Since our launch, we saw the S&P 500 climb to an all-time high in October of 2007, only to watch it plummet nearly 58% to a level first seen in May of 1996. Some of the causes of the drop were highly predictable. Some of the events, such as the September 2008 disaster, were completely unpredictable. And through it all, we were largely, if not entirely, invested in individual stocks.

Let’s see how we did.

Portfolio Performance

If you recall, I started the F Wall Street portfolio with $100,000, and compare it to the Diamond Trust Series (DIA) – an ETF that tracks the Dow – and the Vanguard S&P 500 index fund (VFINX). I compare to these two funds because investors can’t invest directly in an index; so, these are two of the broad “index-type” investments.

In the roughly two years since F Wall Street was launched, $100,000 in the F Wall Street portfolio grew to $103,224 (+3.2%) while $100,000 invested in the DIA and VFINX fell to $68,246 (-31.8%) and $63,225 (-36.8%), respectively. On an annualized basis, we have outperformed the better of the two investments (the DIA) by 19.6% per year.

What’s In Our Portfolio?

The portfolio snapshot below is as of yesterday’s close. This morning, I sold DBB because it didn’t work out as planned. I will discuss it in a later post.

Thoughts on Our Portfolio and Performance

Had I been able to spend more time and energy on the blog, I am certain that our results would have been much better. As the markets plummeted, I found myself with less and less time to post, as is indicated by my lack of activity here over the past year. I first mentioned this problem in March of 2008 in this post:

When the markets were flying high, I had all the time in the world to write posts for an hour or two a day. Trying to maintain that pace in this market would be detrimental to our future returns.

It is important to remember that I am not a professional blogger, living off advertising revenue and blogging for dollars. Nor am I a professional author, living off book royalties. (Trust me – there’s no money in writing books unless you’re Steven King.)

Some opportunities that were missed in the F Wall Street portfolio:

• Graham Corporation, which was discussed ex post facto and never included in our results.
• The InBev acquisition of Anheuser-Busch workout which, at one point, offered a substantial premium.
• As I mentioned in this interview on First Business and back in November to my friend Barry Pasikov, Managing Partner at Hazelton Capital Partners, Sears Holding Company was an amazing opportunity in November, when it was trading at just $30 and less.
• And, of course, Wells Fargo which, in February, fell to just $7.80 a share. In response to Dan’s question whether or not WFC was a screaming buy, I responded: “Screaming,” but didn’t have the time to post more about it.

These investments would have had a significant impact on our results. The total impact of these investments, as of June 1, 2009, would have added another 33% or so to our returns, broken down as follows:

• about 2.5% from Graham, in which a 5% investment would have doubled,
• about 0.5% from the InBev workout, in which a 10% investment would have grown about 5%,
• 10% from Sears Holding Company, in which a 10% investment would have doubled, and
• 20% from Wells Fargo, in which an additional 10% investment would have tripled.

And that’s net of some of my more boneheaded moves, like overpaying for American Eagle or getting my butt kicked in the Landry’s workout-gone-bad.

The point here is not that I’m backward looking or playing with the numbers, but that the market presented investors with some amazing opportunities over the past year, if, of course, you were looking at the business and not the media or stock markets.

On a relative basis, I’m bubbling over with joy at how we continue to outperform the markets and at the amount of safety our portfolio enjoys. On an absolute basis, I am upset that I didn’t have more time to discuss some of these amazing opportunities in greater detail and include them in the F Wall Street portfolio.

Still, we own some wonderful businesses at great prices. While my primary responsibility is to manage money for our clients, I will continue to run the F Wall Street portfolio on this part-time basis because, as I discuss in the book, casual investors can invest conservatively, confidently, and at satisfactory rates of return without taking a lot of risks. This portfolio will continue to be run “casually,” unlike the portfolios we manage at Ponzio Capital.

Thoughts on Diversification and Buy-and-Hold

Clearly, and once again proven over time, broad diversification just doesn’t cut it. Having extremely small positions (1% of the portfolio, or broadly diversified mutual funds) doesn’t allow your best ideas to have a meaningful impact on your returns. And though the losses have a greater impact (and we’ve had a few), a 5% loss in the portfolio due to a 50% loss on a 10% position is not impossible to overcome, so long as you can remove emotion and media hype from the equation and focus on making smart business decisions.

The number of positions an investor should hold is inversely correlated to the predictability and discount one receives in any investment. You could put your entire net worth into a single U.S. Government bond, and never diversify outside of that one bond because you have absolute certainty and predictability. Conversely, if you’re going to invest in a highly speculative, debt-laden, poorly run company, you wouldn’t want to risk too much of your savings.

That, of course, is one of the problems with mutual funds, and particularly index funds. Both the DIA and VFINX held General Motors as it fell from $90 to bankrupt and worthless over the past ten years. From a value standpoint, it was as worthless at $90 as it is today; however, if you have to own a GM (like when you invest in index funds), you certainly want it to be a very small portion of your portfolio.

This, of course, leads us to the constantly-asked-and-wrongly-answered question: Is buy-and-hold investing dead? The short answer is an emphatic “no.”

Whether stocks are rising, falling, or hanging flat, Wall Street wants you to believe that “it’s a trader’s market.” When the markets are rising, it’s a trader’s market because easy profits are aplenty. When the markets are falling, it’s a trader’s market because you need to be nimble and liquid. When the markets are flat, it’s a trader’s market because “buy and hold ain’t working” and you have to do something to make money.

The truth is that it’s always a trader’s market on Wall Street because Wall Street gets paid when you’re buying and selling. The broker handling the F Wall Street portfolio couldn’t buy an iPhone with the money he would have made from us.

Buy-and-hold is a poor strategy if you’re buying anything at any price, and holding it no matter what. If, however, you are buying great businesses at great prices, the overwhelming majority of active traders won’t be able to match your results over the long-term.

I had written the following to clients a few weeks back about this exact topic. Though it’s not an exact comparison, I think you’ll get the gist of it:

Warren Buffett has built his fortune on buy-and-hold investing. His company, Berkshire Hathaway, is not only larger than every brokerage firm in the United States (many of which are much older than Berkshire Hathaway), but it is larger than Goldman Sachs, Morgan Stanley, State Street, Citigroup, Charles Schwab, and E*TRADE combined. (Based on market capitalization at the close of business on May 7, 2009.)

A Final Thought, On Volatility

It’s easy to look at our results and think that the ride was smooth. All you see in the above chart is three points in time, and a straight line joining each of them. The truth is that the results were volatile, and we suffered wide swings in the prices of each of our investments.

There is no way to control the daily swings of the markets or any individual position. Then again, there is no need to worry about it if:

1. You hold great investments at great prices, and
2. You have no intention of selling that day.

When the markets pounded Wells Fargo down to $7.80 per share, we were down 67% from our initial purchase at $23.41. We invested again at $16.63, but that only gave us an even larger loss on a dollar-basis, and we were still down 63% in a matter of days.

It’s easy to sweat over the market action if you need to sell, or if you don’t fully understand your reason for buying. Even my own brother, whom will remain nameless but trusts me implicitly (I have four, so don’t try to guess), commented on the unrealized loss and was tempted to swear off stocks completely until we had more clarity in the markets.

The truth is that stock prices, on a daily, monthly, and even quarterly basis, are quite silly. Buffett and Munger commented on this at the annual meeting, I discuss it in detail here on the site and in the book, but I’ll reiterate it: A major key to the success of one’s investment program is having the right emotional make-up to handle the market’s ridiculousness.

As I stated in this post, most people don’t have the emotional constitution for investing in stocks. With the markets down nearly 40% from their October 2007 highs, people that were plowing money into stocks two years ago are now sitting on cash and looking for bonds. It’s not just individual investors – many pensions, mutual funds, and other institutions operate with this backwards mentality that investing should be done when prices are high and may go higher, instead of when prices are low, even if they go lower.

Over the long-term, the markets work very well; but, your investment results will depend on how much time you can put into your investing and how well you suppress your emotions while focusing on making smart business decisions.

The results of the F Wall Street portfolio will not do as well as I’d like going forward (that is, very high, non-conventionalist returns) due to my lack of time for blogging; so, I’ll focus on trying to make smart business decisions when I can post here.

(Of course, we’ll keep on trucking at the firm!)

I’m going to quickly run through the latest filing so that you can ignore the noise going forward. First, let’s look at the “reporting entities” in the filing. For Berkshire, there are 21 reporting entities on this filing which means that holdings listed on the 13F-HR include decisions made by…and not made by…Warren Buffett.

If you actually look at the filing, you’ll see the list of entities reporting in this filing. Buffett. Blue Chip Stamps. GEICO. Wesco. And a number of other entities, some of which have their own investment managers, portfolios, and decisions.

Later in the filing, where the positions are reported, Column 7 itemizes the “Other Managers” – the entities or people that were involved in making the decision to hold those securities. As Chairman of Berkshire, Buffett is listed on every position. Beyond that, the positions are reported in groups based on who made decisions and/or holds the position.

When Buffett Moves Money, He Moves Money

Rather than immediately assuming that Warren Buffett is shedding his Johnson & Johnson position, let’s see the changes to the portfolio based on the “Other Managers” and entities that hold the stock:

What we see here is that National Indemnity, OBH Inc, BH Columbia, and Columbia Insurance reduced their stakes in Johnson & Johnson. Other entities directly controlled by Buffett and Munger – for example, Berkshire Hathaway itself and Wesco Financial and subsidiaries – did not sell a single share of JNJ.

When Buffett is buying or selling stock, he typically does so in bits and pieces through various entities in an attempt to mask his purchases and sales for a while. In this case, large sales were made by a few insurance subsidiaries rather than a “sneaking in or out” move.

Did Buffett Sell Johnson & Johnson?

Maybe. Maybe not. Time will tell as we won’t see another 13F-HR for three months. Still, I think it’s premature to say that Buffett is dumping Johnson & Johnson based solely on the amount of shares controlled, directly and indirectly, by Berkshire Hathaway, especially when some of the entities he directly controls with little or no outside influence did not sell a single share in the last quarter.

Regardless of what Buffett did or didn’t do, buying or selling JNJ based on his 13F-HR or the noise in the media is a poor investment strategy. If you want to do that, buy Berkshire Hathaway stock and put it on the shelf.

If, after reading this post, you think I’m fixating on the short-term, feel free to send me an e-mail to spark up a discussion.

On Selling Stocks To Raise Cash…

Let me pose somewhat of a rhetorical question, though you can answer it in the comments if you’d like: 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?

Why not invest your assets in the companies you really like? As Mae West said, “Too much of a good thing can be wonderful.”

Save Landry’s and AEO, I sold out of positions that I didn’t necessarily “really like.” I sold Adobe and Apple. Why? Let me bring up a quote from the August 9, 2008 Investment Performance post:

Adobe is fairly priced but I think it is a solid company. If I run out of cash and need to sell something, I’m happy to sell Adobe. If I don’t need cash, I think my money is better parked in Adobe at $34 and change than in a money market for a few years.

In this case, as the markets began to melt down, I felt that I’d have a chance to find companies I “really like” and wanted to have cash on hand to pull the trigger. What is the problem with dumping mediocre positions at mediocre prices? Why do I think they were mediocre opportunities? In my sphere of confidence and competence, if I had felt more strongly about these positions, I would have gladly invested 20% of the portfolio in them.

As an example: Though they are both down considerably from their highs, I never considered selling Johnson & Johnson or Wal-Mart, again keeping this quote from the same post in mind:

If you find four to six Johnson & Johnsons and Wal-Marts trading at discounts, you need not worry about owning anything else. You can put 20% or 25% of your portfolio into wonderful, rock solid businesses selling at discounts and walk away from your portfolio for years.

Selling Out of Landry’s

Landry’s was a workout that went bad. Plain and simple – no need to hang around.

Reassessing American Eagle Outfitters

While I don’t believe that valuations change rapidly based on price movements or that we should consider the current markets in investing, I do feel like I overpaid for American Eagle. Assuming I’m spot on with my valuation (which we never are, which is why we must demand a margin of safety), what could I expect from my American Eagle investment?

Buying at $26 when the value is just $18 or so, the only thing I can hope for is that the value eventually creeps back above my price point, and that I eventually break even on my investment. But note the key word: Hope.

Optimism and pessimism have no place in investing. From a realist standpoint, I’m not willing to wait for American Eagle to grow to that $26 level, nor am I willing to hope that “some fool” is willing to pay $26 for an $18 business like I did.

Which is the better allocation of capital: Hope that time will correct your mistakes, or admit your mistakes and move on to better opportunities? Remember: You don’t have to make it back the way you lost it.

Perhaps there are other solutions that make more sense than mine; however, wishful thinking – and its usual companion, thumb sucking – is not among them.

I don’t know if Buffett was talking about admitting mistakes and taking losses in that quote, but it is quite appropriate when you overpay for a business and then rely on time and hope to correct your errors. I’m not willing to suck my thumb, hoping that I didn’t make a mistake when other opportunities are so clear.

Now, you can make the case that AEO was not a wonderful business, and I’d agree – that’s why I didn’t invest 20% in it. I still think it’s a good opportunity…but at the right price. $26 is not the right price, and if it falls to $7 or $9, I’d consider buying again. Still, at $7 or $9, I’d have to first ask if there are any companies I “really like” out there at attractive prices. If not, AEO is an option.

How The Economy Affects The Valuation

The economy affects the valuation to the extent that AEO’s cash flow will likely pull back to a lower level, which would then be the starting point for a new valuation. We can’t use last year’s cash flow as a starting point for projecting future cash flows because future cash flows will likely have a lower starting point when the dust settles.

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.

It’s paramount to remember that these things are actual businesses. The fact that AEO generated $x of cash flow last year doesn’t mean it will necessarily do so in the future. Management will have an uphill battle to get people in the stores spending money, and they won’t rush back to do so. This is business, no matter how rosy the spreadsheet says the past was…and business is tough.

Maybe I’m wrong again on AEO. Maybe it really is a $25 or $30 or $70 per share business. And maybe you can find confidence in buying it today at $11 or holding it from $26. That’s what makes investing so great – the fact that we all see value (or a lack of value) in different ways.

This is my thesis, and the reason that Joe Ponzio sold American Eagle Outfitters. If you personally see more value or disagree, load up the truck. Don’t let me sway you one way or the other…you’ll never sway me just the same ☺.

The F Wall Street Portfolio

Excluding LNY which was a workout that went bad, I sold $18,000 or so worth of stocks, and turned around to purchase $25,000 worth of two companies – $20,000 of MMM and $5,000 of NTRI.

It’s a tough market for all long-term investors; and, because we’re looking to beat the markets by five or ten points a year over the long-term, that means we hope to lose less when the markets are falling, make money when they are flat, and hope to keep up or out-perform when they are on the rise over the long-term.

Since June 25, 2007 – the day the site started – the F Wall Street portfolio is up 2.9% versus a 30.2% loss in the Dow and a 35.3% loss in the S&P 500. The relative out-performance is still quite stunning. (There’s something to this “buy good businesses at attractive prices” hullabaloo.) A $100,000 investment in F Wall Street’s portfolio would be worth $102,898 as of 10/31/2008, versus $69,840 in the Dow and $64,681 in the S&P 500. (I didn’t have time to run it against the DIA or VFINX like I did in this review.)

We’re still sitting on about 28% in cash, waiting for another fat pitch from the markets.

For you visual folks:

Of course, the portfolio has only been running for about 16 months – way too short a time to judge performance. Still, I’m quite pleased with the results.

Keeping the long-term in mind…no matter what happens in the markets, we’re not going to look at the performance again until June of 2009.

I hope that clarifies things and satisfies curiosities. Happy Halloween!

This crisis is unlike anything we’ve seen in recent history (and perhaps not-so-recent history); so, what should we do now?

First, Stocks Stink. Consider Buying Bonds.

One year ago (actually, on October 11, 2007) the S&P 500 topped out at 1,576.09. Today, it hit 1,007.97 – a 36% loss. From top to bottom, the Dow lost 32% over the past year. While the news is reporting that we closed at 2004 levels, I think a much more sobering reality needs to be addressed: Over the past ten years – from October 8, 1998 through today’s close – the Dow has grown just 2.6% on average for ten straight years.

Add in dividends, take out some management fees and commissions, and you’re lucky to have a 4% or so return for a decade.

(And I won’t say anything about how irresponsible, foolish, or downright fraudulent some of Wall Street’s finest were over those ten years. Remember Lucent? WorldCom? Enron? Merrill Lynch? Bear Stears? Really – I don’t want to beat a dead horse.)

(Morons.)

What can Joe and Jane American learn from all this volatility? First off, remember that stocks stink! A portfolio of solid bonds would have crushed the stock markets over the past ten years; and, while I don’t necessarily advocate 100% bonds for everyone, I do think that most people should own them.

Wall Street doesn’t talk about bonds except to the extent that they try to get you to buy bonds funds. Individual bonds are not very profitable to Wall Street; bond funds will pay your broker the quarterly kickbacks and allow you to be put on the back burner. (What adviser wants to track all those individual maturities or have to actually do some research?)

That leads me to my first point: Beware of bond funds.

The Danger of Bond Funds

Simply put, when you invest in a bond fund, you give the manager $x to purchase bonds. The manager then takes your cash, pools it with cash from other investors, and buys bonds of varying maturities.

Sounds pretty harmless.

The problem with bond funds is not in the buying, but in the selling. When investors sell their bond funds, the manager must generally sell bonds to pay the investors. The problem is that bond prices change; so, the manager might have to sell some bonds that you personally would have held to maturity.

How does this affect you? Consider this: You want to hold bonds for income and stability; but, in bond funds, your income and stability is directly affected by the actions of other investors. If a ton of people are buying into your bond fund today, your manager will be forced to buy bonds for you in a low interest environment. Then, when those same investors want to get out of that bond fund in five years – and if interest rates are higher – your manager might have to sell those low interest, now low priced bonds at a loss.

At the end of the day, you got a raw deal.

Instead, focus on buying individual bonds with the goal of holding them until maturity. If you buy a high quality bond offering a 5.5% yield until June of 2009, you know exactly what to expect – a 5.5% return for two years, and a definite dollar amount upon maturity, regardless of how happy or scared other investors are.

In short, don’t let the panic and fear of other investors determine your return if your goal is stability, income, and a defined return.

Second, Realize That Volatility Is Here To Stay.

I’ll admit – 6% or 8% daily swings in the markets are out of line. Still, volatility is here to stay. If you recall from this earlier post, the average number of daily transactions in the markets have grown 562% over the past ten years. Every day, 4.4 billion transactions occur, each moving a stock price in a certain direction.

Over the past two weeks, this number has grown to more than 8 billion transactions. If you are waiting for things to calm down, you’ll be waiting a long time. There is simply too much excited money floating around to ever return us to consistently small and “comfortable” movements.

If 36% losses make you sick to your stomach, it’s time for a reality check and a new strategy. Diversification (ie. holding a bunch of investments) is not the key – asset allocation is what will help you sleep at night.

When you are putting money to work in stocks, you must have a completely iron constitution. If watching your portfolio drop 50% will make you nervous, you shouldn’t be 100% invested in stocks. Nobody likes 50% drops and we’d love to avoid them whenever possible; but, if you’re 100% invested and prices drop quickly with no fundamental change in your businesses, you’ll suffer some big temporary losses in your portfolio.

Combating Volatility the Intelligent Way

Many advisors will tell you that “diversification” will help mitigate losses and maximize returns. Then, they sell you a mutual fund that holds hundreds or thousands of stocks.

It doesn’t make sense.

If the key to growing and preserving wealth (as Buffett has said) is putting your money into great investments and great prices, how can it make sense to buy a basket of great, mediocre, and bad companies at great, mediocre, and bad prices?

As of June 30, AllianceBernstein Holding LP; ClearBridge Advisors, a subsidiary of Legg Mason Inc.; Fidelity Management & Research LLC; Barclays PLC unit Barclays Global Investors NA; Wellington Management Co.; and State Street Global Advisors were the mutual-fund managers with the largest stakes in Lehman’s stock, according to FactSet.

So said the Wall Street Journal on September 16, 2008. While most of the funds did not comment, Vanguard’s Rebecca Cohen had this to say:

If you look at the absolute number of shares, we end up as one of the larger holders of Lehman…but on a relative basis, it’s a relatively small portion of our funds.

Oops. We lost hundreds of millions of dollars of your money; but hey, you were diversified. You only lost a little (even though you shouldn’t have lost anything in Lehman).

The intelligent way to combat volatility is to realize how much volatility you can handle, and then invest the rest in bonds. If you take a step back and realize that 50% losses are possible, then you have a base for building your portfolio.

Comfortable with a 10% drop, but not a 15% drop? Invest 20% in stocks and 80% in bonds and cash. Okay with a 25% drop but not a 30% drop? Put half of your money in stocks and half in bonds.

Focus on intelligently allocating your portfolio, not on broadly diversifying into more and more mediocre and bad investments. After all, those broadly diversified, armchair investor stock and index funds are down just as much – if not more – than the markets right now.

Don’t Change a Darn Thing in Your Approach

It is times like these that many investors panic and change their investment strategy in stocks. The fact that the markets are down does not change the fact that:

1. stocks are pieces of businesses with intrinsic values;
2. the value is the amount of cash that can be taken out of the business during its remaining life; and,
3. price follows value, even if it takes a few years for that to occur.

When we bought Johnson & Johnson last year, we looked sheepish, as though JNJ was a boring buy at $62 or so. A few months later, we looked really smart as JNJ topped $72 a share. Today, it was down as much as 14% from its near-$73 high, and many people are kicking themselves thinking, “Boy, I wish I took my profits $10 ago.”

Why did we buy Johnson & Johnson at $62? Because we saw more than $62 – and more than $72 – of value. As the company’s value continues to grow, we have to sit back patiently until Mr. Market is ready to realize it.

It may take a few months; it may be years.

Finally, Realize That It Will Be Better In a Few Years

I wish the internet was around in the 1970s. From its peak on January 11, 1973, the Dow began a two year, 47% slide from 1,067 to its December 9, 1974 low of 570. With no internet or stock market channel, most people continued on saving and investing, cognizant of the losses but not completely panicked or terrified.

Today, the doomsday crowd is calling for the end of the world and a total and final financial collapse. If we were to drop 47% from our high, the Dow would be 2,300 points lower at 7,568. Possible? Absolutely. Anything is possible.

But, like we did after the Great Depression and the 47% drop in 1973 and 1974, and like after so many other times throughout history, we will get through this, great businesses will be more valuable five- and ten-years from now, and price will eventually follow value.

Believe me – there are some very attractive bargains developing in this market, and you should look for them the same way you looked for them when the Dow was at 14,000.

That said, let me paraphrase many investors I talked to last week: Is the world coming to an end?

No, Chicken Little. It will still be here tomorrow. And you have to invest the same way for one simple reason: If everything does go to hell in a hand basket and the US (or your home) economy – and every business in it – fails, your money is worthless anyways. That’s true whether you hold stocks, bonds, cash, real estate. Even gold.

Just ask the fine folks in Zimbabwe. Eleven million percent inflation and growing. Yep – $100 million Zimbabwean dollars invested in gold last year would be worth less than $1,000 today – and that includes gold’s 50% rise in price.

Don’t get me wrong – we face some very tough times ahead. Let me take a quote out of a post I wrote when I was talking about the recession and the US Dollar back in March:

The credit mess needs to work itself out. (Later this week, I’ll talk about how stupid and irresponsible that Bear Stearns, Merrill Lynch, and crew have been for the last ten years.) Regular Joe American who can’t pay his mortgage today ain’t gonna be able to pay his mortgage at the end of higher-price, higher-inflation 2008.

I won’t try to predict the direction of the markets over the next six months. I’ll simply say this:

• Expect high inflation for a while;
• Expect to see some severe market swings – up and down;
• Expect to see trouble in the overseas markets if we do tighten up our trade policies;
• Expect to see trouble in US markets if we don’t;
• Expect to see the US Dollar strengthen if we do tighten up our policies;
• Expect a weaker dollar if we don’t;

Are our problems “fixable”? Yes. Still, it won’t happen in a quarter or two. We went through a trade problem like this in the mid-1980s and it took three or four years of fixing before we entered the boom of the 1990s. By that logic, our next boom would start around 2011 or 2012 – and that’s only if we can solve these more severe problems in the same timeframe.

Looking Down The Road

Five years from now, things will be better. They have to be, because planning for the alternative (total collapse of everything) will virtually guarantee your financial demise.

Think about this: Two weeks ago, Lehman Brothers, Merrill Lynch, and AIG stood tall. Today, they are all but gone. Do you think Johnson & Johnson or Wal-Mart changed their strategy or outlook over the past two weeks? Do you think that people will stop buying healthcare products…from Wal-Mart (the deep discount store)…because Lehman is gone?

At the Pabrai Funds annual meeting (I’ll post about that later this week), Mohnish said:

If you depend on borrowed money, you have to worry about what world thinks of you everyday.

You need to avoid toxic businesses. I can’t value financial companies, and that has helped us avoid this entire mess in financials. Then again, the “mess” reaches far beyond financials. Companies with toxic levels of debt are in for a real treat.

Spreading Beyond the Financials

Long-time readers know that I’ve discussed Amylin Pharmaceuticals a number of times on this site. I got some anonymous hate-mail on those (presumably from some of the management I ballbusted for taking home $21 million plus in compensation while the company’s value continued to decline last year).

Over the past six years, Amylin has increased its long-term debt by about 55% each year, and the shares outstanding have nearly doubled…without a split. In the first six months of this year, Amylin’s interest expense has nearly quadrupled on a 14% increase in revenues.

Amylin has a tough road ahead of it. It owes money to banks…banks that need to charge as much interest as possible to shore up their weak and withering balance sheets. And now, Amylin is between a rock and a hard place. Amylin has to worry about what the world thinks of it.

It can’t sell stock to raise capital. Additional debt is going to cost more than it had in the past. And Amylin can’t generate enough cash to finance its own operations. Today’s buyers of Amylin are hoping for one of two things:

• a miracle drug rushes out of the pipeline, increasing revenues so dramatically that the business can begin generating cash; or,
• a miracle cure to the credit crisis, so Amylin can continue to finance its operations and get their drugs to market.

Otherwise, Amylin will get nickel-and-dimed to financial death, as will many other companies that have to worry about what the world thinks of them.

Maybe there is something to this “buy great businesses” malarkey.

