Sunday, August 31, 2008

The BMW Method

Jim Schout believes he's uncovered a trick to finding long-term winning stocks that have temporarily stumbled -- and he needs the potential for 25% annual returns before he becomes interested in a stock.

Granted, the investing industry abounds with prophets touting "winning systems" -- for a price -- but what grabbed my attention at a recent conference was that Jim doesn't charge a penny for his system. He's happy to exploit it for his own gain. We'll get to several stocks Jim likes -- and doesn't like -- shortly.

From its beginnings 13 years ago, Jim's "BMW" method has steadily gained adherents, blossoming into a self-propelled mini-industry of message boards (the BMW Method board is a staple of the Fool community), websites, conference calls, annual meetings, and T-shirts. Not to mention what seem to be great investing returns.

Invited to the 2007 BMW method conference to both speak and listen, I came away intrigued -- and armed with an interview from Jim Schout, the man who scoffs at 24% returns. (Note: This interview was first published Dec. 14, 2007.)

James Early: In a nutshell, what is the BMW method?

Jim Schout: The BMW method is about exploiting something in plain view, yet something the market seldom looks at: the really big picture. In the short run, the market may be very irrational, but the market is always correct in the long term. Like a band in formation, or sports fans collectively spelling out enormous words at a stadium, investors often don't see the big picture -- but with a bird's-eye view, it's easy to spot.

I achieve this by applying lines of constant growth to a stock's long-term price data. Let's say a company's stock price has average growth of 12% annually over the past two or three decades. I might apply lines representing 10%, 11%, 12%, 13%, and 14% growth to the chart. What often jumps into view is [that] the share price continually rises after reaching the 10% CAGR line. The price tends [to] "bounce" up from that low growth line over and over again. That is the BMW method in a nutshell. It is quite simple to spot underpriced equities this way.

If a stock is presently priced at its historically low CAGR, what's wrong? I'll dig deeper here with due diligence to determine if I think the problem is temporary. It's essential to see if there has been a fundamental shift in the company's ability to add value. Maybe a law changed, or a technology became obsolete. More often, Wall Street has decided to act irrationally and undervalue the shares. I love it when that happens.

At the end of the day, if I believe that the underperformance is temporary, or it exists for reasons that make the downturn irrational from an investing sense, then I will buy that stock.

Where have we heard this before?

Here's a couple of predictions I recently came across:

"We are in the early stages of a long cycle of generally accelerating inflation."

"If we do not solve the energy crisis, the American Dream is over."

Where'd I find these bearish remarks? They weren't part of a Jim Cramer rant or a Barack Obama speech. In fact, they weren't made by anyone contemplating recent headlines.

Nope -- these are from the pages of Howard Ruff's 1981 book, Survive & Win in the Inflationary Eighties. These eerie predictions -- which sound like they were stripped from the front page of a recent Wall Street Journal -- are nearly 30 years old!

Charlie Munger quotes

Had Warren Buffett never been born, there's a good chance we'd award the "world's greatest investor" honor to his right-hand man, Charlie Munger. Not only is Berkshire Hathaway's (NYSE: BRK-A) co-chairman a phenomenally talented investor, but he'd probably school almost anyone in a debate about philosophy, biology, physics, or just about any other topic. The man's disturbingly smart.

I'd continue this introduction, but as Munger might bluntly say, "Nobody would listen." Without further ado, here are five Munger quotes you should study before making another investment decision.

[9/5/08] Five more Munger quotes

Da Bear

If we exclude the two most extreme bears -- the grinder of 1973-1974 and the dot-bomb bear of 2001-2003 -- some fairly consistent patterns emerge. The total market declines from top to bottom ranged from 21.5% to 36.1%. Yet while the typical length of bear markets ranged from just over three months to more than a year and a half, they usually ended within six months after hitting that 20% decline.

Compare with where we are now: about 1.5 months past the 20% marker, almost 11 months of bear-dom so far, and the low point so far (as of this writing) was 22.4% off the high, set on July 15. All of which is right in the historical ranges -- so far, this bear isn't extraordinary by any means.

