Phil Town's Four Ms

Whenever we look at buying a stock, we should have Warren Buffett's main philosophy ingrained in our minds. That is....

We want the business to be (1) one that we can understand,
(2) with favorable long-term prospects,
(3) operated by honest and competent people, and
(4) available at a very attractive price.

This core framework can be easily remembered reading Phil Town's book, Rule #1. It refers to the four Ms.

1. Does this business have Meaning to you?
2. Does the business have a wide Moat? (duarable competitive advantage)
3. Does the business have great Management?
4. Does the business have a big Margin of Safety?





This is a great book and it reconfirms to me about Buffett's teachings. It actually teaches you step by step how to buy companies and get a 15% compounded return.

In analyzing the company, the order of importance is

1. Return on Invested Capital (ROIC)
2. Sales growth
3. EPS growth
4. Equity growth
5. Free Cash Flow or Cash growth

With calculating intrinsic value with future EPS growth rate, I liked the idea of using the equity(book value) growth rate vs analysts EPS growth rate(whichever is lower) because what good is a business if earnings grows but you have to take money and put it back into capital expenditures and no surplus cash is generated? Warren Buffett says the best proxy for the growth of intrinic value is the growth of equity.

I will continue to give more gold nuggets as I finish with this book...

Simplicity is the secret to investing

I'm reading the book, the Dhandho investor, by Mohnish Pabrai, and it states:

Simplicity is a very powerful construct. Henry Thoreau recognized this when he said, "Our life is frittered away by detail... simplify, simplify." Einstein also recognized the power of simplicity, and it was the key to his breakthroughs in physics. He noted that the five ascending levels of intellect were, "Smart, Intelligent, Brilliant, Genius, Simple." For Einstein, simplicity was simply the highest level of intellect. Everything about Warren Buffett's investment style is simple. It is the thinkers like Einstein and Buffett, who fixate on simplicity, who triumph. The genius behind E=mc squared is it's simplicity and elegance.

I'm still reading it and I'll let you what other gold nuggets I find....

How to make money with call options

Options can increase your return a lot faster than stocks but are more riskier. So like speculative stocks, it should be only a small portion portion of your portfolio.

For a more detailed explanation, click the link below.

Options 101

When I buy options, I go for the LEAPS (expires in 1 or 2 yrs), although I pay more of a premium, it allows the stock enough time to move in my favor.

For example, I like Motorola (MOT) stock due to Carl Icahn & Eddie Lampert's buys but it's not a long term buy for me (my definition of long term is like 5-10 yrs). Because MOT is in a competitive environment and when technology can change in a hear beat, I prefer to buy the option if the premium paid is reasonable. With MOT stock at $18.00, I consider it a turnaround value stock play with the potential of going to $25 within 1-2 yrs. If I buy 100 shares of it, I'll make only 39% return on investment ($700 profit) if it goes to $25.

However if I buy a one, Jan 2009, 20 strike, call option, I pay only $210 premium. If it goes to $25, my return will be 138% return on investment ($500 profit). If I buy 2 options, I make $1000 profit (less commissions, of course)!

What's the downside if the stock stays at $18 in 2 years?

If you bought the stock, $0 gained/loss. If you bought the option, expires worthless and you lost $210.

What's the downside if the stock goes to $15 in 2 years?

If you bought the stock, $300 loss. If you bought the option, expires worthless and you still only lost $210.

What's foolish is if you used all $1800 to buy options. What's prudent would be to buy 1 contract and keep the rest in cash to yield interest or use it as a reserve. Money management is the key to options trading.

Here's another example of buying a call option compared to the stock. Recently I bought one call option on Walmart, Jan 2009, strike at 50, for $440. At the time, the stock was at $47. Now the stock is up to $49.50 and my option is worth $610. That's a 39% return ($170 profit using $440 capital). If I bought 100 shares, my return would only be 5% return ($250 profit using $4700 capital).

