How to become a value investor

First a quick note of news…I’m moving this blog to a self-hosted site in the very near future. In fact, the blog has actually already been transfered, but I’m sorting out some issues with getting traffic on this site to automatically forward to the new one.

For you, this basically means that you’ll need to update your bookmarks to the new site once it’s up (I’ll post the new domain once it’s active). For people who subscribe to the site through Feedburner, the transition should happen seemlessly. For those who subscribe some other way, I’ll also post the new feed address once it’s up.

———

A story of mine from the May issue on value stock investing just hit the website a couple days ago. While I’m happy with the final product, it’s a classic example of why I started this blog. For space issues, editors and I cut the story down to 650 words or so. But as you can imagine, value investing is just a tad more complicated than that.

Security Analysis by Benjamin Graham and David Dodd

Security Analysis by Benjamin Graham and David Dodd

Over the next four days I’m going to give a primer on value investing. I’m also hoping to have my regular news-based posts for readers who know this stuff already.

Here’s what’s coming up:

Today: Where value investing comes from. What is a value investor?

Tomorrow: What is a P/E ratio and how is it used properly?

Wednesday: Understanding a company’s business. How to make sure a company’s earnings don’t disappear after you buy it. Building in a “margin of safety”.

Thursday: What’s different about value investing today? Other measures of “value” in a company.

I hope you find it informative.

———

The invention of “value investing”

You might not be sure of the definition of value investing, but you probably do know its greatest living proponent, Warren Buffett. If you spoke to Buffett, he’d actually point to his mentor, Benjamin Graham, as the greatest value investor of all time.

Graham, and co-author David Dodd, literally wrote the book on value investing—- Security Analysis. In the preface of book’s latest edition, modern value investor Seth Klarman aptly summarized their philosophy this way:

Value investing, today as in the era of Graham and Dodd, is the practice of purchasing securities or assets for less than they are worth—-the proverbial dollar for 50 cents. Investing in bargain-priced securities provides a “margin of safety”—-room for error, imprecision, bad luck, or the vicissitudes of the economy and stock market. While some might mistakenly consider value investing a mechanical tool for identifying bargains, it is actually a comprehensive investment philosophy that emphasizes the need to perform in-depth fundamental analysis, pursue long-term investment results, limit risk, and resist crowd psychology.

Whereas speculators hope that their purchases gain rapidly in value, Klarman says, value investors strive to avoid losing money.

You see, Graham and Dodd wrote the first edition of the book in 1934, after seeing the most dramatic stock bubble in history followed by the most dramatic bust. Their book was meant as a way of sorting through the thousands of low-priced securities to discover which were good investments.

It might surprise you to know that times like today, when stocks of nearly all companies are severely beaten down, are when Graham and Dodd would find the most bargains. It’s during manias like the tech bubble and real estate bubble that fairly valued companies are hard to come by.

The trick is figuring out what “fair value” is.

What is a value investor?

Imagine that your cousin Joe started a hero sandwich restaurant a year ago. Its earnings steadily increased for the first few months as customers got word about the place, but now they’ve leveled off, and Joe thinks it will earn about $30,000 this year after paying his rent and employee salaries. Joe’s grown tired of the fast food business and wants to sell it to you for $400,000. You have the money to buy it, but aren’t sure if it’s a fair price.

This is the dilemma facing any stock investor. An owner (the stock’s seller) doesn’t want to own it anymore. The stock’s buyer needs to decide what he’s willing to pay.

You could put your money in a money market account right now and earn about 2% on your investment without any risk. So if you bought Joe’s restaurant, where a competitor could come in and snatch your business in a heartbeat, you’d want a much greater return than that.

Before buying Joe’s company, you do a bit of research. You look in the classifieds of your local business newspaper, and find a lot of other companies similar to Joe’s. One is selling his burger restaurant for $500,000 and it makes $60,000 a year. Another is selling his pizza joint for $200,000, but it only makes $20,000 a year.

All told, you find that restaurants like Joe’s give their investors about a 10% return for their invested money.

But you take it a step further. You go to the local library and look at the microfiche of your local newspaper’s classifieds to find the prices that restaurant sellers were requesting for the last several years. During good economic times, when lots of people are eating out, you find that sellers requested prices that only have 6% or 7% returns. During bad economic times, they sold at prices that would give a 15% to 20% return, mostly because they were afraid that their earnings could keep falling or disappear.

On average, when evening out those good and bad times, companies like Joe’s gave their owners a 11% return.

Now back to Joe’s selling price. He wants $400,000 for a business that generates $30,000 a year. That’s a 7.5% return. On its face, and assuming there’s nothing about Joe’s company that make his earnings more certain than the next guy’s, Joe’s asking price is too high. You think the business is worth more in the range of $330,000 based on historical figures. But since you could buy companies very similar to Joe’s for a return as high as 12% (the burger place), you’re only willing to pay $250,000 ($30,000 divided by $250,000 gives you a 12% return). He declines, and you move on to other investment ideas.

