Graham's Enterprising Investor Risks
Benjamin Graham's AdviceSecurity AnalysisStock TipsValue Investing

The Enterprising Investor Part 1: The Risks

on May 21, 2017

To continue our series on the two types of investment strategies Benjamin Graham outlines in The Intelligent Investor (defensive and enterprising), we’ll jump into part one of Graham’s enterprising investor: the risks.

Before we start, let’s take a moment to consider how Graham differentiates the defensive and enterprising investor. The defensive investor, which we wrote in our last post is a patient investor and an investor who doesn’t have the time, interest, or capital (think doctor, widow, or early 20s investors) to really analyze the stock market and pick out names which may outperform the overall market. The defensive investor is wise, they recognize that frequent trading negatively effects their portfolio returns, they commonly buy ETFs which will likely outperform their individual stock choices, or favor well-known blue chip stocks.

However, I’d take a bet that the majority of this blog’s followers are likely students of the market. We know we can buy an S&P and or other market-wide ETFs, leverage dollar cost averaging by adding more money to our portfolio regularly, and sleep comfortably with the reasonable expectation of tremendous long-term returns. But… there’s just something, well, boring about that strategy. Could we not invest a little more of our time to find high-quality stocks at good prices? Would we not be able to squeak out a few more percentage points of return most years by developing and managing our portfolios more closely? Of course we can, but before we cannon ball into the deep end, it’s worth taking a look at some of the risks and pitfalls Graham warns us that enterprising investors can fall for.

Those Who Do Not Remember the Past are Condemned to Repeat It

“Any well defined and protracted market situation of the past may return in the future.”
Benjamin Graham, The Intelligent Investor

There are a number of major stock market events we can all call to mind – the Great Depression, the run on banks, Black Monday, the Oil Embargo, the dot-com bubble, the 2007-2008 financial crisis; and the list goes on. Every investor knows the stock market is cyclical, yet prices don’t get driven to their all-time highs and bearish lows without a flock mentality. What objective, first-person signs can we look for to recognize over-valuations (feel free to add your ideas in the comments!)?

Here’s a short list of market signals I’ve seen personally:

  • In the midst of the dot-com bubble, my mom (who despite this story is actually a wise investor!) joined an all-women’s investment club of realtors and house wives. Please don’t misunderstand my point as a criticism of women (many studies have found that women are better investor’s then men), but the take away was that people who were never before interested in investing began to hear about how much people were making and flocked to the market.
  • In late 2011-2012, gold was breaking record highs every month, and it seemed every TV commercial break included a commercial for buying gold or trading in your old gold.
  • In the lead-up to the 2007-08 financial crisis, we heard endless stories of people flipping homes and new homes being built.
  • “Experts” talking about paradigm shifts in a particular market. In the dot-com bubble there were plenty of market analysts talking about how the internet has changed the game, earnings and P/E ratios no longer mattered nor did sound business plans. Similarly, in the darkness of the recent financial crisis, investors became overly-weary of the housing market and began to think there was a shift where long-term housing appreciation could be stalled or fall. We wrote in our December 2008 Real Estate Outlook (not to toot our own horn =)) that the fear was overblown.

Benjamin Graham’s Intelligent Investor Risks to Look Out For

My own experience is all well and good, but what risk factors does Ben Graham outline in the Intelligent Investor?

Bond Risks

We don’t discuss bonds often in this blog, mostly because interest rates are currently at artificial lows. However, Graham’s advice for bonds is extremely relevant today, he warns that when bond market yields are low, investors often look to steal an extra 1-2% in yield buy purchasing low grade bonds. In exchange for over-reaching for 1-2% yield, we can risk the entire loss of our principal.

IPOs: Graham’s Favorite Stock Market Factor

Graham counsels us that while investors generally prefer to invest in blue-chip companies, as bull markets rage investors become less selective and more aggressive. As a result, companies which investors would never have taken an interest in begin to receive more attention. A quantifiable response to investor’s becoming less selective are the number of private companies which become attracted to the high valuations the stock markets appetite may award them with, and the lower quality threshold the stock market demands for an Initial Public Offering (IPO).