Wednesday, August 27, 2008

bearish sentiment

A recent New York Times article pointed out that bearish sentiment, as measured by the Conference Board, has hit an all-time high. Fully 55% of the people questioned in July expect the stock market to decline over the next 12 months.

Why is this important today? Because each time the bearish sentiment has exceeded 35% over the past 21 years, the market has confounded that sentiment by gaining ground over the following year, at an average pace of 20.5%.

10 Things Millionaires Won't Tell You

7. "I was a B student."

Mom was right when she said good grades were the key to success — just not necessarily a big bank account. According to the book "The Millionaire Mind," the median college grade point average for millionaires is 2.9, and the average SAT score is 1190 — hardly Harvard material. In fact, 59 percent of millionaires attended a state college or university, according to AmEx/Harrison.

When asked to list the keys to their success, millionaires rank hard work first, followed by education, determination and "treating others with respect." They also say that what they absorbed in class was less important than learning how to study and stay disciplined, says Jim Taylor, vice chairman of the Harrison Group.

Thursday, August 21, 2008

How are oil prices set?

Crude is a commodity, a raw material like natural gas, corn, wheat, gold, coffee, and cattle used to produce other goods. The costs of extracting oil from its source could vary widely from $5.26 a barrel in the Middle East region to $63.71 for U.S. offshore crude, based on 2004-6 averages from the EIA. Petroleum is bought and sold under exotic names like Nigerian Bonny Light, North Sea Brent Blend, and West Texas Intermediate on a variety of futures markets -- where traders deal for the rights to buy and sell product at a specific price on a future date -- around the world and governed by the rules of a particular country.

"The energy markets are among the largest and most liquid," says Timmer. "The oil market is no different from the stock market in that oil futures are traded on exchanges where buyers meet sellers." For an outsider, however, locating precise figures to explain how crude is currently priced is harder to unearth than a gusher in Central Park.

Generally, there are two ways to trade commodities: either market trading or over-the-counter trading (OTC). Market trading takes place through the New York Mercantile Exchange (NYMEX) and is self-regulated with oversight by the Commodities Futures Trading Commission (CFTC), the government agency charged with regulating the commodities markets. In contrast, OTC trading is conducted without any such regulatory controls.

Only about 25%-35% of all energy trading occurs on the NYMEX,4 which means up to 75% of all oil contracts go unchecked by the federal government. Because OTC trading is unregulated, the exact volume of trades -- not to mention the legality -- is unknown. To compound matters, despite growing activity in the commodities markets, the CFTC has a staff of less than 500, compared to 3,700 for the Securities & Exchange Commission.

Other legal escape routes allow energy trading on so-called "dark markets," exchanges not subject to the transparency and accountability laws governing U.S. exchanges. For example, the "foreign markets loophole" lets investors buy and sell millions of barrels of U.S.-bound oil multiple times overseas before ever reaching American shores, thereby driving up the price with each change of hands.

The standards for trading crude oil and setting prices should be, theoretically, consistent among different international market regulators. However, recent U.S. congressional hearings have introduced terms like "dark markets" and "swaps loopholes" used by some investors to skirt largely toothless government controls. Oil speculators -- typically hedge funds and investment banks -- have come under a spotlight amid allegations of exploiting gaps in the regulatory system.

According to the CFTC, the government agency charged with regulating the commodities markets, the percentage of petrol contracts controlled by speculators has surged to 71% in 2008 from 37% in 2000.

