Everyone knows Buffett’s rules number one and two, never loss money and don’t forget rule number one. They’re great rules and if we could apply more patience in our investing and weave in as many complementary rules like capital is scarce opportunities are plentiful then maybe we wouldn’t suffer many losses. My reality is that I incur losses and the same is probably true for you.

So how much profit does it take to recover from a loss? The following chart highlights conventional wisdom. The greater the loss the ever greater the gain required to make you whole again. For example a 10% loss only requires an 11%, a 50% loss requires a 100% gain and a 90% loss requires a massive 900% to make you whole again.

Scary stuff isn’t it? 10 baggers don’t come along very often.

As I said that is the conventional wisdom and one that is often used to promulgate stop losses and small position sizing opinions. I say the conventional wisdom is bollocks. It takes exactly the same percentage gain to make up for a loss. If you loss 10% it takes a 10% gain to make you whole. If you loss 90% it takes a 90% gain to make you whole.

Why conventional wisdom is wrong

Conventional wisdom is based on serial betting an entire stake. If you make serial bets (one after the other) of your entire stake then it does indeed take a 100% gain to make up for a 50% loss. Do you make serial bets of your entire stake? I doubt it. If like me you have a portfolio of stocks then you’re making parallel investments. If one investment losses 10% you are made whole by another similar sized investment gaining 10%. You never invest your entire stake in one stock, you spread your investment over many stocks.

Pull the weeds and water the flowers. Peter Lynch’s phrase was so good that Warren Buffett asked if he could use it in his annual report. While you may make a 100% loss on an initial investment, I know I have a few times, hopefully you’ll have headed Lynch’s advice and added to your winners. So your wins are magnified as they have more capital invested in them.

I’m not trying to encourage you forsake patience or forget the all important rule of never loss money, just realise that when viewed from the perspective of a portfolio some conventional wisdom is not so wise after all. Mental stop losses also make a lot sense in some cases and are almost essential for traders.

Long term investors, especially those investing in special situations, growth stocks or any other companies where major losses are a possibility should view their investments within the framework of a portfolio and cut their losers and let their winers run.

I’ll conclude with one of Peter Lynch’s 20 Golden Rules:

If you invest $1,000 in a stock, all you can lose is $1,000, but you stand to gain $10,000 or even $50,000 over the time you’re patient. You need to find few good stocks to make a lifetime of investing worthwhile.

If you want to read more then this post on position sizing is in a similar vein.

ValueHuntr has generously posted a 96 page pdf compilation of 40 papers originally written by Benjamin Graham into an easy-to-read book format. If you’re interested in long term investing and value investing then ValueHuntr’s compilation is a real treat.
Here are a few excerpts I enjoyed.

[On Efficient Markets:] I deny emphatically that because the market has all the information it needs to establish a correct price the prices it actually registers are in fact correct. … Descartes summed up the matter more than three centuries ago, when he wrote in his “Discours de la Methode”: “Ce n’est pas assez d’avoir l’esprit bon, mais le principal est de l’appiquer bien.” In English: “It is not enough to have a good intelligence”—and I add, “enough information” — “the principal thing is to apply it well.” … any security analyst worth his salt should be able to make up an attractive portfolio out of this “universe.” [NYSE stocks]

[On Beta:] What bothers me is that authorities now equate the Beta idea with the concept of “risk”. Price variability yes; risk no. Real investment risk is measured not by the percent that a stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earning power through economic changes or deterioration in management.

Do those things as an analyst that you know you can do well, and only those things. If you can really beat the market by charts, by astrology, or by some rare and valuable gift of your own, then that’s the row you should hoe. If you’re really good at picking the stocks most likely to succeed in the next twelve months, base your work on the endeavor. If you can foretell the next important development in the economy, or in the technology, or in consumers’ preferences, and gauge its consequences for various equity values, then concentrate on that particular activity. But in each case you must prove to yourself by honest, no-bluffing self-examination, and by continuous testing of performance, that you have what it takes to produce worthwhile results.

I ran a screen today looking for companies with good ROE and forward earnings growth. Here are the results. I searched for 20% average two year earnings growth and ROE above 20%. The next step is to see if any of them are undervalued.