Stock Market IPOs By Year, 1990-2016

IPOs By Year 1980-2016

I created the above chart of IPOs for 1990-2016 using Univerisity of Florida’s Jay R. Ritter’s data, Prof. Ritter uses a tight definition of IPOs which I believe is more helpful for getting a sense of where we are in the current bull cycle by excluding some noise, “follow-on offerings, oil & gas partnerships or unit trusts, ADRs (9 offerings), REITs”, etc.

The 74 IPOs in 2016 was the lowest IPO total since 2009! By Graham’s standards, this relatively low IPO output last year would indicate that the current bull market is far from over. At the same time, there has been some reporting in the last few years that private companies are shying away from the high-pressure and myopic stock market, as this Business Insider article details. Could this mean a paradigm shift is causing the slowdown of IPOs and Graham’s indicator is losing its value? With any paradigm shift, I’m doubtful, I believe greedy human nature, and genuine working capital advantages of going public will continue to make IPOs are useful indicator in the years to come.

If you are interested in tracking IPO data, the best available source I found on the web is Renaissance Capital’s IPO Stat Center. Please keep in mind they don’t have as tight a definition of IPO as Prof. Ritter, but they have more information on proceeds raised, filing activity, pricing activity, and a breakdown of IPOs by sector. Watch this space.

Defensive Investing - The Tortoise & The Hare
Benjamin Graham's AdviceSecurity AnalysisValue Investing

Graham’s Stock Market Strategy for the Defensive Investor

on April 30, 2017

To begin our series on the two types of investment strategies Benjamin Graham outlines in The Intelligent Investor (defensive and enterprising), we’ll start with Graham’s guidelines for the defensive investor.

I like to think of the defensive investment strategy along the lines of the The Tortoise and the Hare:

Hare ran down the road for a while and then and paused to rest. He looked back at Slow and Steady and cried out, “How do you expect to win this race when you are walking along at your slow, slow pace?”

Hare stretched himself out alongside the road and fell asleep, thinking, “There is plenty of time to relax.”

Slow and Steady walked and walked. He never, ever stopped until he came to the finish line.

The animals who were watching cheered so loudly for Tortoise, they woke up Hare.

Hare stretched and yawned and began to run again, but it was too late. Tortoise was over the line.
After that, Hare always reminded himself, “Don’t brag about your lightning pace, for Slow and Steady won the race!”

As silly as drawing investment advice from a children’s fable seems, there are a lot of parallels between the strengths of defensive investing and the tortoise’s winning strategy. Yes, the tortoise may not have a hot year where his portfolio is on fire; but he also won’t be subject to the same or greater downside risk. While the hare counts down the minutes to their latest hot stock’s earnings call, only to find out the value of the stock options they purchased have been crushed; the tortoise may be thinking up his dinner plans on the drive home from work, oblivious and unanxious at his blue chip’s stock’s earnings which just hit Wall Street expectations.

The tortoise will seldom have exciting stocks to brag about at dinner parties, but he will slowly but surely grow his investments while focusing on his main source of income – his career.

So what are the four rules for defensive stock picking?

  1. Reasonable Diversification – Graham recommends holding 10-30 names at any given time. Too few names, and the risk of any one stock plummeting can derail your portfolio, too many names and all the work you do in choosing quality stocks will become diluted.

    I would add that diversification requires a bit more thought than simply the number of stocks in your portfolio, having 20 gold stocks would still be a risky proposition. In a recent podcast interview with Howard Marks the founder of Oaktree Capital Management, Mark’s suggested a novel defensive investment strategy I – since none of us can consistently accurately predict the future, develop a portfolio which will do well in a range of outcomes we can imagine instead of betting the farm on one potential outcome. Mark’s noted that over the last 20 years, his flagship fund has never been above the 40th percentile in returns, but the fund has also never been below the 25th percentile in returns; and amazingly enough over the 20 years his cumulative return is above the 95th percentile.

    Returning to the topic over-diversification, while Graham didn’t have this intention when he first published TII in 1949, his warnings about over-diversification seem to dip into 21st century debate over active vs passive investing. Buying an S&P 500 ETF would give you a portfolio of 500 stocks, far more than the 10-30 names Graham recommended. Does this mean that Graham would be against index funds? The Motley Fool investigated the subject and concluded he would support index funds.

