Joe,

Great work. Your solid thinking has certainly helped achieve above average returns.

Shane

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Thanks for keeping us updated!

I know you’ve always got the long term in mind, regardless of what some posts are saying.

Cheers and thanks again.

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You should consider using Covestor.com to start tracking your trades. I think an audited portfolio history would help build creditability. I use it and like it.

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Hi Joe,

I am trying to locate an excel spreadsheet that will track and graph my annual returns and compare it to a number of benchmarks. I also make sporadic contributions during the year and it will have to take that into consideration. Do you happen to have such a spreadsheet or know where I can get one?

Thanks Joe.

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Impressive. I was down 21% as of the 22nd but we’ve had a big rally this week, so I’m not sure where I’m at now, nor do I particularly care. The only real disagreement I’ve had with the portfolio was the original buy of AEO. A lesser disagreement is that I don’t emphasize the JNJs of this world nearly as much. How that will work out for me won’t be known next week or next month or even next year.

Some Buffettisms resonate more than others with me. “Be greedy when others are fearfull” is one that keeps echoing in my mind as I see certain companies with what I think are great futures being practically given away. JNJ might make a rich guy richer, but it won’t make a regular guy rich. I’m a regular guy. Regular guys should not try to win home run hitting contests, unless everyone else withdraws from the game even though the fence has been moved in 150 ft. That’s what’s happening right now and I’m taking my cuts.

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Joe,

1. How much in cash?

How do you know how much to hold in cash? I’m surprised that you’re still holding 28%. If you take great opportunities when they come, especially in this market, don’t you come to a point where you commit all your cash?

I guess this is the hardest thing for me…I see a great valuation right now and I want to jump on it. Buffet says that great investors let lots of opportunities pass waiting for the right one….the opportunity of a lifetime. But right now there are so many “opportunities of a lifetime” out there that it is hard not to park a lot of cash in them.

2. Regarding AEO

AEO has a 10-year history of thriving through thick and thin. That 10 year period includes 2 other “fundamental” market events, where everyone said the sky was falling: the dot-com bubble and 9/11. You still have failed to convince me that your sale was grounded on long-term thinking. It seems to me that, instead of selling a solid company, you should have used some of your excess cash.

However, my perspective on AEO is perhaps a little different because I bought mostly at $16-17, not $26. Even with your current evaluation, I paid a very fair price for the stock. I can see how it makes sense to put that money into better long-term opportunities right now, but again, how do you know to keep 28% in cash right now?

Thanks for all that you do. I hope you make tons of money off your website and the business it brings.

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First time I’ve seen Joe get somewhat irritated lol! Listen, I read somewhere that posters in F*wallstreet will follow anything Joe says… this is not true. We all know the rule that guides us: DIFFERENT PEOPLE SEE VALUE IN DIFFERENT THINGS. So for me, I would be WILLING to pay 8$ for AEO and put 20% in that position because the risk is worth my money! And if the market drops heavily like it did sept-oct than I might find better opportunities to park that money with LESS risk.

We are all with you Joe(at least I am, some people think this is mindless immitation, but I can understand why people are getting confused…

Regardless, Joe’s looking for as MUCH certainty as possible with high rates of return. There’s a little difference between this strategy and mine. I have MANY years of investing possible, I can take a loss and learn from it but I am content if I can buy AEO at 7$ (20% position) because if I am right…the return will in the LONG-RUN will be astronomical.

The only problem with AEO:

AEO can turn out to be a wonderful opportunity but carries higher risk of failing to predict the future due to the nature of the business(fashion). If you are right though, this could be a company you practically payed 33 cents on the dollar(if its cashflows return to previous levels, this would support 28$ stock(which the market values at 8-11 atm, remember this is without 15% your going to make)

In contrast, I don’t believe you would obtain as high of a return on JNJ if things went exactly as expected because the price is FAIR and not cheap. (i.e when you pay 60$ for JNJ your going to make 15% per year and not more, unless it did better than expected).