To My Friend Chicken Little

The world isn’t going to end. Sure, we have a long, tough road ahead of us. But, we’ll get through, and great businesses will survive and thrive. Five years from now, we’ll look back and say, “Man – that was crazy. I’m glad that’s over.” Twenty years from now (if not sooner), Wall Street will throw us into another mess, and Chicken Little will poke his head out again.

And if some businesses have to go away, so be it. Just because the stock market falls or stays flat doesn’t mean your investments have to. Invest in businesses that don’t have to worry about what the world thinks about them. As their competitors falter due to massive debt loads, huge interest expenses, and an inability to obtain financing, your businesses will grow more valuable.

Then, you simply have to wait a while. Price follows value, but it doesn’t necessarily happen overnight.

Changes to F Wall Street

Regular visitors will likely notice the redesign here on F Wall Street. I had to make some changes to make it more “user friendly” and get some of those old posts back out here. There is a lot of information on the site, and it gets buried deeper and deeper each time I write an article.

So, here’s what’s new:

• Amazon Banner Ad: Gone. It was slowing down the site and annoying me. We’re back to the old F Wall Street – articles and comments.
• Related Posts: Now appear at the end of each post. This randomly draws four articles in the same category so you can find relevant articles to read when you’ve finished the current article.
• Social Bookmarking: You can now add posts to Digg, Delicious, or Stumble. Admittedly, I have no idea what these are; but, the designer suggested this.
• Add Your Website: If you run a website or blog, you can now add your website to the comments section and it will appear as a link under your name in the comments.
• Latest Comments: They have returned and can be found on the left of the page (under “Categories”) as well as on the home page. You can still subscribe to the comments RSS feed; but, you don’t have to.

Those are the major changes. I hope you enjoy and thanks for visiting (and coming back) to F Wall Street!

In this “rough and turbulent” market, let’s take a look at the first year’s success and overall performance.

How Mr. Market Has Fared

I find it somewhat silly to compare performance to the indices for one simple reason – it is impossible for most investors to hold a portfolio equal to the indices. So, we’ll compare our performance to the Diamond Trust Series (DIA) – an exchange traded fund that closely tracks the Dow Jones Industrial Average – and the Vanguard 500 Index Fund (VFINX) – a mutual fund built to track the S&P 500. The Diamond carries fees of roughly 0.18%; VFINX has an expense ratio of roughly 0.15%.

From June 25, 2007 through August 8, 2007, DIA fell roughly 10.3% when factoring in the effect of reinvested dividends. Because we are looking at a period of just over 13 months, let’s convert to an average annual return – the average annual return for the DIA was (9.2%). A VFINX investor fared a bit worse – down 11.6% over the thirteen months, or (10.4%) on an average annual basis.

The F Wall Street Outperformance

Just following the blog closely, the F Wall Street non-conventional investor did much better. The total return for the thirteen months was 14.6%, with an average annual return of 12.9%. The relative outperformance was stunning. The DIA was the better of the two passive index investments, and F Wall Street outperformed it by 24.9% on a cumulative basis, and 22.1% on an annualized basis.

A $100,000 investment in the Diamond on June 25, 2007 was worth $87,765.63 on August 8, 2008. Throwing $100,000 into a brokerage account on June 25, 2007, patiently practicing your assiduity, and buying the no-brainers discussed on F Wall Street would leave you pleasantly surprised to find $114,629.08 in your account on August 8, 2008.

Admittedly, judging performance based on thirteen months is silly. You can’t look at ten years of business history, project the future of the company for twenty years, and then focus on daily or annual performance. Still, if visitors are on the fence about practicing assiduity, waiting for a fat pitch, and ignoring the markets, this first year might help push you off the fence and into the annual reports.

The Chart of Performance

For you visual folks out there:

F Wall Street Stock Holdings

The F Wall Street portfolio would currently contain just five investments:

• Johnson & Johnson (JNJ) purchased at $62.33 on June 27, 2007;
• American Eagle Outfitters (AEO) discussed on July 12, 2007, but purchased on July 25, 2007 when the price fell back to the $26.31 target;
• Wal-Mart (WMT) purchased at $43.43 on August 16, 2007;
• Adobe Systems (ADBE) purchased at $34.93* on February 1, 2008;
• Nutrisystem (NTRI) discussed a number of times, but ultimately purchased on July 9, 2008 at 13.79*.

* Because no price target was discussed, I used the average of the open, high, low, and close for the day.

You’ll note that I did not include any other positions discussed (eg. Graham Corporation (GHM), Pfizer (PFE)) because I never really analyzed them thoroughly on the blog or talked about them after the fact.

F Wall Street Workouts

In addition to the five long-term purchases, we engaged in two workouts – both of which were highly successful:

• Tribune Company, purchased on December 4, 2007 and sold on December 20, 2007;
• Radiation Therapy Services purchased on January 21, 2008 and sold on February 11, 2008.

I did not include the Clear Channel Communication workout that I bought and sold the week of March 25, 2008 because I never really discussed it here, I didn’t assume a double-dip on Tribune when the price tanked for a brief hour the day of the deal for no reason (but I think I mentioned it somewhere on here after the fact), and I didn’t assume an “average down” in RTSX – purchasing more when the price kept tanking to the mid-$20s prior to the deal’s close.

In short – I didn’t pretend that every transaction was perfect and at the perfect price. Instead, I tried to use plain vanilla purchases and sales based on the dates I discussed them (or the day following the evening I discussed them) and I assumed $9.99 trades on the stock purchases and sales. I assumed we purchased every stock that was attractive, cheap, and timely. For example, I didn’t assume a late March purchase of Nutrisystem because I talked about it later. I did assume we bought it that day after I posted this comment one evening.

Sitting on Cash

As of August 8, 2008, the portfolio would have about 40.2% in cash.

Portfolio Construction

Building a portfolio is all about confidence and risk. If you find four to six Johnson & Johnsons and Wal-Marts trading at discounts, you need not worry about owning anything else. You can put 20% or 25% of your portfolio into wonderful, rock solid businesses selling at discounts and walk away from your portfolio for years.

In the F Wall Street portfolio, I put 20% into Wal-Mart and 20% into Johnson & Johnson.

The mid-caps and the “it’s a cheap mid-cap but I wouldn’t hold it forever” stocks may have a place in your portfolio, but each position shouldn’t be more than 5% to 15% of the overall portfolio. Adobe and American Eagle Outfitters both fell into that range; so, I put 10% of the portfolio into each.

The small-caps and the “it’s a cheap small-cap but I wouldn’t hold it forever” businesses are riskier in that a large competitor can crush them; so, each one should be less than 8% to 10% of your portfolio. Nutrisystem falls into that category and I assumed an investment of 5% into the company.

As many of you know, I don’t mind using leverage on workouts if I’m fully invested. In the case of the F Wall Street portfolio, there was a ton of cash; so, no leverage was needed. Each workout was 20% of the total portfolio, even though I’ve talked about using as much as 30% as well as leverage.

