In this article, we compare municipal bond market returns to the S&P 500 historical market returns from 1991 to 2016. You may be wondering why compare two financial instruments that are as similar as apples and oranges. The reason is simple, one instrument presents less risk and volatility versus the other and by comparing historical returns, it is easier to determine if the extra risk is warranted. Furthermore, if the assumption is that future returns will mimic historical returns, then the analysis could be useful for future decision making at best and teach high level investing concepts at worst.
Before we dive into the comparison, here's some general information on municipal bonds. Municipal bonds are issued by municipalities such as city governments, state governments, or some other government or agency. What makes municipal bonds unique and attractive is their tax advantaged status. According to federal tax law, qualified municipal bonds are free from federal income tax. If the municipal bond is issued on behalf of a municipality in the state in which you live, most states will treat municipal bond income as state income tax free as well.
Be aware that not all municipal bonds are federally tax free. There are certain municipal bonds that don't qualify for tax advantaged status. It is important to consult with a municipal bond professional to be assured of their qualifying tax status.
Why is it important when comparing municipal bonds to another investment vehicle for municipal bonds to be federally income tax exempt? If one is investing in a taxable account, then you'd have to get higher return in a taxable investment to equal the tax-free return of a municipal bond. To demonstrate this concept, this municipal bond calculator calculates the tax equivalent return based on a person's marginal tax rate. This will tell you the rate of return needed in a taxable account to equal the municipal bond return.
S&P 500 Stock Market Index
The S&P 500 stock market index is one of the most popular benchmark stock indexes. It has been known as the S&P 500 since 1957. The S&P index has existed since the mid-1800s, although not in its current form. It currently tracks the performance of 500 of the largest companies on the New York Stock Exchange and NASDAQ Composite.
It's worth mentioning that the S&P is made up of stocks rather than bonds. What is the difference? Stocks are another term for equity ownership in a company while bonds are a debt instrument where money is lent to a company with the expectation of receiving it paid back in full with interest. In the event that a company enters default, the bondholders are paid back with remaining assets first, and then equity/stockholders. Therefore, bondholders assume less risk.
Lastly, it is important to point out that the S&P historical returns are sometimes measured with dividends accounted for and without dividends accounted for. For purposes of this article we look at the S&P 500 both with and without dividends.
S&P 500 versus Municipal Bonds Risk and Volatility
Why is the S&P 500 so different than municipal bonds? The S&P 500 fluctuates with the value of its underlying holdings and because it assumes more risk, the price fluctuates as the value of the underlying companies change. The value of the underlying companies is generally calculated as a function of the company's future earnings potential. Because future earnings are much less certain and predictable than the interest payments on a bond, the stock market fluctuates more.
One way to measure this difference in volatility is the standard deviation. The standard deviation is a way to measure how much the rate of return from year to year deviates from the average rate of return. The standard deviation can be calculated on any set of returns to determine its relative volatility to another set of returns. For example, the S&P with dividends, from 1991 to 2016 had a standard deviation of 17.23%. When compared to the standard deviation of 5.35% for municipal bonds during the same time period, you can get the picture that stocks are more than 3 times more volatile than municipal bonds.
What else can be learned from the standard deviation? As we stated earlier, the standard deviation is the expected amount that returns deviate from the average return each year. The S&P 500 with dividends has an average return each year of 11.45% with a standard deviation of 17.23%. This means that one can expect there to be some years with a negative rate of return as the standard deviation of 17.23% below the average rate of return would cause the return to enter negative territory.
On the other hand, the average return of municipal bonds is 6.03% with a standard deviation of 5.35%. This means that when municipal bonds have a less than average return, it's possible that it will be negative but not likely that it would be extremely negative which is more likely with the S&P 500 index.
Average vs Annualized Returns
We've talked briefly about the average returns of the S&P 500 versus municipal bonds. To revisit those, the average return of the S&P with dividends is 11.45% while municipal bonds averaged 6.03% during the same time period. To rely on the average return to make decisions is misleading. That is because the average return doesn't consider volatility into its returns. For example, if a person loses 10 percent one year and makes 10 percent back the next year, the average return is 0 percent, but they're annualized return is still negative. This demonstrates how the average return can be misleading. That said, the annualized return of the S&P 500 with dividends from 1991 to 2016 is 9.90% while the municipal bonds return is 5.9%. That is almost a four percentage point difference over the course of 25 years. At this point, it seems like a no brainer that a person would invest in the S&P over municipal bonds every single time.
Not so fast! In the next section we talk briefly about the relative tax implications.
Do Taxes Really Make a Difference?
Let's examine an extreme case where an individual is in the top marginal tax bracket of 37% and they are investing in a taxable account. That means that any short-term capital gains they receive from the S&P 500 will be taxed at the 37% income tax rate. If they receive an annualized return of 9.9%, they will have an after-tax return of 9.9% times 63% (100% minus 37%). This equals an after-tax return of 6.23%. So, you can see that this return is not that far from the 5.9% that the municipal bonds offer.
We acknowledge that this example doesn't account for returns that would be taxed at the long-term capital gains rate or the dividend tax rate which are both lower than 37%. But nor does it account for state and local income taxes which would potentially further eat into the S&P 500's return.
It's worth mentioning that this set of returns is from 1991 to 2016. In the large scheme of things, this 25-year set of returns won't be like any other set of returns from a 25-year period. It is likely that there will be 25-year returns that are sometimes better than this 25 year and sometimes returns are much worse than these. So, use this at your own risk, however, there are high level concepts that can be learned here.