Fast forward to next year. The economy has gotten much worse. Joe’s earnings are falling. His company will probably survive, but until the economy gets better, he only thinks he’ll make $25,000 this year. Right now, it looks like no one’s ever going to buy a hero sandwich again, and in a panic, Joe offers to sell you his company for $200,000.

That’s a 12.5% return. Your research on the economic cycles of restaurants shows that investors earned an 11% return on average. So you buy the company from Joe, knowing that once the economic mess passes, you’ll own a company that’ll still make you good money.

There, in Joe’s panicked sale of his hero restaurant, is your proverbial dollar for 50 cents.

Ok, so that example was a little quick and dirty, but in a nutshell, that’s what a value investor does every day. A growth investor buys shares of companies in the hopes that the company’s earnings will grow rapidly and make his investment worth it. A value investor finds companies with a proven track record of earnings, but waits until the company’s share price has been beaten down enough to make his purchase worth it.

Start thinking about every stock purchase you make as if you were buying Joe’s restaurant. That is, think of it as if you’re buying the entire business and as if your profits rely on how much the business makes in earnings, instead of on how much the stock price goes up the next day.

Even just that change in mindset will put you on the path of thinking like a value investor. Of course, figuring out how much similar businesses sell for, how safe a business’s earnings are, and what price is “fair” takes a bit more practice.

I’ll talk about how to learn to do that tomorrow and Wednesday.

– Joe Light

Advertisements

Dear index buyer, you too are an active investor

The “consensus” view of personal finance right now is that we should all be index investors. It’s been well documented that active mutual fund managers have a poor track record of getting above-average returns. According to Standard & Poor’s, the S&P 500 beat 72% of active funds that invest in large companies. So, the theory goes, stick with a mutual fund that simply invests in everything and charges an extremely low fee.

But even if you’re an index investor, you do ultimately have to make choices about your asset allocation. You need to decide how much you’re going to put in a U.S. stock index fund, how much you’ll put in a U.S. bond index fund, an international index fund and on and on.

At first, financial planners and magazines like mine started making recommendations about that allocation based on readers’ ages and risk tolerance. Then “balanced” funds came along. They would let you decide on what mix of stocks and bonds you wanted based on your age or risk tolerance, and the fund manager would maintain that 50-50 (or 60-40, 70-30 etc) mix between a stock index fund and a bond index fund.

I previously wrote about my interview with Chuck de Lardemelle and Charles de Vaulx of IVA Funds. As part of my end-of-the-magazine-cycle clearing up of my desk, I listened through the interview again. De Lardemelle and de Vaulx run active funds that cross all asset classes. They can move money to cash, high yield bonds, U.S. stocks, international stocks, gold…you name it.

For a passive investor trying to build out his asset allocation, such a fund is a nightmare. If you invest in a set of mutual funds and an IVA Fund is one of your picks, you might think you have 50% of your money in stocks and 50% in bonds. But if de Lardemelle and de Vaulx decide to, they could swing the balance in one of their funds from stocks to…gold. Or, recently, to high-yield bonds.

So here’s the question: Should you decide your asset allocation or should an “expert” do it?

You can’t answer, “But I’m a passive investor! I invest based on my age and risk tolerance.” To me, allocating based on age is also an active choice. You’ve decided that in the long-term, certain historical trends will continue, making an age-based portfolio the most likely solution to get you to your goals. 50% of my savings will go into stocks today just as 50% went into stocks at the height of the tech boom and the trough of the tech bust.

I’ve seen enough evidence to convince me that most active managers are poor stock pickers. But I haven’t seen a lot of research telling me one way or the other if active managers are poor asset pickers.

Here’s what de Lardemelle said when I asked, “Since they don’t have much time to devote to thinking about investments, shouldn’t our readers just allocate a certain amount of their portfolio to each asset class and be done with it?” When reading his answer, keep in mind that he’s trying to sell his fund.

You’re right that it’s hard to pick companies to invest in internationally if you don’t spend time doing it. But if you try to do it yourself through index funds, what you’re basically doing is trying to figure out an asset allocation. And that’s not that easy either. You need a lot of data. You need a lot of experience. Usually the stuff you want to be in is the stuff that’s been forgotten by anybody and everybody.

There are few funds that have taken on that challenge of being a fund for all weather and that can shift gears from one asset class to another. Usually you have a mutual fund that does Southeast Asia, another fund that does small-cap value in the U.S. or whatever. That is I think how we differ from so many others. We can do high yield, cash, gold. There are few funds like that. I think it is a small piece of the market that’s going to grow. Basically, financial advisors themselves are looking for funds that take the burden of asset allocation off their shoulders.

Is that the right path? I’m waiting for someone to come out with an actively managed fund that only invests in index funds. “That’ll be the day,” you scoff. But is that much different than hiring a financial advisor to determine your allocation?

