Proposed securitization rules

I see that the administration has come to some roughly similar conclusions as me, in regards to reducing incentives to willy-nilly securitize crappy loans. Have they achieved the appropriate balance between efficiency of capital, and systemic risk reduction and system redundancy?

According to reports, the administration intends to reduce the vile habit of bankers throwing crappy loans through to unsuspecting investors (imagine, investors EXPECTING banks to have performed some sort of reasonable underwriting in the first place).

It appears that the administration intends to force the underwriting firm to hold at least 5% of the securitized loans through to completion, and further disallow firms to immediately book securitization profits. Instead, they would book the profits as the loans matured and would have that securitization income reduced if the loans performed badly due to weak underwriting standards.

While this is not quite as good as the 15-25% loan book hold-back I felt would be prudent, this is certainly a large step forward.

The 5% hold-back still amounts to 20 to 1 leverage in effect, atop the normal leverage that banks enjoy. Given banks particularly important place in our economy, I am not sure that is prudent enough.

While this is not quite as good as the minimum 15-25% hold-back, it is a large step forward from existing standards - yet I am still left wondering whether this is not a half measure.

I'm therefore hopeful that FASB rules will further help to dampen the capital leveraging effect through some proposed rules, yet to be issued.

Now, of course, reforming executive pay remains a important topic which needs serious attention in order to also reduce further systemic risk.

This is something I have written about previously, and that my internet "colleague", Rick Konrad, at Value Discipline, is writing about in greater detail.

I encourage you to visit his blog, read some of his posts (1, 2, 3) on the matter, and to add your voice by sending your elected official a quick email (find your congressperson here, find your senator here) encouraging such reform.

Note: If you're on a blog aggregator, you can visit The Confused Capitalist here (or here: http://confusedcapitalist.blogspot.com/) for additional articles and exclusive content!


JW

The Confused Capitalist

Market Tremors

Image: Portland Oregon skyline, Mt Hood in background.

In my family of origin, reading something you thought interesting to a sibling, parent or child was a sign of love and affection, as well as a way to stay connected and to expand your world. Receiving one of those readings was taken similarly.

So, on a recent multiple-family shopping expedition to Portland, I asked my wife to read to me, as I ground it out for the fifth hour on the freeway on our way there.

“Read what?”, she asked.

“Globe & Mail – business pages, please.”, I replied.

But then I glanced down at the paper and saw the front page headline – “Markets Pounded – TSX/S&P drops 7% over past three days”. Knowing my wife’s market nervousness, I told her to skip the reading. Instead of it being an enjoyable pastime for us both, I know she’d be pounding me with questions about our holdings, feeling sick if we lost anywhere near the average and dismal if it was more.

Which brings me to the point of this exercise: she reacted just like many people do. At a sign of market decline, they seriously question the market in general, and their holdings in particular.

Unfortunately, it is usually only at times of market extremes like these that people begin ask these questions, and it is usually in this order:

1. Market Exposure – Am I comfortable with the levels of equities I hold?

2. Holdings – What are my specific holdings – what is their orientation, what is their risk profile? How much am I counting on “the future” (potential growth of earnings etc.), rather than “the past” (historical earnings, etc.)?

3. Emotions – What is my emotional readiness to handle declines or lags in my portfolio, without changing strategies?

4. Rationale – What was my thought process for assembling this particular portfolio, and how well will this rationale hold up if market conditions are reversed?

5. Process – What process and tools did I use to construct this portfolio? Have I given myself an edge in some way?

In a bear market, the predictable answers to #1 and #2 are “I have too much equities – I need to lighten up”, and “I have too risky holdings, I need to sell”. In a bull market the answers are of course reversed. Typically, whether in a bull or bear market, few bother to get around to questions #3, #4, and #5.


If you want to outperform the market, aside from being willing to assemble a portfolio that looks unlike the market – and all the perceived and real risk that can entail - you need to spend considerable time on questions #3, #4 and #5.

In fact, I believe you need to reverse the order of asking these questions. That’s because they form the long-term framework for sticking with your ideas. And retail investors are notorious for dumping both their strategies and equities, just as market conditions begin to favor those very equities and strategies.

So, over the course of the next few postings, we’ll look more deeply at all these questions, in what I regard as the proper order (1. Process; 2. Rationale; 3. Emotions; 4. Holdings; 5. Market Exposure), through the lens of my own recent portfolio reconstitution.