For example, when accounting for taxes and volatility, it may not be hard to understand why someone would rather invest in municipal bonds over the S&P 500 equity index. This is especially true for someone in or near retirement when taxes and volatility play a bigger role in one's investment decision making.
Also, from the data and the charts, it is evident that municipal bonds and stock index funds can also serve a complimentary role in an investor's portfolio. Buying an S&P 500 index fund in a tax deferred or tax advantaged account makes sense to gain faster growth, while buying a municipal bond in a tax advantaged account may not the best idea. However, for investors in the highest tax brackets, who have more to invest than the tax advantaged accounts can allow, municipal bonds can be a great asset class to own inside taxable accounts.
Regardless of one's decision, we hope this article helps people make more informed decisions so that they can maximize return while minimizing risk over the long term.
Data for the Municipal Bonds Vs S&P 500 Comparison Analysis
S&P 500 Ex dividend
s&p 500 w/ dividend
S&P 500 w/ dividend, adjusted for 30% Marginal Tax Rate
Is Amazon like Berskshire Hathaway, circa 1985? Already having grown incredibly, and likely to continue to grow dramatically? From my perspective it appears unstoppable…am I wrong or right?
I think your question boils down to
Can Amazon turn into a well managed conglomerate like Berkshire Hathaway is?
I don’t know the answer to this question directly. That requires a crystal ball. What I can do is to provide some perspective, and from their we can make educated guesses.
Conglomerates are hard to sustain
There was a time when conglomerates were popular. Think of companies like General Electric, Tyco, etc. The trick to running a conglomerate is to find a way of creating additional value than just sum of its parts. 1+1 truly needs to be greater than 2, otherwise the conglomerate structure has no advantages over separate companies. Generally, where conglomerates destroy value, there are now well funded activist investors who push the company to break up into constituent parts, and thus release the value.
GE created additional value due to its management excellence in Jack Welch’s era. Tyco was run well, although ostensibly a lot of its value creation was based on its tax domicile.
Berkshire Hathaway is an anomaly because it is run as a portfolio of businesses with the top managers being excellent capital allocators. They have excellent businesses, but that is not where the advantage lies. These businesses will be excellent on their own too (and were excellent before Berkshire Hathaway purchased them). Buffett and Munger wisely understood where their strengths are and they leave the businesses alone.
Amazon does acquisitions but is still mostly a retail business
If you look at the footer of the Amazon website, they list all the different companies they have acquired over the years. These include such disparate businesses as http://zappos.com (shoes), http://diapers.com (diapers), and Goodreads (book reviews). While all these businesses have different products or services, you will note that they are all singularly dedicated to retail.
Yes, I am aware of the cloud and other tech related products/services. They might get into offering logistics and distribution services to others too (Prime Air, for example), but pretty much everything they have built or are developing goes on to pushing their singular focus of being the world’s largest shopping destination.
They have found their focus and have stuck it it over the years.
Washington Post is not part of Amazon. Blue Origin is not part of Amazon. Can they be integrated into Amazon in the future? Perhaps, but most likely not. There just doesn’t seem to be any useful reason to do so.
So, I do not consider Amazon to be growing in a Berkshire Hathaway like conglomerate. So the answer to your question is NO.
But wait! There is more…
There is one way Amazon and Berkshire Hathaway are identical.
Both companies optimize the heck out of their core strengths.
Berkshire Hathaway does a fantastic job of
Finding great businesses with deep competitive advantages and acquire them
Allocate capital intelligently between the portfolio companies, and,
Let the managers do what they do best – run their businesses to maximize the value over the long term (not just for the next quarter). Most businesses today, if they are public, operate on short term quarterly cycle. They have to report to the wall street. Berkshire Hathaway takes away this pressure and allows its companies to engage in long term strategic growth
Amazon does a fantastic job of
Finding great complimentary acquisitions and integrating them within their retail channel
Relentlessly test and optimize each part of the buying cycle, and,
Famously be okay with losing money for years as they execute their long term strategy over a decade or more
Conclusion: Amazon and Berkshire Hathaway are two very different companies that are very similar in some respects
So, will Amazon grow into the next Berkshire Hathaway?
I don’t think so.
But it may be able to create shareholder wealth that far exceeds what Berkshire Hathaway was able to do, for a couple of reasons
The core advantage of Berkshire Hathaway pretty much lies in 2 men – Buffett and Munger. After them, it is hard to see the advantage carry on. The 2 investment proteges have done well, but arguably not shown the same temperament and skill as Buffett and Munger. In the next 2 decades, I fully expect Berkshire Hathaway to be broken up in many different companies
Amazon on the other had has built systems, processes, and a culture of optimization that can last long after Bezos has called it a day. There are limits to the growth, and antitrust issues can hound Amazon more then Berkshire. But I think it can navigate these waters.
Hope this helps in adding some perspective and answers the question at a few different levels.
Could a new employee quit suddenly … and then share crucial proprietary information with your competitors?
Is information sharing hampered within your company because you’re worried about important secrets falling into the wrong hands?
If you have an innovative idea, invention or business process, it’s time to learn about what a nondisclosure agreement, or NDA, can do for your company and for your own peace of mind.
What an Employee NDA Does
An NDA can protect your business in many ways, and is one of the most important documents you can have a new employee sign. Not having any NDAs in place at all could potentially be a serious weakness of your current business setup.
A properly drafted and executed NDA creates confidentiality between two parties to prevent one of them from disclosing certain information to outsiders.
Indeed, in drafting a nondisclosure agreement, you should be specific as to what information is covered to make sure that what you want covered is in there and also to provide proper notice to the person signing it.