Update: After thinking about it for a bit longer, I guess actively managed funds of index funds do exist. Many target retirement funds or balanced funds have investment committees that tweak allocations based on what they see in the marketplace. I never thought of target-based retirement or lifestyle funds as being “active” funds before but I guess that’s not far off base.

– Joe Light

For Sale: College savings plan. Includes leverage, derivatives, mortgage-backed securities

Hi Get Rich Slowly readers! Click here to subscribe to my feed. You can look here for a summary of how this blog can help you. Thanks for stopping by.

———

Morningstar, which is one of the biggest mutual fund trackers, came out with its annual review of the best and worst 529 plans today. 529 plans are tax-advantaged investing accounts to save for college expenses. Some states let you take a write-off for contributions. Your earnings grow tax-free, and your withdrawals aren’t subject to federal income tax. It’s a good deal, and one of the best for college savings. You don’t have to invest in your own state’s account, but most people do, since most states only give you the tax break if you invest in its own account. graduation-by-sara-haj-hassan

Each state partners with two or three mutual fund managers, and investors in that state’s plan must choose from the variety of mutual funds offered. The funds include your run-of-the-mill index funds and a smattering of actively managed funds, depending on the state. While under a different name, many of the funds offered are similar to target-date retirement funds. You give them your kid’s age or when he’ll matriculate, and the fund will become more conservative as the date comes closer.

Sounds easy, right? Well, what if your state picks a real stinker of a mutual fund manager?

Such was the case with the five states that chose OppenheimerFunds to manage some of their savings plans. Investors in the Oppenheimer funds might have been allocated properly between stocks and bonds. But the actively-managed bond fund that Oppenheimer allocated them to lost more than 35% in 2008.

Now, the average bond fund was down only about 4.7% last year. What in the hell were Oppenheimer’s bond managers doing? According to Morningstar, “management gained exposure to the battered commercial mortgage-backed securities market through derivatives that had a leveraging effect on the fund, amplifying losses.”

“Mortgage-backed securities,” “derivatives,” and “leveraging” are three words that I would never want to see attached to my child’s college savings plan. What’s even worse, the fund managers were upping their stake in mortgage-backed securities in 2008, even as the market had started to fall apart.

Almost laughably, the Oppenheimer Limited-Term Government bond fund and U.S. Government bond fund also experienced losses even though U.S. government-backed bonds were pretty much the only asset class last year to make money. The reason? Oppenheimer made bets on non-government, mortgage-backed securities in those funds too!

Some states, like Illinois and Oregon, plan to file or have filed lawsuits against Oppenheimer. I say, it’s too little, too late. The last couple years have shown that every investor needs to pay extremely close attention to what his fund is invested in. But if a state is going to attach its name to a fund, and even restrict its state’s residents to investing in certain funds, state officials better pay attention to how the fund managers invest the money before something like this happens.

If you’re deciding between 529s right now, keep in mind that you don’t have to invest in your own state’s plan, though you may lose a tax break if you don’t. Nearly every plan will also let you choose between fund managers and fund styles. (Illinois’ college savers could have chosen Vanguard funds, for example.) For this category of investing especially, I would stick with index funds with low fees and have a relatively low amount of money allocated to stocks. Unless you’re saving for your kid’s college tuition before he or she is born, there’s just too short of an investment window to take big risks.

Savingforcollege.com is a great resource to research and choose 529 plans. Just make sure you get the mutual fund prospectus also.

– Joe Light

Diversifying your bond portfolio

First, I’d like to welcome any Get Rich Slowly readers still trickling in. Thanks again for visiting the site. There’s a quick summary of what the site’s about here. And subscribe to this site’s feed here.

Recently, I’ve written about allegedly shady practices at a popular mutual fund company, why many popular assumptions about stock returns might be false, and a big problem with target-date retirement funds.

——-

Onward.

Yesterday, I wrote a basic intro to bonds for J.D.’s site, and a follow-up, slightly more complicated post on how to screen for and choose bonds. bond-by-paul-jursa

Today, I’m going to address two areas:

1) How to build a bond portfolio or a bond ladder, and

2) How to actually buy a bond

How to build a bond portfolio

You probably already invest in mutual funds or might even have a portfolio of individual stocks. If so, you’re probably familiar with the concept of diversification. In short, you want to spread your investments among many types of securities to make sure that if any one of them gets hurt, your portfolio doesn’t unduly suffer.

Bond portfolios are no different. Here are the considerations you should have as you pick bonds.

1) Pick only high-grade bonds.

Yesterday, I defined this as a bond with a rating of A3 or higher by Moody’s. You might want to pick an even higher grade. Why? In the current environment, the ratings agencies have been downgrading bonds like crazy. Even Warren Buffett’s Berkshire Hathaway recently lost the highest investment grade rating. If you don’t have much to invest in bonds (Say, $200,000 or less), I would stay with bonds that have a AA rating or higher and whose companies are known as conservative, stable earners.

2) Diversify the maturity dates of your bonds.