Disclosure: Long MTU

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

M2 Telecommunications (MTU.AX) delivered strong results across their businesses in 2009-2010. With underlying EPS up 72% to 16.7cents on the back of the People Telecom acquisition and organic growth. 2011 forecasts were strong with underlying EPS targeted in the 20.7-22c range.

With the current price of $1.80 you’re buying earnings growth of 28% for a P/E multiple of 8.4, which is an appropriate multiple for a no-growth company. In others words, current buyers are getting all M2′s growth for free. Alternatively the market believes M2 is not going to grow in the future despite their excellent management, strong history of growth and strong position in the changing telecommunications market. I think the market is wrong, YMMV.

The final dividend is 5c bringing the combined 2010 dividend to 10c, an 82% rise on 2009. That represents a fully franked yield of 5.6%. As M2 has a stated 70% payout ratio the forward dividend yield is 8.3%, based on their eps and payout guidance.

A Quick Look Behind the Numbers

Return on equity is increasing pushed by many financial commentators as “the number”. I don’t believe any single number adequately captures a companies value.  Even a justifiably good albeit problematic number like ROE is better viewed as the sum/product of its parts. While most of my readers probably know the constituents of ROE, I’ll go through it with M2′s numbers so everyone can get some benefit.

ROE is easily calculated by dividing profit by average equity, hence return on equity. However, that is not what I mean by constituent parts. ROE is more meaningfully viewed as the product of  profit margin times asset turnover time financial leverage. The first two items, profit margin and asset turnover give you return on assets (ROA).

Let’s run through the key numbers you need for M2, in thousands.

From those four figure we can calculate

The product of those constituent parts give an ROA of 10% and ROE of 21%. Once you’ve got those ratios you can look for trends over time and use them for comparison to similar companies. That’s when the numbers actually become useful. In M2′s case the profit margin and asset turnover increased while financial leverage decreased (2009 figures respectively 3.64%, 1.43 and 2.92 giving an ROA of 5% and ROE of 15%). From that we can hazard a guess that management are improving the business while simultaneously reducing the risk, which is what I like to see.

Interest coverage, current ratio and the acid test are three liquidity ratios worth keeping an eye on.

To calculate those we need a few more numbers

• EBIT 26,411
• Interest 2,244
• Current Assets 78,466
• Current Liabilities 66,473
• Inventory 338

To give us

• Interest coverage: EBIT/Interest is 11.8, which means M2 earns over 11 times the amount they need to cover interest.
• Current ratio: Current assets/current liabilities is 1.18, which means M2′s assets which should convert to cash within the next year can cover their liabilities due within the next year.
• Quick ratio:  (Current assets – liabilities)/current liabilities is not really required for a company like M2 with low inventories, as it is almost the same as the current ratio. The quick ratio is generally more useful for companies that sell stuff, as that stuff (inventory) is less further away from being converted to cash and in the event of distress is likely to be heavily reduced.

Click to Enlarge

Related Documents

• M2 2010 Investor Presentation
• M2 2010 Earnings Press Release
• M2 2010 Annual Report
• Vaughn Bowen discusses 2010 results on BRR

Disclosure: Long MTU

First let me say I don’t have the answers, but I’m confident I will have someday. I feel a quick recap of my investing past is worthwhile for the sake of this post. For almost score years I was a growth investor. Sometime during the naughties I was bitten by the value bug, perhaps it was after reading David Dreman. I then tried to fold value into my growth investing. I’m still trying.  This post continues my retrospection on what has and hasn’t worked.

Here are a few of my guiding principles applicable to investing.

1. There is no black and white.
2. There is almost never certainty and most people who are certain normally have faith rather than certainty.
3. Mistakes are in a way considerably more valuable than successes.
4. Keep it simple.
5. Happiness, enjoyment and play old fun are among the numerous things more important than money.

You may disagree with one or all of those, it would be a boring world if we all agreed. That is not a definitive list, they are simply the first five principles that popped into my head. The numbers are meaningless, except that it makes it easier to refer back to them.

Before I continue, the above picture is by my six year old daughter. She discovered Paint last week and has been producing art at pace every since. The other day when she was having a problem applying a colour she sheepishly came to me to confess that she’d used up all the blue on my computer and could I get some more. It seems she does not yet have a mental divide between the physical and digital worlds.