If you've never played options, start slowly...... Also just like stocks, buy in stages and in wide scales. And because options can expire worthless ....it's better to just sell it when you've got a quick profit. I may sell my Walmart call option pretty soon.

Oh by the way, it's good to compare options with the same price stocks so you don't overpay. At the time, Best Buy's similar call option when it was at $47 was at $6.00 vs Walmart's $4.40. (I guess people are more bullish on Best Buy).

Warren Buffett - Preservation of capital

Preservation of capital should be your number 1 priority in stock investing. If you lose 50% of your investment portfolio, you will have to double it just to get back where you started. It will take you six years to get it back if you average 12% a year (about 4 years if average 20% a year).

The next time you plan to buy a stock, the question should not be, "how much can I make?", but "how much can I lose?". Figure out the risk/reward factor (ie. I think this stock has 2 down but 10 points up.) Jim Cramer says if you speculate, make it only a small percentage of your portfolio...

"Rule No. 1: Never lose money. Rule No. 2: Never forget Rule No. 1" - Warren Buffett

"An investor needs to do very few things as long as he or she avoids big mistakes." - Warren Buffett

"Survive first and make money afterward" - George Soros

Warren Buffett - Have infinite patience

At Berkshire Hathaway's 1998 annual meeting he told shareholders:

"We haven't found anything to speak of in equities in a good many months. As for how long we'll wait, we'll wait indefinitely. We're not going to buy anything just to buy it. We will only buy something if we think we're getting something attractive... We have no time frame. If the money piles up, then it piles up. And when we see something that makes sense, we're willing to act very fast and very big. But we're not going to act on anything if it doesn't check out.
You don't get paid for activity. You only get paid for betting right"

"The trick is, when there's nothing to do, do nothing" - Warren Buffett

Earnings growth is like crack on Wallstreet.

"People may bet on the hourly wiggles in the market, but it's the earnings that waggle the wiggles long term" - Peter Lynch

Rapid earnings growth dictates long-term performance. Wallstreet is addicted to growth.

ie. Growth stocks, 1995-2005

Wal-mart,
Earnings per Share (EPS) 15% compounded annual growth rate (CAGR), Stock Price 15% (CAGR)
$1 invested in 1995 is $4.21 in 2005.

Microsoft,
EPS 22% CAGR, Stock Price 17% CAGR
$1 invested in 1995 is $4.77 in 2005

Dell,
EPS 35% CAGR,Stock Price 39% CAGR
$1 invested in 1995 is $27.68 in 2005

Starbucks,
EPS 29% CAGR,Stock Price 28% CAGR
$1 invested in 1995 is $12.02 in 2005


Source: FactSet, ThinkEquity Partners.

Finding the next hot stock!

By far the best stock screener on the web is Yahoo's stock screener . I use it maybe once or twice a week and I have to say, it's a great tool to have in finding stocks that are undervalued but you have to make sure you use the Java version vs the basic HTML because it gives you a lot more criteria to work with. You can even save these screens so you can come back and use it again without starting all over.

My Stock Screens
------------
1. Trading at 1 or below book value
2. PEG between 0 and 1.00
3. P/E under 10
4. Yields over 4%

So try using it and I'm sure, you'll find some hidden gems!

Warren Buffett - Long term investor and TRADER?

Warren Buffett says his favorite holding period is "forever" but he does reallocate his funds from time to time. When the stock price gets ahead of itself or he sees better opportunties, he does sell within a 1 to 2 yr time horizon. I'm going over the annual reports for each year where Buffett reveals his common stock portfolio.

Here's some of his short term trades. (Some he might have bought for the dividend and some may have disappeared off the list because either he sold it, or it may have gone private).

Cost is how much Warren Buffett paid. Market Value is what it was worth when the annual report was published.

Pinkerton's, Inc
1980 Cost $12.144 million
1981 Market Value: $19.675 million
1982 off the list.

Cleveland-Cliffs Iron Company
1980 Cost: $12.942 million
1981 Market Value: $14.362 million
1982 off the list.