In other words, your employee should have no doubts as to what information mustn’t leave the company. They should also be clear about the potential penalties if information is shared – whether inadvertently or deliberately – with someone outside your company.
Many NDAs also cover the period after an employee’s departure from a company, which can be crucial to maintain the integrity of your important intellectual property — including intangible assets such as a new technology, patents or trade secrets.
How an Employee NDA Can Help Protect Your Business
You may think your company is too small or even too new to care about protecting corporate information, but, no matter how long you’ve been around or how many employees you have, NDAs are a must, and here are a few reasons why. An NDA:
Makes it clear what information is confidential. While you might think it’s obvious that your employees shouldn’t chat about your as-yet-unreleased game-changing new product while having a beer with their buddy from another firm, they may not realize this. (This can be particularly the case if you have a young workforce fresh out of college.) An NDA spells things out so that employees know exactly what they’re supposed to be keeping to themselves.
Provides a remedy for breach. Even if your employees know the importance of keeping certain information confidential, without a signed agreement, you are left with no remedy in the case of a leak. The NDA should clearly state the ramifications for disclosures of confidential information.
Covers accidental disclosures of information. You may think your employees are trustworthy and don’t need a signed document to keep them loyal. You may even be right! Still, accidental disclosures of confidential information happen and, when they do, an NDA can help you fix the situation by putting at least some of the burden on the party who divulged the information. This can save your business some hassle — and even money — in the case of an accidental leak.
Clarifies who owns IP (intellectual property) produced by employees while under your employ. For instance, if your employee creates a new piece of software while under your employment, this would normally be expected to be your company’s IP rather than the employee’s IP. Having this clarified in an NDA, though, can avoid any ambiguity.
May provide future evidence. If you end up needing legal protection for your trade secrets, having an employee NDA in place early on can be used to show that you took reasonable efforts to protect your information from the start. This would strengthen your argument that your trade secrets deserve legal protection.
Can show an employee’s true colors. The reaction of a potential employee to a proposed employee NDA may tell you something about their intentions regarding your company and its prized assets. If they balk at signing it, you may want to dig a little more deeply into why. They may have valid reasons, but, if they don’t, you may have just dodged a potential bullet.
Gives a professional appearance. If your business is looking for investors, they will be impressed that you are doing everything you can to protect their investments. Signed NDAs show them you’re serious about your company’s success now and well into the future. They may even potentially raise the value of your business.
Keep in mind, however, that an NDA is not a substitute for strong information security measures. It’s still vital for you and your employees to make sure that information and data are protected by (for instance) using secure passwords and having robust network security policies. Don’t forget about the physical side of things too: sensitive files should be kept locked away when not in use, for instance, not left lying on employees’ desks for anyone else to see.
When to Get Your Employees to Sign an NDA
Some key situations in which you might use an NDA with your employees include:
When hiring, as a condition of the job offer. This is the most obvious scenario, but if you haven’t already got NDAs in place for your existing employees, you can still go ahead and introduce them.
When offering a promotion. If an employee is asked to sign an NDA after being employed for a while, they should receive some form of “fresh consideration” in return. This means that tying an NDA to a promotion (or at least a raise) makes good sense, especially if your employee is going to be privy to additional sensitive information after the promotion.
When terminating an employee. It might be appropriate to ask an employee to sign an NDA in return for a severance agreement. This can protect you against future lawsuits from aggrieved employees and can help reduce any risk of negative press attention (as the NDA can prevent the employee from disclosing the terms of the severance agreement).
Overall, NDAs protect your business by helping keep your most important information safe and secure — and this can give both you and your investors great peace of mind moving forward.
If you are an innovative company, there’s simply no good reason not to at least explore the possibility of having NDAs for your employees. Doing so now can mean avoiding a huge headache — and even the collapse of your business — later.
About the Author: Erika is a content strategist and producer who believes in the power of networking and quality writing. She’s an avid reader, writer, and runner.
Take Advantage of Our Considerable Value Investing Expertise
Value investing practice grows by learning from investors who have come before us and found success. Although I no longer put Warren Buffett in the category of classic value investors in Ben Graham‘s mould, he does espouse some of the key philosophies that we all can learn from.
This article lays out the top 9 investment advice that Buffett has imparted over his considerable career, and I along with countless other value investors have learned from. I am sure you will find considerable value in this list of key value investing principles.
The Top 9 Pieces of Investment Advice from Warren Buffett
1. Investing is a long game
Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.
How long are you willing to stay with an investment, if it does not perform the way you expect?
These are hard questions and they go deep into your suitability as an investor. Not everyone is well disposed to be an investor, and not everyone should invest on their own. Most people are looking for validation – they need a sign quickly that their investments are good. The only way to play the long game is to be utterly confident in yourself as an investor.
How can you be so completely confident that a market disruption does not shake you off your investments?
By knowing your investments well.
2. Know your investments well
What an investor needs is the ability to correctly evaluate selected businesses.
You need to remove all the risk in your mind before you invest in any stock. There are 2 ways you can go about doing this
Use external tools to “remove risk”, without spending time to understand what the risks are. For example, you can blindly diversify your portfolio to hedge against the “risks” you don’t even know exist. The downside of this is that you also “hedge away” your returns.
Know everything there is to know about the business so you completely understand the fundamentals and the business specific risks. If you know what makes the business tick, what drives the industry, where are the strengths, what is the management strategy, etc., you can indeed not worry about your investment if the market shuts down for 10 years. Why? Because now you are thinking more like a business owner, and less like a speculator or a passive indexer.
