the retail investor has never had it better

Its easy to see if one brokers commission is cheaper than another's. Before now, however, it was hard to know which brokers were saving you the most money through good trade execution—for example, by getting you a stock price that's better than the quote you saw when you pressed the "Place Order" button. For such "price improvement," discount brokers squeeze Wall Street market makers to give up some of the bid-ask spread to benefit the broker's retail customers. New numbers released recently by the industry indicate that a retail trader can get the best pricing from Fidelity's discount brokerage unit. This confirms the findings of Barron's computer-aided analysis earlier this year ("The Little Guy Wins!" March 2).

***

In the furor surrounding last year’s best-seller Flash Boys, by Michael Lewis, many retail investors were spooked by the book’s claim that high-frequency traders use their technology edge to pick off the little guys, who, the author claims, were “easy kill” for the professionals. That part of the story was just wrong. While some institutional traders have fallen behind in the computer arms race, the evidence shows that retail traders enjoy some of Wall Street’s best prices on their stock orders. Surprisingly, the little guy’s advantage has grown in the past couple of years.

“The retail trader has never had it better,” says Robert Battalio, a finance professor at the University of Notre Dame who wasn’t afraid to criticize stockbrokers at Senate hearings amid the Flash Boys debate. “When you place a market order today, you pay a lower commission, you get an immediate confirm, and very rarely are you getting worse than the price you saw when you pushed the button,” he says. • The competition for retail traders’ orders actually yields a price that’s better than the published quote, on average, when small investors go to buy or sell at the market price. The resulting savings can be trivial or as large as a discount broker’s commission, but across the industry, these price improvements were worth almost $600 million to individual investors last year, according to financial-market analytics firm RegOne Solutions. That’s much less than the billions paid out in commissions, but it’s hardly chump change. As irony would have it, these savings mostly result from the computerization of market makers and retail brokers.

The public has never seen much information on which firms do the best job executing stock trades. So Barron’s spent months analyzing trade-quality reports of the big “wholesale” market makers, where discount brokers send most buy orders to find a matching sell, and vice versa.

By our scoring, Fidelity Brokerage Services finished No. 1, and Charles Schwab (SCHW) and E*Trade Financial (ETFC) tied for second among discount brokers.

in defense of active management

This month, Charley Ellis published "In Defense of Active Investing." The headline intrigues because Ellis is an indexing legend. In 1975, he wrote that active investing is "The Loser's Game." The article became an instant classic and was later incorporated into the curriculum for Chartered Financial Analysts candidates.

"The Loser's Game" argued that investment success lies not in hitting the most winners, as it's very difficult to strike winners while competing against hordes of other informed investors, but rather in minimizing the "losers" of turnover, costs, and taxes. (All right, taxes are my addition, as 1970s institutional investors never considered the subject, but Ellis would certainly have discussed them had he thought about retail accounts.)

He writes that, although it's difficult to win the Loser's Game, it is also "hard to lose." After all, the corollary of the criticism that active managers mostly hold the market is that active managers mostly hold the market. The biggest success for any prospective investor lies in getting into the game. After that, the leakage caused by active managers is modest. Besides, investing actively is good entertainment. "Since active investing is exciting and fun, investors who are losing a bit in purely economic terms surely enjoy a significant social good by being part of the action."

While I don't believe the case for active management is as hopeless as Ellis presents, as investors can improve their odds by seeking funds that share certain common attributes, I do not dispute his thesis. Active managers do set efficient security prices. They do help global markets to function smoothly. But there's no particular reason why you need to own them.

Ellis' "defense" of active management is in reality a highly effective attack. He came not to praise active managers, but to bury them.

Grexit has gone

Greece reached a desperately-needed bailout deal with the eurozone on Monday after marathon overnight talks, in a historic agreement to prevent the country crashing out of the European single currency.

Leftist Prime Minister Alexis Tsipras agreed to tough reforms after 17 hours of gruelling negotiations in return for a three-year bailout worth up to 86 billion euros ($96 billion), Greece's third rescue programme in five years.

"EuroSummit has unanimously reached agreement," EU President Donald Tusk said. "All ready to go for ESM (eurozone bailout fund the European Stability Mechanism) programme for Greece with serious reforms and financial support."

The new rescue for Athens is the country's third since 2010 and came after a bitter six-month struggle following Tsipras's election in January that put Greece's membership of the eurozone in the balance.

Greek banks have been closed for nearly two weeks and there were fears they were about to run dry due to a lack of extra funding by the European Central Bank, meaning Athens would have had to print its own currency and effectively leave the single currency.

"Grexit has gone," European Commission President Jean-Claude Juncker told AFP, ruling out the threat of Greece leaving the single currency, which could potentially destablise not only the euro but the world economy.

Tsipras insisted the deal was good for Greece despite the fact that the harsh terms were near identical to those rejected by Greeks in a referendum just one week ago.

Mitch Zacks 2015

[7/19/15]  There’s a big piece missing from the Chinese ‘stock market mania’ narrative, and it’s probably the most important part of the story – explaining how China’s equities markets actually work!

The basic premise is that Chinese equities are divided into A-shares and H-shares. A-shares are available for trading almost exclusively by Chinese investors, meaning that the market is missing two critical components of efficiency: maximum liquidity and global participation. It follows that A-shares have virtually no correlation to global markets—one zigs and the other zags, one soars while the other only nudges higher.

It’s the A-shares that are creating all the hubbub in the press. Over the last year (through July 14), A-shares climbed almost +150% through June 12, then fell nearly 35% to their low on July 8. That’s the type of market activity investors are wise to avoid.

Chinese H-shares are a different story, and they matter more for the narrative. H-shares trade on the Hong Kong exchange, which is an open market where international investors can participate. The difference in the market action is astounding: H-shares went up a little over +40% to a peak on May 26, and have fallen about 20% over the last month or so. That’s eyebrow raising volatility, but it’s not an Armageddon-like swing many are now associating with China.

If you look at global stocks over the same period, you’ll notice that they have virtually no resemblance to Chinese equities, A-share or H-share. The MSCI World is essentially flat over the last year.

[7/12/15 Mitch Zacks] If you had just one word to describe the market so far in 2015, it might be: volatile. And, this can be concerning. Regardless, for all the market machinations, performance essentially finished flat eking out a 0.7% (S&P 500) gain. So, what do we think will happen next?

At first glance, the economic backdrop might raise eyebrows: a second estimate of U.S. GDP shows contraction of -0.7% in Q1 and incoming data point to a tepid rebound in Q2, perhaps +2%. Additionally, if you consider uninspiring domestic growth, an escalating Greece situation, the wild China stock ride and imminent U.S. rate hike(s), you might conclude the odds are stacked against a strong finish in 2015.

And, you may be right. But these factors are not enough to turn bearish for these four reasons:

1. Markets Tend to Do Well in Rising Rate Environments – the last three rate hike cycles have corresponded with strong market performance. In 1994 – 1995, the Fed raised rates 7 times and the S&P 500 annualized 18% in that period; in 1999 – 2000, there were 6 hikes and the S&P 500 annualized 5%; from 2004 – 2006, 17 rate hikes and 16% annualized on the S&P. It makes sense why this occurs: if the Fed is raising rates, it’s because the economy has underlying strength! Stocks tend to do well when that’s the case.

2. We Expect GDP Growth to Average 3% Over the Next Four Quarters – we expect earnings to recover and for the economy to expand at a moderate, but reasonable, pace. This should push unemployment down to 5.1% by the end of Q4 with core inflation, based on Personal Consumption Expenditures [PCE], creeping up to 2% by 2017. Not too hot, not too cold. With multiple expansion that has come with Fed easing the last six years, we think the market should move more in-line with earnings growth versus seeing P/Es climb much further. That could mean single digit S&P 500 growth in the next year or two.

3. Greece is a False Fear, Creating a Wall of Worry Markets Love to Climb – the Greece story is now over two years old, which means the market has had plenty of time to price-in the worst. Even if there is a “Grexit,” we think it’s probably only capable of inciting a bit of short-term volatility. All this talk of the European banking system collapsing or systemic issues surfacing (if Greece leaves) are over-reactions in my view. False fears are almost always tailwinds for stocks.

4. Global Growth Should Continue Apace – in spite of Europe’s Greece dealings, the region should see growth in the range of 1% - 2% this year, which is more than it has grown in a few years. Having Europe back in the plus-column is good for global GDP, and I think the U.S. and China will hold up in spite of the jitters that appear to be surfacing. China is willing to ease and the U.S. should recover in the back half like we did in 2014.

The Bottom Line for Investors

With the Fed tightening, modest corporate earnings growth, and a further decline in the equity risk premium, we expect the S&P 500 to notch up +4% to finish the year. While 4% isn’t the kind of return we’ve become accustomed to as of late, it still beats what you can get from U.S. Treasuries, or much of what can be attained in fixed income markets. And, the outlook for equities beyond 2015 remains positive with the possibility of upside surprises in my view. For the long-term growth investor, equities likely remain the best asset class for now.

