w w w . t i c o n l i n e . c o m

RUNNING OF THE BULLS

In an April 1995 Time magazine article written by John Rothchild it was reported that Robert Hagstrom, the infamous author of The Warren Buffett Way, worked with Joan Lamm-Tennant, a professor of finance at Villanova, to test the buy and hold strategy. Setting up 3,000 fictional portfolios, with the number of stocks in each portfolio ranging from 10 to 150, they calculated returns over the last 10 years. They found that portfolios that contained the fewest stocks and lowest turnover outperformed those with more stocks and higher turnover.

This was not the first study of its kind, and the results are hardly revolutionary. However, with the amount of evidence supporting the buy and hold strategy (in theory and as practiced by Warren Buffett, Robert Hagstrom, Philip Fischer and others) it is still surprising that the majority of stock investors lose money. In fact a recent article in the Toronto Star cited a study that found that, over the last 10 years, the majority of stock investors did not made any money!

"If we are to hit the bull's-eye, we will need markets that allow the purchase of businesses and securities on sensible terms. Right now, markets are difficult, but they can - and will - change in unexpected ways and at unexpected times. In the meantime, we'll try to resist the temptation to do something marginal simply because we are long on cash. There's no use running if you're on the wrong road."
Warren Buffett, 1993 Chairman’s Letters to Shareholders

A large majority of investment losses stem from market timing aficionados who play the market as they would a game of blackjack or craps. By trading in and out of the market, investors destroy their chance of achieving any kind of positive return. Why is trading in and out so popular? It probably has to do with the human desire for getting rich quick. As with overnight weight-loss programs, the result of market timing is usually disappointing. Because of our need for the quick fix there will never be a shortage of takers for the peddlers of penny stocks and options and futures.

"It is somewhat ironic that investors tend to favor markets that put them at a significant disadvantage and frown upon those that give the best discounts."
Robert Hagstrom, The Warren Buffett Way

Market Timing and the Bull

The hype surrounding bull markets can sometimes reach incredible proportions. Otherwise intelligent people rush to throw thousands of hard-earned dollars at the stock exchange in a frenzy of 'instinct investing'. In an effort to avoid 'wasting time' they rush to catch the Bull.

If you are dead-set on buying something in a bull market, I would strongly recommend checking at least a few key numbers in the company's annual report before you drop a dime. If you can't get a good price, you might as well try for a good company.

1. Cash vs. Long-Term Debt

On a company's Consolidated Balance Sheet take the company's cash and cash equivalents and subtract it's long-term debt. If it's positive, that's great, if not, then you should compare this number to the company's shareholder's equity. The ratio of debt to equity should hover at 0.2 of equity or less. What we're looking for here is a company's survivability in tough economic times.

If, in the unlikely event that you find a lot of cash, you can determine how much you have per share by dividing by the number of shares outstanding. A $60 per share stock with $1 in cash is nothing, but a $15 share with $15 in cash is like getting the stock for free.

If you find that the debt is excessive, you can do one of two things: pray that the debt won't be called during the time you're invested or check to see that the debt is fundable debt rather than callable. Callable debt is usually bank debt or loans from venture capitalists. The issuer of callable debt can ask for their money back at any time, with or without reason. Funded debt can take the form of corporate bonds. Money is provided by investors of corporate grade bonds and is generally used for expansion or refinement of business operations. If the company starts to hit rough waters, bondholders are in for the ride as well.

"The disciples of debt assured us that (this) collapse wouldn't happen: Huge debt, we were told, would cause operating managers to focus their efforts as never before, much as a dagger mounted on the steering wheel of a car could be expected to make its driver proceed with intensified care."
Warren Buffett, Letters to Shareholders 1990

Aside from the savings account, corporate bonds probably provide the worst investment vehicle for small investors. Not only is the investor stuck with a bond that may decrease in face value if the business goes bad, but if the company does extremely well, the bond may be redeemed early to the company's advantage. This lose-lose proposition has the investor losing money when the company goes down, and the rug pulled out if the company does well.

2. Capital Expenditures

On the Consolidated Statements of Cash Flow seek out the net cash provided by operating activities. Subtract the cash used for capital expenditures or some similar value. The difference basically represents the company's ability to meet it's annual costs for remaining competitive (equipment upgrades and purchases.). If a company can't generate enough money to keep pace with it's competitors it must either resign itself to falling behind, take on debt or cut underperforming operations.

On a side note, you should keep in mind that a company should only borrow money to finance operations that produce returns greater than the cost of funding it. Generally it is not a good idea for a company to borrow at 15% to keep an operation that returns 10% on invested capital.

"The most common cause of low prices is pessimism - some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer."
Warren Buffett, Letters to Shareholders 1990

3. Price to Earnings Multiple

Price to earnings multiple or P/E is a gauge of how much investors are willing to pay for a company's earnings; not it's present earnings of course, or else the P/E multiple would always hover at 1 time, but it's past, present and future cash generating ability. A company that has consistently increased earnings and which appears to be poised for future growth will be priced at higher P/Es than it's peers.

Although P/Es vary from industry to industry, it is fairly safe to say that a high P/E indicates high optimism. A good thing to keep in mind is that the P/E represents the number of years an investor must wait before he/she gets their money back if earnings stay the same. So, for a company with a P/E of 15, the investor will typically need to wait 15 years to make his/her money back. The trick here is to find a company that grows earnings at a rate far higher than it's P/E. Thus, a company growing earnings at 20% per year and trading at a P/E of 10 will return money back to it's shareholders in 5 years.

Today, many companies are trading at ridiculously high price to earnings multiples such as Microsoft: 61, Coca Cola 48, Gillette: 48 and AOL: 612. If this isn't an indication that people are optimistically buying on instinct, I don't know what is! If earnings at AOL stay at $0.12 per share it will take over 6 centuries to get your money back!

Although you won't make a lot of money buying in a bull market (buying high and selling higher isn't in the handbook of success), by checking out your company's cash, debt levels and expenditures should at least help you in picking a company with a few redeeming qualities.

Cheers,
Jim Chuong