Where was I? Principles. I find balancing number four with one and two is incredibly difficult. It would be simpler to adopt one approach than to try and fuse multiple approaches. Fortunately number five comes to the rescue, I enjoy the challenge and find investing a lot more fun trying to forge my own path rather than following a clearly sign posted road. My aim is to achieve fusion and make it simple.

Investing successes are wonderful, but it is my mistakes I find more instructive. With that in mind let’s dig into Netflix. I’ve invested successfully in Netflix a few times, most notably for a double from June 07 to Feb 09, when I parted ways for a price around $40. Fourteen months on Netlix (NFLX) closed last night at $100. With patience my 100% gain could have been a 400% gain. So why did I sell? I think my mistake was applying value thinking to a growth stock during the sell decision. I’ll say that again, applying value techniques to when to sell a growth stock is a mistake.

I believe momentum works, i.e. stocks which have outperformed over the last period (various definitions of period exist, but let’s say 6-12 months) are likely to outperform gong forward. However, most of the same studies show that longer term outperformance generally results in future underperformance, i.e. eventually companies revert to the mean. I knew the Netflix story well and it’s growth was reasonably certain as it had successfully fought of all challenges and most importantly the CEO has the same fist name as my son, Reed. So why did I sell? As I said in Jan 2009 “It is now essential to value the company and trim or sell if NXLX becomes overvalued.” Wrong, wrong, wrong. David Gardner at TMF patiently tried to guide me back to the growth path when I made sell calls on growth companies based solely on valuation. David loves it when analysts call stocks overvalued and I now finally realise why. Growth stocks are not about valuation, they are about the story.

Good times to sell growth stocks include when the story changes and when they reach the inevitable upper part of their sigmoid curve, when growth slows and the company begins to reverts the mean. Bad times include when the current ratios and valuation point to an overvalued company.

So where does value fit in? The buy decision. The greatest outperformance can be achieved by buying growth stocks using a value framework.  Put simply, aim to buy growth stocks when they’re cheap. That does not only restrict you to buying them early on in their growth, all growth stocks become cheap at various points along their growth cycle. That point is brilliantly illustrated by Bruce Greenwald in in Value Investing From Graham to Buffett and Beyond using Intel. It’s a fantastic book for experienced investors.

In summary, I’m going to use value to buy growth stocks and momentum to sell.  Congratulation to all Netflix longs who have remained invested  since 2007 or before.

[Update: Catching up on some discussion board reading this afternoon and I came across this comment. “Amazon is a great consumer business. Netflix is a great consumer business. Vistaprint is a great consumer business. Chipotle Mexican Grill is a great consumer business. Apple is a great consumer business. Blue Nile is a good consumer business. There have been numerous short write-ups on all of them — all based on valuation, many of which were 100, 200% and 300% ago.

My only opinion, never go short a basket of great consumer oriented businesses based on valuation arguments unless you want to get fried or have tight stop prices in place (did I really say that? Huh).” DRWHISKEY Deranged Monkey Criticism

The following article was generously contributed by a regular reader and commenter. I hope you enjoy reading West Wind’s journey as much as I did. He raises some interesting questions those considering retirement should consider.

Before starting, let me make it clear that I am not an Accountant or a Financial Adviser. This is just a tale of how one individual managed the transition from everyday share punter to contented self-funded retiree. For more intricate detail, seek professional advice.

Having started investing in shares during my student days, my early experience was listening to tips and reading newspaper articles and occasionally accepting broker advice. This was OK whilst the market was bubbling along with an upwards trend. The common call was “speculate to accumulate”. There was never any thought of dividends. In the 70s this seemed to work. There was profit taking for a car and later a house deposit (pre capital gains tax!).

Later came marriage and kids and associated responsibilities. A couple of significant dips in the market saw some of the exuberance go out of the investment behaviour. I became a bit more interested in what the companies did and who ran the company. I also started reading investment newsletters (Huntley, Intelligent Investor, Marcus Padley). Further on there were some short courses in understanding financial statements. So in my 30s and 40s there was a shift to doing my own research. The emphasis was still on capital gains, as I tried to select companies that were either just emerging as profit producers or were companies that had done something wrong and were fighting their way back. The indicator of success was when they started to pay a dividend, and the price rose – but then they were sold to move on to the next prospect. Capital gains tax was an issue that had to be kept an eye on, as I was inclined to fully reinvest all the profits then be scrambling to pay the taxman when the end of the financial year rolled around.

