Chroma Investing » Beginning Investor

Beginning Value Investor Terms – Exchange Traded Fund (ETF)

chroma — Sun, 07 Aug 2011 02:55:30 +0000

Although this site is largely geared toward individual stocks, it seems to me, to better serve the beginning investors I need to address the more passive investment strategies that may be attractive to individual investors without much time on their hands to investigate individual companies but want to understand their investments.

ETF Defined

An Exchange Traded Fund (ETF) is similar to a mutual fund, but has similarities to purchasing stocks. The SEC says that ETF’s are “investment companies that are legally classified as open-end companies or Unit investment Trusts (UITs).” An open-ended investment company is one of the three primary groups of companies as described by the SEC. Unlike a close-end investment company, an open-end investment company can offer to buy back its shares from the investors.

A normal mutual fund is a pooled investment where the money from thousands of investors are joined together and invested in whatever the focus of a mutual fund is, such as equities, bonds or commodities. Conversely, a common stock is traded on a stock exchange. An exchange traded fund tracks a stock index, a commodity or pool of stocks, but is also traded on a stock exchange like a stock; the price variations occurring as people buy and sell the fund over the day.

ETF – Good Value Investing Tool

ETF’s are very popular with value investors since they often have tax advantaged status. That is you don’t pay on the capital gains with the ETF only when you sell your investment. In the current law if you sell after one year that means long term capital gains which as of this writing is only 15%. Another reason ETF’s should be popular amongst the value investing crowd is that unlike mutual funds Exchange Traded Funds can trade at the same price as a stock Trade. Both TradeKing and Zecco charge $4.95 for an ETF trade the same as an individual stock.

ETF the Nitty Gritty

An ETF often represents a set of stocks. For example the SPDR 500, the oldest ETF follows the Standard & Poor’s 500 Index, which is an index of the 500 largest companies in the US. ETF’s portfolio would not change over the course of their lifetime and that means that investors are aware what they are investing into. If an ETF says that it is investing in energy stocks, then it is investing in energy stocks.

An ETF’s price is determined by their daily trade volume which is not the case with other funds. Because of the inherent benefits of Exchange Traded Fund, they are widely used as a preferred mode of trading across the globe with more than a few hundred Billion dollars having been invested in various funds across hundreds of indices.

ETFs do not sell individual shares to investors like Mutual Funds., large blocks of shares known as creation units are issued. The creation units are not purchased by the investors in cash, rather they are purchased in the form of a portfolio of shares which would represent the portfolio of the ETF. Investors after purchasing the creation units can either sell the shares in the secondary market or sell them back to the Exchange traded fund.

Another difference between a Mutual Fund and an ETF is that Mutual Funds have their Net Asset Values computed at the end of a trading day based upon the values of their holdings; they constantly trade in the market to reflect a better price. However Exchange Traded Fund gets their prices determined by the push and pull of the market since they follow a fixed basket of stocks.

Mutual Funds – Beginning Value Investor Terms

chroma — Sun, 31 Jul 2011 05:14:00 +0000

Mutual Funds are investment vehicles that are designed for people who do not want to spend a lot of time researching individual stocks, bonds or other assets, but still want part of their portfolio investment in these markets. It is not quite so simple as you will see. Your money is pooled with that of other sheep, er, investors, then stocks, bonds, or whatever is the focus of the mutual fund are purchased. These purchased assets make up the portfolio of the mutual fund. The money you invest in a mutual fund are shares of the fund.

The mechanics of investing in a mutual can be simple. Say you decide on particular mutual fund, you sign onto your online brokerage account and purchase. Oh wait. This is where the not so simple part comes. There a couple of type of Mutual Funds. The first and most important is what is called a No-load Mutual Fund. Load stands for Load of crap or commissions. A No-Load Mutual Fund doesn’t charge commissions. There is no advantage to loaded Mutual Funds (pun intended). The take can be as high 5% or in the case of a level load fund, be an ongoing tax on your returns. There is no advantage to paying the commission in terms of investment returns, since mutual funds with loads don’t outperform no load funds as a group over time.