(This series will be published every Monday and Thursday until complete)



JW

The Confused Capitalist

Learning, ever learning

One thing I love about the markets, is that there is so much to learn. To become a better investor, you must want to learn more and then put that knowledge to use.

Stockcoach recently wrote a great posting about one of his favorite sites to learn from, CXO Advisory. I too enjoy the insights that this site affords.

To become better in the markets necessarily involves continuous learning, both about strategies that can better the market, and also your own inner human psychology.

Many strategies to beat the market are fairly simple, straightforward, and well known. Studying these things for a while, allow you to come to know them. Further incremental improvement is possible, by learning more advanced techniques. However, many market-beating strategies, it has often been said, can be written on a matchbook cover.

Buying low book-to-value stocks, for instance, is a perenial winner on the whole. As is buying low PE stocks. As is buying stocks with a record of increasing dividends. All well-known, market-beating, strategies.

Implementing and sticking with those strategies is something else altogether, for many, many people.

Two quotations I recently posted on my site relate to fundamental reasons for market underperformance. In my view, most underperformance can be traced to poor emotional control, particularly patience. Both sayings touch on the subject ...

Most of man's troubles come from his inability to sit and be quiet for 20 minutes.

- Pascal (b. 1623, d. 1662)

A man may see straight and clearly and yet become impatient or doubtful when the market takes its time about doing as he figures it must do… the market does not beat them… they beat themselves, because even though they have brains they cannot sit tight.

- From Reminiscences of a Stock Operator, published 1923.

Most investors would do well to ponder these sayings, both before they set their strategy, and after. Just as I have, and continue to do so - to improve my performance.


JW

The Confused Capitalist

You got a problem with that?

Have your good intentions of investing perhaps turned into something else, something else you fear has become a gambling addiction?

With the rise of the internet, discount brokers and the rapid fire world we live in, it's all too easy for some investors to turn into gamblers, in the world biggest casino - the world's stock markets.

According to psychologist Paul Good, if you exhibit five of the following 11 traits, you most likely have a gambling addiction:

1. You engage in high volume trading, where "action" is more compelling than the objective of the trade;
2. You are constantly preoccupied with your investments;
3. You need to invest more and more money or increase your leverage to feel excited;
4. You have repeatedly tried to stop or control your market activity and failed;
5. You become restless and irritable when you try to cut down or stop investing;
6. You invest to escape problems, relieve depression, or distract yourself from painful emotions;
7. You sometimes have to increase your position in an investment after a loss - chasing your losses;
8. You have lied to conceal the extent of your involvement in the market;
9. You have committed an illegal act to finance your market activity;
10. You are jeopardizing significant relationships or your job because of excessive involvement in the market;
11. You have relied on others to bail you out when you got into desperate financial situations.

Tally up your score. For those who scored five or higher, why not check out a Gambler's Anonymous meeting near you?



JW

Adapted from Canadian Business.

The Confused Capitalist

Informants in the investment process - rating and ranking

Separating good leads from bad is crucial in assessing investing leads. Avner Mandelman of Giraffe Capital has a method to do so.

Essentially, it's from a page stolen from spy agencies. In order to be able reliably assess information coming from a variety of informants, some sort of ranking system had to be devised.

These agencies rate their information from informants in two ways:

1. Based on the past track record of the informant, and,
2. Based on the informant's confidence in this particular piece of information.

Similarly, in assessing investing leads, whether they come from brokers, analysts, industry sources, customers, etc. we can assign a letter grade rank to each of the above. For instance, an industry source who has proved highly reliable in the past might be assigned a letter grade of "A", under point 1 above. Secondarily, they provide you with a particular piece of information that they claim they are highly certain is accurate (another "A", but under point 2, above).

This can provide you with a certain level of confidence in using this information as part of your investment process. For instance, an "A" ranked informant with an "A" piece of information would play higher in your investment process than a "B" informant, with "C" level information.

Mr. Mandelman even suggests that those so poor at any type of accuracy, can eventually become "A" level informants, by being contra-indicators. In other words, you studiously avoid their recommendations.

Of course, all of the above pre-supposes that you start tracking and rating your own informants, and keep those in your investment scrapbook. A worthwhile idea, in my view. By the way, I rate Mr. Mandelman as an "A" source.



JW

The Confused Capitalist

Single Best Investment - some of the rules

I recently reviewed the book, The Single Best Investment, which provided a framework for investing in stocks likely to outperform the market over lengthy periods of time.

I am going to provide a synposis of some of the rules that the author suggests to find suitable candidates using this dividend-and-value-oriented approach:

1. Company has to be financially strong, minimum B+ Value Line rating, or BBB+ S&P credit rank;
2. Dividend yield at 150% of the S&P500, but hopefully at 200%+;
3. Yield has to be expected, and shown to have grown over 5-10 years, at at least 5% annually (twice the expected inflation rate);
4. Dividend payout ratio less than 50% (except for utilities and REITs);
5. Company should have at least moderate earnings growth of 5-10% annually (both historically and going forward);
6. Price/Sales ratio below 1.5, and hopefully less than 1.0;
7. Price/Earnings ratios lower than the market, AND must less than the reciprocal of the long-term bond rate;
8. Book value ratios should be lower than the market, and;
9. Growth of cash on the balance sheet is a big positive.

There are, of course, other rules and suggestions, but I'd suggest to you that these encompass the heart of the book and suggested technique.

Since almost all of these rules as stand-alone situations have been shown by various academic studies to produce some level of market outperformance, combining them is obviously going to provide a platform for outstanding results with enhanced safety of capital.





JW

The Confused Capitalist

Insider Ownership & Long Management Tenure

When management and insiders have significant economic ownership and management has longer tenure ... (see illustration, left).

I recently recieved one of those ubiquitous The Motley Fool ads in my hotmail box recently, and I found the message they conveyed worth contemplating ...

10-Bagger Tenures
By Tim Hanson (TMF Mmbop)

More than 700 CEOs have already resigned this year, putting 2006 well ahead of pace to break the record (set in 2005) of 1,322 CEO exits in one year. That statistic, published in Fortune, should be worrisome for investors. Why? Because companies that do not have steady leadership at the top get lapped by companies who do.

Seriously. It's true ...
Need evidence? I found that of the 100 top-performing small caps from 1996 to 2005, 84 of them had either a founder at the helm or a CEO with more than five years of experience at the company -- far greater than the market average.

And the trend continues across the best-performing stocks of any size. Fully 164 of the 308 stocks that returned more than 20% annually, from June 1996 through June 2006, continue to have insider ownership of more than 5% today. That's 53% frequency. Now let's compare that to the broader market. According to Capital IQ, there are 21,959 companies trading on U.S. exchanges. Of that enormous number, just 3,550 have insider ownership of 5% or more -- a measly 16%.

Clearly, then, there's correlation between long-term shareholder rewards and insider commitment to the company they're running.

While I sometimes find the frequency of these ads irritating, it's worth thinking about this.

In fact, this is one of the things that I look at, when I analyze a stock in my small and microcap blog: a consideration of insider ownership. Perhaps I'll start considering the tenure of the CEO hereafter too ...


JW

The Confused Capitalist

Outperformance - some key thoughts

Outperformance in the world of Resolute Growth Fund manager Tom Stanley (there since 1993 inception).

One year return, 91%, five year return 45% p.a., since inception, 26% p.a. Investing principles according to Mr. Stanley:

1. Be a long-term investor - it's easier to spot long-term trends than quarter-to-quarter movements;
2. Be flexible - use whatever works at a reasonable price;
3. Hunt for ideas;
4. Be skeptical of information sources - try to verify important information from a secondary source;
5. Buy your best ideas - last year, Resolute held only 14 stocks in it's fund ("we had 14 great ideas - I don't have 150 great ideas, so I'd rather just buy the 14");
6. Strive for effective rationality - filter out the noise;
7. Outperform by being different - if you really want to outperform the index, you have to strive to position yourself differently;
8. Stay humble - humility breeds an open mind that continually seeks good advice and is willing to listen to others (and is thus open to heeding good advice);
9. Stay in your circle of competence - define it, learn within it, stay in it;
10. Be a contrarian - some of the best opportunities are found in unloved sectors and stocks;
    
11. Be patient - being a contrarian means sometimes underperforming the index, while the long-term trend you've seen fully develops and is more generally realized;
    
12. Apply spiritual principles - a daily prayer for wisdom can help you avoid making investment mistakes.

JW

The Confused Capitalist

Long Term Investing and Fighting the Tape

Left: 7' 2", 450lbs, wrestler Andre the Giant. b.1946 d.1993

There's a saying in the stock world, that goes, "Don't fight the tape." What it means is that when there's powerful selling going on against a stock, only the foolish step in and start buying, because the price is likely to continue to decline.

While there's obviously some point at which the selling will stem, and the "tape" may turn (provided there's some underlying positives to the stock), the short-term investor is well-advised to take note. To some extent, it would be like trying to fight Andre the Giant.

While I generally pay very little attention to "fighting the tape" in my own investing over the short term (hey, if I'm willing to buy the stock at the price offered, I don't particularly care whether I've bought at the precise bottom anyway), it makes sense to pay attention to "fighting the tape" over the longer haul.

Where I think one has to be very careful "fighting the tape", is when powerful long-term forces are at work against your investment. In my opinion, an example of this includes things like the computer industry, where costs keep getting driven down, as do margins. Investing in businesses in the midst of commoditization are situations where above average caution is warranted. That's not to say don't do it, just be aware of the forces at work, and be cautious.

I think that this is something to particularly keep in mind these days, as commodities themselves have risen from the ashes, to become a very popular asset class - and commodity oriented companies - and their stock prices - have thrived.

One day this tide will turn (probably when inflation is seen as a benign future factor - unlike today), and commodities and commodity-oriented company's stock will "return to earth". In the interim, some careful thought is warranted, to ensure that you're happy with your level of exposure to any situation based on a commodity product.


JW

The Confused Capitalist

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Portfolio Construction - As easy as 1,2,3 - A,B,C

The other day I talked about portfolio outperformance, suggesting one method to outperform the broader market. This method, a "focused portfolio", has plenty of academic support for its effectiveness and rationale. Yet, it doesn't suit every investor. It's time intensive and requires at least average investing skills (i.e. the ability to read a balance sheet, earnings and cash-flow statements). So it's definitely not for everyone.

But the great thing about investing is that there is more than one way to "skin a cat", as the saying goes. That means you can outperform the broader market (which I define as the S&P 500), by doing other things well. One way is through asset allocation and the use of low-cost ETFs to build a portfolio.

A way to enhance these returns is by investing with history on your side - in other words, finding the type of investments that have historically produced above average returns. Of course, also investing with an eye to what the world might be like in ten to twenty years, is another way to boost your returns.

So, having said that, what are some practical ways to build a low-maintenance outperforming stock-market based ETF portfolio for the next ten to twenty years?

Firstly, to acknowledge that so-called "value" stocks and "value indices" produce better market returns - on average - than so called "growth" stocks and "growth indices".

Secondly, to consider that small company stocks traditionally produce better returns than large company stocks.

Thirdly, to see the rapid rise of the emerging markets, and to acknowledge they are likely to be far larger in twenty years than today (they are producing about 20% of global goods today, yet their stock markets only hold about 5% of the capitalized value of stocks in the global economy).

Fourthly, that these advantages should also be stabilized with some large company stocks and broad-based market exposure, that will produce relatively reliable returns over a longer period.

Fifthly, to consider that the US trade and fiscal deficits are likely to continue impairing the currency for a while longer, and therefore willingly have greater than average exposure to other markets.

Finally, to consider your particular own thoughts and ideas, and to add these into the mix somewhat. This might be the idea that health-care stocks will prosper into the future, or perhaps that technology stocks now appear reasonably priced, or that commodities appear to have a bright future for the next five to ten years. Whatever - the point is is to add one or two of those themes into your overall investing mix, if you feel comfortable doing that.

Now, here is a sample portfolio I've constructed that I think would be suitable for an investor with a twenty year horizon (this is the all-stock market portion of the portfolio), and with a willingness to overload promising positions, as discussed recently. For the twenty year investor, this is the type of portfolio that probably needs only to be re-visited and re-balanced every five years or so. So remembering our themes of:

1. Value orientation;
   
2. Small companies orientation;
3. Emerging Markets exposure;
4. Some Broad-based;
   
5. Consideration of currency implications (ie more exposure to international);
   
6. Your own ideas (in this case, mine);

here's the low-maintenance ETF portfolio I'd construct with an eye to the next twenty years:

1. 20% Broad-based international - EFV - $64.91 - ishares product tracks the MSCI EAFE Value Index, which tracks European, Australian, and Far Eastern markets. This index has outperformed the broader (non-value) index MSCI EAFE index by about 2% annually over the past five year. Five year return on the index is 11.7% annually.
2. 20% Small company - IWN - $74.99 - ishares product tracks the Russell 2000 Value Index (US small cap). It has outperformed the broader (non-value) Russell 2000 Index by about 3.4% annually over the past five years. Five year return on the index is 16.2% annually.
   
3. 25% Emerging markets - EEM - $105.45 - a broadly-based (for emerging markets) ishares product tracks the MSCI Emerging Markets Index. Five year return on the index is 23.2% annually.
4. 20% S&P 500 - IVE - $70.62 - an ishares product tracking the value portion of the S&P500. Produced a 5.0% annual return over the past five years, beating the broader based S&P500 by 1.0% annually.
5. 15% Own Ideas (in this case, my belief that commodity-oriented countries will do well for the next five to ten years). I'd equally weight a Canadian ETF (EWC) - $24.86 - and a Brazilian ETF (EWZ) - $44.25 - or Australian ETF (EWA) - $21.94. Five year returns on these indices have ranged from a low of 18.2% to 27.9% annually.
   

Now, you lose a little bit due to the management expense ratios but, over a decade or so, this looks to me like a portfolio that should significantly outperform the S&P500. By comparison, SPY is trading at $131.47.

Of course, you can always tinker with this, but this is a simple, pretty well-balanced stock portfolio, constructed with the aforementioned moderately overweighting themes in mind. I personally would sleep very easy with this portfolio. We'll check back in with this model portfolio in six months to a year.



JW

The Confused Capitalist

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Portfolio Construction - Outperformance

If you want to outperform the market, to build a better portfolio, then you have to be willing to do things differently than most of the herd.

First among these is committing to your positions. Today, this is called a "focused" portfolio or if a mutual fund does it, a "focused fund". Recent academic studies have shown that focused funds perform, on average, a couple of percentage points better than the typical fund. This is no surprise really, since you are willing to commit more capital to those positions holding the best promise.

While some diversification has it's place, too much will produce only market performance at best. Think of it like a game of Texas hold 'em poker: If you got dealt two aces "in the hole" to start the game, would you start off with an average-sized bet? If you did, you'd be wasting your huge advantage.

Investing is like that too: you should commit larger amounts of capital to the most promising positions, and less to the ones which are still promising, just less so.

I personally think that no one who wants outperformance should have more than 25 positions, and that the minimum amount of any position should be at least 4% of the portfolio value. Without being willing to commit at least 4% of your capital to a position, shows a lack of confidence in it, perhaps underpinned by a lack of understanding of it, its industry, etc. In that case, you shouldn't invest at all.

In some exceptional cases, you might want to commit 20% or more of your capital to an exceptionally promising situation. Superinvestor Warren Buffett has remarked that early in his career he held over 50% of his net worth in a single stock, and slept like a baby every night (presumably because he felt the stock was remarkably under-valued).

You need to ask yourself a few questions before your undertake your purchase - before deciding on the percentage of your portfolio you're going to commit to it:

1. What are the odds that something could go wrong with this stock, and
2. If something goes wrong, how much damage will it do, and
3. If things go as I foresee, how much upside does this add to my portfolio?

When you can answer these questions to your satisfaction, then you'll have an idea how much capital to commit. Never forget to build a "margin of safety" into all your estimates.

Thinking differently: the first step to outperformance.

JW

The Confused Capitalist

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Prospecting for great stock values

How do you find great stock prospects?

Well, it's easy but it requires work. The easiest way to begin with some sort of specified list - typically, this works best if you've defined an area or areas of the market that you prefer to invest in. That way, when you see a "wonderfully" priced stock (i.e. read "cheap"), you'll know it, and be able to act on it. This is one of the keys to outperformance - being able to recognize value.

Let me give you two examples from my own portfolio - two stocks - very cheap stocks - that I found. The first was Xceed Mortgage Corp., a Canadian sub-prime lender.

At the time I bought it, it was growing its earnings at a 40-50% rate annually, and yet the PE of this "undiscovered gem" was only in the nine or ten range. In situations like this, you're apt to get rewarded very quickly ... like I was ...



