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Bitcoin: No Future

Bitcoin: No Future

Everybody talks about Bitcoin nowadays. They use words like “miracle”, “tremendous”, “unbelievable” and so on to depict the prospects of cryptocurrencies. Some false prophets predict that its price will be chopped in half very soon and they use technical analysis to prove their point. Others naively predict that cryptocurrencies will substitute money and Blockchain will substitute core banking system. All it takes is to announce that your company is going to use Blockchain, and your stock prices could drastically surge overnight! The hype is that big, that even several of my clients in Black Belt Investments were almost “seduced to the Dark Side of Bitcoin”. In this article I’m going to tackle its technical and its financial nature. I decided to put this in writing in order not to repeat myself again and again when telling off somebody else who also wants to invest into Bitcoin. Also, since recently its price dropped quite significantly, so it’s high time to publish this article: maybe it can prevent some impulsive decisions.

Technical Details

If you are technically savvy, I apologize for a maybe too simplistic explanation. I added these technical details, because I saw that many people who praise Bitcoin and Blockchain simply don’t have a clue what all this about.

Blockchain

Say, we have some text:

line 1
line 2

line N.

And we decided to make sure that nobody can change any line. Each line is called a block. In cryptography there is class of functions named hash-functions. When you apply such a function to a block, you get some gibberish. This gibberish will change significantly if you change the block even a little bit. For example, MD5 hash of “line 1” is “22b597f64a2484189f4e3b9a3e0bc73a”, and for “mine 1” (just one letter was changed) is “5bd6c84598094b4b749832cc38969741”.

So, we calculate hash of “line 1” (hash1). Then we add hash1 to “line 2” and calculate hash of this combined line (hash 2). Then we use hash2 the same way when we calculate hash of “line 3” and so on.

What can we achieve by doing this? If some villain wants to change some line, he has to recalculate all the hashes of subsequent blocks. If the chain of blocks is long enough and the blocks are stored in distributed system, hacking it becomes a very tough nut to crack.

This was a very simplified explanation of Blockchain and it models only the main chain. In fact, this directional list allows also so-called orphan blocks aside (please refer to the picture).

Many people, including some of my friends and clients, repeat studied statement: “Blockchain is the technology of the future!” What they do not fully understand, is that yes, Blockchain is a great technology to secure data, but with quite limited area of use. It is effective to make sure that some data stays unchanged, but absolutely useless in majority of cases where we need to delete and update the data.

How Blockchain Used in Bitcoin

That is quite simple: Bitcoin uses Blockchain to store and secure its own transactions. So, the blocks of data in the system look like this: “John Doe bought 10 bitcoins”, “John Doe sold 5 bitcoins” and so on. Yes, yes, all what it does, Bitcoin just secures itself.

This tells me one distinct fact: Bitcoin is a thing in itself. It is not connected to some real world, it is not backed by anything; it is just a decentralized accounting system.

Financial Aspects

Is it a Currency?

No, it is not. Real currencies have legal status. Bitcoin was not legalized as a currency. Many people would retort that you can buy things for Bitcoins. True. But this itself doesn’t make Bitcoin a currency. Yes, some businesses accept bitcoins and sell you goods for them. But they do it only to increase their own private stashes of bitcoins. They cannot pay to any vendor with bitcoins, they cannot pay taxes with bitcoins. Bitcoin for them is a means of barter. It is not a currency.

Will it Ever Become Legal?

Printing money in every country is monopolized (Fed in U.S., Bank of Canada in Canada and so on). If somebodyillegal else wants to coin their own money, it is 100% illegal. Put yourself into the shoes of any center-bank: would you deliberately waive your power? I guess, the answer is no.

Moreover, such a precedent can become very detrimental: the next day after you legalize Bitcoin, everybody will be able to create their own currencies. The history already knows examples of such a chaos: for instance, U.S. was flooded with gazillion of different currencies in 19th century before U.S. dollar became the only currency.

So, my own conclusion is that Bitcoin will never become legal currency.