The International Monetary Fund has concluded that speculation has played a significant role in the run-up of oil prices, according to testimony at a June 23 House Energy & Commerce subcommittee. Also at that meeting a Lehman Brothers analysis suggested that more than half of the price of a barrel of oil may be attributed to speculation. Even the Saudis, the world's largest oil producer of 9.7 million barrels a day as of July, contend that supply-and-demand seems to be in balance and that there is no substantive basis for current price levels.5

At this stage, however, no one knows for sure if any improper oil transactions have been executed. In part, that's because American authorities can neither fully police nor gain access to data in most overseas commodities markets.

dividends and growth

In 2003, Rob Arnott -- former editor of the Financial Analysts Journal, a publication of the CFA Institute -- and Clifford Asness, managing principal at AQR Capital Management, looked at dividend yields and subsequent 10-year earnings growth. Their findings? Amazingly, earnings growth increased with dividend payout, right up to the highest payers having the highest next-10-year earnings growth.

a long bear

From 1959 to 1974, the Dow Jones Industrial Average gained precisely 0%. It has gone down as one of the longest and most painful bear markets of recent history.

The Nasdaq is currently in what is shaping up to be an even longer bear market. It's down around 50% from its peak of more than 5,000 in March 2000, and I would argue that it's likely to take another 12 years -- until 2020 -- to reach that level again. That would mean a roughly 20-year period of 0% returns for the index. Like the 15-year bear market from 1959 to 1974, it will go down as one of the biggest bear markets of all time.

But the truth is, there's still money to be made in bear markets.

... the first thing about making money in this bear market is clear: Don't buy and forget. Monitor your existing holdings, sell if your thesis has radically changed, keep cash ready to pounce on new opportunities, and put that money to work on a regular basis. It may seem obvious, but an individual investor would have made far more money by investing throughout the bear market than during the irrational exuberance of the bull.

The Secret of Dividends

Between January 1926 and December 2006, 41% of the S&P 500's total return sprang not from the price appreciation of the stocks in the index but from the dividends its companies paid out.

That's right -- a cool 41%. Annualized, that amounts to 4.4 percentage points. To put it in dollars-and-cents terms, consider this: An investment of $10,000 over that stretch would have grown to $1,013,000 without dividends. With dividends kicked in and reinvested, however, that same sum would have been worth a whopping $24,113,000 by the end of the period.

Talk about the miracle of compound interest!

Tuesday, August 19, 2008

300 Point Rallies

We're in a very confusing atmosphere. People didn't really know what to make of a 300-point rally in the Dow the other day, but my main message was that 300-point rallies from the Dow don't happen in bull markets. In fact, they never happened in the bull market from October '02 to October '07, but it has happened 6 times in this bear market and happened 12 times in the last bear market. You don't get moves like that in bull markets. As Rich Bernstein has said time and again, "This is the hallmark of a recession and a hallmark of a bear market."

Monday, August 18, 2008

Mauldin not bullish (surprise)

I think we are likely to stay in recession for perhaps the rest of the year and well into 2009 before we start a very slow recovery. It is not time to get bullish on stocks, as I have been writing for the past few months. Earnings are going to continue to come under pressure, and earnings are what drive the stock market over the long term. We could see total S&P 500 as-reported earnings drop below $50. You do the math. Even with a 20 multiple, that does not yield a pretty picture.

I think we are going to test the recent lows and then watch the market go lower as the market gets disappointed in the earnings from the third quarter, and re-test those lows again. We are in for an extended period of Muddle Through, while we wait for the housing market to find a bottom and the credit crisis to abate. Banks and other institutions have written off about $500 billion. There is at least another $500 billion to go. The amount of capital that is going to need to be raised is astronomical, and it is going to be very dilutive to current shareholders.

Wednesday, August 13, 2008

gurufocus financial data and charts

About two months ago, we informed our users that we have licensed 10-year financial data. The data is now available to all users. Here we like to introduce the features in the new page.

The Accidental Billionaire

About 10 years ago, Forbes Magazine ran an article about an "accidental billionaire" named Franklin Otis Booth Jr.

In the early 1960s, Booth tried to buy a printing company that contracted with The Los Angeles Times. The deal fell through, but he became good friends with the lawyer working on the case.

After discovering they had similar investment philosophies, they partnered up to build a 40-unit condo complex in Pasadena, Calif. -- and managed to double their money in just two years.