This process worked pretty well. Instead of having a large number of companies and frequent trades, I limited myself to 3-4 at a time and usually held them for 2-3 years. Stock picking is a great leveller. You have some successes but you also have your losses. Typically out of say 3 selections, I would get one where you might lose 50%, one that earns 50%, but also one that is a 5-10 bagger. If one of my selections started to develop as predicted, I would buy more. I always had a figure in mind of what I thought it was worth. This would change as more information became available, so my valuations might have increased 3 or 4 times during the holding period.

But I am getting away from the topic. When I reached my 50s, I was coming to the conclusion that I would like to manage my own super in retirement. I thus started a Self Managed Superannuation Fund. I also had an employer/industrial super fund running in parallel, to which I contributed all my working life. Upon retirement this was transferred into the SMSF

I also had to think about what will I live off and how much will it be. Questions arose like how much capital will I have, will I draw down the capital, or will I preserve it and live off the dividends. If you choose the former, there is always the risk that you will outlive your savings. If you choose the latter, you need to structure your investments appropriately.

On this basis, I now had to transfer my private investments into the SMSF. This brings on a whole new bout of managing capital gains taxes. One of the very few advantages of the GFC was that share prices were depressed and capital gains were substantially reduced. Mr Costello also provided a window of opportunity for transferring substantial amounts into Super Funds. Hopefully the GFC is behind us, but the Federal Government is now tightening the ability to transfer funds into Superannuation. Both these factors reinforce the need to have a strategy to transfer personal assets from outside the Superannuation environment, into Superannuation. In terms of minimising capital gains, you need time. In fact you also need good accounting advice, because by the time you pay capital gains tax and Superannuation contributions tax, it may not be worth the exercise of transferring the funds into super. You need to sort this out well before retiring.

You also need to consider wether you have the right investments in your portfolio. If you choose as I did to preserve capital and live on dividends, you need to develop a dividend stream that will provide you with your needs. If you don’t, you will find that upon retirement, your regular salary has ceased but you have a less than desirable income stream. Hence, in the process of transferring assets you might also consider changing the type of investments

So, presuming you can get all your realigned investment assets into the super area, once you elect to move from the accumulation phase to the pension phase, the benefits are substantial. These include no income tax, no capital gains tax, and full reimbursement of dividend franking credits.

Initially on starting to develop my portfolio within the SMSF, I stuck with the conventional wisdom. This is my family’s life savings, my wife and I have to live off the income and it should be invested in blue chip, dividend paying shares. This included the banks, infrastructure trusts and large insurance companies. However, with the GFC, not only share values, but dividends also took a hit. I had to decide to accept a 20-40% decrease in dividends or try to do something about it. So I decided to move away from the original SMSF philosophy of diversification and revert back to the selective stock picking. That is, I have picked up on Dean’s theme, “concentrate to accumulate”. I now look for businesses that I think are in a growth area, have low debt, are well managed and are paying, or within 12 months of paying, a franked dividend. Ideally the dividend should be greater than 5%.The investment horizon is nominally 2-3 years – unless they severely disappoint. If they continue to grow they may be held longer. Instead of holding 20 stocks, I am down to 14 and still looking to reduce.

I sometimes ask myself, have I raised the risk profile? I probably have, in that the shares we now hold tend to be smaller companies and they will be harder to sell in a falling market. However, the shares have been bought for the longer term and pay a better dividend. Provided the dividend stream works essentially to plan, I feel the risk-reward relationship is acceptable.

How has the SMSF performed? After losing 44% of capital value in 2008, we gained 98% in 2009 so we are 9% above where we were at the end of 2007. However, the more important issue is dividends. In terms of the dividend stream, it averages about 6% of the market value, which is more like 8.5% when we get the franking credit cheque from the taxman. In terms of annual performance (I add the dividends, franking credits and capital returns each reporting period to keep it simple) it grew 16% in 2008 and 28% in 2009.

So the conclusion I make is if in your SMSF you wisely (and can) choose to not live off your capital, start thinking about dividends, and what makes a good dividend paying company. Start to include these companies in your portfolio as you approach retirement so you can start this enjoyable part of your life without a discontinuity of cash flow – and if you feel a bit depressed about approaching retirement, don’t be, because you are not really retiring, you will just have more time to think about your investing!