The Amount of Bitcoins is Constant

You probably know that once upon a time somebody decided to use video cards instead of CPU for mining. You have probably seen mining farms (like on a picture):

MiningFarm

And now let’s look at this from the point of view of videocards manufacturers. Say, you can sell a video card at a price of $100. If somebody buys it and uses for Bitcoins mining, it will break even, say, in 2 months. You, as a manufacturer, give a warranty of 12 month. So, the buyer can use it for at least 10 more months and generate, say, $500 of net income. What is the minimum price you should sell this video card at? I would say, if you don’t sell the videocard and instead use for mining yourself, you will get at least $500. So, there is no point to sell it cheaper.

That’s exactly what has happened to video card prices. The demand increased, and manufacturers detected the reason and increased prices accordingly. Mining became unprofitable.

And since nobody mines Bitcoins anymore, the amount of bitcoins became constant. To be more precise, the amount of Bitcoin is almost constant: still some people mine it, and there are some huge mining farms in China (which, I guess, should belong to video card manufacturers, who can get video cards dirt cheap).

What Drives the Price of Bitcoin?

demand2That’s simple. Just imagine some thresholded resource (above we discussed why the amount of bitcoins is almost constant), which demonstrated growth from its inception. People look at it, see its constant historical growth, and decide to buy. The fact that the amount is thresholded coupled with their desire to buy makes its price higher. Indeed, you have to pay more than the previous owner did in order to convince him to part with this resource and sell it to you. Then next portion of speculators knows about such a precious resource: they also want to buy. And this in turn makes the price to surge again and again. And so on. The miracle is very simple: speculative demand on some limited amount of Bitcoins.

It is not bad, if you are not the last one to buy bitcoins at insane price (the historical maximum was about $20,000). In my opinion, what happens now is that people started to understand that there is no bright future for Bitcoin. I think, that in foreseeable future its price will stabilize at significantly lower mark. It will never get to initial next-to-nothing values, because there are always some believers (or I would call them “people with cognitive dissonance”), who will buy bitcoins and wait hoping that the miracle happens and it becomes a legit currency.

Summary

If we leave technical details aside, our summary is:

  1. Bitcoin is not profitable to mine, so the amount of bitcoins is capped-off;
  2. Speculative demand together with (1) drove it price insanely high;
  3. Very doubtful that Bitcoin will ever become a legitimate currency;
  4. Oh, Bitcoin is currently NOT a currency;
  5. If my assumption (3) is correct, then Bitcoin will drop further.

And the last, but not the least, if you share this opinion, stay away from Bitcoin.

P.S. I have been thinking what kind of caption image should this post use. Finally, I asked my wife and after one or two seconds of thinking she said: “Soap bubble”.

Lesson 008 – Inventorytelling

Lesson 008 – Inventorytelling

It’s been a while since I wrote the last investments lesson. In this lesson we are going to discuss such thing as  Inventory. I think there is no need to define it, because everybody either knows or at least intuitively understands that Inventory is finished goods or raw materials on a balance of the business.

Inventory

According to Karl Marx’s General Formula for Capital, the business process is a transformation of Money into Products and then back into Money (of course, in the ideal world this pile of money is greater than the initial one). The same thing is reflected in Financial Statement of any business: Cash -> Inventory -> Cash. In a nutshell, this is how business functions. Further in our lessons we will talk about how to read the business story from Financial Statements.

Inventory is a pretty important value: as we can see from above, it’s like a blood of a business. And, as many other headings, this one tells not too much just by itself. But the dynamics of Inventory is very eloquent thing. In fact, what would you say when you see that Inventory grows significantly faster than the business itself? Obviously, something is wrong with this business: customers are not interested in buying their goods anymore. And the management doesn’t want to recognize this problem (typically because if they admit this, there will be no quarterly or annual bonuses). That is why this problem is not addressed and Inventory continues to grow. It is very dangerous: if today no one is interested in buying, what makes them to buy same stuff tomorrow? (We are not talking about some seasonal demand). Plus, even if they manage to sell out the Inventory later, it is not going to be very profitable: try to sell the clothes which is out of fashion already, try to sell cell phones or electronics which got outdated yesterday and so on. In other words, growing Inventory can be a HUGE risk.