    We will revisit Graham’s views on index funds and passive investing in a future article. However, I do believe the new craze of passive investing deserves some reflection. Is it truly “passive”? An investor still decides the ETFs they want to purchase, sometimes by market – US, Global, Europe, Emerging, other times by sector – financial, technology, utilities, etc. Then the “passive” investor may still face the same challenges of active investors – they may interrupt or disrupt their returns by following the herd and pouring money into ETFs when they are most expensive; or they may sell in fear when the market takes a turn.

  2. Stock’s should be “large, prominent, and conservatively financed.” Graham defined large as a company with a market of at least $50 million, but because that number was established in his ‘72 edition, we’ll use Investopedia’s definition of a blue-chip stock as a market cap above $5 billion. A defensive stock is considered “prominent” if it is above the 65th percentile in it’s industry.

  3. A defensive stock should also have a long record of dividends. Graham recommends a stock having a dividend history of longer than 10 years, at which point a company has established a track record of consistent profits and returns for the company’s investors.

  4. Set a maximum Price-to-Earnings ratio that you are willing to pay for stocks. Graham recommends a maximum P/E of 20.

    Interesting, especially in a chapter outlining defensive investing strategy, Graham doesn’t rule out growth stocks, which he defines as stocks which are poised to double their earnings in 10 years (7.1% per year). Graham writes, “obviously stocks of this kind are attractive to buy and to own, provided the price paid is not excessive.” Using Graham’s open definition of defesinve stocks, I believe a case can be made for Facebook, the poster-child of growth stocks, based on today’s valuation. Even though Facebook has an incredible market cap of $441 billion and a P/E of 43 (as of April 28, 2017); their earnings growth over the last 3 years is an astronomical 90% per year, from $1.5 billion in 2015 to over $10 billion in 2016. While a 90% growth rate is unsustainable, even a 20% per year growth rate over the next ten years would lead Facebook’s earnings to be rise from $10 billion per year to $62 billion per year, which given a more conservative 20 P/E makes the stock a $1.2 trillion company. Although Graham might not have, I would exempt FB from Graham’s third requirement for dividends, as I believe Facebook’s return on investing moneyin their own business is higher than the return a shareholder would find with dividends. In sum, Is Facebook’s P/E high by traditional standards, yes; is it excessively priced based on its track record and prospects for growth? I don’t believe so.

Finally, Benjamin Graham closes his advice for the defensive investor by recommending an annual review of our portfolio. If we choose high-quality companies, at reasonable prices, we remove both the need and the risk over micromanaging and over-trading our portfolios. In a poignant (if not slightly depressing) paper by U.C. Berkley, “Do Investors Trade Too Much?” they wrote:

“This paper tests whether the trading profits of discount brokerage customers are sufficient to cover their trading costs. The surprising finding is that not only do the securities that these investors buy not outperform the securities they sell by enough to cover trading costs, but on average the securities they buy underperform those they sell.”

Benjamin Graham's AdviceValue Investing

Value Investing vs. Speculative Investing

on March 20, 2011

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

Dividend Discount Model Example

on July 26, 2009

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

10 Value Investing Rules to Remember

on February 26, 2009

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

How to Create a Medium Risk Portfolio

on December 31, 2008

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:

Happy Holidays!!

Financial News

What is a Ponzi Scheme?

on December 17, 2008

Charles Ponzi

The Madoff scandal may have you asking: What exactly is a Ponzi scheme?

The essence of a Ponzi scheme is better known today as a pyramid scheme.

In 1920, a Boston investment broker named Charles Ponzi told investors that he could earn them 50% returns on a 45 day bond, from his mysterious investing technique. Within the 45 days, Ponzi would recruit larger investors, and use their investments to pay interest on the last round of investors. When word spread that Ponzi had been delivering on his high yield promises, huge lines of eager investors formed outside his office. In his own words:

“A huge line of investors, four abreast, stretched from the City Hall Annex . . . all the way to my office! . . . Hope and greed could be read in everybody’s countenance. Guessed from the wads of money nervously clutched and waved by thousands of outstretched fists! Madness, money madness, was reflected in everybody’s eyes! . . .To the crowd there assembled, I was the realization of their dreams . . . The ‘wizard’ who could turn a pauper into a millionaire overnight!”