In sum, my personal preference is to buy when people are greedy and fearful. If the opportunity has NO MOAT… I will still consider it given it is EXCELLENT in many other regards(management etc)

I wouldn’t recommend this for anyone, as I am MORE THAN WILLING to lose all my money invested in this opportunity. Needless to say, I would jump on the occasion to buy JNJ at 40$ instead of AEO because my OWN risk/reward parameters would justify this.

Thanks for keeping such a lively discussion everyone, I love this place!

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Seth Klarman’s Margin of Safety discusses the cash issue. In short, he explains that there is an opportunity cost to having your funds committed entirely to securities over cash. I think this is a really good way to think about it.

When the market goes down a lot, such as it has in the past few weeks, almost everything (even the good companies) take a hit. If you had devoted 100% of your portfolio to stocks, it is likely that you would not be able to raise the cash you would like by selling those stocks right now. At the precise times that you want to take advantage and buy new companies at a great discount, you would be unable to raise the amount of cash that you need because the stocks that you own have also taken a short-term price hit.

I think that the AEO sale, regardless of whether you think it was a good purchase or not, can be viewed this way. The portfolio could have used the idle cash, but then if the market falls further (and creates better opportunities) you will have to sell your stocks at even lower prices to buy into the new opportunities.

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Joe, I have a recommendation for your website(telling you here because I cannot reach you by e-mail lately)

It would be NICE a Forum or blog pages on particular Investment opportunities. Why?

Our community could then participate in objective criticism and opinions on specific company’s prospects as “good investments”. This would not put you in any position to endorse any specific companies but would allow people to make more informed decisions! After all… we are ALL helping each other by contributing to F*wallstreet.

For example, a forum would encourage ANYONE to post and start a discussion about a specific company!

Thanks for reading this Joe,

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It seems to me that this line of thinking will always get you to sell out your positions when the economy turns south.

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Let me start off by saying, Joe, that I respect your opinions and if it sounds as if I’m attacking you (or anyone on this blog for that matter) that isn’t my intention. I agree with the majority of what you write here, or else I wouldn’t have spent the time to read the majority of your posts. I do however disagree on a few points, as you’ve all seen from my prior comments, and I feel any discussion of differing views can be a valuable discussion.

So, let me start by answering your rhetorical question! “When buying a stock, what is the difference between taking the money out of cash, or selling a seemingly mediocre opportunity to raise the cash?” Easy! TURNOVER=TAXES. And for that reason I avoid 99% of all mutual funds. In my opinion, high portfolio turnover can be one of the most devastating effects on long-term performance. I am of course speaking in general now as I realize your AEO sale and perhaps several others were at losses and thus provided a tax benefit. But I think it’s a key point to bring up.

I get what you’re saying, why not sell a mediocre investment that you original project to earn 15% a year over the long-term, if you can sell that investment and purchase something else that you determine is so cheap, it could earn 25% a year over the long-term? My only problem with that is as Joe said very correctly before, this stuff is more art than science. In that case, you can’t be any more certain your new valuation is any better? The only thing you CAN be assured off is a hit to performance due to capital gains taxes, which could potentially be even more damaging in the near future as Sen. Obama appears likely to lock up the election in a few days, and he wants to raise capital gains taxes back to where they were under Clinton for higher income people.

Regarding how the economy affects valuations, Joe says, “Lower cash flow means lower valuations. In this case, we have a lower starting point than we projected, and future cash flows will all likely be lower than projected as the business recovers from taking a step back.” I disagree that ALL future cash flows are likely to be lower than initially projected. If assuming the 10 year look-back period captures both economic highs and lows (which as a previous poster pointed out does capture the dot com crash, 9/11, as well as the subsequent bull market), than it’s important to remember that you are looking at the median growth rate. In one year, FCF growth might be negative 10%, but in a future year it could be positive 20%, giving you a median rate of say 5% (just throwing out a number in between).