High-Tech vs Brick-and-mortar businesses

One very important thing to remember is that the more high-tech the business is, the less Inventory it will have. Of course, a high-tech company can have, say, software on its Inventory account, if its business is reselling this software. But generally all what we discuss is more applicable to old school brick-and-mortar businesses rather than IT world.

Additional Metrics

There is one more metrics which goes hand in hand with Inventory. It is Days Inventory Outstanding, or a timespan needed to completely substitute (sell out) the Inventory. It is calculated by dividing Revenue by Inventory and works as a very good business performance gauge.
Example 1: Company X has $10,000 of Revenue per annum. Its Inventory at any time is approximately $1,000 (so called average inventory). It means that its being completely turned 10 times a year (aka Inventory Turnover): $10,000 / $1,000 = 10. I.e. the inventory stands out for 365 / 10 = 36.5 days approximately. So, Inventory Days Outstanding is 36.5 days for this business.

That said, we can formulate what we ideally want to see:

Days Inventory Outstanding must be consistent and should not grow.

Problem 13 What would you say about the company like this:

Couple More Caveats

First, when you use this criterion you actually compare Inventory dynamics with Revenue dynamics. Don’t forget to look at Net Profit Margin and make sure it is consistent! Otherwise, it possible that Revenue grows but Net Income doesn’t or even drops. You don’t need such a Revenue growth. And you definitely don’t need such a business!

Second, how to assess inventory. Sometimes your main motivation is to buy some company is that on its balance it ALLEGEDLY has more assets than its stock quoted. A dream of a value investor! The only niggle is that you must know the exact nature of those assets. And in case of inventory, the rule of thumb is:

The closer inventory to raw materials, the easier to assess how much it costs.

Summary

  1. Inadequate Inventory growth (faster than Revenue and Net Income) is a red flag;
  2. Ideally, Days Inventory Outstanding should not grow and be consistent;
  3. All this is not applicable to Hi-Tech companies (where all this is typically automatically satisfied);
  4. Inventory can be very tricky to assess;
  5. The closer the inventory to raw materials, the easier to estimate its cost.

P.S. I apologize if this lesson was rather boring, but my excuse is that even Elon Musk plans to start a boring company :)

Lesson 007 – Investment Risks: Montana!

Lesson 007 – Investment Risks: Montana!

A group of prisoners is bored to death already: they discussed all the topics possible, told all the jokes they knew and played all the card games they knew. They don’t know how to entertain themselves. So, when a newbie enters the cell, they ask: “What card games do you know?” The new guy says: “Well, I know poker, preferans, whist, ombre, montana…” Everybody is curious about this new game, montana, so they say: “Let’s play montana!” The newbie say: “Okay, the game is so simple that you will get the rules down the road. Let’s start!”
So, the deck is shuffled, and each player receives six cards. Our hero gets up, throws his cards on the table and says: “Montana! I won.” And takes all the money. Everybody looks adverse and puzzled, so he explains: “Whoever gets up first, says “Montana” and throws his card on a table, wins. Very simple.”
Everybody grins and offers to play again. The new guy is shuffling the deck again and is handing over 6 cards to each player. While he is doing this, everybody who just got cards, gets up, throws the cards on the table and says: “Montana!” Our hero is the last to take his cards. He waits till the last one throws the cards and says “Montana!” Then he slowly puts his cards on the table, and says: “Trump montana! I won again.” And takes all the money…

(An old-old joke)

In fact many people repeat the same mistake when it comes to investing: they don’t know about trump Montana! In this article we are going to discuss the most remarkable risks you definitely will face investing. First we will list the most important risks. Last and foremost – we will discuss how to mitigate them.

Market Risk

Pretty much everybody knows about this risk. It is the most obvious one: if you invest in stocks or mutual funds, be ready that if the whole market drops, your investment will highly likely drop too.

