The following advice is offered with Matrix Composites & Engineering Limited (MCE) owners in mind, but it applies to all value investors who are holding on to fully valued companies.

I offer this unsolicited advice as I believe there are a number of new “value” investors who are sitting on substantial gains in MCE and my view is they should book those gains and move on.

1. Is there a margin of safety at the current level? I think not, the only way to get see a decent MoS is to use a very low required rate of return and optimistic forecasts. The valuation to the right is from the excellent MyClime service. To get a decent MoS I had to use a ROE of 50% and required return of 11%.
2. True value investors don’t forecast. Basing analysis on what analysts forecast is appropriate for growth investors not value investors. Analysts in general are over-optimistic in the long run.
3. Surely you can find a better MoS else where. If not there is nothing wrong with holding cash, it gives a decent return plus the option of buying when bargains do appear.
4. Who is buying at this level. MoMo (momentum) investors that’s who, there is no-one left to buy after them and they’ll head for the exists quicker than you.
5. You never go broke taking a profit.
6. Don’t fall in love with a position.
7. If you don’t want to sell at least put in place a trailing stop.
8. Mr Market is in a great mood at the moment and that means it is time to sell to him.

Put all the above together and I hope you conclude that taking your profit and looking for an investment with better margin of safety is the prudent path of value investing. I’d love to know if and why you disagree.

Disclosure: No position in MCE.

Bill Miller from Legg Mason provides an excellent summary about investing in this video. His outlook is also interesting, even if it is a few months old.

Investing is about expectations. Look for companies where the expectations are too low. This is usually caused by pessimism, controversy, complexity or fear. This belief has been echoed over the ages and expressed in many ways by Ben Graham, Warren Buffett and other value investing luminaries. The idea is very simple, yet surprisingly hard for most investors to implement. Buy fear and sell greed!

The video is well worth seven minutes of your time.

BP is an excellent recent company specific example. Late 2008 early 2009 is a great macro example. Many people are currently arguing that Microsoft is a great example of expectations being too low. MSFT certainly is shrouded with pessimism and deserves a very close look at the least.

Telstra is a blue chip Australian company that almost fits the bill. With a current reasonably safe fully franked dividend of $0.28 and price of $2.65 TLS.AX is sitting on a yield to SMSFs of over 12%, that implies a lot of pessimism. I’m certainly a considerably more comfortable holding Telstra than any if the Australian banks. Telstra should do more than simply talk about floating Sensis, they should flog that cash cow, before it is fully milked and only fit for dog food.

DAVID Thodey has given his first indication that Telstra may be open to spinning off its directories business, Sensis.
The Telstra chief declined to rule out a possible sale of the subsidiary in an interview with BusinessDaily.

Disclosure: Long Telstra, considering Long position in MSFT

So you want to be an investing superstar. Or at least retire comfortably with control over your own finances. Here’s a simple starting point for Buffett like returns.

1. Buy a basket of stock in the highest book to market decile, rinse and repeat. (Lowest price to book.)
2. Hold more cash when the market is above long term trend lines, deploy that cash when it is below.

http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

What do you think when you look at the above graph and consider the following?

More thoughts

• While markets are reasonably micro-efficient they are certainly prone to times of macro-inefficiency.
• The high risk premiums from equity market can be reasonably explained by investors taking a short term view. Those taking long term views are better placed to exploit the risk premium.

Yesterday I found the following email from early December.

“Just purchased MTU last friday at 1.64 and it is down now to 1.47 closing today. Bit discouraging, but as you suggested it might cross 2.00 mark, what would you recommend to sell it at a nominal profit price of any thing above 1.64 or wait it out.”

Salina, if you’re reading this sorry for the tardy reply, your message slipped through to the keeper.

Firstly, all my comments are general in nature and I am not qualified to provide financial advice. Second, I’m still learning and always will be so don’t rely on my valuations. Third this is a short article aimed to help new investors think, as such it contains many generalisations and less than expansive explanations. Finally, these are my opinions for long term investors.