If you project future cash flows at 5%, you are smoothing earnings to calculate an intrinsic value. So just because from 2007-2008 your company had a decrease in FCF of say 10% (as might have happened this year), that doesn’t mean all future years will be below your initial projections, because if the company is stable, management is capable, the competitive advantage remains, and over the LONG-TERM FCF grows at 5%, than it’s reasonable to assume that in say 5 years the company may grow FCF by 25% when the economy recovers. Thus, your year 1-5 FCF projections may be lower, but year 6-10 may be higher so that in total, the 10 years of future cash flows are the same. Arguably, your valuation would still be slightly overpriced because the PV of cash earned in years 6-10 (the higher years) is worth less than that earned in years 1-5 (the lower years), but isn’t that the purpose of the 25-50% margin of safety? To price in these nuances that can occur because the future is unpredictable?

Please, feel free to provide counter-arguments to my argument. Or, if everyone is tired of this topic, I too will let this lie.

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Quote” I read somewhere that posters in F*wallstreet will follow anything Joe says… this is not true.”, “some people think this is mindless immitation”

Damn right it’s not true, I hang on here everyday, the lessons are invaluable to any investor. I dont invest in the DJ as I live in Australia. Instead I apply the wisdom learned to the ASX and the property market. The AEO debacle has just increased my work load as I have realised that there maybe some easier pitches in the market.

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BPal, you should start your own blog.

AEO has to re-invent themselves every so often and target different age groups. If they fall behind earnings take a big hit. They don’t have great earnings power.

On AEO. What’s AEOs durable competitive advantage? case closed. would Buffett even buy this company? case closed.

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BPal said, “Easy! TURNOVER=TAXES. And for that reason I avoid 99% of all mutual funds. In my opinion, high portfolio turnover can be one of the most devastating effects on long-term performance.”

Now you’re getting into the early Buffett vs. late Buffett argument. If taxes are a primary concern, all you look for is permanent holdings as Joe calls them. What happens if you buy AEO at $20 because you think its a $40 stock, and then it runs up to $40? You don’t sell a fair valued “good” company to find a cheap one?

IMO, it looks like there are a bunch of different schools of thought here. Some people are true blue mature Buffett looking for great companies they can buy and forget. Some are down and dirty old school Buffett/Pabrai. And others are a blend of the two.

I don’t think anyone would follow Joe blindly. But I do think you’d be hard pressed to find a site that better explains how to THINK about and approach investing. That’s why this is the best website I’ve seen on investing. Some collect Buffett quotes without knowing how to interpret them while others HEAR Buffett but don’t LISTEN. Some use Buffett as a tag line to attract visitors.

And kudoes to Joe for letting us have these sort of intelligent conversation. Comments have to be approved, and he let’s all of them through- even the ones that slam him or that he disagrees with. On other blogs, I’ve posted comments that never show up. So before you get your panties in a bunch, consider that. Joe is encouraging discussions and arguments and disagreements, and I assume its to help everyone (even him) to THINK and become a better investor.

Let’s face it. You’re not Buffett. I’m not Buffett. Joe’s not Buffett. Pabrais not Buffett. That doesn’t mean we can’t all earn high returns using the same, slightly different, or very different approachs. The key is THINKING, not agreeing.

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Mark –

There is no “correct amount of cash” to hold at any given time.

But my guess is (if you are like me), you would do well to worry more that you are overinvested rather than worry about being underinvested. If you are actively seeking value opportunities, you will probably wish in the long run that you had been more selective, not less selective.

Seth Klarman is well known to keep one of the largest cash positions of all the super investors. I believe that Seth Klarman had about 15% in cash when the market was at $8000.

Even though the DOW jumped 15% or so since then, I doubt he is sad that he wasn’t more fully invested.

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I saw someone ask about this before, but does anyone have a good spreadsheet or website that calculates portfolio performance, and takes into account adding cash through the year? (I’m not focused on the short term , but I would like to begin tracking my performance…)

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hey G, one of th above posters mentioned:

Covestor.com

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I went to covestor but to do it there you need to allow them access to your brokerage account, and I’m not comfortable with that.