Mutual funds are like stock investments in that they are not guaranteed to hold their value by any governmental agency like the FDIC does for bank accounts.

I use the word sheep earlier to describe investors in mutual funds. That is not quite fair. Warren Buffett has famously said that for an investor who does not have the time understand equities investments a good index fund is a good place to invest your money. The problem is that the majority of index funds under-perform the market over time. Even when a mutual fund out performs the general market, most individual investors still do worse than the market as a whole. They tend to buy right after a manager has had a great year or two and sell when the manager has had a bad year or two. In other words they buy at the top and sell at the bottom. In general, you can expect to under-perform the market by the amount of fees and expenses the mutual fund charges. This varies. Zecco, one of the discount online brokers I use, charges $10 for a no-load mutual fund purchased on line. TradeKing charges $9.95, this compares to $4.95 for a stock trade.

And don’t forget the tax ramifications. If you buy an active fund, every time they sell for a gain (assuming the holding period is less than a year) the fund will pass along the capital gains to you. This takes away the control of when you want to have capital gains or losses. This may be fine with you. It isn’t for me. If you are interested in someone else managing your money.

What are your Investing Goals?

chroma — Wed, 13 Jul 2011 03:34:29 +0000

We all have investing goals, but they can differ in substantial ways depending on when we are investing, how much capital we start with or add to our investments. It is important to determine our investing goals and write them down. O.k. you don’t have to write them down if you don’t want to, but the act of writing them down will force you to think about what direction you want to head.

In many ways you must start with life goals to evaluate your investment goals. What kind of life do you want to lead? Are you an alternative lifestyle enthusiast or buttoned down American Dreamer? There is no right answer. But start with who you are and what you want out of life before turning to your investing goals.

IF you are young, the most important thing you can have as your goal is to set aside some money to invest for the future. You may be interested in capital appreciation. The principle of compounding can often do more than the work of a good fund manager over the long haul. If you are older, you may be more concerned with capital preservation. You don’t want to lose a third of your nest egg if another down turn comes if retirement is on your horizon.

Depending on your life style, you may need to factor in other investing ideas. If you believe, that over the long term the US dollar will lose value vs a large number of other currencies either through inflation, or defacto currency devaluation, you should also consider what this means if you part of your future goals is international travel. How will that effect your investing. There are a lot of what if’s. If we spend all our time trying to make a killing we will miss achieving our real goals, which may, on reflection be easier to achieve that we originally considered.

This is a post without answers, because only you can decide what you want. Please share either some life goals and how investing will help, or investing goals and why they are important?

Save $1400 Learning about Value Investing

chroma — Wed, 09 Mar 2011 02:40:29 +0000

One of the ways you develop an edge is continuing to refine your investing chops. One of the best ways, apart from reading this blog, is to learn from masters, investors who have the skill and experience to help you develop insight into the process of value investing.

What if I told you could do just that on May 3rd and 4th. Would you be interested in saving nearly 32%? If you act by March 15th you save $1400 off the full price for the Value Investing Congress. I am cheap. That is part of why I am a value investor. I don’t want to pay full price for my stocks, and I certainly don’t want to pay full price to learn to be a better investor. Here are some of the fund managers/gurus who have spoken at one of the seminars just in the last two years, Bill Ackman, Monish Pabrai, David Einhorn, Bruce Berkowitz, Paul Sonkin, Eric Sprott, Joel Greenblatt and Whitney Tilson. Most of the biggest names are added to the speakers list after the price goes up and the discount I am sharing with you ends.

I have written about the Value Investing Congress previously here, and here and linked to it here. I did so because I believe that the right kind of information is power. Not all information, mind you. Too much information can be crippling. Just ask anyone who is coming off a five hour binge of internet. In the past I did not benefit from the recommendations, nor could you. However, now I am able to offer my readers a special deal to the Value Investing Congress. To save $1400 you can click on the link or the banner ad.