National Detroit Corp
1980 Cost: $5.930 million, Market Value: $6.299 million
1981 off the list.

Time Mirror
1980 Cost:$4.447 million, Market Value: $6.271 million
1981 off the list.

National Student Marketing
1980 Cost: $5.128 million, Market Value: $5.895 million
1981 off the list.

Arcata Corp
1981 Cost: $14.076 million, Market Value: $15.136 million
1982 off the list.

GATX Corp
1981 Cost: $17.147 million, Market Value: $13.466 million (may have lost on this one)
1982 off the list.

Crum & Forster
1982 Cost: $47.144 million, Market Value: $48.962 million

Exxon Corp
1984 Cost $173.401 million, Market Value: $175.307 million (Big bet but disappears the next yr)
1985 off the list.

Lear Siegler, Inc
1986 Cost $44.064 million, Market Value: $44.587 million (disappears the next yr anticipating the 1987 crash)

PNC Bank Corp
1994 Cost $503.046 million, Market Value: $410.951 million
1995 off the list.

Gannett Co. Inc
1994 Cost $335.216 million, Market Value: $365.002 million
1995 off the list.

McDonald's Corp
1996 Cost $1.2653 billion, Market Value: $1.368.40 billion
1997 off the list.

Warren Buffett does not just "buy and hold", he does what Jim Cramer preaches..."Buy and homework".

Johnson & Johnson (JNJ) still a good buy under $62.

Back in June 2006, I rated Johnson & Johnson (JNJ) a buy at $58.71 and thereafter, went 10 straight points up all the way to $69.41 and then stayed in a range of $65-$66 until recently coming back down. If you played your cards right and wasn't a hog ("oink, oink" that's me being piggish), trading around your core position was the right way to go. Meaning if you had 100 shares, you should have sold 30-50 shares at the high $65-$69, and keep your core position. If it went higher, you would look for another stock to buy. But because it went lower, you can buy it back at lower prices. Trading around your core position is what made Jim Cramer get 24% annualized compounded return for 14 yrs and he still preaches this strategy to his Mad Money viewers.












I still think JNJ is a great buy. It's one of the best managed drug stocks out there selling at current p/e levels that are the lowest in its 10 year history (maybe more but the S&P report only shows the last 10 yrs)

If you like to trade options, Lenny Dystra from theStreet.com has some good insights on JNJ - Dykstra: Johnson & Johnson a Healthy Play

Remember Warren Buffett owns over 21 million shares of this stock at price of $58.59.

The World's Most Expensive Stocks!

Here is the list of most expensive stocks per share as of yesterday's closing price but are they really expensive?

Symbol	Company	Retail Price
BRK-A	BERKSHIRE HATH HLD A	107300.00
SWBC.OB	SUNWEST BANK CA	3400.00
FBAK.OB	FIRST NATL BK ALASKA	2105.00
SEB	SEABOARD CP	2040.00
WPO	WASHINGTN POST CO B	755.50
FCBN.OB	FIRST CITIZENS SC CM	695.00
NVR	N V R L P	646.75
WTM	WHITE MTN INS LTD	565.25
CME	CHICAGO MER EXC A	564.55
FMCB.OB	FARMERS & MERCH BCP	520.00
MKL	MARKEL CP HLDG CO	472.00
GOOG	GOOGLE	457.55
WSC	WESCO FINANCIAL CP	452.00
ALX	ALEXANDERS INC	401.00
Y	ALLEGHANY CP	390.00
MITSY	MITSUI AND CO ADR	360.00
TPL	TEXAS PACIFIC LAND	233.00
NWLIA	NATL WESTERN LIFE	228.88
RTP	RIO TINTO PLC ADS	210.62
FCNCA	FIRST CITIZENS A	208.72

Full stock list here using Yahoo! Stock Screener.

