Wednesday, June 28, 2006

Make your Investment Returns Take Off

by Bryan Kelleher

The point of investing your hard-earned capital is to attain a lot more money in the future by giving up the enjoyment and use of your cash today.

You want your returns to soar like a jet plane.

But think about how much work goes into pre-flight planning. The ground crew maintains and inspects all mechanical systems. Air traffic controllers make certain all routes are clear. The pilot consults his checklist of procedures that must be completed before take-off. Great amounts of time and resources are spent to keep airline passengers as safe as possible.

In the same way, investors should develop a mental safety checklist before making serious investments in the stock market.

This is why Warren Buffett says that the first rule of investing is never to lose money and the second rule is never to forget rule number one.

The math is simple: if you lose 50% on an investment, you must gain 100% to reach your breakeven level. Another interesting mathematical truth is to look at the performance of two portfolios:

Portfolio A: $1,000 invested, compounding at 8% per year for 4 Years would result in an account balance of $1,360.

Portfolio B: $1,000 invested, compounding at 15% for 3 years, and then losing 15% in the fourth year would result in an account balance of $1,293.

The point is that you want to avoid losses as much as possible.

Sometimes investors tend to emphasize their anticipated returns over all other factors. They get so excited and enamored with sell side analyst opinions and company projections that they often fail to consider all of the problems that can occur with stocks. Buffett has stated that investors would be well advised to pay more attention to credit analysts than sell side analysts.

You cannot control how much your stocks make. But you can control the risks you take when making stock picks.

What are you to do?

As Charles Munger has stated on several occasions:" Invert, always invert." Instead of thinking about the upside of your investments, you should emphasize the downside that can beset your stocks. The internet bubble of the late 1990's taught us all powerful lessons about what can happen when focus is applied to promised returns as opposed to all the things that can go wrong. A lot of portfolios crashed and burned.

Just as an airline pilot, most of your efforts and preparation should be directed at avoiding mistakes.

Businesses and markets are competitive and unpredictable. Investors that have prepared for worst-case scenarios, and have not paid too much for their investments will fare the best when inevitable setbacks happen.

Successful investors have developed the skills to assess the financial strength of the companies they have invested in. How much cash does a company have? How much debt does the company carry? Is the company using strange techniques to get debts off the balance sheet?

Next, as an investor, you need to assess a floor value of an investment. You need a method of calculating a "worst case scenario". If the company were to fall on hard times, or if the stock market goes south, what would the company trade for? An adjusted book value - (tangible assets less all liabilities) would be a good place to start. By focusing on this number, you will get an idea how far a current price of a stock could fall. If you identify an investment where this number is not too far from the current market price, you might have an interesting stock investment idea.

Your final analysis should be to measure the true or intrinsic worth of the security you are considering. Remember, stocks are not just pieces of paper that float around day to day based on nothing. Stocks are actual assets that represent claims to assets that throw off real cash at some point. Companies pay dividends, buyback their shares, merge, reorganize or liquidate. Your job is to estimate the fair value of these future cash flows.

Since you can't possibly know with certainty the exact value of a company, the key to being successful is to use conservative values and compare these values with the current price of the security in question. Your aim is to find companies with upside potential that are trading near the floor level you have established, and are trading below what you believe is the real intrinsic worth of the company.

You can generate a lot of investment ideas by looking at what the investment masters are doing right here at They are buying fallen angels like Dell and Pfizer.

Often this approach will take you to unpopular or out-of-favor companies. You just have to do more homework than the average investor, and once you arrive at logical conclusions, stick to your assessments.

These steps will not only ensure that you will not overpay for a stock, but they also have the effect of magnifying your returns if the gap between the current market price and intrinsic value narrows. If the intrinsic value of the company also grows, and the market value eventually follows - this is when investment returns soar.

Remember: Before taking off, ask yourself how safe your investments are.

No comments: