Profit magnitude AND duration

It’s not enough to focus on a company’s profitability–especially if it’s huge; you must also understand the durability of that profitability.

A single payout of $1 million is not worth as much as a lifetime payout of $150,000 a year forever (unless you can get better than 15% returns forever). The same is true with buying businesses (whether in the form of a whole private business, or shares of stock).

This may seem elementary, but some investors lose this focus when they dwell on short term high or low profits. A couple of examples may help concretize this point.  

Exxon Mobile is a hugely profitable company. But, there are non-trivial questions about whether it can replace its current productive capacity over the next 10 years.  

Or, consider Apple. It’s hugely profitable right now, but can that profitability be sustained and grown in the face of many smart and well-resourced competitors (that are spending 2x to 4x as much on research and development)? The answer to that question is vitally important for Apple’s valuation.

Or, what about Sprint (the telecom company)? It’s clearly not making money now, but the price paid for the company should reflect profits 5 and 10 years from now as well as this year. Does Sprint’s valuation reflect its current profitability or its profitability over time?

Think about Research in Motion, the maker of Blackberry mobile phones. It had rapidly growing sales and profits within the last year, but both have started rolling over. Will that trend accelerate, continue, or reverse?  The value of the business hinges on the outcome.

I don’t mean to imply that answers to these questions are easy–they aren’t. In fact, I’ll be the first admit I don’t have the answers to any of those four questions. But, they must be thought about in order to achieve good investment results.  

I should know, I’ve fumbled that ball several times in the past (business analysis is extremely complex, and no one is omniscient). I bought Reebok and Novell in 1996 after years of outstanding profitability. Over the following 10 years, though, both saw profitability and their stock prices tank–a great lesson that durability of profits is more important than recent magnitude.

Think about stalwart companies like McDonalds, or Coca-Cola, or Proctor & Gamble. They have extremely high profitability and almost zero chance of seeing that profitability vaporize like we could see happen with Exxon, Apple, Sprint or Research in Motion. That’s why their stock prices are almost never as low relative to fundamentals. Investors as a whole get this concept, even if they forget it at times (1999 and 2000 for technology, 2005 and 2006 for housing).  

As I said last week: it’s not about market share, it’s about profitability. Now, I’d like to add that it’s not just about profitability, but also durability. Your investing future depends on both.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Profit magnitude AND duration

Measure what matters

Measuring what matters is one of the hardest things to do in life.

Take happiness.  Everyone wants it, but few get it.  Why?  Because most pursue short term pleasures, becoming hedonists, and chase their tail instead of becoming happy.  You have to think long term, and focus on virtue to become happy.  Short term pleasure is the wrong thing to measure; long term virtue is the right thing to measure.

Or, take weight loss.  Almost everyone wishes they weighed less.  But, most fail to lose weight because they try some crash diet they couldn’t possibly stay on over the long term.  The result: they lose a little weight, but put it all back on again because they focused on the wrong measurement–short term scale measurements.  To keep the weight off, you need a long term change of lifestyle–usually less food and more exercise.  You need to measure less food and more exercise over the long term.

But, it’s not easy to measure what matters most.  It’s hard to do and doesn’t give instant results.  C’est la vie!

I run into this all the time with investing.  People want to build long-term wealth, but they try a quick fix instead of measuring what matters most. 

Take, for example. investing in fads.  Many think investing in the latest thing or making a big lottery-style bet is the way to build wealth.  It isn’t, so the vast majority of those who try this approach don’t build wealth.

Or, take index investing.  People hear or read that you can’t beat the market, that low fees matter most, so they jump on the index investing bandwagon (usually after several years where it has worked–too bad we can’t drive by looking in the rear view mirror).  But, paying low fees doesn’t do you any good if the index goes no where for a decade. 

Which brings me to the measure that matter most for investing: after-tax, after-fee returns. 

There’s no benefit to avoiding taxes if you get lousy returns, can invest very limited amounts of money, and pay all kinds of extra fees.  Many 401k and 529 plans exhibit this “benefit.”

Avoiding taxes is not the measure that matters most.  If you can get 10% returns in a tax deferred plan and 10.91% returns in a taxable plan (assuming 33% turnover and 25% marginal tax rate), you end up with the same after-tax money.  That’s right, just find someone who can beat the market by 0.91% over the long run and you might as well save in a taxable account.