You can't judge a book by it's cover and you can't judge a stock's potential by its stock price. I hear it all the time from friends, "Oh I bought Nortel (NT) at $120 and it went all the way down to $4. I'm never buying a high priced stock again!" But even a $4 stock can go to $0 if you buy a company with bad fundamentals run by bad management. A stock should be judged by the market cap and it's future earnings performance.

ie.

Two best of breed companies in the same industry with the same future earnings potiential. Which company would you choose?

X company has 10 million shares outstanding at $10.00 per share, market cap is $100 million.
Y company has 1 million shares outstanding at $90 per share, market cap is $90 million.

Understanding Stock Splits- Article

For most investors, people would buy X company just because of price and not market cap but it is actually Y that is more undervalued.

If you are a long term investor, the high priced stocks are actually worth investigating because investors usually shun away from high priced stocks which gives you opportunity to buy at a discount.

Also, companies that don't split their stock, are looking for long term investors that are in line with management's thinking instead of short term profits just to appease analysts' expectations.

So don't let a high priced stock deter you. Commissions are low and discount brokerages allow you to buy less than 100 shares. Just imagine if you bought 1 share of Berkshire Hathaway in 1990 at $6000 and where you would be today.

Lou Simpson - Warren Buffett's rumored successor

Lou Simpson, who has run the equity portfolio at Berkshire's wholly owned auto insurer, Geico, for the last 25 years. As Buffett laid out in Berkshire's 2004 annual report, Simpson's investment record is impressive in its own right, having outpaced the S&P 500 by an average of almost 7% per year. (Simpson's average annual gain from 1980-2004 is 20.3% vs S&P 13.5% during the same period.)

Lou Simpson manages his portfolio according to five basic principles. He outlined these timeless principles in GEICO’s 1986 annual report, and he explained them at greater length in an interview with the Washington Post the following year:

1. Think independently. We try to be skeptical of conventional wisdom, he says, and try to avoid the waves of irrational behavior and emotion that periodically engulf Wall Street. We don’t ignore unpopular companies. On the contrary, such situations often present the greatest opportunities.

2. Invest in high-return businesses that are fun for the shareholders. Over the long run, he explains, appreciation in share prices is most directly related to the return the company earns on its shareholders’ investment. Cash flow, which is more difficult to manipulate than reported earnings, is a useful additional yardstick. We ask the following questions in evaluating management: Does management have a substantial stake in the stock of the company? Is management straightforward in dealings with the owners? Is management willing to divest unprofitable operations? Does management use excess cash to repurchase shares? The last may be the most important. Managers who run a profitable business often use excess cash to expand into less profitable endeavors. Repurchase of shares is in many cases a much more advantageous use of surplus resources.

3. Pay only a reasonable price, even for an excellent business. We try to be disciplined in the price we pay for ownership even in a demonstrably superior business. Even the world’s greatest business is not a good investment, he concludes, if the price is too high. The ratio of price to earnings and its inverse, the earnings yield, are useful guages in valuing a company, as is the ratio of price to free cash flow. A helpful comparison is the earnings yield of a company versus the return on a risk-free long-term United States Government obilgation.

4. Invest for the long term. Attempting to guess short-term swings in individual stocks, the stock market, or the economy, he argues, is not likely to produce consistently good results. Short-term developments are too unpredictable. On the other hand, shares of quality companies run for the shareholders stand an excellent chance of providing above-average returns to investors over the long term. Furthermore, moving in and out of stocks frequently has two major disadvantages that will substantially diminish results: transaction costs and taxes. Capital will grow more rapidly if earnings compound with as few interruptions for commissions and tax bites as possible.

5. Do not diversify excessively. An investor is not likely to obtain superior results by buying a broad cross-section of the market, he believes. The more diversification, the more performance is likely to be average, at best. We concentrate our holdings in a few companies that meet our investment criteria. Good investment ideas--that is, companies that meet our criteria--are difficult to find. When we think we have found one, we make a large commitment. The five largest holdings at GEICO account for more than 50 percent of the stock portfolio.