Let’s say you’re saving for a son or daughter’s tuition payment that comes in 10 years. The highest yielding bonds that you see are probably ones that mature right around the time you need the money. But that doesn’t mean you should put all of your money in those bonds, even if they’re with highly rated companies.

A bond portfolio’s greatest risk actually isn’t that companies default. It’s that interest rates could rise before the bond matures. Imagine that you bought a 10-year bond yesterday at face value ($1,000) that yields 5%. Today, the Federal Reserve surprises the world by letting its target interest rates rise by 3 percentage points. Now, investors can find corporate bonds similar to the one you just bought that yield 8% instead of 5%. You can’t just sell your bond for $1,000 and reinvest the money. Any investor who buys the lower yielding bond will want to purchase it at below face value to compensate for the lower interest rate.

You’re holding your bonds to maturity. Small investors get ripped off when they try to sell bonds on the secondary market. So the only way that the change in interest rates really hurts you is that your $1,000 is tied up in a bond with a lower yield than what you could get now.

So, instead of buying $100,000 worth of 10-year bonds, the college saver might buy $10,000-worth of bonds that mature in 10 years, $10,000 that mature in 9 years, and each year until next year. That way, even if interest rates go up, you’ll always have bonds maturing whose principal you can reinvest in the higher yielding bonds.

Some folks argue that no one should invest in 10-year bonds right now, because interest rates are most certain to go up. I’d answer that the market should already be pricing those fears into the yields of 10-year bonds (that’s why they’re higher than one-year bonds). If you think you know better than the market, good for you. But for those building a simple bond ladder, since you’re holding bonds until maturity, you’re not going to get hurt if they’re right.

3) Diversify among industries in addition to companies.

You probably already gathered that you wouldn’t want to put all your money into bonds put out by one company. You should also consider spreading your bonds out among as many industries as possible. Your portfolio should not only have industrial manufacturers, but utilities, retailers, foodmakers, and so on.

Buying a bond

I’m just going to say this at the outset: Buying a bond is not as easy as it should be. Whereas stock and mutual fund platforms have gotten easier and easier over the last decade or so, bond buying still has silly impediments that the big brokers either can’t or don’t want to sort out. Until a few years ago small investors couldn’t even find out how much some bonds traded for! It’s gotten better, but not by much.

1) Use a broker who gets most of his business from bond trading. The reason for this is simple: The bonds you can buy will often be limited to what bonds the broker has in his inventory. If he doesn’t trade bonds often, he won’t control many bonds himself and won’t know good sources to find the bonds you’re looking for. As an alternate, you can use an online bond platform, like the one at E*Trade, which will aggregate the inventories of many different bond brokers. But when using a platform like that, you effectively pay two commissions. More on that later.

2)Start with “newly issued” bonds. Investors get better deals on bonds if they buy them right when the company is first asking to be lent money. As a small investor, if you can get in on a new issue, you’ll get a much better price on the bonds than if you bought them on the secondary market. Depending on how much money you have to invest, you might not be able to get in on many offerings, but it doesn’t hurt to ask.

3) Try to buy at least 10 bonds of the same company at once. The bigger the purchase of bonds you can make of a company, the better the price you’ll get. Some financial advisors say that an even better increment is $25,000 worth of bonds (about 25 bonds). If you try to purchase smaller amounts, you will get very poor prices.

4) Bond prices are negotiable. Don’t take your broker’s first offer. I can’t emphasize this enough, and this is the primary mistake I hear small investors make. Unlike a stock broker, bond broker’s don’t make a flat commission. In fact, they don’t specify their commission at all! Instead, they make money on the “spread” between what they can buy the bond for and what they sell it to you for. So a broker might buy a bond at a price that yields 6% but sell it to you at a price that yields 4%. His commission is difference in price that causes that 2% spread.

Brokers don’t disclose that difference. So it’s important that you come to the phone call armed with information. You can find the prices that bonds recently traded for here. Click on “Corporate Market At-a-glance” and search for the company whose bonds you’re considering or for the CUSIP (the bond’s id number) if you have that. Once you get to the bond you’re looking for, you should see a list of recent trades of that bond. screen-shot-of-ge-bonds

The “price” on the screen is given in cents on the dollar. So a bond sold at “100.000”, went for $1,000. Under “size” you’ll see how many bonds were bought at once. So in the first line of the preceding image. An investor (or a bond broker, it’s difficult to tell) bought 10 bonds of GE at $1,000 each.

When you negotiate with your broker, try to get a yield as close to what you see at SIFMA’s website as possible. If he wants more than 1.5 percentage points as his commission, look for the bond elsewhere or try for a different bond. Honestly, a 1.5 percentage point hit on an investment-grade bond is already pretty high.

A note on online bond platforms: An online bond platform aggregates many bond brokers onto one site. That’s good because you have access to more inventory. But in exchange, you’ll probably pay a higher commission. The online broker will take the first cut, usually somewhere in the range of $1 per bond. The live-person broker will still earn a commission on the spread. I know E*Trade allows customers to make an offer on a bond and negotiate its price down. But some online brokers don’t let you do that.