Also please note the use of the phrase “selected businesses”. You do not have time or skills to understand every business or industry or company that exists. You have to figure out and become an expert in selected businesses. You need to operate in your ‘circle of competence’.
This is the only way.
3. Diversification is not always a good idea
Diversification is protection against ignorance. It makes little sense if you know what you are doing.
You want to diversify because you want to cut down on the “risk”. You have “risk” because either you don’t understand the investment or business, or you do not have the appropriate long term orientation. You diversify by buying more stocks, that you understand even less. Sure, you will eliminate some risk by the random chance of something cancelling out something else. But you are also increasing your correlation to the market and at the same time reducing your potential returns.
All because you do not wish to spend time learning about the business you are investing in (or finding someone who does).
Yes, you should own multiple stocks. Each stock should have its own thesis. But if you have only 1 idea, does this make your portfolio very risky because it is not diversified)?
I don’t think so, unless you decide to put 100% of your capital in this one stock that you know not much about. Nothing compels you to do this.
You do have a choice to invest according to your convictions.
4. Be patient
Stock market is designed to transfer money from the active to the patient
What do you get when you cross conviction with long term orientation?
You get patience. And patience is the absolute requirement to succeed in your investment career.
This also means that day trading or frequent transactions are not advised. Transaction costs, of course are a big factor, but also worth noting is that when you do this, by necessity you are putting less trust in the business you are investing in (you are only in there for a quick profit), and you are putting more trust in other investors to be greater fools than you (they will create opportunities for you to make quick profit).
When you invest with patience, you trust the business to create value over time, and you trust that the value of the stock will reflect the improving business value. You are trusting the economic system to continue working the way it has since man started trading berries for tools.
Unfortunately, patience is in short supply.
The research firm DALBAR finds that an average investor underperforms the funds they have invested in by over 4% annually, by constantly getting in and out at the wrong times (for example, buying when things are looking great, and selling when the mood is sour, the exact opposite of buy low and sell high).
5. Never lose money
Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1
Great investments compound your portfolio. You do not wish to reverse the compounding effect. It is easier to not invest in ideas you do not feel confident about, then to invest and lose money and set your portfolio back a few years.
Or put it in more tangible terms, it takes 20% to grow from $100 to $120. However, if you lose 20% of your $100 capital in one year, you will need another 3 years of 20% annual growth to grow past $120. That is setting you back 3 years. You can choose to not invest in a shaky idea and look for another that you feel more confident about.
This is the mathematical reason anyway.
Psychologically, if you follow this rule, you will be more diligent in finding investments that will be profitable. You will be more diligent in considering all sorts of risks before you make an investment. You will be more diligent in insisting a margin of safety to cushion you in case somethings don’t turn out the way you expect, as things inevitably will.
But it takes time and effort and skill to peg a value of a dollar to an investment that is selling for 50 cents. Most investors are not able to do this, so they don’t. They look for stocks that sell for a dollar today and are likely to be worth $2 tomorrow based on some complex projections and analyst sound bites.
Speaking of sound bites, we are all taught as a kid “A bird in hand is worth more than two in a bush”.
An undervalued stock is a bird in hand. But still, investors would rather chase the two in the bush.
7. Investing is simple, but not easy
The business schools reward difficult complex behavior more than simple behavior, but simple behavior is more effective.
The way I judge my investment theses is how simply can I explain it to a 5 year old. If I can’t do it well, than maybe I do not understand the business well. Or the business is just too complex.
If I have to build an excel model to forecast 10 years of earnings at a certain growth rate and a terminal value and figure out the value of the cash flow, all well grounded in theory by the way, it just means that I do not understand the business enough to invest in it.
This is also the reason why I gravitate towards smaller company stocks. A company with 1 or 2 products or services is much easier to understand and profit from.
The simplicity requirement pervades all aspect of investing.
For example, my businesses do not need to have a strategy for everything. They just need to do what they do well, and if they can’t, return the money to the shareholders.
The Occam’s Razor comes into play as well. You can question yourself a thousand ways. For example, I get asked this question frequently: “if the stock has such and such value, why is it selling for less?”. The simplest answer is, most investors do not know of the value. This answer is most likely to be true, but yes, people have many complex hypothesis and eventually they talk themselves out of a lucrative investment.
8. Load up the truck when you find a great opportunity
Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.
What does “load up the truck” mean?
it is not a call for you to be indiscreet. It just means invest according to your convictions. You buy more of the stock that you feel a greater conviction for. You buy less or none of the stock that you do not have enough conviction for. I cannot give you a formula for this, although there is a mathematical formula to maximize your wealth. I will just say that you will figure this out with experience.
You do things when the opportunities come along. I’ve had periods in my life when I’ve had a bundle of ideas come along, and I’ve had long dry spells. If I get an idea next week, I’ll do something. If not, I won’t do a damn thing.
A simple idea but so hard to execute.
Some people believe that there is always something there that you can invest in. Sometimes there is not, unless you violate other tenets of good investing such as staying within your circle of competence, or being patient, or need to understand the business well, etc. Some investors are compelled to buy something, anything, because they do not have the long term orientation. They need to see the profits NOW. And if it doesn’t work out, there was something wrong with the stock.
Doing nothing when it is the wisest thing to do is you taking responsibility for your investments.
Doing something in haste because you just have to get into something, is being irresponsible.
Take Buffett’s Advice. These Investing Principles will Help You Create Your Own Investment Approach
These are the 9 nuggets of Warren Buffett’s investing principles that I find incredibly important to learn and live for me as a value investor. None of these go into the actual mechanics of finding undervalued stocks. These advice do not talk about any investment strategies. They do something more important. They teach you the right investment mindset. Tools and strategies do not work if you do not know how and when to use them.