Investment Performance vs. Portfolio Performance

Throughout the year, the portfolio sat (and continues to sit) on a considerable amount of cash as we look for new ideas. That cash is a drag on performance. Though the portfolio grew 14.6%, that return includes the effect of cash. The investments, excluding the effect of cash, grew 24.4 % – an average annual return of 23.5% – which includes some stellar performance, some mediocre performance, and American Eagle’s 50% haircut.

The investments on F Wall Street outperformed an investment in the Diamond Trust Series by 34.7% over thirteen months.

The Portfolio Plan

The logical question is: Now what? What is plan for these holdings? Should we take our profits and/or beatings and run? The market may get worse. Should we cash out and wait to rebuy on the dips?

I look over the portfolio and I don’t see anything worth selling yet. American Eagle Outfitters has seen its business take a turn for the worse; so, I’d institute Phil Fisher’s three year rule. Management has two and a half years left to get the business growing again or I’m gone.

Nutrisystem was grossly overpriced last year at $70 and change. When it hit $13 and change, I felt like the slowed growth (and some shrinkage) was factored in and it was still cheap. Assuming things play out as I expect, I see no reason to sell considering my ultra-cheap buy price. Of course, I’ll monitor the business going forward, but not daily.

Adobe is fairly priced but I think it is a solid company. If I run out of cash and need to sell something, I’m happy to sell Adobe. If I don’t need cash, I think my money is better parked in Adobe at $34 and change than in a money market for a few years.

Johnson & Johnson and Wal-Mart are permanent holdings so long as their businesses remain solid.

I don’t have to make any real decisions today. Sitting 40% in cash, I have to look for new opportunities – not fret over taking profits or losses on long-term businesses I just purchased in the past thirteen months.

The Portfolio’s Expenses and Risk Measures

To date, we’ve effected nine transactions – five long-term purchases and two workouts (for two transactions each). The total paid in commissions was $89.91, assuming $9.99 trades. Thus, the total expense ratio of the F Wall Street portfolio was 0.08% – half that of the funds mentioned earlier, two of the lowest cost funds in the universe.

How “risky” was the F Wall Street portfolio? Let’s think of it this way – the two funds had to be fully invested the entire time, and they had to hold stock in all of the companies of the DJIA or S&P 500 respectively, regardless of how great, mediocre, or bad those companies (i) were or (ii) were expected to become. The F Wall Street portfolio was 81% invested at its highest, but largely held and holds a ton of cash as we looked around for great opportunities.

The two pillars of the portfolio – JNJ and WMT – are massive, international companies with little business risk. Though many will argue that having 20% of a portfolio in a single company is crazy, those same people would love to own JNJ or WMT outright, even if it was their only investment. Add to that the fact that these businesses were purchased when they were on sale based on our estimations of intrinsic value and our risk plummets well below that of other investors (speculators) that blindly invest 20% of their portfolio into a single company with absolute disregard to value or fundamentals.

I’ve said it before – beta measures are nonsense and I don’t even look at or consider them. Still, for you numbers-oriented investors out there: The beta of the F Wall Street portfolio was 1.3 and the R-squared was 0.57 (or 57, depending on how you like your numbers). So, the portfolio moves faster than the market – a good thing. And, it moves largely independent of the market – another good thing.

Putting It All Together

One year performance means nothing. To date, however, F Wall Street has largely been a series of posts with no coherent portfolio to track. Even I was getting confused as to what we’ve discussed. In the past thirteen months, we’ve had a lot of successes, we’ve taken a short-term beating (AEO), we’ve engaged in some successful workouts, we’ve missed some short-term beatings (BX, ALU, AMLN, to name a few), and we’ve missed some high fliers (RIMM). And we’ve done it all without any regrets – comfortably, confidently, and at high rates of return.

All in all, I think we’ve had some very intelligent discussions and I think our performance, albeit short-term, is quite satisfactory, particularly in relation to the overall markets.

Happy belated birthday F Wall Street. Thank you to the more than three million visitors around the world that make this website enjoyable and educational. Let’s have many more years just like the past one.

The Market and The Looming Recession

To help delay or stop the looming recession, the Fed cut interest rates by 75 basis points. What does this mean for silent partners/business owners? Not a whole lot. Mr. Buffett on this year’s stock market, economy, interest rates, and the upcoming election:

Stop trying to predict the direction of the stock market, the economy, interest rates, or elections.

The hardest part about watching the markets crash is, well, watching the markets crash. We will see the markets up 20% or down 20% (or more) in future years; still, great businesses will grow and their stock prices will follow. The solution? Stop watching the markets!

I’ll admit – it’s easier said than done. And yet, for decades leading up to the 1990s, that is exactly how regular people had to invest. Quotes were only available the next day, in the newspaper. To invest in the stock market, you had to buy great companies at great prices and then let time do its thing.

Yesterday morning, I work up to an e-mail sitting in my inbox that read:

Tomorrow (or I guess it’s today) is going to be a blood bath for U.S. markets. Right now, U.S. futures are posting steepest decline since 2001. I’m predicting the DJIA to be down 500 tomorrow. People are already calling tomorrow “Black Tuesday.” It’s going to be bad.

Watching CNBC in the morning, you would have thought the world was coming to an end. And what did I think? In fact, what was my exact response to that e-mail? (Word for word):

I know. I have been excited all morning. Businesses are going on sale today!

The Lesson

Buffett tells us:

Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.

If, for even a second, you became “panic-stricken” yesterday and sold – or considered selling – your great, underpriced companies because of market movements, you probably shouldn’t be in the markets. Unless there was a fundamental change in your business from Friday to Tuesday, there was no real change.

The Major Drops In Prices

I don’t know what you experienced, but here is what I noticed: A lot of great, underpriced companies have not dropped nearly as much as the markets. In fact, a combination of workouts, patience, and long-term outlook have provided some very rewarding results over the past six months. (Not a good timeframe, but appropriate for this discussion).

In the past six months, I have only showcased three underpriced companies (JNJ, WMT, AEO) and one complete workout (Tribune). Hey, investing is boring.

Putting 10% of your portfolio into each position at those prices (Note: Do your own research, don’t just buy what I say, and don’t judge your portfolio on six-months results!), your portfolio would be up 4.1% since June 27, 2007 (the JNJ post and first position) versus down 10.6% for the DJIA (and likely more for those fee-heavy mutual funds).

If you can lose less in down markets, gain in sideways markets, and keep up (in whole or in part) in up markets, you’ll end up with some very satisfactory results.

What Does This All Mean?

If nothing else, it should remind you that there are always a ton of overpriced companies that, from time to time, must be corrected by moderate to severe market drops. When the value of those companies cannot support the inflated prices, prices begin to drop. Considering that great, underpriced businesses are hard to find, it is no wonder that, regardless of the markets, you often get more protection in great, underpriced businesses than great, fairly priced businesses, speculation, or any other form of “investing”.