If 10% wiggles in price cause you concern then you shouldn’t invest directly in shares. One of the worst aspects of shares is their frequent quotation. The wiggles play havoc with investors’ emotions. If the wiggles cause you lost sleep then you probably shouldn’t be a direct investor. However, if you’re determined to invest directly in shares and to learn and grow, then the best advice I can offer is look at major announcements from the company not the share price.  At the most look at your share prices once a month. [Speaking of major announcements MTU will announce their half year results tomorrow, Thursday 25th February]

If you can’t do a basic valuation of companies then you’re on a hiding to nothing. As Salina’s message demonstrates without your own reasoned valuation you’ll have no idea about what price you should buy or sell at. You’ll be at the mercy of the market and forever concerned about those wiggles. The valuation doesn’t need to be complex, a simple P/E based valuation is better than nothing, as it at least starts you on the path to thinking about value. There’s an example of a basic P/E matrix valuation in my original analysis of M2.

Taking a small loss is the best thing new investors can do. All to often new investors let small losses become big losses. Heck even I still do! Damn me TREES 3! While the debate over using stop losses is never ending, new investors will do well to consider themselves lucky if the price goes up and wrong if the price goes down. I don’t advocate a fixed stop loss, but if you look at the chart below you’ll see how once a loss goes over 20% making that loss back quickly gets much harder.

Taking a small loss teaches a good habit. Being flexible and realising you may be wrong will make you more money is the long run than holding on and hoping the stock goes back up so you can get out of even. If you’re nervous about a stock then sell. Remember you can always re-buy. Also remember opportunity cost, holding that dog has a cost.

Buy with a margin of safety. Buy at a discount. Pay less than what you believe the company is worth, lots less! Think mega closing down sale. If you’re buying with a wide margin of safety, i.e. the price is a lot less than value, then it doesn’t matter if your valuations skills are weak. The discount helps hide your valuation errors. For example, I value Woolworths at $32. I think an appropriate discount for a large cap stable company is 30% so I’d buy in the $22.50 range. Yes I’ll miss out on buying a lot of companies only to see the price go higher, but as I’ll cover next, that’s a good thing.

Avoid the need to trade. Most new investors want to buy and buy and then buy some more. Don’t do it! Use Buffett’s 20 punch-hole analogy, i.e. treat each purchase as one of the only 20 buys you’ll make in my life. While we’ll all buy more than 20, thinking that way focuses the mind and can stop the urge to buy.

Avoid chasing shares. Capital is scarce opportunities are plentiful.

Investing is a marathon not a sprint. I don’t care what the price of MTU is today, unless it is above my sell point or below my current buy point (not my original buy price). I care what it will be next year and the potential it has after that. At 42 I hope to be investing for another forty years. With that in mind the price wiggles become meaningless.

Salina’s message also demonstrates why technical support and resistance lines work. Investors are obsessed with not losing money. Once a share rises back to where there was previously large volume then there’s a lot of investors relieved to get out. The price then falls due to the increased sellers, hence resistance.

Back to Salina

Her first mistake was buying with no idea of the value of MTU. She then bought with no margin of safety. Thirdly she focused on the price wiggles rather than the fundamental story. That played havoc with her emotions and while I hope she didn’t sell, she would be typical of those who did sell at below $1.40 in mid December.

If I was to make a recommendation, which I don’t, I’d say read MTU’s 2009 annual report, do a rough valuation and then decide if it is one of your best current opportunities. If not sell. If that seems too hard, then sell and buy an index fund.

Investing in individual shares is a lot harder than most people think. I’ve been doing it for over twenty years and am only now getting comfortably with my decisions, granted I’m a slow learner.

A regular commentator, Sean, posted the following comment. You can read his full comment here, it’s comment three.

stockval is interesting but after a brief trial, I’m not sure it adds much to Morningstar/huntley. Thanks for the link though! Valuecruncher, although less user friendly is free.

For $300, Morningstar/ Huntley is great value for money. Try out the trial if you haven’t.
http://www.morningstar.com.au/ [I'll give it a trial during my mid year break.]

Eureka report is ok for a read but I’ve made very little money on any of the ideas or information from it. I like Alan Kohler though, he’s entertaining.

About the only thing I find worth reading in AFR is Bassanese. I pretty much buy the weekend AFR, read his column and throw the rest out. I found out he has a site on investing/trading ETF’s :  http://www.pennywiseinvestment.com.au/webpages/1_home.php

Which is basically my philosophy except that I trade a bit more. I’ve signed on for the trial subscription but I’m not sure it’s worth the $300 per year.