Let these make up your investing operating system.
Take Advantage of Our Considerable Value Investing Expertise
True, we are all guilty of taking price to book ratio at a superficial level to quickly value a stock.
However, a good value investor is not a superficial value investor. A good value investor understands and knows that the accounting book value as reported on the financials is not a clean number.
It contains assets that can be severely undervalued due to age and depreciation. Real estate that is carried at old values. Fully depreciated inventory that is still productive.
It contains assets that are not even counted properly as they are not tangible enough to place value on (R&D, patent portfolio, customer list, etc.)
It contains assets that may be severely overvalued and need to be written down or charged off. Perhaps investments gone bad.
The point is that us value investors are aware of these things, and we adjust for them. There are metrics such as tangible book value, net current asset value, etc. that take us closer to the real book value. We may adjust more depending on the specific situation of the company and our own industry knowledge.
So, Buffett is right that the accounting book value is not always relevant. He is wrong in suggesting we should abandon book value as a valuation metric or a basis to calculate the intrinsic value.
Intrinsic Value is a Better Metric for Valuation
True. No value investor will question this. The real problem is how do you arrive at the intrinsic value. Do you take the market price of the asset and declare that to be the intrinsic value of the asset?
If you do so, it is no longer value investing.
Value investing lives in the gap between the market price and the intrinsic value. Declare the gap to be irrelevant, and value investing ceases to exist.
Market prices are more relevant.
Now this is just being lazy.
Market prices are relevant to know the … market price of the asset.
One can argue that Buffett is talking about the market value of the owned assets of the company, that goes into calculating its intrinsic value.
He may not be talking about the market price of the stock itself.
I will rebut both these positions.
Buffett may be suggesting that we take the market value of the owned assets of the company when we calculate the intrinsic value.
I am sure this is something a lot of investors struggle with. You do want to mark the owned assets to the market when you adjust the book value and calculate an intrinsic value number. However, we also know that marking to market makes sense in certain situations, and does not make sense in other situations. As value investors, we do have the tools to handle these different situations. There is a concept of liquidation value, that considers different scenarios of orderly or forced liquidations and estimates the value that can be received. Some assets can be exchanged at even value – for example, cash and cash equivalents, others may just end up getting scrap value, for example old machinery.
He is indeed talking about the market price of the stock itself. This is evident when you consider the following statement
“In future tabulations of our financial results, we expect to focus on Berkshire’s market price. Markets can be extremely capricious: Just look at the 54-year history laid out on page 2. Over time, however, Berkshire’s stock price will provide the best measure of business performance”
So what is Buffett Really Saying Here?
He is saying that book value of Berkshire Hathaway is no longer going to be the metric they want to use to make decisions about the valuation of Berkshire Hathaway.
It is just his personal choice as a manager. Berkshire Hathaway has changed its portfolio from mostly equity investments to now mostly operating companies. Perhaps this change in how he looks at the Berkshire stock makes more sense to him.
It does not mean that book value is no longer relevant for value investing.
It also does not mean as investors we should look at Berkshire Hathaway valuation in the way Buffett chooses to do. We should feel free to ignore him and use that valuation methods that make more sense to us in judging Berkshire Hathaway or any other company. He is just being a manager and we choose to disagree with managers all the time.
What about the Changing Nature of the Business?
In older and simpler days, industry used to be full of heavy machinery and tangible assets. These assets had tangible values and were less mobile (or liquid). Which meant that the values are clearly defined and predictable. These assets also made up a significant part of the company’s balance sheet.
Today with technology and productivity powering most of the output, and service companies dominating the economy, companies are able to create more value of a smaller tangible asset base.
So average price to book ratios today are higher than they used to be.
Additionally, average price to book ratio for a tech company like Microsoft, will be much higher than, say, Ford Motor Company that still relies significantly on tangible assets to produce value. There is a variation between the industries and sectors.
Therefore, it follows that Return on Assets or Return on Equity is becoming a more important metric now, since it measures the value that the company is able to generate out of its asset base or equity.
As value investors, we do understand that the price to book ratios vary by the sector. The old guideline of buying stocks under a P/B ratio of 1 will generally not give us many options today.
We can account for this change in the nature of the business.
Value investing is not a static paradigm. The practice changes and evolves.
The argument goes like this – a company that can generate a better return on its equity than competitors and can reliably keep it up over time, does so because it possesses some kind of competitive advantage.
When you find a company that has a defensible moat, you can get away buying it at a fair or even slightly overvalued price. Over time, the competitive advantage will work in your favor and you will get a good return.
As you would note, Warren Buffett abandoned classic value investing long time ago and starting buying good companies at fair price.
For one, he became too large to be able to invest as a classical value investor. These tend to be smaller companies, too small for Buffett to buy. And of course, Munger had a big hand in changing his style towards the “Quality” investments.
Nothing wrong with this. This is a proven strategy that works in the right hands.
The point I am making is that when Buffett talks about increasing irrelevance of Book Value, he does not mean it is no longer relevant for value investors.
It is just no longer relevant for what he does.
Take Advantage of Our Considerable Value Investing Expertise
James Holzhauer is currently in an unprecedented run on the game show, Jeopardy. He has broken many records so far, and he is going for the highest cumulative prize money haul in the history of the show. He already has won $1.69 million dollars as of this writing.
He plays with one goal: maximize his total winnings.
It turns out that a rational investor has identical goal im his investing.
It also turns out that investing and Jeopardy have similar attributes and allow for similar approaches for success.
