Category: Value Investing Ideas

Benjamin Graham's AdviceValue Investing Ideas

Value Investing vs. Speculative Investing

Benjamin Graham, Value Investing vs. SpeculationWhile you contemplate a major investment decision, you need to ask yourself if you will be making a value investment or a speculative investment. You can use Benjamin Graham’s extensive writing about the difference between value and speculative investments to categorize potential investments you are considering.

Speculative investors bet on the Yankees in a Vegas casino. When the Yankees are on a hot win winning streak, the speculator can double his investments after each victory, but when the Yankees’ bats turn cold, the speculative investor will be walking the streets hat in hand.

Value investors buy bonds for Yankee stadium’s construction.

Speculative investors buy a stock with a hunch that the price will go up or down quickly. Value investors buy a stock after determining the long-term value of the business.

Although value investors outperform speculative investors in the long-run, value investors do not expect to outperform the market. Value investors accept the reality that no one can predict market behavior; instead, value investors work to control their own investment behavior.

Benjamin Graham’s 3 Types of Value Investments

1) Well established investment funds – examples are 5-star Morningstar mutual funds, corporate bond funds, & municipal bond funds.

2) Common trust funds (separate accounts) – High net worth investors can hand their portfolio over to a commercial bank or investment firm that will responsibly manage their money on a one-to-one basis.

3) Dollar cost averaging – Deposit a consistent amount of money at specific intervals (monthly or quarterly) into your portfolio. The easiest way to dollar cost average is to buy a mutual or bond fund (from Vanguard for example) where you can setup automated deposits – this way you don’t have to pay trading fees for buying new stocks or bonds every investment cycle. Suze Orman offers a dollar cost averaging calculator on her website.

Benjamin Graham wasn’t alive to see the days of Exchange Traded Funds (ETFs) but I would add ETFs as a fourth value investing option:

4) ETFs – ETFs allow you to buy a stock index (i.e. SPDR S&P 500 ETF – SPY) or a weighted stock sector (i.e. Ultra Basic Materials – UYM). The advantage of ETFs, is that you can buy a diversified investment without having to pay the associate trading fees if you bought a number of stocks, and the ETF management fees are considerably lower than their mutual fund counterparts, about .1% vs. 1.5% respectively.

Benjamin Graham’s 3 Types of Speculative Investments

1) Trading in the market – Shorting stocks that have had a short-term run-up in price.

2) Short-term selectivity – Buying stocks with upcoming earning releases that the speculator believes will beat Wall Street estimates.

3) Long-term selectivity – Picking stocks with high returns in the past, or stocks with promising product releases like tech and drug companies. A risk of “long-term selectivity” is that the speculator may buy a company with an upcoming product that eventually undersells or never makes it to market. Or the speculator’s estimates were correct, and the firm’s upcoming product is a hit, but the previous market price already consider the product’s success. Or even though the speculator’s assessment was correct, he could suffer from the John Maynard Keynes’ proverb, “The market can stay irrational longer than you can stay solvent.”

Special Situations

In between value and speculative investing are “special situations.” A prime example is investing in merger & arbitrage opportunities. Companies announce mergers for shareholder approval far in advance of any formal agreements. The announcement includes a suggested buyout price, and there is usually a spread between the market price of the company being purchased and the suggested buyout price. Immediately in response to the announcement the spread between the market price and buyout price begins to close. However, up until the day that the deal is finalized (or canceled), the spread fluctuates based on investors’ assessment about the likelihood that the deal will be completed. A recent example of a successful M&A closing is 2008 purchase of Anheuser-Busch by inBev. As close as two months before the deal closed, the merger spread widened on credit concerns, causing Anheuser-Busch to sell at $64.86 a share, while the buyout offer stood at $70 a share.

Conclusion

Do you find that you are more of a value investor or a speculative investor?

I find that my natural inclination is to be a speculative investor. So before I make a trade I ask myself how easily I will be able to sleep at night, or as Benjamin Graham puts it, I ask myself if the trade promises “safety of principle and a satisfactory return.”

High Dividend StocksValue Investing Ideas

Dividend Discount Model, Pro Stock Analysis

Stock AnalysisThe Dividend Discount Model (Gordon Equation) calculates the intrinsic value of a stock based on the present value of a company’s future dividends. The model is a powerful investing tool to evaluate if a stock is over or undervalued compared to the market price. Professional investors use the Dividend Discount Model (among others) to value a stock, but for some reason casual investors have a habit of looking at a stock’s price chart to determine if a stock is a good value. The ill-fated chart approach has caused many casual investors to lose a bundle, after all – how can you profitably drive your portfolio if you’re focused on the rear view mirror?

This post is divided into the following sections: Dividend Discount Model’s equation, a sample valuation using Microsoft, and problems with the model.

The Dividend Discount Model

Where:

D1 (Estimate of next year’s dividend) = Current annual dividend * (1 + g)
r (Required Rate of Return for the Stock) = Real Risk Free Rate + (Market Return – Real Risk Free Rate) * Beta of Stock
Real Risk Free Rate = 52-Week T-Bill Yield**
Market Return = Estimate for the stock market’s return in the next year
g (Dividend Growth Rate) = Estimate for the stock’s dividend growth rate (you may calculate g by using the growth of the dividend in the past)

** 52-Week T-Bill Yield – You can find the yield by going to the U.S. Treasury Direct website, selecting the most recent year under auction date > 52-week bills > PDF of the latest auction results.

Sample Valuation

Here’s a sample valuation of Microsoft (MSFT) using the Dividend Discount Model..