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thats exactly what i was looking for! thanks so much joe

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g,

you can try out http://finance.clockstrik... or http://icarra.com/ but you would have to enter it manually.

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Schools of Thought: There are clearly a few different ways to approach investing, as this brief chain of comments suggests. The best part is: No one particular strategy is “right” or “wrong” — they just are.

One dichotomy in the school of intelligent investing is the “large cap” vs. “mid and small cap” debate — one that has been around for as long as people have classified capitalizations. I’m going to chime in here with two thoughts on it:

1. Investors will usually find more inefficiencies in smaller cap companies, which makes that area of the markets potentially more lucrative under “normal” market conditions;
2. There is no rule or law that says a large cap offering a 25% discount will return to intrinsic value more or less quickly than a smaller company at a wider margin of safety.

In my view, a large, stable company offering a 25% MOS is just as attractive as a mid-sized (or smaller) company offering a larger MOS. Sure, we look to minimize losses by finding easily understood opportunities; but, we have to realize that a lot of the big companies got and stay big precisely because they are easily understood and powerful.

When Mr. Market is throwing a bunch of fat pitches without regard to value, investors should jump on their best ideas, regardless of the size of the company. That said, the “best” is not quantified solely in the size of the margin of safety. (Just something to consider.)

With all of that, let me say that I don’t think anyone here follows what I say blindly. This is definitely a community of thinkers. Though some people will get the wrong impression, most people — and most active visitors — keep coming back to F Wall Street because we all have great, challenging discussions.

Cash Position: As far as cash is concerned, I don’t like it burning a hole in F Wall Street’s pocket; but, I’m in no hurry to get anything done. Whether the portfolio has 90% in cash or is fully invested, I think investors should be looking for opportunities and putting their money in their best ideas, even if that means selling other opportunities.

Audited Results: After the first year’s performance, I had some discussions with visitors regarding a portfolio people can track. The problem with doing so is that a lot of people would then focus on short-term results, and that detracts from everything this site stands for. If this was a day-trading site, I could see the benefit of (or absolute need for) a real-time portfolio. As our focus is long-term, a purchase on Tuesday that is then discussed Wednesday is as good as real-time.

As a recent example, I discussed NTRI and MMM in this post. The MMM purchase was at $58 and change, though the stock was around $60 the next day. NTRI (I believe) hung around the purchase price when I announced it. Inconsequential moves to a long-term investor.

If I were out here announcing that I just covered a SHLD short from $200, I could see where a question of credibility would arise.

Portfolio Performance Spreadsheet: g, if you are good with Excel, learn the XIRR function. You can see an example of it in practice below:

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Amit:

The fact that you have a higher risk tolerance is fine, but it seems to me that you are bordering on speculation, rather than “investing”. With all due respect. I fail to see how AEO has proven to have a great management at the wheel or any overriding advantage over other retailers of clothes to the teens and twenty somethings (or beyond). In fact, I would say that,, in those categories, Abercrombie would be the more strongly run business. I don’t like retail though, so don’t mind me.

Basically, I think you are speculating. Nothing wrong with speculating….if you are willing to lose money ..and it appears you are. However, thats not business or value investing persay. Mr Buffett would most likely refer you to Rule #1…and Rule #2 for that matter.

Being young does not excuse being a speculator. Just cause you have time to make it back, doesn’t mean you should take unnecessary risk and lose it…… With today’s prices on good quality companies, I can’t see why you would take the risk you seem to be taking. I think I make a good salary, and I could probably afford to lose money too….but why would I set myself up for that? If the richest man on earth got that way by not taking more risk than necessary, I am thinking there might be something to that philosophy. To each his own..but I would seriously ask yourself why you would take on that level of risk in today’s market. Seems totally backwards to me….

JNJ vs AEO? …..The Tortise and the Hare my friend….who won that one again?

Have a great day

Darren

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Joe,

I think you should include the section where you recommended books like previously.

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How does the “wash sale rule” affect stock returns or tax-returns? I was recently hit with it when I sold a position only to re-enter at a much cheaper price. I’m not sure of the implications of this rule, or it’s purpose. Any info would be appreciated. Thanks in advance.