5) Monitor your portfolio and reinvest bond payments. One of the biggest mistakes financial advisors tell me they see is that someone sets up their bond portfolio but doesn’t reinvest bond payments or even the bond’s principal as it matures. Unlike with a mutual fund, you can’t instruct your broker to simply reinvest your bond payments. Brokerage accounts generally pay extremely low interest rates. So even though your bond yields 5%, if its bond payments simply sit in the account, your portfolio’s yield will be less.

If you’ve set up a bond ladder by having bonds mature regularly (such as once a year), revisit your portfolio at least that often to find bonds to reinvest in and to keep that income stream coming. Someone who is investing in bonds for income and who wants to keep an average maturity of 5 years, would want to buy a 10-year bond every time one of his bonds comes due. That way, he’ll always have a bond coming due in the next year.

Phew, I hope this post, the two others made yesterday, and the story in Money have given you at least a basic understanding of how bonds work and how to build a portfolio. As you can imagine, there’s more to learn and entire books have been written on the subject. I will recommend two, whose authors I’ve spoken to extensively:

Bonds: The Unbeaten Path to Secure Investment Growth by Hildy and Stan Richelson, and

The Bond Bible by Marilyn Cohen (this one is a little older)

Thanks for reading and hope you come back tomorrow — when I won’t be talking about bonds.

– Joe Light

Finding bonds to invest in

If you’re arriving from Get Rich Slowly, welcome, and enjoy the site. You can see a quick summary of what this site’s about here. Or go ahead and subscribe to this site’s feed here.

Recently, I’ve written about allegedly shady practices at a popular mutual fund company, why many popular assumptions about stock returns might be false, and a big problem with target-date retirement funds.

Now to building a bond portfolio:

Hopefully, you’ve read my summary of how bonds work at Get Rich Slowly and maybe even seen the basics of deciding whether or not to buy individual bonds here. If not, you might want to check those out, because this post assumes at least a rudimentary understanding of how bonds work and that you’ve decided you want to consider individual bonds (the linked stories will let you explore both those issues).

This story will tackle two issues:
1) How to find bonds to invest in, and

2) Understanding the risks in the bond

Tomorrow I’ll write about:
3) Constructing a bond portfolio/bond ladder, and

4) Finally, the process of actually buying a bond

How to find bonds to invest in

Unfortunately, it’s not nearly as easy as looking up a few ticker symbols on Yahoo! Finance and signing into your broker to buy them. Fortunately, it is a lot easier than it used to be, for what that’s worth.

The bond universe is tracked by the Securities Industry and Financial Markets Association at their website. While you can search for corporate bonds or municipal bonds by the name of the issuer at SIFMA’s site, it might actually be easier to start with a bond screener like the one on FINRA’s website, which is powered by MarketWatch.

This is what the initial bond screen page will look like.

This is what the initial bond screen page will look like.

We’re looking for corporate bonds right now. So under “Select Bond Type”, pick “Corporate”.

The rest of the selections will depend on your personal requirements for the bond. Here’s a quick rundown of each category, skipping ones that I’d leave blank:

Search by maturity: Select a range of dates by which you want to get your principal back. If you need the money for a tuition payment by April 1, 2014, for example, you might pick a range between today and that date. Don’t pick a maturity date past when you need the money. Selling a bond is difficult and costly for small investors. If interest rates go up after you purchase the bond, the bond’s value will also be much lower in a resale.

Coupon type: For the purposes of this exercise, select “Fixed.” This means the yearly payments that you receive will be set in stone. “Variable” rates will move depending on the terms of the bond. For example, they might be pegged to a popularly tracked interest rate like that of Treasury bonds. “Zero”-coupon bonds don’t make regular interest payments. Instead, you make money on the value of the actual bond going up and from the accumulated interest all at once, when it matures. You receive no payments in the interim.

Moody’s Rating (Or Fitch Rating or S&P Rating): Select “A3” or higher as the “Lowest” . This is the credit quality of the bond, as measured by the three big bond rating’s agencies. It’s basically their guess as to how likely it is that the company won’t be able to make all of its payments. The higher the letter grade, the more safe the bond (at least, according to the agency). Each of the agencies have a different ratings system, but the form on the website presents the letters in top-down order.

Industry Group: Leave it as “All” but understand that when you build your portfolio, you’ll want bonds from across industries, in the same way that you would diversify a stock portfolio.

Callable and Putable: Select “Exclude Callable” and “Exclude Putable”. Callable bonds can be “called back”, or paid off, by the company issuing the bond before the stated maturity date. A company might do this if interest rates go way down and the company wants to refinance its debt. Putable bonds, on the other hand, let you choose to sell the bonds back to the issuer. There are situations where you might still buy a callable or putable bond, but let’s keep things simple.

Convertible: Exclude for simplicity’s sake. Convertible bonds give you (or sometimes, the issuer) the option to convert the bond into the company’s stock at a predetermined price. It can add value if the conversion rate is better than the current stock price.