The Five Richest Superheroes

It’s pretty good to be a superhero. As if it weren’t enough to have the awesome fighting powers themselves, the men and women who grace our comic book covers and headline blockbuster action movies also get spiffy outfits, cool names, dashing good looks, and, in many cases, a huge fortune to help fund their crime-fighting adventures. As Comic-Con kicks off in San Diego, we at Money decided to research how much the wealthiest caped crusaders are worth and see which champion is the most (economically) powerful.

[Surprise spoiler: the richest is not Bruce Wayne or Tony Stark.  And it's not even close...]

China's crash continues

China’s stock rout spread to the country’s commodities markets as investors rushed to raise cash.

Everything from silver to sugar to eggs tumbled with the Shanghai Composite Index, which crashed to a three-month low on Wednesday. Government measures to stabilize equities are failing to stop a stock market collapse.

“People are selling everything in sight to get their hands on cash,” Liu Xu, a trader at private asset-management company Guoyun Investment Co. in Beijing, said by phone. “Some need to cover their margin calls in the stock market, while others are gripped by fear that the Chinese economy will be affected by this crisis.”

Metals including nickel and silver on the Shanghai Futures Exchange fell to their daily limits, while rubber entered a bear market. The volume of copper traded was almost six times the three-month average. Steel rebar and iron ore, as well as eggs, sugar and soybean meal dropped to the lowest level allowed by their exchanges.

“Agricultural products in my view are collateral damage in this selloff,” said Liang Ruian, a fund manager at Shanghai-based Jianfeng Asset Management Co. “Pigs are still going to eat, so what does this stock market stampede have to do with soybean meal?”

***

SHANGHAI — Stock prices in mainland China fell sharply again on Wednesday, continuing a decline that began last month despite another series of government measures meant to restore confidence and stabilize a market that has grown increasingly turbulent.

Just days after Beijing introduced a number of bold measures to prop up share prices, including a pledge by some of the country’s largest brokerage houses to create a $19.4 billion stabilization fund, regulators announced new initiatives early Wednesday, including an easing of rules to allow insurers to invest more money in stocks and the creation of a fund to buy up shares in small and midsize companies.

Still, China’s biggest exchanges were battered. The main Shanghai index plunged 5.9 percent Wednesday, and the Shenzhen index fell 2.5 percent. The Shanghai index is down 32 percent and the Shenzhen is off 40 percent from the highs reached in mid-June.

In Hong Kong, which had escaped much of the mainland market’s rout, the Hang Seng index fell 5.8 percent.

The sell-off has also spread to other parts of the Asia-Pacific region. In Japan, the Nikkei 225-stock average dropped 3.1 percent, Australian stocks were down 2 percent and South Korean shares fell 1.2 percent.

Fear is gripping the markets after a phenomenal bull run in which mainland China’s major stock indexes doubled, tripled and even quintupled over the last few years. Sentiment has turned down too sharply and investors have lost confidence, analysts said, and because buying shares with borrowed money was a critical part of the increase in prices, there is now pressure to sell.

“China’s stock market remains under stress, as investor confidence will take some time to recover,” Li Wei, the China economist at the Commonwealth Bank of Australia, wrote in a report to investors.

Panic selling may also be extending the downturn because each day trading is suspended for hundreds of stocks after they drop by 10 percent, under exchange rules. Some companies are even asking that their shares be temporarily suspended, hoping to ride out the downturn.

Since late June, on almost every trading day, there have been more than 900 stock trading suspensions, according to Xinhua, China’s official news agency. On Tuesday and Wednesday, 900 to 1,700 stocks were suspended from trading. That means that among the approximately 3,000 listed companies on the two major exchanges, up to half may have been suspended during the first two days of the week.

“This is wrong,” said Francis Cheung, the head of China and Hong Kong strategy at CLSA, the brokerage firm. “It just delays the correction. So it delays the downturn.”

The Chinese authorities have been moving swiftly, apparently worried about the potential impact the sell-off could have on the financial markets and on a broader economy that is relatively weak. Although experts say they doubt there could be systemic damage, banks and brokerage firms could be threatened because of the huge amount of margin trading, or borrowing to purchase stocks.

By some estimates, margin trading may have amounted to as much as 3.4 trillion renminbi, or nearly $550 billion. And because some of the borrowing probably took place in the shadow banking sector, no one is quite clear how big it was.

The bubble seems to be bursting on a stock market run that began last summer. In a rally that began roughly a year before the market’s high point on June 12, the Shanghai index jumped 157 percent. The Shenzhen index rose even more during that period, rising about 208 percent. A smaller stock market in Shenzhen called the ChiNext, geared toward technology companies and start-ups, began its own bull run much earlier, in late 2012, and soared about 540 percent before the markets began to falter several weeks ago.

Based on company earnings, the prices of many Chinese stocks began looking incredibly expensive, trading at far higher prices than could be found in Hong Kong or the United States, worrying analysts and investors.

“It’s gone up too fast, and it’s too much borrowed money,” said Wendy Liu, an analyst at Nomura Securities in Hong Kong. “A lot of first-time equity buyers were too excited and didn’t know how to temper their excitement.”

Even after the big sell-offs, though, stock prices in China are still considerably higher than they were a year ago. The Shanghai composite is still up 74 percent from mid-2014, and the Shenzhen composite is up 84 percent since then.

the single biggest risk

Investors who do the least will likely do the best over time. For the huge majority of people, investing a set amount of money each month consistently over a long period of time will outperform any trading strategy they attempt. The evidence on this is overwhelming. It's so overwhelming that I think the single biggest risk you face as an investor is that you'll try to be a trader. It's the financial equivalent of drunk driving -- recklessness blinded by false confidence. "Benign neglect, bordering on sloth, remains the hallmark of our investment process," Warren Buffett once said. It probably should be yours, too.

The Penny Hoarder

Somehow I have started seeing these Penny Hoarder stories on facebook.  Maybe they're paying to be seen.  Or maybe some of my friends like them.  Anyway, they have some handy stories which appeal to penny-pinchers (like me).

So I created this post to list some of their articles.

[7/2/15] 10 Ways You Waste Money

9. Paying for Extended Warranties
Almost a third of consumers buy extended warranties each year, according to a study reported on CardHub.com. These policies provide manufacturers with 50 to 60% profit margins, because appliances and electronics just don’t break down that often.

In other words, don’t buy this expensive insurance. Yes, your printer could break just after the regular warranty expires, and you’ll have to pay cash to replace it. If this happens, just remember all the money you saved by not buying extended warranties on the other items — the ones that didn’t break down.

[This one I noticed on 5/6/15] 32 Ways to Make Money at Home

questions to ask your financial advisor (or yourself)

If I was going to trust someone to manage my life savings for the years and decades to come, I would make sure that all of these questions were answered beforehand:

(1) What is your investment strategy?
This should set your expectations if you ultimately decide to invest with this person; it also gives you a way to confirm that they’re sticking to the strategy. I would want a rough idea of how much turnover the manager expects in the portfolio, the number of holdings, any cap on position size, etc; the advisor should be able to clearly explain what it is that they will do for you. If you don’t understand what they’re talking about, ask questions and make sure that it is clear before you walk out of the door; if you’re still confused when you leave, I’d personally look elsewhere. You might find it odd that people wouldn't ask this; you would think it would be the first item addressed. In my experience, the issue is that this rarely goes deeper than a few sentences from the advisor hitting the high points, with no follow up from the client; there really should be more.

(2) What are your thoughts on active investing versus passive investing?
The person you’re talking with should be able to put this in terms you can understand (read around online before you visit with them if you’re unfamiliar with the debate or else asking won’t do you any good). If they plan on taking a passive approach, I have no problem with that: I still see a need for some clients to do this through an advisor (primarily for having someone to talk to). However, the fees in that scenario should be quite low; I think that anything above 50 basis points or so (0.50%) would be excessive - and even that might be a bit steep. If they make the argument for an active strategy, that’s fine as well; at that point, I’d ask the following:

What makes you think that you can outperform the major indices like the S&P 500 over time? What is your competitive advantage as an investor long term?
People all over the country and the world wake up every day hoping to make money in the stock market. Many are essentially gambling, while others have a near infinite set of resources at their disposal (or even insider information). I think that if you plan on being successful long term you must have something that distinguishes you from the herd; being different on its own obviously doesn’t guarantee success, but it is a requirement for performance that differs from the index (hopefully to the upside). I would simply want to know why they believes they can do better than the market over time. Hopefully this was touched on when you asked about their strategy.

(3) How do you make money from my account?
I’m a big believer in the power of incentives; I would want to be assured that my advisor’s interests are aligned with mine at all times. If someone is being paid to sell you a certain product or fund, you better take a hard look at whatever it is that they’re selling you. My personal opinion is that you would be better off taking your business elsewhere.

I want the fees generated from my account to be correlated with changes in the account value; that would call for either a fee based on the assets managed or a fee based on annual returns (like Warren Buffett’s arrangement when he ran his partnerships); I can’t think of any other way of paying my advisor / manager that I would be comfortable with.

(4) What type of returns can I realistically expect long term?
As with the first question, it’s important to ensure that you’re on the same page with the person who will be managing your money. If you’re only comfortable with limited volatility and they tell you 15% a year is attainable, there’s a misunderstanding that needs to be addressed. Just for clarification, I wouldn’t expect (or necessarily want) a specific number – a range is fine.