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Jason: Wash sale rules keep you from being able to claim a capital loss on your tax return. You can carryforward this loss and tack it on to any additional loss (or offset it against and subsequent gain) when you ultimately sell the position and don’t repurchase shares within 30 days. An example:

Tax Year 2008:

Buy 10 XYZ @ $100 = $1,000 basis

Sell 10 XYX @ $50 = $500 proceeds ($500 capital loss)

Rebuy 10 XYZ @ $52 (10 days later) = $520 basis

The $500 capital loss is disallowed in tax year 2008.

Tax Year 2009:

Sell 10 XYZ @ $80 = $800 proceeds ($280 capital gain)

No rebuy of XYZ stock.

The $280 capital gain can be offset by the $500 capital loss, and you can report a net capital loss on your 2009 tax return of $220.

Hope this helps.

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Oh, and the purpose of the rule is to keep people from selling a position they want to keep, only to receive a tax benefit. You can do it but you have to wait at least 30 days, which builds in some risk to the strategy because prices could take off before you are able to buy back in.

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Darren:

While I completely agree with you that AEO is speculative TO YOU.

It would be speculative if YOU don’t know the facts about the business:

1. I am WILLING to make an educated investment decision. This is NOT speculation as I have a good idea about management and their pay structures and well as their depth. (I have studied this and I am aware that the players are heavily invested and their pay structure will punish them in lean times such as now).

There’s not much you can do but depend on able managers to weather the storm. This is as true for AEO than it is for JNJ, this is a FACT.

2. I would pass JNJ at 60$. But I would jump at the opportunity to buy AEO at 6-7$

Im not Blindly investing here! Was Peter Lynch stupid for buying GAP when it was a small company with NO competitive advantage?? Many of his investments were 10 baggers and 100 baggers.

3. Sure JNJ has a competitive advantage, but at 60$ will it offer the returns THAT AMIT IS LOOKING FOR?

Nope. That is a fact, the company is already too big to be a “2-3bagger” unless I am going to wait 30 years which I am not interested in holding for that long.

Just because I do not follow Warren Buffet 100% does not make my investment decision “speculative” that’s a LOAD of BS. I would rather get a “5 bagger” THAN WAIT 10 years to double my money.

The reward is just NOT worth my time. (BTW I am a real estate investor in appt buildings so there’s more lucrative options available to me than 15% per year, just like the stock market you have to WAIT for that FAT PITCH)

I applogize if I may sound irritated but I don’t EVEN OWN AEO!!!! I sold out for a profit =)

In fact, I bought Mcgraw-Hill at 18$, a duopoly with outstanding competitive advantage and a very pessimistic sentiment on the stock.

I hope this clarifies that I am not “speculating”. If anyone thinks I am stupid so be it! I am in for the long-term anyways =)

Once again: I DO NOT OWN AEO

AMit

And just for your information, NO I do not own the company. I sold at a GAIN and have invested

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Oh darren, I my bad I realized when i read:

“your bordering speculation” your not wrong at all because I certainly am.

Sorry I didn’t understand you meant that I was BORDERING speculation.

But then again, we’re all bordering speculation in SOME sense.

How do you know a major catastrophe or sagging economy won’t affect owner earnings

SIGNIFICANTLY; thus, changing the valuation of JNJ?

What if you had payed that “maximum” price at 62$. This would have been a mistake in valuation.

Darren,Nobody truly knows the future so a competitive advantage SURE helps I agree on that! =)

But I Still believe you can, at times(very sparingly), invest in a business with no moat given that your sphere of competence makes up for it <–better judgment

But at the end of the day, I am not speculating, IF I HAD OWNED AEO for I would be valuing the company and assessing its performance based on REASONABLE metrics.

These metrics have been introduced to us by the generosity of Joe ponzio!