Run the screen, and you should get a list of several hundred bonds.

This is what the bond screen results page should look like.

This is what the bond screen results page should look like.

How do you choose among these? Well, for one, your inventory might be limited based on what your broker has available.

If you have a live-person broker, call him up and give your criteria. He’ll be able to quickly call up what bonds he has available that meet it. You can then compare the yields in his list to the ones you found in your own screen. If his inventory seems very limited, try another broker.

If you have an online broker, the online site’s inventory will most likely be a network of many different brokers (if it even has a bond component! Some don’t.). Keep in mind that with online brokers, you’re basically paying TWO commissions — the per bond commission (maybe $1) that the online broker charges and the commission to the broker in its network. Bond broker commissions are different than stock broker commissions. I’ll tackle those tomorrow or you can see the difference described in my Money article.

Understanding the bond’s risk

You screened out many risky bonds by selecting A3 or higher for the Moody’s rating (honestly, you might want to go even higher than that). But unfortunately, the credit agencies are often slow to update their ratings to reflect recent company announcements or new risks that have become apparent. Sometimes, it’s easy to see when they’ve been slow. In my screen (where I used the above criteria and April 1, 2014 as the latest maturity date), the highest yielding bond in the list pays 608%! Now which do you think is more likely, that the ratings agency is wrong or that the market just happened to leave such a sweet deal lying around?

A good rule of thumb is that the corporate bonds you buy should not yield more than a few percentage points above that of comparable Treasury bonds. You can see what treasury bonds are yielding here. If you did my screen, you’ll notice that that excludes the first 20 pages or so of bonds. The names of the issuers on those pages (almost all financial or auto companies) shouldn’t be surprising. And if you want to exclude them from the outset, you can do so on the original screen page.

I’d personally recommend picking a company that you recognize and whose business you can understand. Then, you can research that company in the same way you’d research its stock. You need to pick companies that are likely to survive until the maturity date. So when looking at a company’s balance sheet, you want low amounts of debt and high free cash flow. It’s hard to be more specific than that without getting into something complicated, but look here for a summary of how to read a balance sheet.

If you’re very uncomfortable with reading balance sheets and evaluating companies, you might want to leave it up to an investment professional or even just stick with a bond mutual fund or something guaranteed, like CDs or Treasury bonds. Otherwise, if you’re still interested, check out my post tomorrow on building the bond portfolio and actually buying bonds.

Thanks for reading,

Joe Light

How this blog can help you

Welcome Get Rich Slowly readers! Thanks for stopping over. Let me give you a quick rundown on what this blog is about and how it can help you — whether you’re just interested in learning more about investing or you’re saving for a specific goal, like retirement or a kid’s college education.

My name is Joe Light, and I’m a writer with Money Magazine. This blog is a side project of mine, but much of the material comes from the frequent interviews and research I collect from some of the best investing minds in the business.

Each post (which will come at least once every business day) is designed to help you think smarter about your investments, understand how fees impact your portfolio, and just generally set up a plan so that you can achieve your investing goals, no matter what they might be.

Recently, I’ve written about allegedly shady practices at a popular mutual fund company, why many popular assumptions about stock returns might be false, and a big problem with target-date retirement funds.

A little later today, I’m going to expand a little bit on some of the basics of bond investing I gave in the post for J.D., and tomorrow I’ll actually go through the process of constructing a bond portfolio for those of you who think you’d like to try.

If you’d like to be clued in on those posts and future updates, subscribe to my feed by clicking here or the button in the upper right corner.

Anyway, I sincerely appreciate you stopping by and hope you come back. Feel free to drop me a line in the comments section. I’m always looking for ideas on what to write about!

Thanks,

Joe Light

The scariest thing a fund manager’s ever told me

I was just organizing some old notes from last year and ran across this gem of a quote from a mutual fund manager. My notes were hasty, and this is an old interview. So you should definitely take this as paraphrasing, but here goes:

Sometimes you have to know when to ride stocks on the way up even when you know they’re overvalued. I mean, if I didn’t do that, I’d miss out on some serious profits. You ride on the way up and then get out before the bottom falls out.

I’m not going to say who this was, because I don’t even remember the context of the interview. But good lord, does that kind of sentiment send shivers down my spine. Normally, when we think of mutual fund managers, we make a distinction between “growth” and “value”. Value fund managers invest in companies based on its low share price relative to its earnings. Growth fund managers are willing to pay a higher share price because they’re in the business of predicting what those earnings will be several years from now.

Dancing with a bull market

Dancing with a bull market

I feel like “momentum” fund managers deserve their own category — the quoted fund manager was definitely one of them (at least a component of his strategy was, anyway). Momentum investors are quintessential market timers or stock timers. They invest in a stock, not based on any valuation metric or growth estimate, but simply on how the stock price has moved in the past. I can’t say that their strategy is bunk. In fact “positive feedback” has become a pretty well established fact as the driving force behind bubbles like the real estate and tech stock booms. (For an early take on the subject, see a paper by the director of the National Economic Council and former Treasury Secretary Larry Summers.)

