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Month: October 2016

Lesson 006 – Buybacks. The good, the bad and… your call

Lesson 006 – Buybacks. The good, the bad and… your call

Hello, my Dear Readers, this is the Lesson #6 about Investing. And, as I promised in one of the previous lessons, I’m going to talk about stock repurchase programs (buybacks) in this lesson. Many beginners either undervalue (like me 7 years ago) or overvalue buybacks. Both are typically incorrect, and both will have to take bitter pills. I hope this article will reduce the amount of bitter failures in your investment career. Let’ start.

What is buyback

Buybacks is a program by which a company buys back its own shares from the shareholders, reducing the number of shares outstanding. The following example will illustrate this concept better.

The Good

Example: company A cannot expand its business anymore – the business is okay, but already reached its physical limits. So, every year they report a growth on net income, but this is the growth mostly due to inflation and population increase. The management decides that every year they will buy back certain percentage of the shares outstanding.  For me as a shareholder it means that now I own bigger and bigger share of the business: I still own the same amount of shares, but there are less shares outstanding.

Problem 10: Last year EPS was $1. This year 10% of the shares were bought back. Assuming that net income for this year will remain the same, what EPS should we expect? Assuming that the average P/E ratio for the company is 10, what was the average share price last year, and what average share price should we expect this year?

Sounds great. But can be better?

A management of the company typically has the following ways of using the profits:

  1. pay dividends;
  2. re-invest into the core business;
  3. save money for a rainy day;
  4. stock repurchase.

And the answer to the question above depends on the type of investor and a situation with the company. If we talk about an income investor, cash dividends is the preferred way (sure! Dividends is the main incentive for such an investor to buy shares in the first place).  If a business is cyclical, the option #3 can make more sense if the management anticipates next downturn quite soon. If the company still has room for growth, and investing into its core business will be more beneficial for shareholders, the management should prefer option #2. And only if they ladled up all other possibilities, they should consider stock repurchase program.

What happens to the shares?

One of two: either they are physically destroyed (cancelled or retired) or they are stored at a company’s Treasury Stock account (we will talk about this account significantly later, when we will plunge into reading financial statements). In any case such shares cannot vote, there are no dividends on them and they do not count into the shares outstanding. It makes sense: a company cannot own itself!

Problem 11: Why would the management opt for keeping repurchased shares at Treasury Stock account rather than physically destroying them?

The Bad

Example: Company Z  has 1,000,000 shares outstanding. Its net income for previous year was $1 mln. This year the management expects an income of $950,000. The management decided to buy back 5% of shares outstanding to mask this fact. As a matter of fact, EPS will remain $1, same as was last year.

We can see that the management wants to get shareholders tricked by earnings per share statistics. This is so called detrimental buybacks.

If you see that Net Profits declines, but due to buybacks EPS looks okay, steer clear of such companies! (unless, of course, you have a short-term speculative interest).

Shares Issuance

As opposed to stock repurchase you may see that some companies issue more shares. Of course, for you it would be rather bad to see that your ownership diluted as a result. Many investors consider such state of things unacceptable, and I totally understand them. But they potentially can miss extremely good investments by refraining from some of such companies. Please look at the partial screenshot from a company report at below – it shows EPS and buyback stats:


As you can see, EPS grew 5 times and Shares Outstanding increased just 2 times during the same period. Provided that other company’s fundamentals are quite strong, I would put up with shares dilution. And yes, it is a real company… Under Armour Inc. Please, don’t get me wrong, I do not recommend this company in any wise. I’m just saying, that sometimes it makes sense to turn a blind eye on the fact that a company constantly issues more shares.

Thanks for reading and may the good buybacks be with you!

Lesson 005 – Golden Rules of Investor

Lesson 005 – Golden Rules of Investor

This is our next lesson regarding investments. It will be about the Golden Rules, or The Commandments Of Investor. Do not treat this list as just nice-to-know stuff: all these rules are written not in ink, but in sweat, blood and tears of many-many investors. Moreover, one of these rules is extremely important for us as for fundamental investors – I will stress it out later on in this lesson. Off we go!

We will start from briefly listing the Rules. Here they are:

Be ready for the losses.

Investing or business without losses is an oxymoron or Utopia. Nobody can always win in investments world. I can’t remember who said that, but the quote illustrates this fact:

Each entrepreneur at home has a sack, tied up with a red band. This sack contains the shares of companies he owned and which went to wall.

I have a collection of stocks like that too. Even though I don’t have them in flesh – they are all physically were at my brokerage accounts – but I have a list of my investments failures with important conclusions beside each one. I call it my Cemetery of Idiot’s Dreams. Second Cup, Real Goods Solar, GII.UN – to name a few. They either a result of over-excitement and reckless speculations or trace their roots into the times, when I knew too little about fundamental investing. Anyway, I will conclude this part with the words of an old and wise Jewish saying:

Thank you, Lord, that you took just the money!