How did I find this? Well, I went through a list of about 400 Canadian financial stocks, eliminating ones that didn't fit my criteria (small/micro cap stocks, as it's easier to find undiscovered value in that area than anywhere else). I then researched the more promising candidates in detail. Overall, this took the best part of two weekends, but I was paid very handsomely for my efforts.

Another area I focus on is herbal medicine/businesses. Spending the better part of a weekend working through a list, I was able to find another undiscovered beauty that also rewarded me very quickly. This was American Oriental Bioengineering, and I found it at a PE of around nine, with an earnings growth rate of better than 50% annually. I was rewarded very quickly in this case too ...



But you can see how much better I would have done, had I even found this stock one month earlier ...

In each case, I also found a couple of other stocks I invested in at that time as well, but it was very clear to me that these two were easily the best ones of those lots, and I invested pretty substantially in both. It probably would have been pretty clear to just about anyone, as the value wasn't that hard to see - what was harder was having the patience and discipline to weed out the others that weren't as promising.

As one final benefit, while the "other" stocks I concurrently invested in didn't do as well, they still did OK, because they at least offered reasonable value. The best thing was that going through those other stocks gave me great confidence that those two both did offer great value and therefore I wasn't scared to overload my portfolio with them - and enjoy the benefits thereafter.

Finding great stock values - easier than you might think.


JW

The Confused Capitalist

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Long division? * 20 / 10 / 5 * A useful analogy.

Every once in a while, you come across a useful analogy that can help you in your own life, in your own particular situation, that helps you better yourself, or break out of a tired old mental model that no longer works for you.

Whatever it is, you strive to remember it, and use it to your advantage.

I've been reading some of the Robert Kiyosaki books (of Rich Dad, Poor Dad fame). Now I've read some disparaging reviews of his books and the like, but frankly, I like them. I think he brings some good information down to a level that almost anyone can understand, and I always admire people like that. The fact that he's overcome his own learning disability to become very successful, makes me admire him all the more.

Anyway, in one of his books, his "Rich Dad" gave him a piece of advice about the markets that can both help one prepare for profit and be mentally ready for diaster.

His rich dad told him that the markets run in a 20 /10 /5 cycle.

For twenty years, the stock market is popular, and produces good returns. For ten years, commodities rule (we're in the middle of this now). And every five years, there's some type of crisis.

His "rich dad" cautioned him that the timing wasn't exactly precise, but was a rough guide that seemed to recur with regular frequency.

This is a useful analogy in my view, because it allows you to be prepared for the next crisis which, according to the guideline, might be arriving very soon. In 1997 we had the "Asian contagion" and shortly thereafter the Long-Term Capital near crisis, and then in 2001 the terrorist attacks. According to the timing of this formula, some crisis may be arriving on our doorstep soon.

What it is, obviously is somewhat unknown. There's been a lot of talk about "global imbalances" with relatively little talk about how that might play out or trigger a crisis. Perhaps it would be in form of a rapid movement away from the US currency. Or perhaps the rising of interest rates and slow drain of liquidity from the markets will trigger some type of crisis in the real estate market that will spill over in some unforeseen way to the broader markets. Or perhaps it'll be something that sideswipes from "out of nowhere". The point is, is that some preparation might be warranted at this point.

This would include, in my opinion, careful review to ensure that your portfolio isn't excessively exposed to any one over-valued or speculative sector, and that it generally appears robust and reasonably valued. And of course, a review to ensure that you can handle any leverage you're using, should one or two factors about it turn negative.

Analogies - use them, or lose them!


JW

The Confused Capitalist

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The Ultimate Question - Customer Relationships and Investing?

A recent book review by Harvey Schachter of The Ultimate Question: Driving Good Profits and True Growth was very interesting.

According to research done by author Fred Reichheld, the vast number of questions asked in relation to customer service aren't all that useful in helping a company to devise metrics that assist in developing profitability.

According to Mr. Reichheld, the only question that's required is this:

How likely is it that you would recommend this company to a friend or colleague?

Respondents are then asked to score this "ultimate question" on a scale of 1 to 10, with ten being the best score.

People rating the company at a nine or ten are considered "promoters" of the company, those at 7 or 8 are considered passive and those below are considered detractors.