As always here are my caveats. If you are just starting out and have a very small amount of money, say $2500, this is not the event for you. You will consume too much capital going to the event and not retain enough to actually invest. This is also not an event if you already think you know everything about value investing. But If you think you are the latter, you might want to consider that you are failing the hubris test and read a book on behavorial finance.

Finally, if you will be attending the Value Investing Congress please let me know. I would like to have a meet up, perhaps after the 2nd day for drinks. I would like to try to link up with other value investors as well. Email me at chroma@chromainvesting.com if you are interested.

If you would like more information about this Value Investing Conference, or any other, please go to my Conference page which has the most up to date information on Value Investing Conferences.

Disclosures: I am a media sponsor of the Value Investing Congress.

Real Returns are the only Returns that Matter

chroma — Mon, 28 Feb 2011 01:28:35 +0000

Recently, I was at the Motley Fool website. I use their CAPS as one the sources for common knowledge, like Yahoo finance message board. But that is another post. I like their breezy style and subscribe to their Hidden Gems service. I decided to check out how they compare their returns to their benchmarks. To me, no one would bother comparing to a bench mark unless you are thinking seriously of buying an index fund. And, if, over time you discover your returns are not as good as that, then you should buy an index fund and save yourself the effort. But most investment services, newsletters do compare themselves to some benchmark like the S & P 500.

I have long maintained that the only return that matters is total return. What this means is, simply, if I have an investment account of $10,000, at the end of the year how much did I make on that $10,000. I mean how much did I really make. That means I have dedcut commissions and fees. It doesn’t matter if I had 80% cash the whole year or whether I was fully invested., It doesn’t matter whether I made all my gains from dividends or capital gains after taxes, it only matters how I am able to profit from all capital I have at my disposal in a real way then compare that to inflation. Since we have been in a low inflation lately the last has been much less important. Although I expect to be MUCH more important in their near future.

Back to Motley Fool. I have posted their service returns list for today below. At the bottom you will see a little note called “How Performance is calculated”, that I am convinced very few people actually read. I have included the unabridged text at the end of this posting, in case you would like to peruse it further. I will admit that I may have misunderstood something in their disclaimer. And if someone from the Fool sends me an email or comment, I will correct whatever error I have made in the body of my post. My goal is to be accurate.

Motley Fool Returns 2-27-11

Here is what I take away from the Fool disclosure:

1) Currently the Fool changes how they calculate their returns, depending on the service. That doesn’t make any sense. For example on the Rule Breakers service they exclude dividends from both the S & P 500 and their Rate of return calculation. For the Dividend Investor, unsurprisingly they includes Dividends for both. The Fool does say they are implementing a time weighted rate of return formula. All rates of return should be simple to understand, and reflect the total return of a portfolio for a specified period of time.

2) They don’t measure cash. “The total return is calculated using a time-weighted rate-of-return formula” after they use a simple rate of return for each individual stock, is how the Fool currently measure returns on their “Real Money” portfolios. This is overly complicated and inflates the returns since cash is not taken into account. The amount a portfolio has in cash is important to Total returns. Cash is an asset and in times of uncertainty, a great one to have in abundance. But having a large cash position will keep your returns down when the market is rising. For example in my 80-20 portfolio, I had only one stock traded in the last year. I made more than 50% on that investment, but my total return was only 5% because, I was in cash most of the year for the entire portfolio. It doesn’t matter how right you are if you are only right once a year, with a small portion of a portfolio.

3) Some of their services aren’t real money, only theoretical. There has been a lot of research showing that while some ideas work great in theory, once you begin investing, the returns are significantly lower. My 80-20 portfolio is real money, and used some good theory like the Piotrsoski F-score and discounted NCAV value as it’s basis. But cash doesn’t earn anything these days, so my theoretical returns were fantastic, but my real returns were worse than the S & P 500.

4) The Fool’s record isn’t great. Even if you buy that you must compare to a benchmark their services haven’t by and large done well. Of the nine services they list, four performed worse or the same as their benchmark. But two out of three of their real money portfolios are performing worse than the S & P 500. Remember my comment about indexing. Perhaps there should be some consideration of that at the Fool.

My purpose isn’t to pick on the Motley Fool. I haven’t canceled my Hidden Gems service even though it was one of the worst relative performers listed. Why? Because I don’t follow everything they say. Nor should you. The only suggestion of theirs I have followed I made nearly 50% on in less than six months.

My purpose is to make sure you have your eyes open. When talking about what the returns are on your portfolio make sure they are real, not theorectical and that they include the trade off from capital gains and dividends, trading costs and the cost holding a lot of cash.

The complete Text of the:

The Motley Fool Investment Return Calculations Disclosures

The Motley Fool is in the process of implementing time-weighted, annualized total return calculations for all of its services. Below are descriptions of the various methodologies that are currently being used by each service.

Real-Money Portfolios – Million Dollar Portfolio, Motley Fool Pro, Hidden Gems
The Motley Fool’s real money portfolios that are included in this table are Million Dollar Portfolio’s Charter Portfolio, Motley Fool Pro, and Hidden Gems’ real-money portfolio. The total return is calculated using a time-weighted rate-of-return formula. The returns of the individual stocks are calculated using a simple average, excluding dividends. Dividends are included for both the total portfolio return and the benchmark, the S&P 500 Total Return Index.

Stock Advisor
Total average returns are the average of all individual stock recommendations (active and sold) and the average of the S&P 500 Total Return Index, starting from the end of the day we make each recommendation. Both the stock and benchmark returns include reinvested dividends.

Rule Breakers
The total average return is calculated by taking an average of all the returns for the stock recommendations. When a stock is sold, returns for that stock are tracked through the sale date and on the S&P 500 going forward. Dividends are not included in the return calculation for the individual stocks, the total average return, or the benchmark, the S&P 500 (SPX).

Inside Value and Income Investor
The total average return is calculated by taking an average of all the returns for the stock recommendations currently on the scorecard. Dividends are included in the return calculation for the individual stocks, the total average return, and the benchmark, the S&P 500, as measured by the SPDR S&P 500 ETF (SPY), with closing prices adjusted for dividends.

Global Gains
The total average return is calculated by taking an average of all the returns for the stock recommendations currently on the scorecard. Dividends are not included in the return calculation for the individual stocks and the total average return. Dividends are included for the benchmark, the S&P 500, as measured by the SPDR S&P 500 ETF (SPY), with closing prices adjusted for dividends.

Motley Fool Options
The return calculation assumes that a cash investment of nearly equal size is made in each position recommended. In the case of option positions that are established with margin, a cash investment equal to 30% of the required buying power is made. The total performance is calculated using a time-weighted rate-of-return calculation. The stated return is calculated by averaging the returns of both co-Advisors. The returns of the individual recommendations are calculated using a simple average, excluding dividends. Dividends are included for both the total portfolio return and the benchmark, the S&P 500 Total Return Index.

Best Online Broker for Penny Stocks and the Small Value Investor

chroma — Tue, 16 Mar 2010 04:28:32 +0000

This is really the third in the series of Investing 101, the second of which discussed setting up a Small Investor Portfolio. But the title would have been too long if I left all that in. As value investors we are not just interested in value of our stocks but the process in which we invest.

The first order of business will be to find a good discount online broker. The good news is that a few of the big name brokers have lowered their fees or commissions recently, making them more competitive, and enlarging the pool of potential brokers. The bad news is that it is a cumbersome process to wade through all the detail of a broker’s website to discover if they have hidden fees or surcharges. I have created a comparison chart called Best Online Broker for Small Investors and Penny stocks, which you can download or see below. This is not a comprehensive list of all brokers. Any company with a commission of greater than $10/trade was eliminated.