Thanks for the comments Darren, and thanks Joe for participating, we love that

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Thanks for providing the explanation on the Portfolio Performance Spreadsheet and on the annualized return function. There is only one minor correction that I would like to point out, which is that the beginning balance and capital injections should be negative amounts and the cash removed and the ending balance should be positive. This will provide you with the correct negative annualized return of -15.02%.

Thanks Joe!! I learned something new once again on your site!!

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Ryan,

Joe has it right. Positive values are used for starting values and cash put into the account, negative values for cash taken out and ending balance. The net cash put into the portfolio was $8,420, and the investor ended up with $9,875 — a gain of $1,455, or 15.02% annualized based on when the cash was added and taken out.

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BPal –

Thanks for the helpful info. So would an online broker automatically apply to the next year or is that something I will have to track on my own?

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Jason: I think the answer is it depends. I don’t know much about full service brokerages (I’ve never used one) so it’s possible that they MIGHT track this for you as an enhanced level of service; however, if you use a discount brokerage (like E*Trade, Ameritrade, etc.) they will not track this for you, so keep copies of all your trade confirmations so you can apply the effects of the wash rule yourself. Alternatively, you could use a software program like Quicken, which can keep track of this for you. Or if you use a software package such as TurboTax to prepare your tax returns, it will store this information for you as well.

Good luck.

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AMIT:

I would be interested on your take with McGraw Hill. I have been reading alot about universities getting fed up paying those text book prices ( Iremember buying text books that cost more then $400 way back in the eighties….i can only imagine what they cost now.) And with Google trying to put books in digital format and make them available to all for much less, I worry about the moat that Mcgraw Hill supposedly has. I could see Google or others wiping out that moat fairly quickly, under the right circunmstances. That being said, I was unhappy when McGraw hit $18 and I wasn’t near my acocunt so i couldn’t buy.

Now, i am not so sure it was a bad thing…..long term I wonder. What’s your take on this ?

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Mcgraw-hill’s moat for textbooks is strong. But as for the digital content, I know the company enjoys a solid moat because more and more courses being given on the university level are online. What is peculiarly good for MHP is that it develops the content and learning experience which are high in demand in university courses in fields such as computer science and even mathematics.

For an example, you would have to pay that hefty 50$ in order to have access to “minicases” (you need a unique code). These minicases are necessary for students to purchase in order to complete the course and get their marks.

In essence, even if you bought the textbook illegally copied, you would still have to pay 40$ to get the activation code… now that’s a solid model that protects profits and reduces costs. It is part of the online digital learning environment being integrated in public schools and Universities.

My cousin told me he bought his minicase, the cashier had to simply dial a specific number at Mcgraw-hill companies to get the unique digits. And voila1 a sale was made, avoiding shipping costs etc

As for google digital content, I don’t think it will affect the demand for textbooks.

Universities are looking for outstanding companies with long history and deep pockets (a by product of high barrier industry). What is fundamentally important is to be, as Joe says “willing and able” to tailor the textbooks for the specific Universities requirements. This is what makes it difficult for competitors to grab market share in this particular niche.

Also, in most cases, no Universities will use the exact same textbooks because Professors are unique and they affect the content which is emphasized for the particular course.

If anything, there’s always a local photocopy shop near universities which will photocopy that book for as cheap as 30$. However, for the digital media directed towards Education, I believe the company enjoys a strong moat aside from the fact that its textbook business is naturally a difficult industry to break into.

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Oh Darren.. Here are some more observations about the company which are important:

1. Mcgraw-Hill’s cash is generated MOSTLY from its highest margin business: Financial services at 43% operating margin.

2. The operating Margin on the education segment is marginal at best, one reason I dislike this company.(give or take 8% if im right)

3. Morningstar MISSES this but Mcgraw-Hill’s Free Cash Flow is even lower when you consider Prepublication costs. In fact, these cash outlays are much higher than Capital expenditures themselves and they must be made.

4. Moody’s advantage of focusing on one business gave it an operating margin for its financial credit rating services of 54% versus 43% for MHP. Just look at Moody’s CROIC and Overall net margin during those good years (2002-2006) You will be very pleased!