What bothers me is that those irrational swings in market sentiment that drive price are far from predictable. The fund of the manager I quoted trailed the market each year between 2005 and 2007 (he underperformed the market by more than 25% in 2007) before outperforming in 2008 and so far in 2009 (he outperformed the market by more than 25% last year.)

When you add those periods of under and overperformance up, you get a mutual fund that’s performed a little bit under the average for the market, a little bit over the average for its category, and I imagine has given quite a few investors heart attacks in the process. I wonder how many even stayed in the fund after those underperforming years.

There’s no question that the market has irrational tendencies. But personally, I prefer strategies that count on the market’s return to reason rather than count on its continued deviation from reason. Why? Well for one, ultimately, a company (or the companies a fund holds) is only as good as the profits it gives you. If a share of Company X had an earnings yield of 10%, that means your money is earning a 10% return no matter where the stock price goes. Alternately, and more accurately, you might look at the dividend yield.

Investing with the expectation that the share price will go up is kind of like buying into a Ponzi scheme. The stock will only give good returns as long as other suckers step in and drive it up even further. If you’re the last one holding the bag, and the company doesn’t make enough money to justify the share price, the price comes tumbling down.

As mentioned in a previous post, investors might already be starting to put a renewed interest in dividends. Some studies have shown that dividends, not rising stock prices, have been the source of market returns for some time.

I think of it this way: Pretend the market shut down, and you were stuck holding all the companies you own in your portfolio right now. Wouldn’t you want companies that are paying you money? Shouldn’t a fund manager want the same?

– Joe Light

Sure, you should invest globally, but I’d stay away from stock picking if I were you

Sorry this was late. I was about to just not post and mark it up to being busy. But I’ve been able to keep up posting every business day so far, and think you guys deserve at least something to show that I am, in fact, working, right? For any of you non-investors out there, this might delve a little into the obscure, but I’ll try to keep it as basic as possible. Trust me, it concerns you, too. map-of-japan

It must be really hard to manage a mutual fund that invests in international markets. Imagine having all of the same concerns about analyzing companies that domestic fund managers do and lay on top of that dozens of different political realities – in one economy (Russia), the government might even decide to nationalize a company, making your investment worth nothing.

Another, maybe more confusing situation was brought to my attention yesterday in an interview with two fund managers from IVA Funds. IVA is a relatively new mutual fund shop brought to you by Chuck de Lardemelle and Charles de Vaulx (among others). They’re all value managers and earned their street cred while working for First Eagle, under renowned investor Jean Marie Eveillard. In fact, even though their IVA Worldwide fund is only six-and-a-half months old, Morningstar’s already given them a hearty endorsement. (I linked to the A shares, but they do have a load-waived share class).

I’m not about to endorse a fund that’s only been around for half a year (or put it down), but I can tell you that they were smart, interesting guys.

One of their more contrarian assertions was that Japan, despite having a price-to-earnings ratio that’s relatively high compared to the rest of the world (last I checked, it came in at around 14), is one of the most undervalued markets.

Their reasoning? Well for that, we need a little bit of a history lesson. Japan suffered its own asset price bubble in the mid-80s. It popped, of course, and Japan went through an extremely slow and painful deleveraging process to bring prices back to Earth. For a time, companies couldn’t borrow money.

As de Vaulx explains it, that fear of running out of money has trained companies to stockpile huge cash hoards “just in case”. You’d think that having an “emergency fund” as a company might be a good backstop in the way it is for an individual, but for investors, it’s meant that Japanese companies have a low return on equity and don’t increase shareholder profits. For a good summary of the problem, click here.

How does that make a good value? Well, because of all that cash on their books, the P/E of a Japanese company gets distorted. Imagine a company that costs $50 on the market and has earnings of $1 per share. That’s a P/E of 50 and is pretty bad, right? But what if it had $45 in cash per share on its balance sheet after taking out all debt. Now, the $50 per share doesn’t look so bad. That’s why a lot of investors look at a company’s “enterprise value” rather than the P/E. To calculate enterprise value, subtract the cash per share (or if they have debt, add the debt per share) to the company’s stock price before dividing by the earnings. In the preceding example, the company’s enterprise value-to-earnings ratio would be 5. (Note: This can work the other way too. If a company has more debt per share than cash per share, the enterprise value ratio would be higher than the P/E.)

Japanese companies have a lot of cash, and that’s why Chuck and Charles think they see great deals in that area of the world.

To me, what isn’t clear is the last step required to make those companies worth investing in. If they don’t ever return the cash to shareholders, isn’t it worthless? Imagine if Google decided it would never pay a dividend for as long as the company was in business and instead hoarded the money or paid it to employees. The stock price would (and should) be $0.

So it seems a bet on Japan is a bet that the culture of those companies changes or that investors force it to change. Otherwise, that cash is just one hell of an emergency fund.