Booth decided he wasn't up for pursuing further real estate development, but he did agree to put $1 million into an investment partnership the lawyer put together. Thirty-five years later his stake was worth $1.2 billion.

The cynics and risk-takers among you will undoubtedly chalk Booth's success up to "luck."

Granted, his is a case of being in the right place at the right time, but the actual process that grew his fortune had very little to do with luck.

He didn't dump his money into penny stocks that took off. He didn't get in on the ground floor of Oracle (Nasdaq: ORCL) or IBM (NYSE: IBM). He didn't make smart options trades.

What he did do was hand his $1 million over to that lawyer and a "clever young fellow." They, in turn, made big bets on unexciting businesses with wide moats that were selling at a discount to their fair value. These businesses all had strong brands, outstanding returns on capital, consistent or improving profit margins, and substantial cash profits.

That's all -- big bets on great companies selling at good prices.

Of course, by now I'm sure you know that the lawyer was Charlie Munger and the clever young fellow he teamed up with was none other than Warren Buffett.

* * *

The Accidental Billionaire

yields are high

It's looking gloomy out there. The S&P 500 is down 12% year to date, led by the financial sector, which has lost one-fourth of its valuation.

Amid all the doom and gloom, one silver lining has drawn little attention: Dividend yields are the highest they've been more than a dozen years.

The recent market plunge has increased the S&P 500's dividend yield to 2.2%, its highest level since December 1995. Not even during the aftermath of the tech bubble collapse in the fall of 2002 -- when the S&P 500 traded at a paltry 815 -- did the yield break 2.0%.

But high dividend yields aren't the only reason this is a great time to be in the market -- stocks are also cheaper than trusty bonds.

The 10-year Treasury bond currently yields 4%. The equivalent measure of return for stocks is the earnings yield (earnings divided by price) -- and it currently stands at 5.5% for the S&P 500.

This divergence is unusual -- and a potential boon for investors. According to renowned value investor Arnold Van Den Berg of Century Management, (whose firm returned 13% net of fees vs. 6% for the S&P 500 over the past 10 years):

The usual difference between a bond yield and stock earnings yield is about 1%. For example, if investors can get 6.3% on a guaranteed bond they are willing to accept 1% less, or a 5.3% earnings yield on a stock. The reason for this is that if you have a 5.3% stock earnings yield and it is growing at 7%, it will equal your 6.3% bond yield in about 3 years. Anytime thereafter, the stock earnings yield will increase by 7% per year.

Investors are usually willing to accept a lower yield in stocks, because of the presumption of future growth. Right now, however, investors can get that growth at a better price than bonds -- and with the added bonus of high dividend yields.

Earnings yields like this suggest the market thinks earnings are likely to fall. But I would counter that even if earnings fell, the S&P 500 still would yield almost equal to the Treasury bond rate.

The combination of high dividend and earnings yields relative to bond yields means that this is a great time to buy dividend stocks.

Wednesday, August 06, 2008

quote of the month

"Wouldn't it be great if we could buy love for $1 million. But the only way to be loved is to be lovable. You always get back more than you give away. If you don't give any, you won't get any. There's nobody I know who commands the love of others who doesn't feel like a success. And I can't imagine people who aren't loved feel very successful." Warren Buffett

-- Warren Buffett Monthly Newsletter Issue #27

what is growth and income exactly?

Generally, a Growth and Income play will have healthy balance sheets, consistent dividend payments, quality products and services and experienced management teams. Usually Growth and Income companies are industry leaders, displaying steady earnings growth.

Companies that continually exhibit stable earnings growth, more than anything else, are ones that should hit the radar screens of Growth & Income investors. After all, companies exhibiting all of the characteristics mentioned earlier should have no problem producing a steady stream of profit growth, right? Analysts will subsequently grow more optimistic about the future earnings potential of the company and adjust their estimates up accordingly.