How is Investing Similar to Jeopardy?
Successful investing is not a random walk. Neither is playing on Jeopardy. Both require certain skill, and an acute awareness of one’s own level of skills. You need to know what you can handle, and where you enter into the realm speculation.
On a tactical level, in Jeopardy, you can choose the answers you want to question. Similarly, in investing, you can choose the stocks you want to invest in. In either pursuit, you are not required to make a pick. You can choose to sit out every round if you wish (but this will hardly be productive).
So you need to choose wisely.
For if you choose correctly, you make money. If you are wrong, you lose money. The amount of money you win or lose depends on how much of your “portfolio” you allocate to each “pick”.
Therefore, in either discipline, the strategies eventually boil down to one of the two: longevity, and/or, maximizing profits in each play.
The Strategy of Longevity
The goal here is to put in a long streak of wins. The profits add up over time, so if you can add time to your kitty, you will come out very wealthy.
In investing, you can do this by investing in a well diversified portfolio. This is the same as investing in an index fund or ETF. You will have a number of wrong picks, but you will also have a number of good picks. The goal is to offset good with bad, and then hope that the resulting portfolio returns are good enough to keep you ticking for a long time.
For a Jeopardy player, this is akin to having knowledge of a wide variety of topics. You may not know any of the topics in any significant depth, but what you lack in depth, you make up in breadth. In many cases, this works well over time.
The Strategy of Maximizing Profits
The goal here is to accumulate as much winnings you can, as rapidly as possible.
The way to do this is to bet large, so when you win, you win large.
However, crucial to the success of this strategy is to make sure that you either do not lose, or when you do, you lose small amounts of money.
A Jeopardy player, for example, could bet smaller amounts in the topics he is not very confident about, or none at all. He can bet larger amounts in the topics he is very confident.
Depth of knowledge helps a lot. At the same time, the player needs to be aware where his strengths and weaknesses lie. He needs to know his past performance in a variety of situations so he can make intelligent decisions in the future plays.
An investor will do the same. He will refuse to invest in a stock where he does not possess enough conviction. In the stocks where he has deep conviction, he may choose to go all in and allocate a large portion of his portfolio.
James Holzhauer plays to maximize profits. This is evident when you watch him in the show.
Let’s see how his strategy transfers over to investing.
Investment Strategy to Maximize Profits
This requires the following 3 sub goals.
Bet big in high conviction cases
Bet small or refuse to play in low conviction cases
Prioritize cases with highest potential rewards first
In Jeopardy, Daily Doubles pay more if you get them right. Unlike most Jeopardy players who like to start with smaller reward picks, James goes straight for the highest point picks. There are 2 reasons – 1. The winnings are large, and 2. Quick accumulation helps give you more options later on if you wish to sit out questions that you are not very confident about.
Can an investor do this?
Warren Buffett likes to talk about a baseball game where you are the batter and you are facing pitch after pitch.
“The trick in investing is just to sit there and watch pitch after pitch go by and wait for the one right in your sweet spot. And if people are yelling, ‘Swing, you bum!,’ ignore them.”
When you get a pitch in your sweet spot, swing hard.
When you are comparing two or more investment to allocate capital in, choose the one that will give you the best rewards.
The Complication in this Strategy
As you might have guessed, this strategy only works if you know the following two things.
Where is your sweet spot?. and,
What is your potential reward?
Let’s consider these two things one at a time.
Where is Your Sweet Spot?
Some people call this your circle of competence. In business, it is often called “core competency”. It doesn’t need to be a particular industry or a type of a company, although you can certainly build your circle of competence around these. It could also be in style of investing – for example, distressed debt investing, or investing in cyclical stocks.
As value investors, you may emphasize cash flow while another investor may be more focused on tangible assets. Whatever your circle of competency is, you need to know what it is, and then stick to it.
How do you know your circle of competency or sweet spot?
Mostly by experience. You can look back, either intentionally, or instinctively, and know that some kinds of investments work out better for you than others. Emphasize what works, and eliminate what doesn’t work.
If you are unsure, or are trying to expand your sweet spot to include newer areas, require a sufficient margin of safety to give you the buffer to make mistakes. Over time you will learn and become proficient.
What is Your Potential Reward?
You could do this one of the two ways.
a. You can fix a minimum potential return that will interest you in a new investment. Let’s say you decide that a 30% potential annual return is what you need at the minimum. Then you will eliminate all those investment ideas where the potential return does not rise above this threshold.
b. Or you could calculate your potential reward from each idea and have a process to determine how much of your capital to allocate to each idea.
b. is where most money is made. Higher potential reward ideas receive larger bets. And you have a process to figure out the potential rewards. This could be based on any process that you have found success in in the past. For me, many value investing principles let me estimate an intrinsic value or fair value of the stock. The gap between the current market value, and the intrinsic value, tells me the potential reward.
Most investors make mistakes. Some make more mistakes and others make less. Once you calculate the potential rewards, you need to modify with your past win/loss performance, to give you a more realistic expectation of winnings.
As you can imagine, the math can quickly become complicated. It is hard enough to estimate the merits of the investment, but you also need to know your own self, and your investment biases, and adjust your expectations based on these. James has a very good grasp of this and an intuitive sense of his strengths and weaknesses and he can work out the probabilities very quickly in his mind. His professional career as a sports bettor helps.
Fortunately, someone already did the calculations to figure out the optimal capital allocation formula, that you can use to invest and maximize your wealth growth. Kelly Criterion was formulated by John Kelly of Bell Labs and gives you the absolute optimal capital allocation system to maximize your portfolio growth. Learn about the Kelly Formula here.