– Charles Ponzi

Bernie Madoff Ponzi Scheme
BiographiesFinancial News

Madoff, “Hmm.. let’s report 36.2% gains “

on December 16, 2008

Bernie Madoff

“I really think very highly of him, people make mistakes,” wrote a Madoff confidant and NYSE broker. At a party over the weekend I met a nice girl from Boston University, and I forgot to ask for her number when I left. THAT was a mistake.

Bernard Madoff, former chairmain of the board at the NASDAQ stock exchange stealing $50 billion through a Ponzi scheme is no mistake. The losses stem from a deliberate and deceitful crime of a magnitude only rivaled by Ken Lay and his chefs that cooked Enron’s books in 2001. The day before his arrest, Madoff told his sons that his investment firm “is all just one big lie.” And with great deciet, comes a captivating storyline including big name victims, a surfacing video of Madoff claiming an “impenetrable regulatory system”, a decieving investment strategy, and another SEC failure.

Mr. Madoff initially used his Wall Street reputation as a former chairmain of the NASDAQ board to recruit early investors at the finest country clubs around the country. He then created fictional returns that attracted more investors….investors who would eventually tell their friends, “I’ve got my money invested with Madoff and he’s doing really well. You can’t get in unless you’re invited…but I can probably get you in.”

Whenever a firm or individual requested money, Madoff would pay them with principal from other investors. Even though Madoff claimed gains throughout this 2008 financial crisis, many of his clients asked to withdraw their stock investments, until the withdrawls got overwhelming and he wasn’t getting new investors to furnish the old.

Blockbuster Names Go Bust With Madoff Securities

Among the big names with considerable investments in Madoff Securities were international banks, hedge funds, and wealthy private investors; some of whom invested 50-95% of their assets. New York Mets owner Fred Wilpon invested tens of millions of dollars of both his and the Mets organization’s money with Madoff. Other notables include Steven Spielberg’s charity, real estate magnate Mort Zuckerman, the Elie Wiesel Foundation for Humanity (Why couldn’t Madoff just say no to charities? Does he have no heart?) and Norman Braman, the former owner of the Philadelphia Eagles. Investment firms taking the biggest losses include Spain’s Gruopo Santander, France’s BNP Paribas, and Fairfield Greenwich Advisors.

Jeff Fischer, a top divorce attorney in Palm Beach, says many of his clients were also Mr. Madoff’s clients. “Every big divorce that came through my office had portfolio positions with Madoff,” he says.

Two of his investors said that among his clients, Mr. Madoff was considered a money-management legend; they would joke that if Mr. Madoff was a fraud, he’d take down half the world with him.

– WSJ.com: Fund Fraud Hits Big Names, December 13, 2008

Watch A Video of Bernard Madoff Lying Through His Teeth

Mr. Madoff’s words to his sons “it’s all just one big lie,” is definitely not an understatement..


Madoff’s Proposed Investment Strategy

Older, Jewish investors called Mr. Madoff ” ‘the Jewish bond,’ ” says Ken Phillips, head of a Boulder, Colo., investment firm. “It paid 8% to 12%, every year, no matter what.” Mr. Madoff explained his smooth returns by claiming that he bought baskets of stocks, and in case the market crashed he placed put-options. Hedging with options is a pretty damn common practice, but it never delivers small gains for dozens of consecutive quarters of changing market environments the way Madoff’s fund did.

“He was a low-key guy,” said Ms. Manzke of Maxam Capital Management, “he would say, ‘Look, I’m a market-maker, and I don’t want anyone to know I’m running money.’ It was always for select people. He was always closed, he wasn’t taking new money.”

The SEC Is Inept

I’m going to go on a limb and assume that no one at the SEC has heard of Frankie Valli or his hit lyrics, “you’re just too good to be true, can’t take my eyes off of you.” Clearly Madoff’s 1% monthly gains every month should have set off flags – either he was cheating the market or he was cheating his clients.