(What are the markets but a collection of businesses? When the majority of businesses are overpriced, that pricing will correct and the markets – the collection – will fall, regardless of any individual company’s price or value.)

What Should We Be Doing Now?

Look for opportunities – workouts, great businesses, etc. I’m not going to tell you to “stay the course” because, well, there is no “course” – just opportunities. If you panic when the markets are down, regardless of the health of your businesses, consider getting out now, buying individual bonds, and never looking back.

And for goodness sake, don’t even think about selling now, just to jump back in when the markets have “rallied” to new highs. If you don’t learn from history, you are doomed to repeat it – at the ultimate expense of your goals and dreams.

The Book

Enough market talk. What’s up with the book? Thanks to my superstar agents at Jonathan Scott, I have signed on with Adams Media to publish F Wall Street. Until the actual release date is firm, I can’t say when it will be out, but we are shooting for in or before mid-2009. Rest assured, you’ll know when I know.

Comment Housekeeping

I am working my tail off to keep up with comments, but please be patient. It may take a day or two for me to respond.

The new comment system has helped kill most of the spam comments, but I fear that some comments aren’t getting through. If you post a comment, you’ll get a “submitting comment” notice while it writes to the database and sends me an e-mail. If you leave during that time, I won’t get your comment.

When submitting a comment, please wait for the confirmation to appear – which may take a few seconds or, in the case of longer comments, up to a minute.

Sorry for cutting in to the Workouts Work Out thread. I’ll finish up on Friday. And thanks for visiting!

Here we go: Great businesses will grow; bad businesses will shrink; stock prices will follow in the long-term. Of course, when I say that, people respond with things like that’s no help or obviously or the likes. We all know that…so why can’t we believe it? And more importantly, why can’t we invest accordingly?

First things first, forget the calendar year. What will make 2008 different from 2007? Or 1997? Or 1967? When it comes to the stock market, the answer is a resounding nothing! The stock market will still be a place to buy and sell businesses – overpriced and underpriced companies, good and bad businesses, large and small operations.

Where is the economy going? The election?

Are we headed for a recession? Depression? What will the election mean to our portfolios? It doesn’t matter! If you are a short-term trader, these questions require a lot of thought and strategy. If you own businesses – businesses with moats that generate a ton of cash – you don’t have to worry. We’ve lived it (some of us, at least) and our businesses have thrived.

The Cold War. The Gulf War. 9/11. The Iraq War. Federal funds rates from 1.79% in 1955 to 16.39% in 1981, back to 4.79% in 2006. 6-month CD rates from 4% to 15% back to 5% over 40 years.

You ain’t seen nothing

In the last 40 years, over a period of six months we’ve seen the Dow drop as much as 32+% (1974) and run up as much as 48+% (1975). Great – but that was 30 years ago. Right – but it was also down 29+% (2002) and up 34+% (1999).

And yet, businesses continued to grow. As Buffett says:

You go to bed feeling very comfortable just thinking about two and a half billion males with hair growing while you sleep. No one at Gillette has trouble sleeping.

Do you own businesses run by management that can’t sleep when interest rates are on the rise? Are your companies largely successful because there is a Republican President? Will the next President’s party make or break their success?

What is 2008?

And that leads to the point of this discussion: Don’t focus on the calendar. Whether it is October of 2007 or January of 2008, the people at your company will be going to work every day to try and make you money. So long as they are banging away at their keyboards, ringing up sales, mixing chemicals, etc., they are working to make you more money. Your businesses aren’t likely to explode – for better or for worse – in just a few months or quarters. It will take years, and if you buy, hold, and sell on that premise, you’ll do very well.

Forget January. Forget 2008. Forget the stock market. Buy businesses and let time reward you for your good decisions.

My AEO stock is down and the markets are tanking!

But what about American Eagle Outfitters? The stock is at $18 and change! And it may go lower – a lot lower. Is it a good business? I think so. Are people still shopping at AEO’s stores? Yep. Is management still trying to reduce expenses, grow revenues, and generate more cash? You bet. Did you buy it hoping to make a quick profit? I didn’t.

When you buy an underpriced business, it may take years for the markets to correct their mistakes. Fortune smiled on us when JNJ and Wal-Mart ran up just weeks after I showcased them. The Tribune arbitrage play was meant to be a 3-week 10% profit. The fact that Amylin is down 23% since my July 26th cautionary post is a function of mere market fluctuations.

The stock market will do a lot of crazy things. It has always been that way; it will always be that way. Had you bought AEO in September of 1994, you would have seen your position slashed by some 80% over the course of the next year and a half. And had you held? A handsome, 13-year 22% average annual return at today’s price.

The market fluctuations are gut-wrenching. That’s why you have to ignore them. If not, you’ll drive yourself nuts and start making some really terrible moves.

If it works for Warren…

Buffett has been profiting from and holding stocks through the craziest, scariest, and wildest markets for more than 40 years. Think today’s markets are bad? You ain’t seen nothing compared to what he went through.

Price follows value. Maybe not today. Maybe not in 2008. But it does.

Now, let’s make some money the intelligent way and invest like real business owners/silent partners!

I don’t try to predict the direction of the markets on a daily basis; still, I hate to lose money. That’s precisely why I like to sell options from time to time.

An Options Primer

Options can be risky investments – particularly if you are buying them or selling them “naked” (when you don’t own the stock). An option is a contract – a right to buy 100 shares of a company’s stock at a particular price. If you are entirely new to options, The Chicago Board Options Exchange (CBOE) has some great tutorials and basics on options.

Selling Covered Calls

When you sell “covered” calls, you are selling a contract to deliver 100 shares of your owned stock at a specified price if the stock price gets above the “strike” price by a certain date. If the price doesn’t get above the strike price in that timeframe, you keep the stock and the premium that someone paid you for that option. If the price does get above that price, you deliver the shares you own…but you still keep the premium.

Reducing Your Basis

Selling options does not actually reduce your cost basis in a stock as far as the IRS is concerned. Still, cash is king no matter what the tax laws say. If you bought 100 shares of Johnson & Johnson at $65.86, you would spend about $6,596 (assuming a $10 commission). If you then sold one contract of the December $65 call, you would collect about $1.90 per share – or $175 (assuming a $15 transaction fee).

You would have essentially invested a net amount of $6,421 ($6,596-$175) to own 100 shares of JNJ. Here’s the rub: someone bought that contract you sold. In order for them to be profitable on that call, JNJ has to get above $66.90 ($65.00 + $1.90 in premiums) by the third week in December.

If JNJ gets above $66.90, you deliver your 100 shares, and you net roughly 1.2% in gains in one month. If JNJ doesn’t hit that price, you keep your 100 shares and the $175 premium.

