Scotia, and from Yarmouth went back to Toronto, visiting Cabot Trail and Prince Edward Island on our way back.

Our route (from our inReach satellite communicator)
Our route (from our inReach satellite communicator)

That was an awesome  ride! But during the trip I had to learn a few lessons and in this post I would like to share those lessons with you.

Mount Washington Lesson

At all of the motorcycle courses they teach you that you should use brakes rather than engine braking (and they are right: you will better indicate that you are braking to the drivers behind you). Mount Washington Auto Road added a niggle to that. There were 3 motorcycles when we climbed the Mount Washington: our Yamaha VSTAR 950 and  2 Harleys. All of us used engine braking, or to be more correct, we all went down at the first gear. And on top of that we all had to use brakes.

I was the first to get a surprise: in on of the turns when I squeezed my front brake, it almost didn’t make any change to my speed. Thanks God, I was able to stop with the rear one. After that me and my wife (who was a passenger) decided to take any stop possible to cool down the brakes and we stopped almost each mile on the remainder of the road.

So, 2 out of 3 riders experienced the same problem – boiling brakes. The lesson was:

Regardless of using low gear when you are riding down steep and long slopes, when you have to use brakes, be very cautious and make frequent stops to cool down the brakes (or at least, to make sure that the brakes are not too hot). It is possible that you will notice your brakes fading too late, when it is almost or completely gone.

To sum up:

  1. Preferably, no passengers
  2. stop as frequently as possible. Plan this route accordingly (allow time for cooling the brakes down).
  3. watch the traffic behind
  4. don’t use both brakes – in case one fails, you will have another one

Ferry Lesson

Alakai - the boat took us to Yarmouth
Alakai – the boat which took us to Yarmouth

I have a quite good balance – I have no problem to put my feet on the pegs right when the bike started moving. I don’t “walk the bike”. Sounds good? Yes, but not at a slippery deck of the ferry. When disembarking, I had to stop right in front of the ferry’s gate, I put my feet on the deck, but the bike just slips and I had to lift it. Thanks God, due to engine guards and big footrests, it didn’t lay flat on the ground. So, it was much easier for me to lift it. The lesson is:

When embarking to or disembarking from the ferry

  • Avoid having a passenger. Ask him or her to walk.
  • Better walk the bike. Don’t put your feet on the footrests until you can guarantee that the surface is not too slippery.

Well, if you know the ferry pretty well, say, you live at PEI and use this ferry quite often, just disregard this.

Big Cities Lesson

If you ride through any urban area surrounding a big city, like GTA, Montreal etc. – plan your trip accordingly. Do not expect high mileage during that day. Constructions and massive traffic will make it significantly slower.

I hope these lessons will help to make your moto-trips more comfortable and safe. Live free, ride safe!

 

Lesson 002 – Method of Learning

Lesson 002 – Method of Learning

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This is the second lesson regarding investments. And though it belongs to the set “Before We Really Start”, it is important, since here we are going to discuss the methodology of learning.

What to expect

First of all, get rid of delusion that I can teach you. The truth is that you can learn, but I can just assist you in this process. Same as many other things, investing can be learned by yourself but not taught by someone else.

Second, do not expect that you will be given everything. The truth is that nobody knows everything on investments. But you will be given enough to start your own way.

Practice

Some say knowledge is power. Very true, but with a huge niggle: only with practice. Everything you know theoretically doesn’t count, because it cannot change your life until it is used. Do you know the difference between knowing and understanding? Yes, it’s practice: Knowledge -> Practice -> Understanding. No practice downplays your knowledge.

The best illustration of this I can remember now comes from the movie “Men of Honor”:

“Boyle’s Law describes the behaviour of gases under varying amounts of atmospheric pressure…
Now why is this important to a diver? Forget to exhale on the way up, and your lungs explode.”

And when I say the practice I do not limit its meaning to just problems and quizzes from the lessons. I actually refer to making real investments.

Iterative process

Learning is typically an iterative process. You build some model based upon your current knowledge and then test it. Your result helps you to make conclusions and update your knowledge. This, in turn, makes your next model more successful:

The key here is not to quit and repeat iterations until you’ve built your understanding. Why am I pulling Captain Obvious? Because it suddenly appears that we, who fell gazillion of times before we learned to walk and kept trying until got it done, we love to quit and do not apply the same approach to learning more complicated skills, like investments, business etc.

This applied to investments means that you based on your current knowledge make investment decisions, then make investments and build your portfolio. Then you from time to time review your investments, make appropriate conclusions (lick wounds and correct your portfolio!) and update your knowledge:

A word of caution

Be ready for losses. Investing without losses is a chimera!

Be ready to really learn, i.e. to really change your understanding by making mistakes. This path is a great school where your learn a lot. And at the end instead of diploma or certificate you will get a good investment portfolio and financial freedom!

The previous lesson can be found here.