Growth & income investors get a dual benefit from following earnings estimate revisions. First, positive estimate revisions help investors buy shares in the companies with the best chances to outperform the market. Second, positive estimate revisions provide the easiest means to monitor the health of companies, providing a rather clear signal when the time has come to abandon ship. Companies experiencing upward estimate revisions will generally enjoy positive momentum going forward. Rarely will a stock suffer a significant price decline in the face of improving fundamentals. Add it all up and it’s clear that Growth and Income investors should only buy shares in companies enjoying upward earnings estimate revisions.

[says Zacks]

The bear market is official ... now what?

One of the saving graces to having officially entered a bear market (a >20% drop) in mid-July is that we no longer need to debate whether we're going to get one or not. Based on long-term averages, we may have more to go with this bear both in terms of damage and duration but, as always, we caution investors about full-scale bailing out of the market at this point.

History has shown that typically, once the –20% threshold has been hit, the majority (two-thirds) of the decline is in the past. [The median bear market lost 33.5% and lasted 250 days.] And, of course, timing the bottom is nearly impossible.

The bible talks business sense

Invest systematically: “He who gathers money little by little makes it grow.”—Proverbs 13:11

Pay tax: “Give to Caesar what belongs to Caesar...”—Luke 20:25

Avoid debt:The rich ruleth over the poor, and the borrower is servant to the lender.”—Proverbs 22:7

Save: “The ants are a people not strong, yet they prepare their meat in the summer.”—Proverbs 30:24

Diversify: “Divide your portion to seven, or even to eight, for you don’t know what misfortune may occur on the earth.”— Ecclesiastes 11:2

[from livemint.com via Chirag@investwise]

Monday, August 04, 2008

who's blog?

While googling around, I noticed there's a blog by veryearly1 called Finance and Philosophy Blog. At first I thought this was the blog of veryearly1 of chucks_angels. After all, there is a lot of information pertaining to investing, in particular on Buffett and Munger. And the guy who's writing it is reflective and sounds quite intelligent.

But now, I don't think it's actually THE veryearly1. The guy writing the blog is a software engineer, while VE1 has a financial background and worked at a hedge fund or something. Also I believe VE1 is a now a full-time private investor whereas this guy works for some engineering (or some such) firm. Also it seems that VE1 apparently used to live in Japan. No mention here of that. (It's kind of scary that I seem to know this much about VE1. :$

In any case, the blog is still pretty interesting and thoughtful.

Friday, August 01, 2008

rating CAPS ratings

despite all of the recent market turmoil, five-star stocks outperform the market by 12%, while one-star stocks underperform by roughly 11%. According to this data, investors would do well to look for new ideas among five-star stocks, while potentially unloading one-star stocks.

what is Morningstar good at?

A couple of clear trends emerge from this data. The first is that we're pretty darned good at picking wide-moat stocks--the wide-moats in the Buy at 5 Stars, Sell at 1 Star portfolio have outperformed our wide-moat coverage universe in all trailing periods, and in every calendar year but one. This conclusion is also supported by the performance of our Wide Moat Focus Index (WMW), which consists of the 20 cheapest wide-moat stocks. The Wide Moat Focus Index was off only about 5% in the first half of 2008--compared with a 12% loss for the market--and it has posted returns of about 11% annually over the past five years.

The second trend is that we have not been very good at separating winners from losers among the no-moat companies that we cover. Our performance in this area leaves much to be desired, and (so far) 2008 is the first year in which our no-moat 5-star stocks have outperformed our no-moat stocks as a group. Narrow moats are a toss-up--we have added value over some time frames, but not overall.

We've thought a lot about the causes for this divergent performance, and while it's a complex issue, I think a lot of it boils down to the simple fact that no-moat companies are more difficult to forecast and value. They're more volatile, they often have weaker balance sheets, and they are more frequently affected by tough-to-forecast external factors like commodity prices.

Estate-Planning Pitfalls

H. Susan Jones, a top estate-planning attorney based in the Chicago suburbs, discusses some of the most common pitfalls of estate planning and how to avoid them, as well as some underutilized estate-planning maneuvers.