“Madoff Securities is the world’s largest Ponzi Scheme,” Mr. Markopolos, wrote in a letter to the U.S. Securities and Exchange Commission in 1999.” Markopolos was one of many members of the investment community baffled by Madoff’s returns, see: “Madoff tops charts, skeptics ask how” from a 2001 hedge fund magazine.

The SEC investigated Madoff Securities when they last filed in 2006 and the commission didn’t find any reason to further their investigation.

I thought the SEC was asleep at the wheel when it missed a decade of banks overleveraging and designing fantasy CDOs, but I’m getting the feeling they’ve been wide awake, just inept.

Conclusion

I need your help, I can’t remember the phrase… something about “good” and “true”? No one beats the stock market, not even Madoff the “market maker.” For every trade their is a buyer and a seller; both of whom might be the most “sophisticated” of investors, but only one will have made the right decision a year from now. Thousands of speculative investors may be early buyers into the next hot industry, but its doubtful they will be correct for years in a row. There is no game if someone always wins.

Sources:

Verizon Stock Dividend
High Dividend StocksStock Tips

Verizon – Stocks That Can Defend High Dividends

on December 11, 2008

In October, Verizon Communications (VZ) raised their quarterly dividend 7% to $.46 a share from $.43 cents, with a dividend yield at today’s price now 5.67%. Verizon should be able to defend its dividend in the next 12 months. The communications company is estimated to grow EPS 4% in the next four quarters, a slower rate than 2008’s 8%, but enough to cover the current dividend. The expected dividend payout ratio for 2009 is 69% percent of earnings, which is comfortably nested between the payout ratios from 2007 – 70% and 2008 – 67%. However, at today’s market price the company appears to be trading at a premium.

Verizon In The Bear Market

Two aspects of Verizon that I believe really help them in the current market conditions are their contract agreements and bundled services. The majority of Verizon Wireless customers are locked into a 2 year contract, with a steep termination fee of a couple hundred dollars, which will help retain customers through this recession. Secondly, Verizon has created a value bundle of their home product line that includes FIOS high speed internet, digital TV, and phone lines. Revenue for their bundled packages was up 45% year-over-year in the 3rd quarter reported in October. When families consider cutting their bills in these hard times, the Verizon package has strengthened its attraction.

Company Strengths

“Can you hear me now?” Verizon spent $2.5 billion on its successful advertising campaign in 2007, continuing to grow its already powerful brand name. 

Verizon has two product and service segments – wireline and domestic wireless that serve businesses and consumers.

The wireline segment was 54% of revenue in 2007 with sales of $50 billion and an above industry average 27.3% EBITDA profit margin. Wireline consists of voice, VOIP, internet access, and digital television. The segment has 41 million lines in 150 countries, with 85% of revenue comes from the United States. 

The wireless segment is run exclusively in the U.S. and in the most recent quarter Verizon added a net 2.1 million subscribers. The EBITDA profit margin for the wireless segment is 44.2%.

Company Risks

The two major risks for Verizon are cut-throat competition and the Telecommunications Act of 1996.

The company faces both solidified communications companies and cutting edge start-ups. Most notably, the company’s wireline phone services have to compete with low or zero cost voice-over-internet-providers like Vonage and the MagicJack which plugs into the a computer USB port and only costs about $20 a year.

The Telecommunications Act of 1996 permits competitors to buy Verizon’s services at a discount and resell them in the marketplace. This cuts into Verizon’s profit margins and ability to add subscribers. However, since the act was put into law in 1996 the company’s bottom line has risen tremendously, so you can make the case that the act has only a slight negative effect that hurts every company in the industry equally.

Additionally, Verizon has a unsettlingly low current ratio of .68 and debt-to-equity of .88. The firm clearly uses a lot of debt to aggressively grow earnings, and if they begin to lose market share from stiff competition their high leverage will backfire.

More Information on Verizon

You can visit http://investor.verizon.com/ to read Verizon’s latest quarterly and annual report.