(5) How long have you been investing personally, as well as for other people? What have your returns been over the past ten-plus years, or since you started managing money?
This question is quite direct; suffice it to say that it’s worth dealing with a bit of discomfort to ensure that the person you’re about to entrust with your retirement money knows what they’re doing. While the returns are obviously front and center with this question, it also gives you a clear opportunity to consider another potential issue: closet indexing. If the long term returns for the manager are nearly identical to the index, it is worth considering whether or not you really should be paying this individual for “advice” that could easily be replicated for a few basis points on your own with Vanguard. I wouldn’t have thought this is nearly as common as it actually is (or has been in my experience reviewing prospective clients account statements).

(6) What benchmark do you judge your results against? Why?
Most people use the S&P 500, but some use other indices (for example, Wedgewood Fund uses the Russell 1000); simply ask for an explanation and make sure the response is logical if it’s anything besides the S&P 500. It’s worth remembering that if they show you their returns and the index is blended (some mix of stocks and bonds), take that into consideration if you’re looking at their returns from a stock only (or more heavily weighted) model / portfolio.

(7) Can you tell me about one of your worst investments in the past few years? What did you learn from the experience?
This sounds like something you might hear at a job interview, but I think it’s important (and fair game): I want someone who is willing to admit that they’ve made bad investments in the past, and more importantly, has learned from those mistakes.

(8) How much of your own money is invested in the same securities that you plan on purchasing for my account?
Again, this seems direct, or even impolite. My opinion, as someone who sits on the other side of the table from clients, is that this is fair game; in fact, I would be happy to be asked this (which gives you a good idea of what my answer would be).

Any advisor / money manager that’s offended by this or the other questions mentioned above should be avoided in my opinion. As for the answer, I think that at least half of the invested assets for the decision maker at the firm (hopefully the person you’re talking to) should be the same as what they put their clients in, and hopefully even more than that (for comparable asset classes – equities to equities). Maybe I’ve been spoiled by Warren and Charlie, but I think 90% or more sounds like a reasonable number. The person you’re giving money to should be personally investing in the same stocks that they’re buying for you – and in a big way.

Conclusion
This isn’t meant to be a complete list; I’ve focused on the issues that are often overlooked (in my experience) that prospective clients should be asking. I’ll reiterate what I said above: if the person you’re meeting with is offended or put off by your questions, look elsewhere.

The person managing your life savings must be someone that you can trust and ask difficult questions to. Hopefully these questions will help you find the person that’s right for you.

the secret buy sign?

http://video.cnbc.com/gallery/?video=3000392322

It's the investment equivalent of Pavlov's dog. Each time the S&P 500 has touched its 200-day moving average, a sharp rally has soon followed.

And with the recent selloff, the S&P 500 is hovering just above that key technical level, and that has one top technician banging the table on stocks.

"Take advantage of the fear that's out there right now," said Rich Ross, a technician at Evercore ISI, on Monday's "Fast Money."

Ross noted that since 2011, the market has touched its 200-day moving average three times and each time the market has waged a significant rally. The first time was in 2012 which led to a 15-percent rally in stocks in the following three months and again toward the end of that year, which sparked a nearly 50-percent rally in stocks over the next 10 months. The third time was in October of last year, which has led stocks to another 14 percent in gains since then.

"There is absolutely no subjectivity in moving averages like the 200-day moving average; in contrast to trend lines and horizontal lines of support and resistance, the 200-day moving average is the same for everyone."


"Three big rallies after the dip below [the 200-day moving average], and I think you're going to see history repeat itself," said Ross.

narrow years and shocks to the system

The first half of this year for the S&P 500 was the narrowest in history. In other words, the market’s range from peak-to-trough on a closing basis this year has been a record low, as seen in the table below, courtesy of Bespoke Investment Group (BIG).

If history is a guide, the rest of the year could break to the upside…eventually. In fact, in the prior top-10 narrowest starts to the year, the remainder of the year always had a positive return.

Shocks and stocks

This analysis is in keeping with the history of the stock market around “shocks to the system.”  The data highlighted below should serve to remind investors that although sensational headlines typically garner the most article views and/or reader clicks, market history shows that “crises” often have very quick and limited impact on markets.


[Down only 10.8% for Pearl Harbor and 11.6% for 9-11.]

As you can see, of the 14 crises/shocks in the table above, the average market decline was less than 6% and losses were recovered in about two weeks. S&P did note in the report that accompanied the table that several of the losses were much greater than the average, with longer recoveries. However, those “extreme situations usually occurred with the confines of a long-term bear market and did not precipitate the initial decline. Examples of these include: 1) Pearl Harbor, 2) President Nixon’s resignation, 3) the terrorist attacks on 9/11, and 4) the collapse of Lehman Brothers.”

active/passive barometer

Few investment topics are as hotly debated as the merits of active and passive investing. The debate will continue to ebb and flow with the regular cycles of active managers' collective out- or underperformance relative to their benchmarks and a fast-growing and rapidly evolving field of passive alternatives. In order to ground this debate with data that reflects investors' shared experience, Morningstar is starting to publish an Active/Passive Barometer. This is a semiannual report that measures the performance of U.S. active managers against their passive peers within their respective Morningstar Categories.

The Active/Passive Barometer finds that actively managed funds have generally underperformed their passive counterparts, especially over longer time horizons, and experienced higher mortality rates (that is, many are merged or closed). In addition, the report finds that failure tends to be positively correlated with fees.

the flexibility of options

Most people know that options afford the investor many advantages, not the least of which is a guaranteed limited risk when buying calls and puts.

And you can also get a great deal of leverage while using only a fraction of the money you would normally have to put up to get into the actual stocks themselves.

But those are just some of the advantages of options.

The real advantage with options is the opportunity to make money if a stock goes up, down, and depending on your strategy, even sideways.

This flexibility gives the options investor the opportunity to profit in virtually any market condition - even when you're unsure what the market will do.

Even though the popularity of options has soared, they are still not as well known or understood as much as stocks.

But it's all a lot easier than you might think.

1) Are You Bullish?

If you believe the price of a stock will go up, you can buy a call option on it and make money as it goes higher.

The option buyer gets a guaranteed limited risk, which is limited to the purchase price (or premium) plus any applicable commissions and fees.

Essentially, at expiration, your profit is the difference between where the stock price is and your option's strike price, less what you paid.

Example:

Let's say a stock was trading at $50.

You buy a $45 call option with a premium of $6.50, i.e., $650.

At expiration, the stock has shot up to $65.

Your $45 call would now be $20 in-the-money making it worth $2,000.

So the option is worth $2,000.

You paid $650.

That's a gain of $1,350.

All on just a $650 investment.

Worst case scenario: if the stock at expiration closed below your option’s strike price of $45, you could lose the entire $650. But even if the price went down to $0, you could never lose any more than that. Whereas with a stock, you'd be on the hook for it all.

2) Are You Bearish?

If you believe the price of a stock will go down, you can buy a put option on it and make money as the price goes lower.

Once again, the option buyer gets a guaranteed limited risk, which is limited to the purchase price (or premium) plus any applicable commissions and fees.

At expiration, your profit is the difference between where the stock price is and your option's strike price, less what you paid.

Example:

Let's say a stock was trading at $60.

You buy a $65 put option with a premium of $7.00, i.e., $700.

At expiration, the stock has dropped to $40.

Your $65 put would now be $25 in-the-money making it worth $2,500.

So the option is worth $2,500.

You paid $700.

That's a gain of $1,800.

All on just a $700 investment.

Worst case scenario: if the stock at expiration closed above your strike price of $65, you could lose what you paid for the option. But even if the stock went against you even more, you could never lose any more than that.

3) Expecting a Big Move, But Not Sure Which Way?

A straddle is a way to make money when you're not sure which way the market will go, but you believe something big will happen in either direction.

With a straddle, you're buying both a call and a put at the same time, with the same strike price, and the same expiration date.

For example, let's say its earnings season and you expect a big move to occur, either up or down, based on whether the company reports a positive surprise or a negative surprise. Or maybe the charts are suggesting a big breakout could be getting ready to take place in one direction or another.

With this strategy you can make money in either direction without having to worry about whether you guessed correctly or not.

Example:

Let's say a stock was trading at $100 a few days before their earnings announcement.

You buy the front month $100 strike call for $150.

And you buy the front month $100 strike put also for $150.

That's a cost of $300 (not including transactions costs) to put on the trade.

Now let's say the stock shoots up $15 as a result of a positive earnings surprise.

The call option is now worth $1,500

The put option is worth $0.

You paid $300.

That's a profit of $1,200.

All on just a $300 investment.

The best part with this strategy is if the stock had posted a negative surprise and it dropped -$15 instead, you would have been just as profitable. The only difference is that the put would have been the profitable side and the call would have been the loser. (But so what, because you didn't care which way it went, you just expected something big to happen in one direction or the other.)

Worst case scenario: at expiration, if nothing big ever happens, you would have lost the entire $300.

4) Expecting a Stock to Fall (or at Least Not Go Much Higher)?

Writing calls can be profitable in mildly bullish markets, sideways markets and bearish markets.