Out of the sites I’d rate (out of 10):

• Morningstar/Huntly 9/10
• Your site 8/10 (love your site, keep it up!)
• Bassanese 7/10
• Eureka/business speculator report 6/10
• AFR 5/10

Since being taken over by Morningstar, huntley doesn’t do small companies as much.

I must buy Sean a beer someday to thank him for the encouraging feedback and worthwhile comments.

I have subscribed to dozens of investment newsletters and sites over the years and used to read newspapers. What follows are my opinions based on past experience, the publications mentioned may have changed since I subscribed.

Traditional Media

• Newspapers 1/10. I gave up reading newspaper about fifteen years ago. Mind numbing garbage written by journalists can not provide an edge. As Sean said there are some good journalists, but I don’t wish to waste time sorting the wheat from the chaff. Journalists are paid to comments on the noise. I prefer to concentrate on the bigger picture, the signals. Consume for entertainment purposes only.
• Television news and finance shows 1/10. A worse time waster than papers. The talking heads may occasionally be entertaining but they’ll rot your brain and blunt any edge you may have. Avoid.

Before I go on I should point out I’m like an empty vessel filled by those around me. Hence why I avoid newspapers and television news. If you have stronger filters than me and plenty of time to waste consuming noise, then suck up as much as you want.

Newsletters

I’ve subscribed to a score or more over the years. I always considered newsletters to be like employing cheap analysts and treated them as a source of good ideas. For me the best newsletters are the ones which teach their subscribers along the way.

• The hands down winner based on that criteria are The Motley Fool newsletters. Unfortunately, over recent years, the Brothers Gardner have eviscerated their value by upping the price of their newer services and spreading themselves to thin. However, there remains great value in many of their newsletters and the associated forums are excellent adjuncts. 9/10 for TMF newsletters under $300.
  

• Eureka Report. I enjoyed a two month free of the eureka report last year. They were the first site I offered free advertising is exchange for a subscription. Alan Kohler said no. I particularly enjoyed reading Roger Montgomery’s articles. If you’re a resources investor then Eureka’s resource columnist, David Haselhurst, has an excellent track record. 7/10 (gets two bonus points for a reasonable price.)

• Intelligent Investor. Good educational material. Reasonable ideas. Unfortunately they take too many savaging from too many dogs for my liking, ROC Oil and GTP TREES spring to mind. They need to focus more on Buffett’s rules one and two; Never Loose Money. A focus on quality not quantity would help them. Good content, but at $545 it’s overpriced. 5/10

• Complete Growth Investor. Excellent value, good ideas, very educational. Was 10/10 prior to Jeff Fischer defecting back to the TMF. 8/10

• ChangeWave. Fantastic idea to entice an army of coal face professionals to give their views on the state of their industries and then try and synthesis that into investment ideas. Unfortunately something is lost in translation. Toby and co talk up their successes and sweep their failures under the mat, sometimes even for the same stock, Sirius Radio is a great example of that. Many subscribers took a bath on Sirius, but all you ever hear from ChangeWave is how one of their calls on the stock worked out.  Low on education high on marketing hyperbole. 2/10

The main problem with newsletters is that only a lucky minority of subscribers ever outperform the newsletter. Newsletters influence market prices, some dramatically so; therefore, subscribers will on average buy higher and sell lower. Another influential factor is subscriber biases resulting in a pick ‘n’ mix approach by subscribers. Investment returns are often skewed by one or two excellent performers. Subscribers have poor odds of picking the winners amongst the dozens of suggestions.

That’s enough opinions from me for one day. I’d love to hear about your experiences with different newsletters and investment services.

“With small companies, you’re better off to wait until they turn a profit before you invest.” Peter Lynch – 20 Golden Rules

Excellent advice that.

I’m breaking it with Catch the Wind,  breaking it in a big way. CTW doesn’t even have sales! Let alone profits. Even if sales eventuate, profits are an entirely different matter. The list of tech companies with hundreds of millions in sales who still can’t crack a consistent profit is long. Heck software companies can have 70% gross margins and still struggle to turn a consistent profit. Investing without profits is playing with fire.