I lied. You need one more thing to make this work …
The formula only works when you stick to it. In the beginning, a lot of parameters may not be defined well for you. Over time, you will get more accurate. However, you need to stick it out and disconnect yourself from the emotional aspects of investing.
If you do not think you can muster up the objectivity, discipline and persistence to make this work, an index fund is your best friend.
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Only about 20% of the IPOs go on to return better than the average market index. Almost half of all IPOs end up losing half their value in 5 years.
Are you going to bet that this is one of the rare IPOs that will give you multi-bagger returns?
You may say, “I am not looking for a 5 year investment. I just want to get in and get out quickly after the stock pops”.
The line of people trying this “strategy” is long indeed.
There 3 kind of people who tend to make money in an IPO
The company insiders who are selling their stock in the IPO
The underwriters who are the middlemen between the company and the selling shareholders and the buyers in the secondary market
Possibly those lucky investors (with significant assets) who receive an allocation from their financial institution
Of these, the company insiders may hold their stock at a very little cost basis. The underwriters have purchased the stock well below the IPO offer price. They will make money on the spread, and of course, in the fees. The lucky investors who received an allocation will receive the Uber stock pre-ipo at $45. Their ability to make money lies in the possibility that the stock price will rise in the initial days, and the investor demand will give them a window to sell.
Most of the investors buying the IPO will end up purchasing in the secondary market. Whether they make money or not depends on how the stock behaves.
Keep in mind that no one wants to be left holding the door when the party ends. Will you be quicker to sell (at profit) then most other investors?
2. I believe in the company and its future prospects and want to participate in its value creation
How much do you know about the company to form this belief?
The company was not required to reveal any financial data while it was private. There is some data in the IPO prospectus, but we have not seen how the company executes. Taking a few Uber rides doesn’t tell us much.
Is this a viable long term business? – Uber’s ride sharing business is flat-lining and growth has slowed
Is their competition? – Yes – And Lyft is not doing that well financially
What exactly is their competitive advantage? – Not really sure. The company talks about the network effects, but the barrier to entry is low, and the switching costs are minimal.
The company is unprofitable and lost about a $1 billion in the most recent quarter.
3. I think the stock is deeply undervalued at $45/share that it is being offered at
I actually do not have enough data to make a valuation call at this time.
After a few quarters of public financials, perhaps we can revisit.
But I will say this.
When a company IPOs, the following 2 conditions hold
The company and the insiders have more information about the true health of the company then you and I. The information asymmetry is huge, and it is a risk that you should consider.
The company, the insiders, and the underwriters, all have a singular goal during the IPO. Raise as much money as possible by issuing as little stock as possible. Pretty much they are running through all the reasons they can muster to convince you to pay top dollar.
At the time of the IPO, I would not consider any stock to be undervalued.
Can they go on to grow and increase their stock price in the future? Sure. But there is no data as of today that gives me any reason to make this judgement.
4. I don’t know. My friends are excited and told me it is a great idea
Herding behavior is common place in investing, but nowhere it is as obvious as it is during an IPO. Of course, the results of doing what everyone else is doing will obviously be the same as what everyone else gets.
Or in other words, average.
If you were to allocate some capital to the Uber IPO to keep up with the Joneses, please realize that it is not a well considered investment. It is speculation. Do not use serious investment money for this. If you do have some play money lying around that you do not need any more, sure, go ahead and “invest”.
FOMO, or the Fear of Missing Out, drives the IPO market. Smart investors choose to avoid IPOs.
Where is the Value in Uber IPO?
As a value investor, I look for values that are too good to pass up. For me, and other value investors, these values are tangible. Not pie in the sky projections and estimates. Without the benefit of observing the company and its historical performance, we do not have enough information to estimate the value and therefore we cannot judge the stock to be undervalued.
Besides, we like to keep a margin of safety. I don’t see any here or in any IPO.
Will I miss out on the Uber IPO? I will avoid it for sure – but missing out implies there is a severe dearth of opportunities out there. I don’t think this is true.
What do you think? Are you investing in the Uber IPO? Let us know in the comments below
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Return on Equity is one of the primary financial ratios investors use to judge a company’s operations. If I were to pick one metric that matters (OMTM) for investors looking into a company’s operational excellence, return on equity would be the that metric. It appears to be Warren Buffett’s favorite metric.
What Does Return on Equity Mean?
Return on equity = Net Income/Shareholder Equity
The shareholder equity, also known as the book value of the stock, is a measure of the shareholder capital invested in the business. Shareholder equity starts with the invested capital when the business starts, and later goes up or down by the amount of retained earnings of the company each period.
ROE, therefore, shows us how efficient the company is in generating profits for each unit of shareholder equity. High ROE is typically better, although the actual levels vary between industries.
Arguably, if the company generates an ROE that is less than the return an investor can get elsewhere, the investor has no incentive to invest in the company. In such cases, the company should either seek high ROE projects for each dollar that is reinvested in the business. If high ROE projects cannot be found, then the company should return capital back to the shareholders.
As you will see, companies have many levers to increase their ROE.
What is ROE Made Up Of?
At the simplest level, the ROE is made up of the Net Income and Shareholder Equity.
This metric crosses financial statements. As you will have noticed, Net Income comes from the income statement, while Shareholder Equity is a balance sheet item.
This number does indeed provide good information about the business. A 15% – 20% ROE is considered to be good, and normally if you see a company in this range, you may not think much about digging deeper.
But that would be a mistake.
You see, two companies sporting similar ROE may be vastly different businesses.