The detractors, says Mr. Reichheld,

... may appear profitable, but their criticisms and attitude diminish a company's reputation, discourage new customers, and demotivate employees. They suck the life out of a firm.

The net ratings are developed by subtracting the percentage of detractors who are customers from the percentage of customers who are promoters.

So if a company had 65% promoters as customers, and 30% as detractors, it's net scores would be 35. The highest ranking firms were USAA (a non-public insurance company, catering mostly to military personnel) at 82, Harley Davidson at 81, Costco Wholesale at 79, Amazon.com at 73, eBay at 71, and Apple Computer at 66.

Interestingly, I looked at the stock charts of all the public companies mentioned therein, looking at their ten year records. While Amazon and eBay had only traded for 8 1/2 and 7 1/2 years respectively, one thing seems very clear. This measure is an unbelievable proxy for stock market performance too. The minimum any of these stocks had increased over that period was by a factor of five and went as high as 24x.

The S&P 500 had only doubled over that same period.

The ultimate question: The only one needed for investing too?


JW

The Confused Capitalist

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Liberation by Following the Rules?

There can be tremendous liberation in setting down some self-imposed rules as an investor, and then seriously attempting to follow them.

Today, like no other generation before, we are swamped by information, and by envy. Both can be self-destructive to an investors long-term goals, which should be the creation of wealth, at the minimum possible risk for the path chosen.

Because we are swamped by information, we often think that we HAVE to act upon these messages to garner the maximum possible return. This is furthered by our natural state to want to be the best, do the best, and be seen as the best. We envy others who are.

This compromises our position as it should be in in order to be successful investors. And that is simply to be as rational as possible.

So without rules, we're kinda like a guy who the media tells him that he's after a woman. Without some rules, we flit about here and there - ranging from the wrinkled 80 year old Elbonian woman who doesn't speak English, to the 20 year old wunderkind with a 170 IQ. And everything in between. Many of whom are obviously ill-suited to us, our situation and even our temperament. So it is too with stocks and investments.

Some of my own rules include not looking at stocks without earnings, avoiding stocks with PE ratios above 30 and trying to find ones below 15, and an inclination towards financial sector stocks (I have a background here), and also away from large-cap stocks and towards small and micro-cap stocks. Because I've got these rules, I now find it much easier to avoid the siren song of "next great thing". While I don't always follow the rules (naughty boy, up to the blackboard you go!), more often than not, I'm sorry when I don't.

So my advice is to set yourself some rules, and try to follow them. Will you miss some wonderful opportunities? Absolutely! Will you make more money because you've focused your mind, and actually concentrated? Absolutely!


JW

The Confused Capitalist

Deep Value Scorecard - Part II

This continues on a scorecard from The Contra Guys, half of which was shown over here, yesterday. The premise was, that in order to properly assess "deep value" investments, a good scorecard is needed.

Given The Contra Guys excellent long-term record of very high returns using their contrarian investing techniques (26% return annually over 10 years), it's felt that this particular scorecard offers unusual utility. Anyway, yesterday, the first 12 items were given; today, the remaining eleven are shown:

1. Positive financial condition +1 or +2
2. Amount of time followed +1 to +4
3. Book value +1 to +2
4. Reasonable price/earnings +1
5. Downtrodden industry +1
6. Readable annual report +1
7. Public awareness +1
8. Excellent cash flow +1
9. Our understanding of the business +1
10. Possibility of a takeover +1
11. Intangibles +1
    

The benchmark of these 23 items that's required before The Contra Guys will invest is a minimum score of ten. The higher the better obviously. If you want further explanation, you can buy their book, The Contrarian Investor's 13.

Still, using this scorecard alone in assessing deep value situations isn't going to guarantee success. However, it should improve your chances of success by allowing you to more diligently assess a situation, and also ensuring that you have methodically looked at a number of different areas that can enhance returns.

Perhaps another day, I'll show you another scorecard I've used that's been well "field-tested".


JW

The Confused Capitalist

Deep Value Investing Situations: Use a Scorecard - Part I

One of the things this site promises is a "value" investing orientation. And one of the things most needed to properly assess deep value" situations is a scorecard. Without a scorecard, it's too easy to get caught up in the pessimism of the investment situation, or to become too euphoric because you think you've found the greatest thing since sliced bread.