5. Take into consideration the meager 31 $ million annualized capital expenditures and you can see which business is BEST at generating cash and KEEPING it.

Always willing to contribute =) Nice disscussion feel free to inject

CONCLUSION: If you feel comfortable investing in Credit Rating services than your BEST bet for an oustanding company is actually MOODY’s =)

The only reason I didn’t buy Moody’s instead is the price is too high for my liking.

Besides, given the Duopolist tendency of the credit rating industry MHP’s moat has proven to be strong. It commands an equal market share(40%) with Moody’s.

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Recently, I have been trying to do some research on buying bonds but I am really not sure where to begin looking. For stocks, I can look up anything I want on Yahoo Finance, but I cant seem to find anything like this for the bond market. Do any readers (or Joe) have tips for where to find bond prices, info on the bonds, etc…

Thanks

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new post?

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No, new posts for a long time now? Hope you are doing ok, Joe.

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Everybody seems shell shocked or something. No new posts in several days?! WOW.

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Not shell shocked here, I figured months ago on S&P 500 at 700. I have to admit that now that it is actually coming to pass, I’m starting to get a little concerned, but I’m still a buyer. Just picked up a little ESEA and doubled up on GLW.

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Cant wait to hear Joe,

This week has been the BEST week so far to grab on bargains damn…

Might wanna take a look at CNI at 35$

Might wanna take a look at NKE at 43$

Might wanna take a look at MHP at 19

Might wanna take a look at JNJ at 55$

Damn so much to look for ! This is just the ones that I’ve throughly analyzed and felt most confident

Purchased NKE, myself.

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I like NKE too, however, with the volatility in the market these days some dollar cost averaging would probably prove beneficial, and off-set any added trading/broker fees.

See this WIKI page, and look at how many of the “largest change %” days are in 2008!

http://en.wikipedia.org/w...

Cheers

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I suppose buying a bond should be somewhat similar to buying a stock. Obviously you have to look up the terms of the bond offering, but the safety of your principal is tied with the health of the company. You can go back to the Graham and Dodd to read more.

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On bonds-

The first thing that you have to understand about the corporate bond market is that it is enormous compared to the stock market. It is much, much bigger. The second thing that you have to understand is that unlike the stock market, the bond market is not an exchange based market. It is an over-the-counter market between buyer and broker where the ability to track pricing information is very fuzzy. There is no big board where you can see the last trade. There is a service called Trace that supposedly tries to act as a gathering point for historical transaction data. Unfortunately, there is considerable leeway for brokers in providing transaction data to this service. It’s slow and can be very slow depending what other peoples motivation is.

The third thing is that there is inconsistent liquidity among issues based on size of the issue (smaller size of issue is less liquid), on-the-run vs. off-the-run (on-the-run is more liquid), total issuance of the issuer (small issuer is less liquid), issuing history of the issuer (how often do they issue, less often sometimes less liquid, more often sometimes less liquid), coupon size (lower coupon equals lower price which tends to be more liquid then really high coupon bonds), and finally are the brokers terrified to do a trade without massive bid-offer spreads due to volatility (see recent times).

Fourth, retail buyers of corporate bonds (versus say institutional buyers) generally get jobbed on pricing and transaction fees. Unlike, the stock market where competition among brokers especially the rise of online brokers has just crushed transaction fees for all, the bond market is still mostly dominated by the big brokerage houses. Thus with control of the market, transaction fees can be extremely high for bonds. The primary driver of profits for large brokers since the deregulation of stock commisions in the 1970s has been fixed income trading. This was especially true during the yield bubble that has just puked all over itself creating the credit crisis as we know it.

In a normal market (not this one), the typical bid-offer spread for an institutional buyer of a corporate bond is 5 basis points (bp) of yield. That’s 5 one-hundreths of a percent. It would be much higher for a retail buyer. This by the way is for corporate bonds of any maturity. The longer the maturity of the bond, the higher dollar amount you are actually giving up in the 5bp spread.