Buying a call option gives you the right but not the obligation to purchase 100 shares of a stock at a certain price within a certain period of time. The price you pay for the option, let's say $500 for example, is called the premium.

If you write an option, you're collecting that premium. Someone else is buying the right to own 100 shares of a stock at a certain price within a certain period of time. And that premium is paid to you.

If that stock goes down and the option expires worthless, the buyer of the option loses -$500, but the writer of the option makes $500.

Example:

Let's say a stock was at $70.

For whatever reason, you determined the stock would go down or at least not go much higher.

Let's also say that you wrote an $80 call for a premium of $5.00 or $500. That means your account would be credited $500.

If at expiration, the stock is at or below the strike price of $80, you'd keep the entire premium of $500.

Even though the stock didn't go down like you thought, but instead went even higher -- $10 higher in this example -- as long as it stayed below your strike price of $80 by expiration, you'd still profit by the full $500 you collected.

Thought the stock was going down.

Instead it went up.

Still made money: $500.

Pretty exciting.

In fact, at expiration, the stock could literally be above the strike price of $80, plus an amount commensurate with what the writer collected for the premium and still not lose any money. (In this case, the stock could literally be at $85 at expiration and you still wouldn't have lost anything.)

Worst case scenario: if the stock went up past the strike price plus the amount collected in premium, then you'd start losing on the trade. And for every $1 above that level, you'd lose $100.

But if the stock looks like it's breaking out above your price level, you can simply buy that option back to limit your loss, or depending on where you are in the trade, lock in a partial gain.

5) Think a Stock Will Go Up, But You'd Like To Buy It at a Lower Price, Yet Still Make Money Even If You Never Get In?

Writing put options is a great way to make money if the market goes up, sideways and even down (to a limited extent).

This is also a way to potentially get into a stock that you'd like to own at a much cheaper price, and get paid while you wait, even if you never get the stock.

As you know, if you buy a put option, you're buying the right to sell a stock at a certain price within a certain period of time. The buyer pays a premium for this right. He has a limited risk - which is limited to the price he paid for the option.

However, the writer is taking the other side. He has to buy the stock if it's put to him at a certain price within a certain period of time. And for this 'risk', the writer collects a premium.

Example:

Let's say a stock was at $50.

And you decided to write a $40 put option, collecting a premium of $4.00 or $400. (Not to mention, looking forward to potentially getting a chance to own that stock a full $10 cheaper than where it's trading at.)

If at expiration, the stock is trading anywhere above your strike price of $40 or higher, you'd keep the entire premium of $400. You may not have gotten that stock, but you still got paid for your wait.

Thought the stock would go up.

But didn't want to buy it at that price.

Wanted it to go down to buy at a lower price.

Never does.

You still made $400.

If at expiration, the stock price is at $40, the buyer of the option could exercise it and you'd now be obligated to buy that stock for $40 a share, which means you've now got that stock at the price you wanted - plus your $400 premium.

Didn't want the stock at $50.

Wished it would go down so you could get it at $40.

Finally does and you get your stock.

Plus $400.

But even if the stock fell to $36 (i.e., down to your strike price plus an amount commensurate with the premium collected -- this would be your breakeven point), you still wouldn't lose anything.

Worst case scenario: the stock would have to fall below $36 to even begin to lose on the trade. And for every $1 below that level, you'd lose $100 due to the stock you now own.

Of course, if you changed your mind, or if you thought the stock could fall below your strike price and even your breakeven point, you could buy the option back at any time, thus cutting your loss or locking in your gain and ending the trade right there without having to even bother with the stock.

Options give the investor numerous ways to make money in the market. Up, down or sideways, decide to make success your only option.

-- Kevin Matras, Zacks Weekend Wisdom

too much information

Some recent articles by our favorite writers – Grahamites and Science of Hitting – got us thinking about an issue we write about every three or four years – emotions and data in investing. It seems about the time of every market top (or at least 6 of the last 3….), we write an article on the ability to face down your own fears and make money the only way great investors do – purchasing stocks at a substantial discount to fair value. It seems so easy. Wait for a really significant correction, step in, and purchase some great stocks. The rest is investment history. Or at least that's what they say.

Reality has a way of getting in the way of such elucidated thinking. The bottom line is that the vast majority of investors take in far too much information, overreact far too vividly to too much data, blame others for their poor results, and begin the cycle all over again. For the first instance, in a classic study[1] by Richard Thaler, subjects managed an imaginary college endowment consisting of two mutual funds. They could choose how often they received information about fund performance and how often they could trade. The experiment simulated 25 years of investing. The results were clear - participants who received information once every five years, and could trade only that often, earned returns that were more than twice those of participants who were updated monthly and could trade that frequently. The bottom line was that the frequency and amount of data availability directly correlated to poorer returns.

Not only do investors who receive too much data trade more frequently and obtain worse returns, their emotions generally proceed in a rather standard format, rising from a state of panic to euphoria. You can imagine where the latter leaves us in the market cycle.

Conclusions

We live in an age where information is available 24/7. Most of this information provides absolutely no function in evaluating value of our specific holdings. More importantly, the information is provided in a format as to play on our emotions. Finally, we live with a human brain that looks in every possible way to blame others for our failures yet make us feel like genius for our successes. These three factors play an inordinate role in the truly horrific losses occurred every so often when we face significant market corrections. By limiting our data intake, creating models with our own intellect focused on value, and building systems to minimize emotional responses, we can prevent such losses.

what would Peter Lynch say today?

What would Peter Lynch say about investor sentiment today? Peter described the cycle of a bull market through his experience at cocktail parties. Near the bottom of the market, people at these parties had no interest in talking stocks. They were more interested in hearing what’s going on with the dentist. Halfway through a bull market, everyone at the party wanted to find out what stocks Mr. Lynch was buying. At the end of a bull market, the guest liked to tell Peter Lynch (one of the greatest stock pickers of all time) what stocks they were buying and why.

To gauge where we are in the Peter Lynch bull market continuum, let's take a look at this week's sentiment poll from the American Association of Individual Investors at their website, AAII.com. This is a group of individual investors who pay an annual membership fee and participate in a wide variety of online and in-person events to improve their stock picking and asset allocation prowess. In other words, these are folks that are naturally inclined to the stock market. Here is their latest poll:

As a 35-year student of the U.S. stock market, I am astounded at these figures. These are comparable sentiment numbers to the bottom of the bear market in 2002-03! This was after tech stocks got crushed in the three preceding years and the index had decline more than 40% from peak to trough. When we access the stock market within the context of these numbers and Peter Lynch's continuum, we find it funny that hardly anyone ever asks us what stocks we bought lately.

Putting all of this together, we like where we are.

Lastly, we love what we heard Peter Lynch say in late 2008 on CNBC with the stock market as miserable as it ever gets. They asked him where he thought the stock market was going to go next. He said, "I'm the wrong guy to ask, I'm always bullish."

Long-Term Winners

Imagine if you had invested in Apple in the ’80s or Google a decade ago. Many investors dream of getting in early on the next big thing, an innovative company that changes the world and enriches them.

But a T. Rowe Price study shows that finding these companies is extremely difficult and holding them through rough markets can be even harder. They often are operating not in such dynamic industries as social media and technology but are engaged in such mundane undertakings as bread making.

To identify companies that achieved a 20% or more annualized return over 10 years—a sixfold total gain—the study examined all companies in the Russell 3000 Index with $1 billion to $3 billion in market capitalization over rolling 10-year periods, from 1996 through 2013.

In the 11 different 10-year periods, an average of only 18 companies achieved such stellar performance per period. When not double counting companies that hit the mark in more than one 10-year span, the average dropped to 10.

“The ability to grow revenue at a double-digit pace is really, really hard to do over an extended period of time, and to be able to compound wealth at 20% or more is very rare,” says Henry Ellenbogen, manager of the small-cap New Horizons Fund.

While discovering such potential overachievers may be rare, sticking with them through rough patches can be even more challenging. To reap the outsized rewards these stocks eventually provided, investors had to endure an average decline of 27.1% at some point during that decade.

“It shows you that even during a period when a stock is compounding between six- and eightfold, its price could drop significantly along the way,” Mr. Ellenbogen says. “So you have to be patient and know that you are going to go through a rocky period where the company may be in transition in which it has to reload for the next phase of growth.”

The study also demonstrates that such success is not concentrated in such high-growth sectors as information technology and biotechnology. In fact, the leading sectors for outstanding performance included consumer staples, energy, and industrials.

Flowers Foods, for example, makes bread, snack cakes, and other household staples but was one of the few companies to star in multiple 10-year periods. “Here’s a company whose end market— bread—has had modest growth at best,” Mr. Ellenbogen says. “But it’s a company with good systems and people, runs itself very efficiently, allocates capital well, makes smart acquisitions, and has organically gained market share.”

Success Keys
Not surprisingly, the companies that achieved exceptional performance over 10-year periods exhibited superior financial characteristics. On average, these leaders had median annual sales growth of 19.5%, median annual earnings growth of 17.1%, and average annual return on invested capital of 18.4%—all significantly higher than the average firm in the study.