This matters because most 401k and 529 plans stove-pipe investors into a few limited options–options that are heavily marketed to make sure lousy money managers can get lots of assets under management.  And that’s before we even get into all the wonderful fees and restrictions that come with such plans. 

There’s no benefit to paying low fees if you get lousy returns, either.  Many investors over-focus on fees.  If you are looking at two options that will generate the same returns, then fees are what matter.  But, that’s a big IF–IF THEY WILL GENERATE THE SAME RETURNS!

If manager A beats the market by 0.5% after fees and index B only charges you 0.25%, you should go with manager A, because your after fee returns are 0.75% better. 

The measure that matters most in investing is after-tax, after-fee returns, not fees by themselves, not tax deferral, not anything else.  Anyone who tries to convince you otherwise is probably selling you something.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Measure what matters

The return of the bond market vigilantes

James Carville, Bill Clinton’s 1992 campaign strategist, is reported to have said, “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”

This quote highlights the power of markets, even over politicians.

The bond market can push around politicians because the decisions of millions of investors can raise or lower interest rates, raise or lower currency values, and push politicians into a corner where they have to change their tune.

Some see this as a dark and mysterious power run amok, but this simply is not true.

The bond market is the largest market in the world in dollar value. It does not consist of a few powerful individuals or organizations, but of millions of investors making independent decisions. When the bond market pushes politicians around, it’s because there are so many people in agreement with each other (and disagreement with government) that prices move very far in one direction.

That’s not a conspiracy; it’s a groundswell.

The bond market vigilantes are not an organized group, but their individual actions can force change. And, change it in the wind.


The vigilantes have been quiet for several years. With low inflation and high growth, there have been profitable opportunities elsewhere.

But, now that governments of the world have spent trillions getting their economies going and propping up weak companies, governments are again vulnerable to the vigilantes.

Nowhere is this more clear than in Europe, recently. Investors are understandably concerned about the balance sheets and cash flows of European countries, especially Portugal, Ireland, Greece and Spain (dubbed the PIGS).

Worldwide, bond markets have been raising interest rates and lowering the currency values of the weakest players.

This is not a bad thing. In fact, it’s quite the opposite.

Like the stock market bashes companies with weak business plans, the bond market bashes reckless countries. Where governments think they can print money and issue bonds without constraint, the bond market brings discipline.

The bond market vigilantes don’t cause problems, they react and point them out.

Without them, things would get much worse. Get ready to hear a lot more about bond and currency markets because sovereigns need reigning in.

Be glad they are enforcing such discipline, but stay out of their way. This is no time to bet heavily on currencies or bonds. Unless, of course, you happen to be a vigilante yourself.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Bonds and cash just aren’t that safe

Bonds are seen as safe. So is cash. But, that’s not necessarily true.

For starters, bonds and cash are susceptible to higher tax rates than stocks. Whether anyone likes it or not, interest on bonds and cash are taxed at much higher rates than dividends and capital gains on stocks. That differential may change with new tax laws, but even then, stocks are likely to be taxed at lower rates.

Most significantly, bonds and cash are more prone to suffer from the impacts of inflation. That may not seem as dangerous as a 50% stock market plunge, but 4.14% inflation over 10 years will do the same thing (and is much more likely to be a permanent 50% loss versus a temporary one for stocks). Does anyone really want to bet that inflation won’t be above 4% over the next 10 years considering huge government debt and budget deficits?

Finally, bonds and cash can be defaulted on. This is probably the risk most people dismiss as too unlikely, but a low likelihood is not the same as no likelihood. Bonds are more likely to default than cash, and stocks are more likely to go to zero than bonds, but bonds are not without default risk. If you hold government bonds and think they can’t default, a re-reading of the history of Germany, Argentina, Russia and the Confederate States of America is in order. Think cash is default free? Check again. History has many examples including Weimar Germany, France after the South Seas Bubble, or any other example of cash not backed by specie (not yet and never aren’t the same thing).