Don’t be too aggressive

The rule “Don’t be too aggressive” also reads as “Avoid too risky companies”. How to measure the risk? In a way it is already statistically measured by such ratio as Beta. Beta measures volatility of the particular stock in comparison to the market. Beta = 1 means that it behaves exactly as the whole market; Beta = 10 means that this stock will react by 10% change in return to 1% of corresponding market change. So, another reading of the same rule: avoid companies with too high Beta. And, of course, if you speculate and you are aware of what you are doing, this rule is not applicable.

Once again,  most of the companies in your portfolio should give you stable not-risky income.

Problem #7: Take a couple of companies – first to pop into your mind. Please find out their Betas.

If you can’t afford to lose

Again, another very Captain-Obvious rule: if cannot afford to loose this money, do not even think of investing it! This an extreme edition of more general principle:

Your investment vehicle must correspond to your goals and time horizon.

An example: you need to buy a car in 2 years.  It would be a very risky move to invest the money into stocks or mutual funds in this case: if the market goes down, your investment will shrink accordingly, and, if it happens, because of short time span, the market will highly unlikely recuperate by the time you need the money. Some may say: “Yeah, but I will invest into blue chips only!” That’s good, but the market risk affects them as well. Of course, they will probably be less impacted by any crisis and will recover very soon, but all this requires time (and since you need a car in 2 years, you may not want to wait, say, 4 years).



We will talk about diversification in more details later. Just couple of recommendations here.

First – companies in your portfolio should belong to ideally absolutely different sectors and industries (the less interconnected they are – the better).

Second – statistics says that the portfolio of 20 companies is almost same good as the whole market index. Provided, of course, that they belong to not-very-interconnected sectors and industries.

Third – 20 companies in the portfolio is already too many for a newbie and non-professional. 10-12 is already enough for a quite good diversification, but much easier to maintain.

Nobody can predict financial future

Nobody in the financial world can predict the future, including interest rates, stock quotes, oil and commodities prices, market dynamics, frenzies and crises, future values of volatility index and so on. Nobody, including fund managers, journalists and financial experts etc. So, please adjust your expectations accordingly! Don’t get me wrong, you will be able to make educated decisions, relying onto fundamental analysis and common sense, and they will be accurate to certain extent. But nobody can guarantee you anything, so, don’t trust “gurus”.

Invest only in what you understand

This doesn’t mean that you need to be a doctor to invest into pharmaceuticals or a programmer to invest into IT etc. This rule should read: Know the nature of business! An extreme edition of this rule:

Never invest in any idea you can’t illustrate with a crayon. (Peter Lynch)

If someone offers you to buy a shop at the corner, you probably will ask a lot of questions (like what revenue it generates, how much is the rent etc), but the first question probably will be: “What does this shop sell?” But by some strange reason people forget to ask the same question about the companies when it comes to buying them at stock market. Never invest if you don’t understand the nature of business.

By the way, approximately 40-50% of my bad investments (see the Cemetery of Idiot’s Dreams above) in the past can be at least partially explained by not following this simple rule!

Do you remember that in the very beginning of this lesson I said that  one of these rules is extremely important for us as for fundamental investors? This is exactly this one!

And now a fly in the ointment: this rule is easier said than done. Sometimes we think that we know what the companies are doing, but in fact we don’t. For example…

Problem #8: What is the main business of McDonald’s?

Problem #9: What is the main business of payroll companies? Say, ADP?

Don’t have too many companies in your portfolio

Another principle is best explained by Peter Lynch:

Owning stocks is like having children – don’t get involved with more than you can handle.

In our case to handle means at least to read annual reports and follow the major news which can affect the business of them.

Moron-resistant companies

This is the only nice-to-follow rule here. But it is important though. When you assess any business, it is very important not only to make sure that it has a durable competitive advantage, but also that this advantage doesn’t require too much of:

  • research and development;
  • capital expenditures;
  • sophisticated management.

To illustrate this: X is a top-notch software company with durable competitive advantage and perfect management. Company Y is a tobacco company. Y also has a durable competitive advantage. All else being equal, which of them is more moron-resistant in terms of management? Look at X, with its short lifespan of the products, tons of research and development and a cut-throat competition from other rivals – it must be very management-sensitive as opposed to Y.

Ideally, you should invest in the companies which can be managed by a complete moron…

By the way, I like the continuation of this phrase: because sooner or later any of them can get a CEO who is not as bright as a bulb!

The last but not the least – Test yourself at Golden Rules of Investor Quiz if you have digested this article successfully.