The most important question here is: how much will the drop of the market affect my investment? The answer for each particular publicly traded company is in its beta. For example, the Beta for MCD at the moment of writing is 0.64768:

It means that if the market drops today by 1%, McDonald’s will drop accordingly by 0.64768%.

Such a risk is called systemic: it affects the whole system, i.e. entire market or financial system. There are also non-systemic risks – they affect particular companies or industries.

Foreign Currency Risk

Let’s assume you bought OGZPY – shares of Gazprom, russian gas giant, back in 2013. All the profits Gazprom makes are in Russian rubles. Because of the sanctions against Russia and other factors, the value of Russian currency has chopped in half. So, even though they can report even some growth, the dividends you are going to receive today will be negatively affected by RUB-to-USD conversion rate.

NOTE: to be more precise, OGZPY are not technically shares of Gazprom itself, it is an ADR.

This risk is also known as Foreign Exchange Risk, or FX Risk, or Exchange Rate Risk, or just Currency Risk.

Interest rate risk

What happens if you buy stocks today, and tomorrow FED will increase interest rate?

To answer this question let’s look at what happens in the financial system. If interest rate grows, any financing becomes more expensive (both for people and organizations). So, everyone’s access to “cheap” money decreases. Many companies depend on these financing in their operations. So, less cheap money for them means shrinking of their business. Plus, of course, their clients are now short of money too. Thus, their earnings will go down. Obviously, less profitable business costs less. So, in general, stock market will go down. So do your shares.

At the same time, bank deposits become more attractive: they now will generate more interest.

Corporate bonds and government bonds will react to growing interest rate differently: corporate bonds will go down (the same reason as for stocks), but government-issued bonds will go up (in a way, they will behave same as bank deposits).

IMPORTANT! When you make any investment (stock or bonds purchase, bank deposit etc.) you must be aware of this risk: what happens if interest rate changes. This is another example of systemic risk.
Problem #12: What happens to all above mentioned investments if Fed decreases the interest rate?

And one more thing: bear in mind, that this risk can affect your investments directly (when it affects their market price, as we described above) and indirectly (when you already locked down your money and cannot switch to another, more profitable investment right now).

Industry Risk

The name of the risk speaks for itself: something affects the whole industry as opposed to single companies. Examples: price of gold affects the whole gold mining industry; recent turmoil with oil prices affected several industries related to oil; a disruptive innovation like Square-Up can theoretically affect not just Mastercard or Visa, but the whole credit card processing industry etc.

Business Risk

There is always a possibility that a company will have lower than anticipated profits or even experience an

All eggs in one basket

unexpected loss. This risk is driven by enormous amount of contributing factors like competition, change of input costs, lawsuits against the company, bad entrepreneurship, some unusual circumstances affecting sales (for example, an unusually cold summer affects the sales of soda pops and ice-cream, it also affects the consumption of electricity etc.) and so on.

How to mitigate this risk? Diversify! By the way, this is a non-systemic (or unsystematic, or “diversifiable”) risk.

 

MMI Risk

MMI stands for “Me, Myself and I”. In many realms your worst enemy is you. Investing is one of such realms. This refers to lack of knowledge, cognitive dissonance (when you continue doing something wrong, because you afraid to admit a mistake), over-excitement (when you buy something just following the hype and frenzy or when you make a stupid speculative decision), lack of patience and so on.

How to fix this? Just learn on your mistakes, be forgiving to yourself, every time explain to yourself what for you are going to do this or that, and refer to other people’s opinion (not necessarily experts or mentors, I ask my wife from time to time).

Call risk

This risk can affect “gentlemen who prefer bonds”. Callable bonds. Or debentures. Say, you bought a debenture which matures in 2049 and has a face value of $100. The price you paid was $115. And you forgot to look at its Call Date (which was, say, in 2014). Now there is a risk that the issuer will redeem them (call) before they mature – at any moment starting Call Date, i.e. even today. If it happens, you will get back just a face value, so, your loss will be $115 – $100 = $15.

And trust me, any issuer of callable bonds or debentures will do that as soon as maintaining them becomes too expensive!