Value, Too
Exceptional performance does not just come from high-growth companies. Value investors seek the same outcomes but from a different starting place.

“We’re trying to find companies that may offer the same kind of compelling growth prospects but they’re not necessarily fully valued and are actually cheap,” Mr. Wagner says. “These are companies that for whatever reason may have fallen on hard times and their returns may actually be decreasing, but with the strategic moves that could actually make them look like a growth stock down the road.”

“There generally are three ways small companies might achieve outperformance,” Mr. Athey says. “The first is that it is truly a growth company and consistently puts up high-growth numbers. The second is a company that may be near bankruptcy or is really deep value and it comes back from the dead. “The third is a little of both—a company that may be under the radar screen, perhaps with a checkered history, and it’s really cheap, but not because it’s a horrible company. It’s just been neglected and hasn’t performed very well, but maybe new management comes in and the company starts doing better.”

Whether a growth or value investor, Mr. Wagner says, the study’s lessons are the same: “Think long term, be patient, and recognize that even the best companies on the planet will have periods when things don’t look so good.

“Also, when you find something really good that’s working well for you, you should appreciate that’s a rare thing. You have to recognize that you are going to look at a lot of companies before you find one that could be a really big compounder of returns.”

-- T. Rowe Price Report, Summer 2014

The Buffett-Munger personality

Success in investing doesn't correlate with I.Q. once you're above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing. - Warren Buffett

No doubt most of us are familiar with the above quote from Mr. Buffett. Probably most of us, as value investors, also think that we possess the temperament to control the urges. However, does our perception reflect the reality? How can we tell if we have the right temperament or not for investing? How do we define the right temperament?

Things can get complicated once we start asking ourselves these questions. Luckily, following Munger’s idea of simplicity, I think we can greatly simplify the problem by observing who has the right temperament and figure out their personality type through a well-known system. We can then figure out our own personality type and compare ours with those of say Buffett and Munger.

The aforementioned well-known system is called the Myers-Briggs Type Indicator (MBTI) assessment. According to Wikipedia, it is a “psychometric questionnaire designed to measure psychological preferences in how people perceive the world and make decisions.”

Essentially there are four dichotomies of psychological differences with a resulting of 16 possible psychological types. The four dichotomies are

• Extroversion (E) versus Introversion (I)
• Sensing (S) versus Intuition (N)
• Thinking (T) versus Feeling (F)
• Judging (J) versus Perception (P)

Each person’s type will be typically referred to by an abbreviation of four letters such as ESTJ or INFP.

Each term used for each dichotomy has specific technical meanings and each combination of 4 (i.e. each type) has its own distinctive set of characteristics. For instance, “sensing and intuition are the information gathering (perceiving) functions. They describe how information is understood and interpreted. Individuals who prefer sensing are more likely to trust information that is in the present, tangible, and concrete and they tend to distrust hunches. On the other hand, those who prefer intuition tend to trust information that is more abstract or theoretical, that can be associated with other information. They may be more interested in future possibilities.”

Assuming the MBIT system is a good enough one for the discussion of temperament, let’s see if we know what type of person Buffett and Munger are. A little bit of google search combined with our observation and experience show that Buffett is most likely an ISTJ type while Munger is more likely an INTJ type.

Below are the descriptions of these two types from truity.com:

ISTJs are responsible organizers, driven to create and enforce order within systems and institutions. They are neat and orderly, inside and out, and tend to have a procedure for everything they do. Reliable and dutiful, ISTJs want to uphold tradition and follow regulations.

ISTJs have a serious, conservative air about them. They want to know and follow the rules of the game, and typically seek out predictable surroundings where they understand their role. You may find the ISTJ doing something useful even in social situations (for instance, organizing coats and hats at a party) as they’re often more comfortable taking charge of a task than they are chatting up strangers. When given something to do, they are highly dependable, and follow it through to the end.

INTJs are analytical problem-solvers, eager to improve systems and processes with their innovative ideas. They have a talent for seeing possibilities for improvement, whether at work, at home, or in themselves.

Often intellectual, INTJs enjoy logical reasoning and complex problem-solving. They approach life by analyzing the theory behind what they see, and are typically focused inward, on their own thoughtful study of the world around them. INTJs are drawn to logical systems and are much less comfortable with the unpredictable nature of other people and their emotions. They are typically independent and selective about their relationships, preferring to associate with people who they find intellectually stimulating.

The description may not fit perfectly with Buffett and Munger but I think we can all agree that they are fairly close. Munger and Buffett both share ITJ, which are introversion, thinking and judging. Just for a fun trivia, Bill Gates is also an INTJ type.

A good amount of readers on this forum should be this IxxJ pattern. It’s the F or T that should make the alarm sound for those of us who have more “F” than “T” in our types.

Again, the point of this exercise is not to say which personality type is better or worse. My educated guess is that if you have a personality type of IxTJ, you are likely to possess the right temperament for value investing. But if you don’t, that doesn't mean you don't have the temperament or you won't achieve superior returns. You just need to be more cautious of the weaknesses in your personality type that may lead to investment mistakes.

-- Grahamites, October 18, 2014

long-term investing

Seth Klarman (Trades, Portfolio) is a self-made hedge fund billionaire. He runs the Baupost Group; the world’s 11th largest hedge fund by assets under management. Seth Klarman’s investing knowledge is highly sought-after. A new copy of his 1991 book, Margin of Safety sells for over $3,000.

Seth Klarman looks for poorly understood or mispriced investments which he can buy for a fraction of their intrinsic value. Klarman has used his conservative style of value investing to average returns of around 20% a year; long-term numbers similar to investing greats Warren Buffett and Shelby Davis.

Seth Klarman has earned his place among investing greats. He is very clear about how investors can gain an edge over Wall Street’s minute-to-minute obsession with stock prices:

“The single greatest edge an investor can have is a long-term orientation”

This is perhaps the most useful quote for individual investors. A long-term orientation frees you from the worries of day-to-day market fluctuations. I find Seth Klarman’s extremely important. In fact, it is the first quote used inThe 8 Rules of Dividend Investing (see rule 1).

Seth Klarman has been referred to as ‘his generation’s Warren Buffett (Trades, Portfolio)’. The actual Warren Buffett has many excellent quotes about investing for the long run as well. Three of Warren Buffett’s quotes on long-term investing are below:

“Only buy something you’d be perfectly happy to hold if the market shut down for 10 years”

“Our favorite holding period is forever”

“If you aren’t willing to won a stock for 10 years, don’t even think about owning it for 10 minutes”

Both Seth Klarman and Warren Buffett are very clear that investors should invest in stocks for long periods of time. When two of the most well-respected and successful investors of the past several decades emphasize an investment idea so clearly and consistently, it is wise to take notice.

Amancio Ortega

A practically unheard-of billionaire, Amancio Ortega, just blew past household name Warren Buffett to be the second-richest man in the world, according to Bloomberg. Microsoft founder Bill Gates, who is worth $85.5 billion, remains first.

Oretega, who has amassed a net worth of $71.5 billion, is the founding chairman of the Inditex fashion group, the world’s largest apparel retailer. Inditex is best known for its chain of Zara clothing and accessories shops, which had sales of $19.7 billion in fiscal 2014.

Worth noting is that Warren Buffett, whose net worth of $70.2 billion puts him at third place, would be in second-place if not for his philanthropic giving.

A native of Spain, Ortega refuses almost all interview requests and until 1999, no photograph of him had ever been published. However, Zara is not so low-profile. The world’s biggest fashion retailer operates over 6,600 stores in more than 88 countries.

Inditex has shown strong growth year over year. In March, it reported net profit up 5 percent from the previous fiscal year. In addition, the company said it planned to open up 480 more stores this year.

Key to Ortega’s success has been keeping Zara’s manufacturing close to its home base in the ancient port city of La Coruña, rather than outsourcing production to China to cut costs. This allows Zara to act quickly on new trends and put new products into stories right away. Zara shops receive new shipments of clothing twice a week, virtually unheard of among retail stores.

If Inditex brands continue to grow and Zara’s popularity extends to millennials and beyond, the mysterious billionaire’s wealth could eventually push him to number one on the list.

Investment Mistakes

BeyondProxy asks fund managers about investment mistakes

Howard Marks, co-chairman of Oaktree Capital Management: “…people tend to get in trouble in investing when they have unrealistic expectations, especially when they have the expectation that higher returns can be earned without an increase of risk. That is a very dangerous expectation. Which is the thing which is most dangerous to omit? I think it is risk consciousness. I think that the great accomplishment in investing is not making a lot of money, but is making a lot of money with less-than-commensurate risk. So you have to understand risk and be very conscious of it and control it and know it when you see it. The people that I think are great investors are really characterized by exceptionally low levels of loss and infrequency of bad years. That is one of the reasons why we have to think of great investing in terms of a long time span. Short-term performance is an imposter. The investment business is full of people who got famous for being right once in a row. If you read Fooled by Randomness by [Nassim] Taleb, you understand that being right once proves nothing. You can be right once through nothing but luck. The law of large numbers says that if you have more results, you tend to drive out random error. The sample mean tends to converge with the universe mean. In other words, the apparent reality tends to converge with the real underlying reality. The great investors are the people who have made a lot of investments over a long period of time and made a lot of money, and their results show that it wasn’t a fluke — that they did it consistently. The way you do it consistently, in my opinion, is by being mindful of risk and limiting it.