For the time challenged here’s a summary of Lynch’s 20 Golden Rules. Though I encourage everyone to read the rules in full and if you haven’t read Lynch in the last five years then it is probably time to do so.

I enjoy and profit from distilled wisdom like these rules, but profiting from them requires more than simply reading the list. It is important to fold the rules into your investment strategy or clearly articulate why you’re not. Can you add some of these rules to your investing checklist? Think about each rule and whether you regularly apply it and if not why not. Like all rules they are made to be broken, but before you break a rule it is essential to understand it.

• Invest in companies or industries you already understand
• Ignore the herd
• The disparity between price and value is the key to success, be patient and own successful companies.
• Know the company and why you own it.
• long shots almost always miss the mark.
• The part time stock picker probably has time to follow 8-12 companies and five is sufficient.
• If you can’t find any companies that you think are attractive, put your money in the bank.
• Never invest in a company without understanding its finances.
• Avoid hot stocks in hot companies.
• If you invest $1000 in a stock, all you can lose is $1000, but you stand to gain $10000 or even $50000 over the time you’re patient. You need to find few good stocks to make a lifetime of investing worthwhile.
• In every industry and every region, the observant amateur can find great growth companies long before the professionals have discovered them.
• Stock-market declines are routine. If you’re prepared , it can’t hurt you . A decline is a great opportunity to pick up the bargains left behind by investors who are feeling the storm in panic.
• Investing is more about your stomach than your brain. If you are susceptible of selling everything in a panic, you ought to avoid stocks and stock mutual fund altogether.
• There is always something to worry about. Avoid weekend thinking and ignore the latest dire predictions of newscasters. Sell a stock because the company’s fundamentals deteriorate, not because the sky is falling.
• Dismiss all predictions and forecasts and concentrate on what‘s actually happening to the companies in which you’ve invested.
• If you study 10 companies, you will find 1 for which the story is better than expected. If you study 50, you’ll find 5 . There are always pleasant surprises to be found in the stock market companies whose achievements are being overlooked on Wall Street.
• If you don’t study any companies you have the same chance of success buying stocks as you do in a poker game if you bet without looking at your cards.
• Time is on your side when you own shares of superior companies. You can afford to be patient –even if you are missed Wal- Mart in the first 5 years, it was a great stock to own in the next 5 years.
• In the long run, a portfolio of well chosen stocks will always outperform a portfolio of bonds or a money market account. In the long run, a portfolio of poorly chosen stocks won’t outperform the money left under the mattress.

Concentrate to accumulate, diversify to protect.
When you diversify do it via a broad index or specific individuals, who through careful analysis you judge to be extremely competent and capable of significantly* outperforming the index.

Remember that indices are not static beasts, they are actively managed funds of the leading companies. Failing or at least flailing companies are cut from the list while successful and growing companies are added. That’s a difficult investment strategy to best, especially when actively managed fund’s fees are going to be meaningfully higher.

• Concentration means 2-20 positions. Small business people can put all their eggs in one basket, the rest of would be foolish to do so.
• Significantly is greater than 3%. As you’ll loose around 1% in fees compared to an index fund or ETF and you want at least 2% return for taking the individual risk.

Index Funds and ETFs in Australia

There are two main choices, though others do exist:

1. Vanguard Index Australian Shares Fund charges a management fee of 0.75% p.a. for the first $50,000, then 0.50% p.a. for the next $50,000 and 0.35% p.a. for the balance over $100,000. There is also a spread of .2% on purchase and .1% on withdrawal.
2. State Street Spiders ETFs on the top 50 or top 200. Management costs are 0.286% and there will be the bid/ask spread.

Index funds and ETFs are the most suitable choice for investors who do not have the time or interest for investing, but desire exposure to a particular asset. I wrote more about investing in Australia here and its related posts.

I’m still working on reducing the number of US equities we hold. I forget the peak, maybe 46. We’re down to 30 now, with three more on the chopping block followed by five more waiting a final thumbs up or down. Pfizer is our largest position.

My son has embraced his creative powers, this image is from his Gorillaz Demon Days concept series. He drew a picture for each song on the CD.