Buffett, also quoted by the Washington Post, Lou has made me a lot of money. Under today’s circumstances, he is the best I know. He has done a lot better than I have done in the last few years. He has seen opportunities I have missed. We have $700 million of our own net worth of $2.4 billion invested in GEICO’s operations, and I have no say whatsoever in how Lou manages the investments. He sticks to his principles. Most people on Wall Street don’t have principles to begin with. And if they have them, they don’t stick to them.

"When you ask whether someone is a value or growth investor--they're really joined at the hip. A value investor can be a growth investor because you're buying something that has above-average growth prospects and you're buying it at a discount to the economic value of the business." - Lou Simpson

Took profits on Harley Davidson and Lowes

I had the day off work today and basically stayed home watching the stock market. With Yahoo! Finance flickering all day with it's quotes, it gets really exciting. But it's really hard to think rationally when the markets are open. When a stock I own is going down, I feel like selling it and when I see a stock I want to buy going up, I feel like buying it. Sound familiar?

I sold half of my position at $69 in Harley Davidson (HOG) since owning it Sept 05 at $47.28 (46% gain in 2 yrs or 17% compounded annually). I'm getting nervous with the union strike coming and I don't want to lose the gain. The rest will be a core position which I will hold forever (Well, at least 5 yrs).

I also sold 1/3 of my position in Lowes (LOW) at $34.15 since I bought it at an average price of $29.75. (14.66% gain in less than a year). I will sell 1/3 again once it goes higher and leave the last 1/3 as a core position.

This will probably be the last time I trade during market hours.

Quote of the Day
Warren Buffett on Lou Simpson, "Temperament is what causes smart people not to function well. His temperament probably isn't different than mine. We both tend to do rational things. Our emotions don't get in the way of our intellect. "

NBR and COP, buying in wide scales.

Even with the oil drop..I haven't added any more money to my Nabors (NBR, my avg price is $31.36) and ConocoPhilips (COP, bought $60.30) position yet. I am staying discipled and waiting for 12-15% drop from my cost basis. Then I might add to it.

Buying in wide scales has protected me. If I bought all at once for NBR, my price would have been $34. And I have been waiting to add to my COP but it run all the way up to $73 before coming back down. I should have taken some profits with a 20% gain but I didn't because I had such a small position. But now at least I still have some cash on hand and waiting for the perfect pitch.

Investing decisions are best made on weekends

When the markets are open especially when you see quotes in real time and have CNBC on, it's an adrenaline rush. Your mind is not clear. When stocks are moving, you feel like buying and selling. My best decisions, however, are always made after the market's close especially on weekends when you have 2 days to evaluate what you want to do.

If you can discipline yourself to make decisions on weekends, then that's only 52 decisions in a year and most of the time, you'll be content with your positions already...the lazy way to get rich.

Learn to trade options in this Virtual Trade Tool

The Chicago Board Options Exchange offers paper trading for newbies. Great for learning how to trade options without losing money and testing your theories out.

Virtual Trade Tool Link

Get Paid Now To Buy Your Favorite Stocks Later... At A Bargain

I've talked about this before but I like to revisit writing naked sell options as a strategy when there really aren't much stocks worth purchasing yet at the price you desire.

Here's an example. Lowes is a stock I like and the Jan 2008 Puts strike price 27.50 is at $1.25. If you write 1 put contract for that option, any buyers that buy your put, you get $125 deposited into your account (less commissions). If the stock drops to $27.50, you may be forced to buy the stock which I regard as a gift if you were to get that price (1 contract = 100 shares, so you would buy 100 shares of Lowes at $27.50). So actually you get the best of both worlds. Get paid for waiting and you get to buy the stock you want.

If the stock goes up instead. The option expires worthless and you get to keep your $125 premium. Also you can exit early as well. If the stock goes to say $35, the option may be worth $0.25. Instead of waiting for the expiry date, you can buy it back and exit your position for a nice profit.

This strategy should be used with stocks you want to purchase and you should not over leverage yourself. (Don't write lots of put options if you don't have the money to purchase them).