Conclusion

Verizon is not poised to break any earnings growth records in 2009, but the company is competitively positioned with its bundled packages to fight this recession and retain past growth rates when we return to a bull market. I believe that if Benjamin Graham could comment, he would conclude that Verizon is not a value investment at today’s price of $32.47. The company does not meet the 2-1 current ratio requirment, nor is it trading 40% below its 52-week high. But, if you can buy shares between $25-$28 the company becomes much more attractive and you can benefit from a sturdy dividend yield between 6 and 7.5%.

Full disclosure: None.

Benjamin Graham's AdviceMacroeconomySecurity Analysis

Benjamin Graham on Market Behavior

on December 2, 2008

In Security Analysis, Benjamin Graham emphasizes the importance of not only focusing on a firm’s potential and accounting statements, but to also pay great attention to the business cycle. Individual investors should research and create their own one year outlook for the market.

Almost any security may be a sound purchase at some real or prospective price and an indicated sale at another price.

– Benjamin Graham, Security Analysis

Think Long-Term

However, Graham also stresses that day-to-day and month-to-month fluctuations of the market should be ignored. Instead, investors should focus on the major shifts in market sentiment and estimating what stage of the business cylce we are in. Clearly today we are in a brutal bear market that has brought down the S&P 500 over 40% year to date. But we have to ask ourselves, what inning of this bear market are we in? Where do we see the strongest values in the market?

Benjamin Graham on Investing in Bear Markets

In a typical case of bear-market hysteria or pessimism the investor would be better off if he were not able to sell out so readily; in fact, he is often better off if he does not even know what changes are taking place in the market price of his securities.

– Benjamin Graham, Security Analysis

Graham’s sentiment on holding onto securities in a bear market could have taken a huge chunk out of someone’s portfolio this year, I know holding onto crashing stocks has severly hurt my portfolio. However at this state of the bear market I believe the above quote is appropriate.

It is ill-advised at this moment in time to liquidate investments into weakness. Your portfolio may depreciate in the coming months, but sometimes you have to take a 3 month deep breath and try your best to not follow your stock prices on a daily basis and just enjoy your dividend yields! To do this you have to be sure that your portfolio is filled with strong, value stocks with years of consistent earnings growth. Ignoring equity prices does not mean you should ignore the latest news from stocks you own. Shares should be sold if there is a fundamental shift in the companies’ long-term outlook.

Even though Warren Buffet’s 2 month-old investment in Goldman Sachs (GS) at $115 a share has fallen almost in half to $65 a share, I’m willing to bet he is sleeping well at night knowing he is invested in a first-in class company (although the investment banking class may be gone forever) and enjoying a 10% dividend yield from his preferred stock.

Don’t Purchase a Stock at Any Price

Finding the strongest values is no easy task, and Benjamin Graham gives some bull market advice that is worth remembering once this cycle changes gears. “Don’t purchase stocks at any price.” He writes that great companies don’t necessarily indicate a great investment if their stock price is comparatively high. Be a patient investor and wait until the company drops to an attractive level. For instance during a bull market in 2006 you could have bought Microsoft (MSFT) at a high of $30.19 or a low of $21.92 (or today at $19.15!) – a 27% variation. If a stock price of a company you have been watching continues to soar far above the intristic value (you can use my post on the Dividend Growth Model to estimate intrinsic value) you give the company, don’t feel like you missed the boat, in the long-term the price very well will come down to levels you like or their earnings will improve to increase your valutation.

When to Invest In Small Cap Stocks

Graham also notes that small cap stocks are more sensitive to swings in the overall market. Your position in small caps should be minimized in your portfolio if you have a weak outlook for the coming year and your small cap positions should be increased in bull markets. This sentiment is supported decades after Graham’s writing, consider comparing SPDR DJ Wilshire Small Cap Growth (DSG) which retreated 49% YTD vs. SPDR DJ Wilshire Large Cap Growth (ELG) which declined only (only!?) 43% YTD.

Beware of Bull Markets

Beware of “bargains” when most stock prices are high. An undervalued, neglected stock may continue to be neglected through the end of the bull market and may potential be one of the hardest hit stocks in the following bear market.

Market Environment, Potential Value, and Intristic Value Produce Market Price

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