Bonds and cash can be safer than stocks, but not always. Bonds are a promise to pay, but that promise can be broken. Cash is a note (debt) issued by the Federal Reserve as legal tender, and that promise too can be broken. Bonds and cash are much more impacted by inflation and have higher tax rates than stocks. They are not without risk.

I was reminded of this recently when I read that individual investors were generally selling stocks to buy bonds over the last year. They are rushing for a safe haven to avoid the pain of another downdraft. In the meantime, they have missed the market rally and are hoping to time the market. The history of individual investors, especially as a herd, being right on something like this is extremely poor.

The very fact that so many retail investors are racing to bonds together as a herd is enough to remind me of how badly bonds and cash can do. The next couple of years are likely to remind investors that not even bonds or cash are completely safe.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Hanging in there is tough, no doubt about it

October has been a brutal month.

I saw this crisis coming years ago, and my returns have benefited from that foresight, but this hasn’t kept me from feeling the pain.

I was feeling pretty good about myself at the end of September. Having beat the market by more 8% over the last two years and by more than 4% over the last three years (annualized, after fees), I was feeling pretty cocky.

But, that was before October. In October, my returns have paralleled the market’s path down. I haven’t enjoyed the ride, even if I started from a higher place.

This has been particularly frustrating because I’ve invested in some of the strongest companies around. You’d think the strongest businesses would be untouched, or much less touched, by recent turmoil.

That hasn’t been the case. When people are under a lot of pain, they do crazy things, like selling great companies at huge discounts to underlying value. Many of those investors were probably buying on margin. Some were hedge funds that were forced to sell long positions and cover short sales after the SEC banned shorting certain companies.

What’s been happening is the usual capitulation you tend to see when markets are bottoming. People are under so much pain that they’re selling everything, regardless of the price they’re getting.

This isn’t fun for a value investor like me because I hate to see my clients’ money or my own money decline in value. I work hard to be sheltered by the storm, even though I know some markets are so brutal that everything goes down.

What’s a person to do? I’m on a buying spree.

I’m taking the opportunity to sell strong performers and buy poorly performing great companies. I’m finding some absolutely astounding bargains and, most likely, boosting future returns. And, although it’s no fun to see the market and portfolios go down dramatically, I’m having a lot of fun putting things in place to benefit when the market does recover.

When will the market recover? No one knows. The market could go down by another 33% to hit historical lows reached in the past, or it could rally by 67% (a 40% decline requires a 67% increase to get back to break even) as it’s also done in the past.

You don’t need to be a fortune teller or have a crystal ball to make money from here, you just need the gut wrenching fortitude to buy great companies at great prices–now. As long as you believe our economy won’t permanently collapse, this is a great time to invest.

Although it’s no fun to live through, I’m quite confident that buying at times like this make for very high long term returns in the future.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Bill Gross’s Investment Outlook

Bill Gross is a legend in the investing industry. He doesn’t work, though, in the more glamorous equity side of investing. Instead, he is a bond market investor, and has one of the best long term records in the business.

Gross also happens to be an outstanding writer. I envy his ability to say a lot with few words, and to explain complex financial concepts with amusing analogies.

For these reasons, his monthly Investment Outlook is a must read for me. As usual, his Investment Outlook for this month didn’t disappoint.

Gross takes to task the mortgage market, how it has performed and will perform in the future. His conclusion is that the fallout is not over, and that we’re just looking at the tip of the mortgage iceberg.

He believes this is the case because many adjustable rate loans made over the last several years have yet to reset, and when they do, many more homeowners will punt their houses back to the market.

He also indicates that these problems will be felt in the Mortgage Backed Security (MBS) and Collaterlized Debt Obligation (CDO) markets. This, along with legislative action, will tighten credit and limit the number of people who can get new loans.

His conclusion is that the housing market will takes years to work through it’s problems (tougher credit, high inventories of homes for sale, anchoring by home sellers), and that the Federal Reserve may soon cut rates in an attempt to limit such problems now that inflation is looking less threatening (according to their narrow metrics).

Am I planning on acting on this advice? I can’t say I am. Unlike a bond market guru with institutional clients who demand short term performance, I don’t need to forecast interest rates or try to guess what the housing market will do. But, I find his thinking very provocative, and it reinforces my desire to stay far away from companies that deal intimately with the housing or mortgage market.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.