What you need is a scorecard - and hopefully one that's been tested as having some utility over time. Over the next few days, I'm going to present one that's been used fabulously by its creators, The Contra Guys, North American deep-value investors, Benj Gallander and Ben Stadelmann. These gents run a very fine newsletter service indeed, with an enviable record has produced a 40% annual return over the past five years, and over 26% over the past ten. As with most deep value situations, trading costs are minimized by relatively long holding periods.

(Note: Since these returns are stated in Canadian dollars, the past five year record would be even higher for those whose investments are denominated in US currency.)

In their book and other places, they have produced an investing scorecard that aids them in deciding whether or not to invest in a deep value situation. Their scorecard consists of twenty-three items, to which ordinal values of between -2 to +4 can be scored for each particular measure. The scorecard will be shown over two postings here, so this only consist of approximately one-half of the measured items:

1. Recent downward share price spiral -1
   
2. Single, double, triple, quadruple price upside +1 to +4
3. Negative margin of safety -1
4. Stock is likely to undergo a share consolidation -1
5. Good or excellent management +1 to +2
6. Management ownership position +1 or +2
   
7. Insider trading -1 to +1
8. Excessive versus equitable executive compensation -1
9. High research and development expenditures +1
10. Favorable demographics +1
11. Excessive, or reasonable debt -2 to +2
12. Dividend payout +1

The rest of The Contra Guys scorecard will be presented later, within the next day or two.

JW

The Confused Capitalist

Risk: Your Human Capital - Stock or Bond?

Professor Moshe Milevsky of the Schulich School of Business asks whether you are you a Human Bond? Or Speculative Stock?

Professor Milevsky does work in the emerging field of Quantitative Wealth Management, trying to help individuals make more rational and better decisions about personal wealth and risk management issues.

Milevsky writes about "You Inc." in Wealth Logic: Financial Planning for the Smart Investor and suggests that the most significant financial portion of "You Inc." is not your accumulated financial wealth in terms of stocks, bonds, 401(k)s, real estate equity, etc. It is the amount that you will be worth as an earning machine over the lifetime of your working career. What he calls your "Human Capital".

Milevsky suggests that you stop and consider what type of capital you are personally and, in the interest of a balanced portfolio, purchase or weigh your other financial investments to offset the type of risk inherent in your "human capital". For instance, Milevsky states that as a tenured professor himself, he's the equivalent of a "human bond". Steady, regular and reliable payments, practically no matter what. In the Quantitative Wealth Management field, Milevsky suggests that this should be offset by a very high ratio of investment into the stock market, rather than into more bonds or other savings type investments. And this is exactly what he himself does.

I also know another individual like this - he's got a very secure government job as a middle manager - another "human bond" - but he's very conservative and probably doesn't invest for the rate of return he should be seeking on those investments, given his "human bond" characteristics. On the other side of the coin, Milevsky suggests that those whose job is more like a volatile speculative stock - a commission salesperson of "big ticket items" comes to mind - should probably invest a higher than average ratio into more conservative investments.

Interesting stuff. Human Bond, Blue Chip Stock, Speculative Stock? What's your "Human Capital" most like?

JW

The Confused Capitalist

Fear is Your Friend: Embrace It!

The other day I entitled an article “Fear: an Investors Biggest Friend & Worst Enemy” and it occurred to me that I’d said why it was an enemy, but didn’t say why it was a friend. The reason is, if you learn to use your fear – which generally occurs after an extended market decline – as a contra-indicator.

In other words, you recognize the fear, but also recognize that a market decline generally represents an excellent opportunity to increase your long-term rate of return. I’d read that an analysis determined that if you added 10% to your stock portfolio after every 20% market decline (an opportunity that admittedly doesn’t happen very often), that you would increase your overall rate of return by 2% annually.

While 2% doesn’t sound like a lot, it has large implications over a long investment horizon. For instance, if you think your return rate is likely to mirror the long-term average of the stock market (large stocks: 10% or so), then increasing your return by 2% annually means this over a 25 year period:

Instead of a $100,000 portfolio being worth under $1.1 million in 25 years, it is instead worth over $1.7 million. What a huge difference when using fear to your advantage.

So this is how to turn fear to your advantage – by using the Warren Buffett saying … “We seek to be greedy when others are fearful, and fearful when others are greedy.”

Fear – your best friend.


JW

The Confused Capitalist