Now, regarding bond pricing information, I am not aware of any easy to access place on the internet where a person can look at Trace data. Institutions normally have Bloomberg access which provided Trace data. Plus, institutional bond managers get daily pricing runs and transaction ideas from the brokers either through Bloomberg email or other electronic service. Incomplete access to market pricing information however should probably not deter retail bond buyers. If you are buying the bonds to hold to maturity or at least for a significant time, as long as you’re happy with a given bond’s risk-return profile killing yourself to get the best price is probably not worth your time. What’s more important is getting a general idea of the bond pricing landscape and understanding the fundamentals of the company whose debt you are buying.

When I talk about the bond pricing landscape, I mean getting an idea of pricing using some benchmarks. I like to have a general idea of what each credit ratings category is going for. Pricing by the way is generally in yield terms and discussed in yield spread to underlying treasuries of similar maturities. This is the credit spread. To figure find the bond’s yield and subtract the appropriate treasury. I like to have an idea of what generic AA, A, or BBB bond pricing is. This gives me something to work off of when considering individual company bonds of similar ratings. There should be places to find this information on the web. If I have a generice idea of pricing then I can start working from there to determine some relative value for the bond I’m looking at. After I determine relative value then I can ask myself if that’s a good absolute value using my risk/reward judgement.

Finally, buying a bond is similar to buying a stock. A bond is just further up the corporate capital structure and gets paid before common shareholders in a liquidation or reorganization. They are both claims on the assets of the company. Before you can buy either though you must have an idea of what those assets are worth and that comes back to the fundamental business analysis that Joe and this community spend a lot of time talking about.

Fundamentally, the price of a bond is the product of the probability of default and the recovery rate. The recovery rate is what your claim is worth after a bankruptcy event be that liquidation or reorganization. The recovery rate is the result of the value of the company’s assets less any claims above you in the capital structure with common equity being at the bottom of the structure. It’s important when buying a bond to know where you are in the capital structure and who’s senior to you.

The probabiliyt of default is determined by a company’s liquidity. Can they pay their bills? If not, they may be declared in default (different kinds of default) and may have to file for bankruptcy protection (classic it depends situation). In predicting a probability of default you must have some idea of the volatility of a company’s cash flows in the future including the risks to those cash flows versue the cash outflows including the risks of increasing cash outflows (see AIG’s situation as reference). You also need to have some idea of a company’s ability to obtain further financing to stave off default or sell assets to raise capital.

There are lot less books on fixed income investing in the market than those telling you about stocks. Some good places to start though besides Graham are: Bill Gross’s book (PIMCO founder); a classic “Inside The Yield Book” by Homer and Leibowitz; and Marty Whitman’s books on value investing. Whitman got his start by investing in distressed securities and workouts. His basic premise on equity investing is that you should first look at a company like a good credit analyst would.

I almost forgot one important point. Usually, corporate bonds like U.S. treasuries have a face value (par value) of $1000. Bond prices are quoted as percentages of this par value. So, a bond quoted with a $93.00 price has an actual cost of $930. Online brokerage commisions for bonds varies, but I think tends to be about $1 per bond with a minimum of $10. So, your $93 price is actually $94 or $940 for one bond ($930 $10 min.). That will squash your yield a bit. The high investment costs also make buying bonds a little bit constraing for small dollar accounts. My suggestion would be to break up your bond holdings by maturity and company. If you can buy 5 bonds, try to buy the bonds of 5 companies (1 bond per company) with staggered maturities to diversify your credit exposure and interest rate risk.

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Great post Jeff, i’m such a rookie to bonds, those books will be of great help.

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Could you please do an article on Walmart valuation.

You bought at $40plus but the MOST valuation from your DCF spreadsheet is around $30.

What made you buy Walmart?

Also, if someone has only a time horizon of 10yrs, but the projection is 20yrs in future, wouldn’t it be impossible to have any MOS as 10yrs DCF is definitely less than 20yrs DCF.

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WJ,

Check out this post on Wal-Mart.

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