Larry Sarbit, chief investment officer of Sarbit Advisory Services: “[Investors] allow emotion take over their investment decisions. That is undoubtedly the biggest problem. They don’t think very much at all. There’s not a lot of thought going on and so therefore don’t be surprised if things don’t work out well. They’re their own worst enemy. Investors do more damage to themselves than anybody else could do to them. If they would just think like they were going to the grocery store, again that’s Ben Graham, if you think about buying stocks, like he said, like groceries instead perfume, you’ll do a lot better. But people don’t and there’s not a heck of a lot you can do for them. The truth is that most people are not going to make money in the stock market. The vast majority of people don’t make money. It’s unfortunate but it’s almost a law that that’s the way it is. The money comes in at the wrong time and it goes out at the wrong time.

If the markets keep going down or if they go nowhere for the next three years, I can see exactly what investors are going to do. They’re going to get out, they’re going to stop investing, and they’re going to get out. They keep doing this over and over and over again, generation after generation, decade after decade, century after century. The behavior just repeats over and over and over again. Not much you can do about it. But that’s what creates the incredible opportunities to buy things. It creates it for us – it’s that people don’t think.

Richard Cook and Dowe Bynum, principals of Cook & Bynum Capital Management: “While we would typically list a few (e.g., having a short-term perspective, overestimating the strength and longevity of competitive entrenchment/advantages, investing with inadequate information), the single biggest mistake has to be investing without a margin of safety (i.e. not buying a company at a large discount to a conservative appraisal of its intrinsic value). By the way, full credit for this idea goes to Ben Graham, who once wrote: ‘Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, ‘Margin of Safety.’’

Ori Eyal, founder of Emerging Value Capital Management: “The key to long-term wealth creation is not earning high returns. Rather, it is earning good returns while avoiding (or minimizing) the blow-ups. The biggest mistake that investors make is not investing in a conservative enough manner. The world is a dangerous place for capital. Inflation, expropriation, revolution, currency devaluation, industry declines, wars, natural disasters, depressions, market meltdowns, black swans, theft, fraud, and taxes all pose a constant and lurking threat to growing (or even just maintaining) wealth over time. In any given year, the probability of disaster is small. But over many years and decades anything that can go wrong eventually will.

Guy Spier, chief executive officer of Aquamarine Capital Management: “The biggest mistake is when we as investors stop thinking like principals. I think that when we think as principals, when we apply Ben Graham’s maxim that we should treat every equity security as part ownership in a business and think like business owners, we have the right perspective.

Pat Dorsey, chief investment officer of Dorsey Asset Management, on the mistake of confusing growth for competitive advantage: “…people mistake growth for having a moat. Anyone can grow. Anyone can grow by building new stores, by underpricing a product. That doesn’t mean it’s sustainable and as investors, we’re buying a future and so that’s sustainability that really matters.

Mark Massey and wide moat investing

The Manual of Ideas interview with Mark Massey of AltaRock Fund:

The Manual of Ideas: How did you get interested in investing?

Mark Massey: Like any son, I was greatly influenced by my Dad. Fortunately for me, one of his real passions in life was investing. He always talked about his stocks around the dinner table and as time went by his enthusiasm stoked a curiosity in me to learn more. During high school and college, I got non-paying “jobs” at the local Merrill Lynch office which gave me some important insights into the ecosystem of Wall Street. By the time I graduated from college in 1986, I had decided that I wanted to be on the “buy side of the street.” Thankfully, with a bit of patience and perseverance, I was able to land a dream job as an equity analyst with Fidelity Investments in Boston.

MOI: Why wide-moat investing as opposed to other value approaches?

Massey: We think it’s a very safe way to generate superior returns over the long term. “Wide-moat investing” is just another way of saying that we try to buy, at a rational price, great businesses whose earnings are almost certain to be much higher in ten and twenty years. Great businesses, by definition, stand the test of time and as a consequence they are always compounding in value — like a savings account, but with a much better yield.

To me, deep value “investing” means buying a less than great business or a pile of assets trapped inside of a corporation at a (hopefully) big discount to some estimate of intrinsic worth. My problem with this approach is that no matter how cheaply you buy, time is working against you. In other words, your risk/return equation is highly dependent upon how quickly you can turn around and sell at a profit. With poor companies and cheap assets, the values can melt away while you are waiting for the market to see things your way. Buffett said it well, “Time is the friend of the wonderful business and the enemy of the mediocre.”

MOI: How do you generate wide-moat investment ideas?

Massey: It’s all qualitative stuff. We really don’t do screens. In fact, the only screen that I find useful is one that spits out companies that have been buying back a high percentage of shares. This MAY be indicative of a well-aligned management team that has great conviction in the durability of its competitive moat… but it could be the opposite, too… so you always have to do a lot of work to get to the truth.

I really think the key to our success has to do with our love for the game. We absolutely love coming to work every day. I literally spend almost all of my time reading. And while it, no doubt, makes me a bit of an oddball, my greatest pleasure is to be constantly searching for wonderful businesses that, for whatever reason, are mispriced. Having done this for nearly thirty years, I have built up a lot of knowledge and understanding about many different businesses, moats and business models. The result is a long list of companies that we would like to own at the right price. And we know from experience that if we continue to be patient and disciplined, a few mouth-watering opportunities will eventually come our way.

MOI: You refer to your portfolio as a “Conglomerate.” Please elaborate.

Massey: I realize it sounds kind of funny, but we really do refer to our portfolio in-house and in our letters to partners as “The AltaRock Conglomerate.” The reason we do this is to reinforce what we believe is the correct way of thinking about stocks, which after all are ownership positions in real operating businesses. I think many investors can lose sight of this when all they ever see are ticker symbols and flashing prices on a computer screen. To counter this tendency, we think of, and speak of, each business in our portfolio as a subsidiary that we own outright. And we try to acquire each one at a price that reduces our risk of loss to zero, while also guaranteeing that our rewards from long-term ownership will be bountiful. If we truly ran a conglomerate, we would always be exceedingly careful that we understood exactly what we were buying before making any acquisition. And we would never sell or trade one of our subsidiaries unless we were absolutely convinced that we were getting significantly more than we were giving up.

MOI: Your portfolio is one of the most concentrated we have come across. Do you target a specific number of “subsidiaries?” Could you also tell us how you came to embrace such a focused investment philosophy?

Massey: There is no target, but most of the time we end up owning between five and ten businesses (stocks) at any one time, and we really try to buy for keeps. Right now we own seven “subsidiaries” and I’d say that’s pretty typical.

As for AltaRock’s investment philosophy, I am afraid I can’t take much credit. We really just copied it from Warren (Buffett) and Charlie (Munger). And I think they borrowed it from Phil Fisher and Lord (John Maynard) Keynes. Buffett likes to joke that the wisdom of concentrating in one’s best ideas has been around since 600BC when Aesop uttered, the now famous words, “A bird in hand is worth two in the bush.”

While I had always been drawn to concentrated, wide-moat investing, there was an important crystallization moment for me. Back in January 2002 my wife and I decided to squeeze in a quick vacation before the coming birth of our second child and the April launch of AltaRock. So there I was, sitting on the beach in Jamaica with my wonderful wife and our beautiful three-year-old daughter… and I start reading this book, The Warren Buffett Way, by Robert Hagstrom…and I am literally dumbstruck. Buffett’s words really spoke to my investment soul. I was so excited by what I read… and I wanted more. So when we returned from vacation, I literally spent the next two months reading everything I could get my hands on about Buffett and Munger… every book, every Berkshire Hathaway Annual Report, every yearend Buffett Partnership letter, every speech, etc.

MOI: Taking John Malone as a proxy for great capital allocators/investors…do you think great investors are born or can you become one with hard work? What key attributes are necessary for success?

Massey: I think you can learn a lot of it, but you probably won’t unless it really appeals to you. I think Charlie Munger said that he has never met anyone wise in any field that did not read all the time, and that is certainly true of great investors. They read and read and read, and of course nobody could sustain that kind of reading about anything unless they found it incredibly fascinating. So I think you need to be someone who finds businesses extremely interesting. And you have to have an innate curiosity about everything, wanting to know the truth about how things really work. So I think there needs to be a little scientist inside of you. I think you also need to have a personality that tends toward rationality, particularly in situations where most people’s decision-making becomes polluted by emotion – like when all hell is breaking loose and the market is going down fast, every day.

You also need to really know yourself, meaning that you need to be aware of, and completely okay with, your own limitations. Otherwise you are likely to start doing things outside of your circle of competence. If you are someone who tends to fool yourself into believing that you know more than you really do, you are going to run into trouble in the investment realm.

Also, believe it or not, feeling comfortable doing nothing for a long time is important. This requires a lot of self-conviction, as there are lots of psychological forces, both external and internal, conspiring you toward action when, in fact, much of the time sitting tight is the most sensible thing to do.