The Dividend Discount Model requires two major assumptions – the return on the stock market for the next year and the growth rate for the stock’s dividend. In this example I will use an optimistic 12% expected return for the stock market, and a 10% dividend growth rate for Microsoft, based off their 2008 dividend growth. When you run the equation you can change these values to high, medium and low numbers, so that you can see a range of strike prices based on differing 1 year outcomes for the stock market and Microsoft’s dividends.

g (growth rate) = 2008 dividend / 2007 dividend
= .44/.40
= 10%
D1 = Current Dividend * (1 + g)
= $.52 * (1 + .1)
= $.572
r (required rate of return) = risk free rate + (market rate – risk free rate) * MSFT’s beta
= .55% + (12% – .55%) * 1.01
= 12.12%
Dividend Discount Model = D1 / (r – g)
= $.572 / (.1212 – .1)
= $26.98

Microsoft closing price as of last Friday July 24, 2009 was $23.45, so with a $26.98 valuation from the Dividend Discount Model, Microsoft would be considered undervalued.

Problems With the Model

For high-growth stocks, the growth rate (g) may be higher than the required rate of return (r), in which case the suggested stock value would be a negative number.

It is important not to use the Dividend Growth Model by itself, but rather as one tool in the value investing toolbox we’re constantly building on this blog

Feel free to ask me any questions you may have in the comments section below..

Value Investing Ideas

10 Value Investing Rules to Remember

Merril Lynch’s David Rosenberg predicted the recession in January of 2008, when the downturn was in its infancy and the Dow Jones was only down about 10%. Rosenberg gave credit for his great insight to Merril Lynch’s former investment analyst Bob Farrell’s “10 Market Rules to Remember”.

Rules one through four, which include the belief that markets always return to long-run averages and excesses in one direction are invariably followed by excesses in the opposite direction, are applicable to this decade’s housing cycle, Rosenberg said.

Farrell’s rules “were a compass in terms of guiding me through the past three years,” said Rosenberg

– Bloomberg, “Merrill’s Rosenberg Inspired by Farrell in Foreseeing Crash” 

Farrell’s 10 Market Rules to Remember:

1. Markets tend to return to the mean over time.

2. Excesses in one direction will lead to an opposite excess in the other direction.

3. There are no new eras — excesses are never permanent.

4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.

5. The public buys the most at the top and the least at the bottom.

6. Fear and greed are stronger than long-term resolve.

7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue chip names.

8. Bear markets have three stages — sharp down — reflexive rebound —a drawn-out fundamental downtrend.

9. When all the experts and forecasts agree – something else is going to happen.

10. Bull markets are more fun than bear markets

For a detailed analysis of the ten rules, check out this MarketWatch article.

Even with the stock market finding a pulse of late, the overwhelming investment sentiment is clearly pessimistic. I can’t stop thinking about October of 2007 when the Dow Jones was at 14,000. The investment community and average investors were unified in their optimism to equal levels that they are now pessimistic. I love Farrel’s ninth rule – when all the “experts” agree, something else is going to happen. I’m still firm in my belief that Mr. Market has given value investors a great opportunity to buy.

Any thoughts on Farrell’s ten rules?

Value Investing Ideas

How to Create a Medium Risk Portfolio

This post focuses on a technique to attain medium risk in your portfolio with a value investing approach. “Medium risk” seems to be an elusive term, which was well illustrated in the bear market of 2008. In Nassim Taleb’s book he shares his brilliant “barbell” investing strategy that comes as close to the essence of a medium risk and value investing portfolio as I have come across. He advises that we invest 80-90% of our portfolio’s in Treasury bills, the safest investment class on the planet. The remaining 10-20% should be invested in high risk bets like options.

Taleb’s strategy is unconventional, but lets take a closer look. In the past year we have seen overwhelming proof of investors and economists inability to speculate. Millions of shares of Bear Stearns were bought above $100 before their sale to J.P. Morgan for a couple of dollars and the majority of “sophisticated investors” were only mildly bearish in January 2008. By investing 80-90% of a portfolio in T-bills you create a safe nest-egg. The percent of your portfolio devoted to options gives you a floor on your possible exposure to massive losses in the equity market – you cannot lose more than 10-20% in any given year. At the same time, if your option bets are successful, you have a large upside.

Let us consider the medium risk math – the most recent 10 year treasury notes sold for about 4%  interest rate (which is near the historical low). Lets estimate that all your option investments have a wide range of 50% returns or 50% loses in a year. If 80% of your portfolio returns 4% that effects your portfolio with an overall increase of 3.2% (80 x 4%). The 20% dedicated to options with a +/- 50% return will deliver a 10% increase in your overall portfolio or a loss of 10%, at either end of the spectrum. So overall in a good year of 50% returns on options your overall portfolio will increase 13.2% (3.2% + 10%) and in a terrible year of 50% loss on options your overall portfolio will decrease 6.8% (3.2%-10%). By a show of hands how many people would be happy to have only been down 6.8% this year?

If you are considering treasury bills you can research rates and buy t-bills at the goverment website – http://www.treasurydirect.gov.

Taleb’s proposal is an interesting blend of very low and very high risk that appears to attain true medium risk. I am interested to hear what you think and if you would consider Taleb’s diversification method. The method came from his bestselling book, The Black Swan: The Impact of the Highly Improbable. Taleb is a sucessful hedge fund manager and professor who studies human’s poor ability to make predictions and the effect of “Black Swans” or random, unpredictable events. Taleb’s book is available on Amazon:

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