A Bad Example

Now, JNJ is actually a bad example because the option premiums aren’t all that high – certainly not high enough to warrant risking your potential gains on such a solid, stable company. If, however, you own stock in a company with extremely volatile stock prices, the premiums are generally higher.

AEO, stock and options

Like most retailers, American Eagle Outfitters has seen its stock hammered over the past few months. Still, everyone at AEO is going to work every day to make money for us silent partners. Today, AEO is trading around $22.20. I don’t know what the price is going to do over the next few weeks or months. Still, I know I have people in at $23.02 per share.

Immediately after buying AEO at $23.02 a share, we sold the December 25 call against it and netted $0.88 a share. In essence, we have $22.14 a share in AEO – $23.02 on the stock minus $0.88 on the option.

Best case scenario: AEO does not hit $25.88 by the third week in December; everyone still owns AEO stock; everyone keeps the premium.

Worst case scenario: AEO hits $25.88 by the third week in December; we deliver AEO stock that we bought at a net price of $22.14; we earn a 13% return in six weeks (164% annualized).

The risk: AEO goes well above $25.88 and we miss substantial gains because we were shortsighted.

What to look for when selling calls

Don’t just run out and buy stocks for the sake of buying stock; don’t sell calls for the sake of selling calls. Be selective.

When looking for calls to sell against my portfolio, I look for three things:

1. The markets have to appear to be near their peak for the month. I don’t expect to go from 14,000 to 15,000 in one month this year; still, to go from 13,000 to 14,000 wouldn’t be all that surprising. I sell calls when everyone else is happy to buy them.
2. The premium must have a meaningful impact on my basis. I don’t sell calls that yield so little (e.g., JNJ above) that delivering the shares would give me a mediocre (or bad) return.
3. The strike price must be above my net cost basis. I don’t want to deliver shares for a loss when I hold a phenomenal, underpriced business for the long term.

Note: In number 3, I say my “net cost basis”. Let’s see what would happen if AEO didn’t hit $25 until July of 2008.

When price won’t budge, your cost basis still can

If the market stayed stubborn, pricing AEO at $20 to $24 for the next eight months, and I kept selling the $25 options against it (assuming the premium was a consistent $0.88), my “net AEO basis” would look like this:

If, come July of 2008, AEO then rose to $30 a share while I held the August option, I would deliver my stock at $25. With a net basis on AEO of $18.62, I would have a 34% return (slightly higher when annualized) be selling the options as compared to a 30% return had I not sold any options.

You have options with options

Of course, the above begs the question: What if AEO ran up to $40 but you delivered the stock at $25?

When you deliver your stock, you have two choices: Buy it again if it is a wonderful company or move on to the next investment opportunity. So many years from now, when you look back on your investing career, you will not judge your success by how much you made or missed on a particular stock – you will judge your success by how comfortably you have set yourself up for life.

Have I missed some high flyers? You bet. But I’ve also turned some dogs into winners (or break-even) because my judgment of value was wrong but my options plays were right.

Watch your fingers

Some parting advice on options: Don’t sell “naked” calls (selling when you don’t own the stock). Don’t sell puts. Don’t buy stocks just because the calls are priced juicily. Have patience when you buy your stocks; use options wisely; make investing a business.

Am I saying you should dabble in options? No. But they’re worth a look.

If you are not familiar with Hagstrom, he is the portfolio manager of the Legg Mason Growth Trust mutual fund and author of several books: The Warren Buffett Way, The Essential Buffett, and The Warren Buffett Portfolio, among others. The Warren Buffett Way presents a myriad of strategies for valuing companies…and that is precisely this book’s weakness.

Determine The Value

Hagstrom picks apart some of Buffett’s larger, more permanent holdings and presents certain valuations and rationale for buying. The problem is that there is no consistency in the valuation methods. Now I admit: There’s more than one way to skin a cat (or value a business), but it all comes down to one simple tenet-the value of a business is the discounted value of the cash that can be taken out of a business during its remaining life.

Owner Earnings = Net Income?

When analyzing Buffett’s purchase of The Washington Post Company, Hagstrom calculates owner earnings as net income-Wall Street earnings. Though Buffett does tell us that, over time, depreciation and amortization will equal capital expenditures, the two can vary widely for long periods of time.

Consider this: A company spends $10,000 on a piece of equipment that it will use for ten years. The IRS allows the company to depreciate that equipment for ten years. In that case, the company will have ten years of depreciation at $1,000-or $10,000 total.

Sure, depreciation and amortization will equal capital expenditures, but our company still had to shell out $10,000 today. If it continued to add $10,000 equipment every year, our depreciation would increase…but we’re still spending gobs of money on equipment.

The long and short of it: Owner Earnings do not equal Net Income.

The Post

Hagstrom then goes on to say that Buffett calculated the value of Washington Post to be Net Income divided by the rate of the U.S. Treasury-6.81% at the time-giving the company a value of $150 million. But Buffett himself said most people would value the company between $400 and $500 million. Time to fudge the numbers to make the formula work.

A couple of quick assumptions about profit margins and growth rates, and Hagstrom’s method shows the company to be worth $485 million. Of course, we have to make assumptions about the future to find the value in a company; still, the problem here is the method.

Dividing Net Income By The Treasury Rate

I was messing around in Excel, trying to figure out the logic of valuing a business by dividing owner earnings (or Net Income in this case) by a discount rate to value an investment. Here’s what I found when simplifying the numbers:

Let’s say I offered you a stream of income-$1,000 a year for 100 years. Let’s further say that you wanted to earn 8% on your money. How much is that income stream worth today? Roughly $1,000 divided by 8%-or $12,500.

Translating That To Businesses

If your company generated $1,000 in owner earnings, and you knew that you could rely on that $1,000 for the next 100 years, you could essentially divide $1,000 by your discount rate to find the value of the business. How practical is that?

Well, not practical at all. First, there is no way to know if your company will be around in 100 years. Second, there is no way to predict, with any degree of certainty, what owner earnings will be in 100 years. Third, if your business closes before 100 years have passed, you will have overpaid.

Strategy Changes

The above valuation is not the only method Hagstrom uses. Throughout the book, he presents three of four varying methods using different assumptions. Why? I can only guess that he presents a method for which the numbers work. That is, he looked at the purchase price and worked back from there.

Final Opinion: The Warren Buffett Way

In the end, the book is a good review of the businesses Buffett bought if you ignore the valuations that Hagstrom derived. Does it need to be on your shelf? It wouldn’t hurt. Still, if you are only going to buy a few investment books in your life, I think you can pass on this one.

Final Opinion: Quicken Stock Analyzer

Using Hagstrom’s method, Quicken shows that Buffett would have no interest in Johnson & Johnson. That may comes as a surprise to Buffett and his $3 billion investment.