I am also reminded of comments by Seth Klarman and George Soros. Seth once said that you need to have a certain arrogance to be an investor, which is true. If you think about it, every time you buy or sell, there is somebody on the other side of the transaction that thinks he’s right. So you have to be somewhat arrogant to think you know more than that other guy all the time. But then George Soros…when an interviewer referred to him as a security analyst, he laughed and said that he felt more like an insecurity analyst. He went on to explain that whenever he bought a new position he was always terrified that he was going to be proven wrong. So before buying anything, he did an incredible amount of work, and after investing he was always checking his facts, and he kept on trying to learn as much as possible about whatever it was – all because of his fear of being exposed as a fool. And so, counter-intuitively, I think both of these concepts are right. You need to be arrogant and insecure at the same time.

MOI: What do you think is the biggest mistake that investors make?

Massey: Several things come to mind as I think about it… making emotional decisions… short-term thinking instead of long… a lack of thoroughness in due diligence… These are all issues, but I think the best answer to the question is a little more subtle… and it’s that most investors fail to properly weigh and adequately take into account that they are players in a pari-mutuel betting game.

So you probably know what I mean by that, but let me elaborate. So most people know how horse betting works, right? So before the race begins, all the bets are tallied up, and based upon all the bets, the odds are calculated… and so what ends up happening is that the top horses – the ones with the best pedigrees, the best jockeys, and the best track records – end up paying out very little profit when they win, which is most of the time. And while the payoff can be great when the worst horses win, the fact is, they rarely do.

Investing is very much the same. Great businesses – the ones that have demonstrated competitive advantages and which have enjoyed long records of success – are almost always priced very expensively, while poor businesses are almost always correctly cheap. Consequently, it is hard to do better than average betting on either. The secret to winning in horses and in securities is the same. You need to study like mad and be really patient. Every now and then you will come across a really great business (or horse) that for one reason or another is mispriced, sometimes severely so, and this is when you invest (make a bet). The rest of the time you just keep working hard and waiting. You only bet when you are convinced that you have a near cinch.

MOI: Are there any books or other investment resources that have helped you become a better wide-moat investor?

Massey: For someone starting out I would submerge myself in as much Munger and Buffett as possible and I would certainly subscribe to The Manual of Ideas. Here are some books, etc. that I have found quite interesting and useful:

• Art of Stock Picking, a Charlie Munger speech http://bit.ly/1ltSBVw
• Berkshire Hathaway Letters to Shareholders http://bit.ly/1eO2UxU
• Damn Right, by Janet Lowe http://amzn.to/1qhw7du
• The Warren Buffett Way, by Robert Hagstrom http://amzn.to/1nK9SrC
• Poor Charlie’s Almanack, by Peter Kaufman http://amzn.to/1jqgdpB
• Influence, by Robert Cialdini http://amzn.to/1qA9a2X
• Seeking Wisdom, by Peter Bevelin http://amzn.to/1qhwsNb
• You Can Be a Stock Market Genius, by Greenblatt http://amzn.to/1pUUj3w
• Moneyball, by Michael Lewis http://amzn.to/1wDSsCq
• The Outsiders, by William Thordike http://amzn.to/1pG2uyT
• Dream Big, by Cristiane Correa http://amzn.to/1lTPGFa

Total Investment Return =

John Bogle has a great formula for describing total investment returns:

Total Return = Dividend Yield + Investment Return + Speculative Return

He defined investment returns as earnings growth/contraction plus dividend yield and speculative returns as the increase/decrease in the respective stock’s P/E ratio. The first two (DY+IR) are direct actions taken or achieved by your investment. The third (SR) is driven purely by the whims of the market. This combination of all three drive both the short and long term returns of your investment portfolio.

To put it in the context of Benjamin Graham’s eponymous phrase, the speculative return is the voting machine while the dividend yield and earnings growth is the weighing machine. Or put in our boxer’s parlance, one happens in the ring and the other outside of it.

We strongly believe our investment selection process that focuses on companies with little/no debt, high free cash flow, high capital returns and deep competitive moats will – over the long term – assure our investment returns. Theoretically, purchasing our investment at a discount to fair value will mitigate risk in the speculative return.

All of this seems quite reasonable until we recognize that a vast majority of our short-term returns and a substantial part of our long-term returns are directly linked to Bogle’s speculative returns. John Maynard Keynes wrote[2], “In one of the greatest investment markets in the world, namely New York, the influence of speculation is enormous. It is rare for an American to ‘invest for income,’ and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that he is attaching his hopes to a favorable change in the conventional basis of valuation, i.e., that he is a speculator.” Things have changed very little since Keynes penned these words in the throes of the Great Depression.

At Nintai we keep a close watch on both investment returns and speculative returns within our individual holdings and how that impacts the portfolio in total. As seen below, since 2005 over half of our returns have come from speculative returns – meaning over 50% of the returns of the Nintai portfolio have come from P/E expansion rather than dividend rates or earnings growth.

Much like a state of equilibrium in physics, this simply cannot go on in perpetuity. Over the next decade we would expect to see overall returns decrease in scope as P/E ratios return to a more normalized level. As the Nintai portfolio’s average P/E is roughly 28% below the S&P500, we would expect this correction to affect the portfolio significantly less than the general markets thereby leading to outperformance in the long term. We believe the financial strength of our portfolio holdings – in combination with lower P/E ratios – provides us significant protection in the case of a market correction similar to 2000 or 2008/2009.

***

[An "ideal" stock might have all three components.  A decent dividend.  Earnings growth.  And a stock out of favor which would swing back to favor (multiple expansion).  AAPL used to fit the latter two criteria.  Now it fits the first two criteria.]

when to sell

Reason No. 5: It keeps you up at night. It is tough to put a dollar value on peace of mind, but if we did, it would be a pretty penny. If you have an investment whose fate has become so uncertain that it now causes you to lose sleep, this could be a great cue to move your dollars elsewhere. We are trying to reduce the stress in our life here, not add to it. We save and invest to improve our quality of life, not to develop ulcers. Adding insult to injury, stressing about a stock might cause you to lose focus and make rash decisions elsewhere in your portfolio. Remember, there’s no trophy or prize for taking on risk in investing. Stick with what you’re comfortable with.

While I am loathe to reference “The Gambler” when discussing our investment philosophy, as the concept could not be farther from what we preach, the Kenny Rodgers line “You’ve got to know when to hold ‘em” fits. If there are reasons to fold ‘em, how do we know when to hold ‘em?

7 Habits of Successful Investors

Christine Benz: As we all know, there are a lot of ways that investors can find success. They can find success through picking individual stocks. They can find success through picking mutual funds. They can find success through using just a simple target-date mutual fund. There are lots of ways to get it done. But when we look across successful investors, we do see some commonalities among their habits, and that's what Adam and I are going to talk about tonight.

We're going to divide and conquer. Adam is going to discuss four habits of successful investors, and I'll discuss the last three. Toward the end of the presentation, I'll also share some model portfolios that we have been working on for Morningstar.com. In a lot of ways, we think these portfolios illustrate some of the habits that we'll go through during the course of this presentation.

So, let's get right into the presentation. Let's talk about, first, what is a successful investor? And I think, in lot of ways, it can be helpful to think about what isn't necessarily a successful investor. Investment success isn't necessarily beating the market. It's not beating Warren Buffett. It's not generating returns that are higher than your neighbors or your brothers-in-law. Really, the main thing when you think about investment success is [whether or not you were] able to reach your financial goals. So, for most of us, this will entail achieving a comfortable retirement. Are we on track to achieve a comfortable retirement? If we wanted to fund college for our children or grandchildren or maybe fund some continuing education for ourselves, were we able to achieve that? Or perhaps we have shorter-term financial goals--and many of us do. So, if we wanted to buy a new car or buy a new home or make some home remodeling, were we able to achieve those goals? So, fundamentally, the question of whether or not you were able to achieve your financial goals should be your measure of your own success as an investor.

Along the way, we want to make sure that investors get there through skill and not luck. A successful investor is someone who understands the basics of saving and investing, who understands some of the key habits that tend to lead to investment success, and also avoids some of the big mistakes and some of the bad habits that investors can fall into.

In addition, we also define investment success as whether or not you were able to achieve peace of mind along the way. So, even if you were, in the end, able to reach your financial goals or maybe save and invest a sum that was way more than you expected, were you able to sleep easily at night? Balancing risk with returns is certainly fundamental to investment success as well. So, when we think about investor success, these are some of the key things we think about as defining investment success.

I'm going to just quickly outline the seven habits that Adam and I will spend a little more time on during the course of this presentation.

First of all, successful investors tend to "cheap out." So, they watch their investment costs every step of the way, because those costs can eat into their take-home returns. Adam will outline some of those investment costs and steps you can take to reduce them.

Successful investors also focus on the big picture and tune out the noise. There's lots of information flowing about the markets, and it's important--to the extent that you possibly can--to tune a lot of that out because, ultimately, it doesn't affect your investment success. Instead, successful investors focus on the big picture. 

Successful investors also know themselves. They know the role that behavior can play in financial decision-making, and they take steps to ward against some of those behavioral traps.

Successful investors also build in discipline, and here Adam will talk about some ways that you can, in some respects, put your plan on autopilot to kind of build discipline into your plan.