How to avoid that? Look through the prospectus and find this information before making decision to buy.

 

Summary

Though this list of risks is not exhaustive, I tried to compose it from the most interesting and practical gotchas an individual investor can face. The risks here are systemic or related to the particular industry or company.

The most important thought about managing risks is this:

In theory you can protect your investments from any risk (in more details we are going to discuss hedging risks later, in other article). But, almost always, the cost of eliminating 100% of risk will be that high, that it will equally downplay your return. So, you have to accept a certain degree of risk.

And now let’s sum up some measures to minimize the aforementioned risks:

  • Form your portfolio according to your risk tolerance;
  • Don’t be too aggressive;
  • Read prospectus;
  • Know what you are buying and deal with only what you understand;
  • Make sure that the business behind equities is fundamentally strong;
  • Keep an eye on the state of things within industry, not just a company;
  • Diversify;
  • Learn on your mistakes.
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 blackbeltinvestments.com 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).

 

Diversify

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.

Lesson 004 – EPS. What can be easier?

Lesson 004 – EPS. What can be easier?

 

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

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.

Lesson 002 – Method of Learning

Lesson 002 – Method of Learning

 

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.
Lesson 001 – Investment Philosophy

Lesson 001 – Investment Philosophy

Investment Philosophy

Foreword

This lesson starts the course of lessons related to investing. The lessons here were learnt by me, but of course I cannot pretend that I invented all the theories, techniques, approaches, practices and advices. So, from time to time I will refer to the wisdom of some other people (and, of course, I will name them).

The lessons will contain problems of rather practical nature. I would recommend to go through them. This will be your first step to practicing all this. Later on I will add a page with answers to all those problems (where applicable). And please remember, that only practice turns your knowledge into skills, and skills (not knowledge itself!) will change your life.

There is a lot more I would like to say, but I cannot stick all this into the foreword… Let’s start the lesson.

Philosophy of investing

There are three main roads to social success: the road for smart people is named career, the road for brave people – business, and the road for rich people – investments. But please don’t be disappointed by the fact that you are not rich as of now: first you have to start thinking like a rich person, and then later your fortune will grow accordingly (I promise, that later on in this blog I will delve into this topic deeper, but for now just believe that tweaking your thinking is the fastest way to change your reality).

So, what do you need to start investing? An intention to think like rich people plus some more: time, patience and self-discipline. You don’t have to be extremely smart, but if you don’t have enough of self-discipline, this road is not for you. If you cannot wait and refrain from impulsive actions and frenzies, this road is not for you. If you have a delusion to become rich overnight, this road is not for you.

There are two more secret components which I didn’t named yet. Some bravery  since you will risk your own money and you will have to be fully responsible for your own actions. If you cannot do that, this road is not for you. That was one. And another one is your ability to change your worldview by learning on your mistakes.

Assets

To describe the philosophy of investing we need to know what assets are. If you read Robert Kiyosaki, you know that an asset is something “that puts money into your pocket”. I like this definition – simple and to the point.

In investments you buy assets (oppose to business, where you create your assets). This is the nature of investing: by buying assets you make your money to work for you.

Quick money vs Slow money

And a little bit on why you need patience and self-discipline. If your activity to make money quickly turns into the money in your pocket, I call this quick money. As an employee, you make quick money – each our of your work turns into the cash at next paycheck, typically twice a month.

Slow money kicks in significantly slower. If you found a business, your money start coming after this business breaks even – typically it takes at least a year before you see the first dollar of net profit. Same with investments – you first go to work, earn your money, then buy your investments, and only next quarter you will see first dividends (and yes, I know that there are some companies which pay dividends monthly; and also you can make capital gains much quicker etc.)

So why would anybody opt for slow money ? The reason is that “slow” and “quick” refer not only to how fast you get the money but also to the inertness of the cashflow: after you got an asset (bought or built), it will bring you money for decades after that without your significant efforts. Compare this to quick money: 1 hour of your work turned into money quickly, but it’s gone. You are paid once. And if you want more money, please go and work again.

As an investor you should prefer slow money.