This becomes clearer when we break down the ROE into its components using the Dupont Model.
We can rewrite
Return on Equity = Net Income/ Shareholder Equity = (Net Income/Sales) x (Sales/Assets) x (Assets/Shareholder Equity)
or in other words,
ROE = Profit Margin x Asset Turnover x Financial Leverage
Now it becomes clearer that a high return to equity can arise from either
More profitable products or services,
More efficient asset utilization to generate sales, or,
More debt in the capital structure (implying less use of equity)
In the next section let’s expand on this a bit more to see what kinds of insights we can derive them
What Does High or Low ROE Tell Us About the Company?
Suppose you are looking at a business with a high Return on Equity.
This is possible if the company is in a business to sell luxury goods (high profit margins). A company like Tiffany’s may sell products in low volumes, but each unit sold is highly profitable. As you can guess, strong brand names fall in this space.
It is also possible if the company operates with very little profit margin, but moves a lot of volume very quickly. For example, Walmart operates with very thin margin, but turns over a lot of product very quickly per unit of shelf space. Walmart has a very high asset turnover compared to many other retailers. This is why Walmart can have a high ROE despite operating in a low margin business. This is where commodity businesses can generate high ROE by making efficient use of their assets.
Finally, none of this can be true, but a company may still have a high ROE because it has low E (equity). This means the company is highly leveraged with a lot of debt. While debt is not automatically bad, you need to make sure that a high ROE company is not carrying unsustainable debt load. Enron anyone?
On the other hand if you find a company that has a low to middling profit margin, and average asset turnover for the industry, but carries very little debt, a judicious amount of additional debt will invariable improve the return on equity and benefit the shareholders significantly.
Where is the Moat?
As value investors we consider wide moat companies as worthy investments, even if we pay up a little bit more. This is because a wide moat implies a sustainable competitive advantage, that will protect a companies dominance in the market for years to come.
But where does the moat come from? Is there a metric, or a number, we can use that shows us the moat-iness of a business?
I suggest the Return on Equity is one such metric, but with a caveat.
From the universe of the high ROE companies, you need to remove the companies that achieve this distinction by loading up on debt to an unsustainable level.
This will leave us with companies that generate their sustainable competitive advantage from either their brand strength, or their operational excellence.
Oh, and One Last Thing …
You know the story … private equity meets an under appreciated gem … private equity thinks with a little polish this gem could be worth more … private equity has no clue how to improve profits or operations … private equity remembers this one weird trick to juice up the ROE … private equity loads up on debt and sells the now high ROE company to the unsuspecting suckers investors.
Earlier we discussed how too high or too low multiples such as Price to Earnings and Price to Book can actually indicate an anomaly that needs to be investigated. I took specific examples to illustrate the point, so please read that post to learn the reasons.
Here, I will provide some guidance on how to research a stock and corroborate what the ratios are telling you.
Check the Following 5 Indicators when Ratios Appear to be Atypical
Did the company have an accounting charge or a write-off? – This can make the earnings look small (or negative) and will cause the P/E ratio to go very high. However, the charge may be one-off and not a typical business expense
Did the company sell a large asset? – If the company spun off a subsidiary or sold property, they may book a part of the proceeds as gains. This inflate the earnings and will cause the P/E ratio to be abnormally low for the period. Even the book value is changed when a tangible asset is disposed off.
Has the company taken on new debt? – This will for sure change the leverage ratios considerably. When you are looking at the trends, this can be alarming. However, it may not be negative change. So be aware and look for these.
Has the inventory turnover decreased alarmingly? – This may mean the business is slowing down. The earnings may not reflect this yet as the revenue recognition lags the inventory turns. Keep this in mind when you judge the valuation
Are Days Sales Outstanding getting longer? – This may mean the buyers are unable to pay on time. This can mean a stress in the industry. Perhaps some buyers are struggling to make payments. A bankruptcy can have a domino effect and can harm the company revenues and profits down the line.
Ratios are Very Useful But Use Them with Open Eyes
Financial ratios help make the analysis quick and help you review the key indicators of a business or a stock. They are very useful in judging the stock valuations. However, always read the annual reports and look at the special charges, events, and trends to paint a complete picture. Ratios should not be used in isolation.
At the same time, you want companies that run a strong franchise. A solid EPS growth is one such indicator that tends to turn up stocks of the businesses that are growing their business (or becoming more efficient by reducing expenses).
The following 18 small cap stocks have been selected to give you ideas with reasonable price to earnings ratio and price to book ratio, and a solid earnings per share growth in the past 5 years. Please note that this is just the first screen. Before you decide to invest, research these stocks further to make sure that the value proposition works out.
P/E (Last Year Actual)
% EPS Growth (5 Year Historical)
Acorda Therapeutics Inc
Century Communities Inc
CM Finance Inc
Cumulus Media Inc
Diplomat Pharmacy Inc
First Choice Bancorp
Hennessy Advisors Inc
Mercantil Bank Holding Corp
Mesa Air Group Inc
Monroe Capital Corp
Olympic Steel Inc
Party City Holdco Inc
Ribbon Communications Inc
Smart Sand Inc
United Financial Bancorp Inc
WhiteHorse Finance Inc
Of these names, CCS is already on the VSG watchlist. However, with the prospect of a real estate slowdown, you have to finely balance the undervaluation with your economic outlook and consider how long you are willing to wait for the value to realize. I will be looking at the other stocks in the name carefully in the next few days. VSG Membership allows you to see further analysis of the stocks we buy.
Which of these names do you find interesting? Let us know in the comments below.