Successful investors also multitask, and this is something I'll be talking about in the course of my portion of the presentation. How do you juggle competing financial goals? Because most of us, at every life stage, are juggling some competing financial goals. How do you set those priorities and determine the best use of your capital at any given point in time.

Successful investors focus on limiting taxes. Just as they focus on limiting costs in their investments, they also focus on limiting the drag of taxes. And I'll talk about some specific ways that you can do that in your own investment plan.

And, finally, successful investors keep it simple. They avoid overcomplicated strategies. They avoid tactical market-timing strategies. They avoid narrowly focused investment products and, instead, run streamlined investment programs.

[Following are some excerpts from the full presentation.]

The first habit that we're going to be talking about is "cheaping out."  when we talk about investing costs, we're talking about things like fund expenses, the expense ratio that a mutual fund charges to manage your money; brokerage fees, the fees you pay every time you buy and sell shares of stock and any maintenance fees that may be involved; advisor fees, what you pay a financial advisor to manage your money, especially if he or she is not earning their keep; also administrative costs, many plans--401(k) plans, for example--have a layer of administrative costs built into the process that can eat away at your returns--the same thing with, for example, a 529 college-savings plan.

Habit number two: [Successful investors] focus on the big stuff. So, these are some of the most important levers that you have at your disposal that can lead to a successful investing outcome for you. The first one seems obvious, but it's still worth mentioning: saving enough. The amount that you are able to save and sock away probably is going to determine how much you end up with, as much as anything else. One obvious example: How much do you choose to contribute to your 401(k) plan at work?

Another important lever is when you start investing. The earlier you start saving, the more time your money has to grow--as we just saw in our Fund A and Fund B example--and the less pressure you'll be under to catch up later.

Asset allocation is another important lever to use. Stocks, of course, tend to outperform bonds over the long run, albeit with more volatility. So, pick an asset allocation that is appropriate for your time horizon and risk tolerance and capacity.

Habit number three, they know themselves. This, I think, is one of the more interesting elements of investing. It's sort of the psychological or behavioral angle. A few important questions to ask yourself: What has been your experience with money and investing throughout your life? Did you grow up in a household where saving and investing was encouraged? If so, then it may be second nature to you. It may be an obvious thing for you to do. If you didn't grow up with that as part of your experience, then it may seem like a foreign concept--something you don't know much about. You may need to take some extra steps to educate yourself so that you understand how investing works. You may need to try to cultivate some good saving habits within yourself.

The other side of the coin, of course, is being overconfident--thinking that you know more about what the market is going to do or more about investing than you really do. One thing that it's important to accept, I think, as an investor is this: No matter how much you know about investing, you don't know everything. You don't know everything that's going to happen with the market. Even if you've had a great run--you've bought some stocks low and you've sold them high and you feel like you're really on top of what the market's doing--that's a recipe for potential future disaster if you become overconfident and start making unwise investing decisions. So, it's really important to sort of stay within yourself. Even the best investors don't hit homeruns every time they bat--not by a long shot. There are plenty of strikeouts mixed in also.

Also, think about what kinds of money mistakes you've made in the past. And these don't have to be investing mistakes. These can be just financial mistakes that you've made. Have you fallen for get-rich-quick schemes? Are you subject to impulse buying? Have you taken on more financial risk than you could handle? If the answer is yes to these questions, these may be clues that you really need to watch taking on too much risk as an investor--that you are prone to a certain kind of behavior.

I have, at number four, building in discipline. As Christine mentioned, there are lots of different ways that investors can systemize these good habits that we're talking about. One, for example, is automating your contributions--a set-it-and-forget-it approach.

One of the best benefits of this approach is that the money never makes it into your bank account or into your wallet, so you're never tempted to spend it. It's taken off the top of your salary, and you don't have to worry about that temptation to use it for some other purpose. It also applies dollar-cost averaging, which is a positive behavioral way to invest. Basically, when you are dollar-cost averaging, you are buying a set amount of securities on a consistent basis.

Rebalancing your portfolio is an important piece of investing discipline. This can be automated as well, however; a lot of 401(k) plans will allow you to put in your desired allocation, and the plan will automatically rebalance if the allocation of the account falls too far out of line by whatever percentage you tell it.

Also, with regard to rebalancing, less generally is more. You really don't need to rebalance more than once a year. But if something extremely dramatic were to happen in the market, you might consider doing it more often than that. But studies have shown that rebalancing throughout the year is generally not as beneficial as rebalancing less often.

Avoid the temptation to dip into your nest egg. It can be really tempting when you see this pot of money just sitting in there that you know you can't touch until you retire; you might want to borrow from it or even withdraw some of the money. Statistics show that many people who borrow from 401(k)s do pay the money back, which is great, except there is an opportunity cost. By taking the money out, you are removing its exposure to the market and, therefore, the money is potentially missing out on any gains.

With that, I'll call Christine back up.

Benz: Thank you, Adam. I'm going to go through three additional habits of successful investors. One of them is that they can multi-task: They can walk and chew gum.

Investors, really at any life stage, are juggling competing financial priorities and goals. Think about students just out of college. They might have college debt, and they may also want to start an emergency fund, because they've heard that they should have some money set aside instead of having to resort to credit cards. And they may also want to invest in their 401(k) plan for their first job. Young savers are juggling those priorities.

Whatever our life stage, we've got to figure out, if I've got this set amount of money to invest each month or each year, what's the best use of my capital? How do I deploy that money in the smartest possible way?

When we think about prioritizing those competing financial goals, for most of us need to put our retirement savings at the top of the list. Unless we're one of that shrinking group of people who has a pension to fall back on in retirement that will fully fund all of our in-retirement expenses, most of us need to put our retirement plan at the top of the list. That's why it's so important every step of the way, even if you're a young accumulator in your 20s and 30s, to spend time thinking about whether, given your current savings rate, you are on track to hit what you'll need to have in retirement.

Another key habit of highly successful investors is that just as they might focus on limiting their investment-related costs, they also focus on limiting their tax costs.

I want to quickly run through the tax treatment of some of the key investment accounts that many of you have. With a traditional 401(k) or IRA, typically you make a pre-tax contribution and you enjoy tax-deferred compounding as long as you've got the money inside that account. When it comes time to pull the money out of the account in retirement, you will pay ordinary income tax on your contributions because you didn't pay taxes on them in the first place, and also on any investment earnings.

With Roth IRAs, it's the opposite. Aftertax money is going into the account. You're enjoying tax-free compounding on the investment earnings, and then when it comes time to pull the money out during retirement, that money comes out on a tax-free basis.

For taxable accounts, you will put aftertax dollars into the account. If you are using some sort of a taxable brokerage account, a non-retirement account, aftertax dollars go in. You'll pay taxes on any income or capital gains distributions that come out of the account as long as you hold it, and then when you pull money out--whether you're in retirement or whether it's before retirement--you'll also owe capital gains taxes on the investment appreciation piece.

Key ways that you can limit the drag of taxes on these various investment accounts: One is, to the extent that you're still accumulating assets for retirement, take advantage of these tax breaks. The government gives us all tax breaks because it wants to encourage our savings for our own retirement. To the extent that you possibly can contribute the maximum allowable amounts, that's a great start.

The final habit of successful investors is that they keep things simple. They don't overcomplicate with tactical trading strategies, market-timing strategies, too many moving parts in their portfolios.

My advice is, if you keep your portfolio streamlined, you keep it simplified, you can get away with a very simplified investment mix without necessarily having to pay someone to manage your portfolio mix for you. Simplicity is definitely your friend.

I have just a few basic tips for keeping your financial plan simple. One is that, at Morningstar, we're big believers in what's called "strategic asset allocation." Basically that means that you set up an investment mix that makes sense for someone at your life stage and then you gradually make it more conservative as the years go by. You don't respond to big changes in the market environment; you don't shift to cash and bonds when things look scary. You don't go full bore with an all-equity portfolio when things are going well, as they have been recently.

Instead you practice only mild changes to your investment mix. You do as Adam advised, regularly rebalance: Periodically scale your winning holdings back and steer them to your losing holdings. But you don't make big shifts based on what you think will happen.

Generally speaking, when we look at the performance of tactical mutual fund managers--those who jockey around and use market-timing maneuvers--what we see is that they're not terribly successful. In fact, most of them don't outperform a very simple 60% equity/40% bond portfolio. My advice is, don't get too fancy in terms of managing your asset allocation mix yourself.

Checking up on your portfolio fewer times per year. Less is definitely more when it comes to this. The market has been really good. I personally have had a little more temptation to crack open my 401(k) and see how I'm doing. But generally speaking, the less you plug into the fluctuations in your portfolio--whether good or bad--the better off you'll be.

Also reducing your own trading. Try to limit your trading to maybe just once a year, where you do that rebalancing. You get in, see how everything is positioned, see if there are changes you need to make in your investment mix. Ideally you'd have parameters for how often you'll check up on your portfolio and how often you'll rebalance specified in some sort of an investment policy statement--a really basic document that says, my asset allocation mix is this. This is how often I'm going to check up on this thing. This is how often I'll make changes. These are the catalysts that I'll use when making changes.