I often say that most investors should let professionals do the investing or stick with an index fund that simply tracks the market. But given the cultural and political complications that come into play internationally, I think a novice would be crazy to try to pick foreign equities on his own. There’s just to much to wrap your head around.

– Joe Light

Why your mutual fund company thinks it can rip you off

For the first time ever, a federal court has sided with investors who accuse their mutual fund company of charging excessive fees. Shareholders of Ameriprise funds sued the company for charging higher fees to the fund investors than what they charge for similar institutional accounts. gavel-by-jason-morrison

This quote, from an e-mail between Ameriprise officials, is priceless:

Even before the Board’s request, there is some indication that Ameriprise knew that a fee discrepancy between institutional accounts and mutual funds might concern the Board. In response to a Wall Street Journal article that discussed the industry-wide disparity in fees, an internal email noted that “this could come up in a Board meeting” and suggested that “we should have a reply, though it may or may not be convincing.”

No kidding.

You can read the entire court opinion here.

Some of the more damning evidence is how Ameriprise apparently set its mutual fund fees. According to testimony from Ameriprise’s own board, they charged fees not based on what their actual costs were, but on what they could get away with.

Ameriprise entered the negotiation with a pricing philosophy wherein it attempted to establish fees that were “in the middle of the pack of funds with a similar size, objective and distribution model.”

Don’t you just love it when a fund company strives for mediocrity?

The funds in question are Ameriprise’s RiverSource funds. Just take a quick look at Morningstar’s fund family page, and you’ll see why investors should have known these were a bad deal going in.

78% of RiverSource’s funds charge a 3% to 6% upfront load for the privilege of investing with them. In other words, to even get into an Ameriprise fund, someone who invested $500,000 over a number of years would have paid an initiation fee of $15,000 to $30,000. Even after that sacrifice, RiverSource funds still charge annual expense ratios of between 1% and 2%. In other words, after paying $30,000 up front, that investor then paid RiverSource about $5,000 a year to keep managing his money.

And, as mentioned in a previous post, that doesn’t even include the mutual fund’s brokerage fees.

But lets take one fund as an example and see just how much Ameriprise was potentially overcharging the little guys in comparison to its top customers. According to recent returns on the RiverSource Disciplined Value fund, institutional clients were charged somewhere between 0.38% and 0.74% in expenses per year. That’s very low.

The equivalent mutual fund? 1.28%, or more than four times as much, depending on the year.

Loyola University professor Charles Murdock testified on behalf of the investors that “the advisory service provided to the mutual funds was similar, if not identical, to the service Ameriprise provided to its institutional clients.”

So riddle me this: Why does a mutual fund company charge small investors twice as much as big investors for the same service?

I have a sinking suspicion that it’s because they thought they could get away with it.

Let’s hope this changes.

– Joe Light

How to frame the Fed’s economic outlook

Sorry for the late post. It’s that time of the month when magazine deadlines overpower more enjoyable pursuits.

The Fed came out with its “beige book” economic reading today. Writers are attributing its results to the market’s 100-point run up this afternoon.

Fed chairman Ben Bernanke

Fed chairman Ben Bernanke

Here’s the sentence that’s supposedly getting investors all excited about a rebound. After noting that the economy has continued to deteriorate, the Fed writes, “However, five of the twelve Districts noted a moderation in the pace of decline, and several saw signs that activity in some sectors was stabilizing at a low level.”

The districts that are seeing a more moderate pace of decline? New York, Chicago, Kansas City, Dallas, and San Francisco. (At least, that’s what I gather from reading the report. I don’t think the Fed spelled out which areas they were referring to specifically.)

It’s good news that some cities aren’t getting exponentially worse anymore, but how would investors react if I rewrote the sentence this way?

“Unfortunately, seven of the twelve Districts noted a steepening or continuation in the pace of decline, and several saw signs that activity in some sectors showed no signs of stabilizing.”

Both sentences are true. But guess what the headlines would have been had my line appeared as the second sentence in the Fed’s report instead of the original line?

As an experiment, I took a look at the June 11, 2003 beige book report. This would have been the tech bubble/September 11 equivalent of the report we’re seeing today. The report noted that four of the 12 districts showed signs of improving, but instead of the sentence of encouragement that we got today, investors got this:

“Although reports from the twelve Federal Reserve Districts indicated some signs of increased economic activity in April and May, conditions remained sluggish in most Districts.”

That day, the S&P 500 closed up a fraction of a percentage point.

Ok, granted, there were 1,000 variables that were different then. For one, investors thought that the weak economic conditions in June 2003 could mean another rate cut was on the way. Of course at the moment, that’s basically impossible.

But could a little bit of framing be going on here? I’m not an expert on the economy by any means, just an interested observer. I wonder how the Fed decides to take a “glass half full” point of view as it did this time versus the glass half empty view it did in 2003. Your thoughts? I’m interested.

– Joe Light