In the spirit of Buffett, who is said to look at the risk of an investment first, I want to mention, briefly, the notion of capital risk because a brokerage companies goes bankrupt or pulls a Madoff. We all know that in a traditional bank account the Federal Deposit Insurance Corporation (FDIC) insures our accounts up to $250,000 per depositor, per bank. This is not a permanent state of affairs, and is set to reset to $100,000 per depositor per bank in 2014. As the FDIC says on their website, the “FDIC insurance is backed by the full faith and credit of the United States government. Since the FDIC began operation in 1934, no depositor has ever lost a penny of FDIC-insured deposits.” Of course, those in Nassim Taleb camp might argue, the FDIC does not make bank deposits risk free, but the guarantee does minimize the risk. The situation with securities is not quite as clear cut.

For stocks, the Securities Investor Protection Corporation (SIPC) is in charge. They have a brochure which you can download called SIPC English 2009. I suggest you read this or go to their website to truly understand what your capital risk is with regard to a broker failing. The high school student version of it is this: the SIPC doesn’t insure an investor against loss. This should be self evident. If you are investing in the stock market you know that you could lose your money, that you have an expectation of risk. The SIPC doesn’t help you avoid the risk. If your stocks decline in value, you will not get a check from the SIPC. But here is what the SIPC does say, “…(the) SIPC replaces missing stocks and other securities where it is possible to do so … even when the investments have increased in value.

SIPC does not cover individuals who are sold worthless stocks and other securities. SIPC helps individuals whose money, stocks and other securities are stolen by a broker or put at risk when a brokerage fails for other reasons.” The SIPC guarantees up to $500,000 per customer, including $100,000 in cash. But the broker MUST be a SIPC member for the investor to be protected. For the small investor we are covered for the time being. But this raises concerns for person’s nearing retirement with large IRA’s. The viability of a firm is vital. As with diversifing bank deposits with different banks to mitigate risk, this suggests that over the long term one should have more than one retirement account if possible and at different brokerage firms. This is a subject for a future post. As of this posting I have confirmed that all brokers listed are members of SIPC. Before you open an account you should check and ensure they still are.

Let me spell out my criteria for best online broker. This will differ, perhaps significantly, from other blogs or websites. What may be right for you, if you have a larger portfolio or if you eschew penny stocks, could look completely different. This is by no means a definitive list, but it should suffice for the Chroma Investing Small Investor Portfolio. You will note that I go into some detail here, because the brokers are quite adept at hiding some fees behind a cute little asterisk. Also, commissions and fees change often. I was surprised how different some companies are since last year at this time when I went through a similar process. My apologies in advance if I missed your favorite broker. Some I eliminated for price, others for minimum deposit requirements.

1) I looked primarily for value in stock trading commissions. The intention is to have little or no mutual funds, ETF’s or bonds traded in this portfolio. That does not mean they are not worth investing, simply that that is not the focus of this investing account. Consequently, factors that effect those type of investments have been ignored.

2) The total brokerage costs including commission & fees will need to be low, under $10/trade especially for Penny Stocks. There will need to be no or additional charges for buying penny or OTC stocks. There are lots of companies with value hiding in 99 cent store of investing, I would hate to miss them because my broker charged too much to trade them.

3) No inactivity or maintenance fees.

4) unlimited shares in a trade without additional fees. This is another way that brokers attempt to limit penny stock purchases. A stock trading at .25/share will require 4000 shares to invest $1000.

5) I will not include a comparison of margin account rates because I intend not to employ leverage of any kind. This means I will also not factor in options or contract prices.

6) I am assuming we will be placing all our orders online directly, with no broker assisted trades.

7) Since short term interest rates are effectively zero, I will not bother comparing interest rates, if any, that cash earns in a sweep account (although I may reconsider and update later, if this factor changes)

You may also want to include a No-IRA fee in your criteria. For the purposes of this blog I will not. But for me personally, in my IRA’s I include this as important screen to minimize expenses.

I will discuss size of positions in another post. But one of the tricks in investing with a small portfolio is not getting killed by the fees. If you expect to have a total of 3-4 positions in the portfolio, at least in the beginning, each $500 invested will have a 1% purchase fee with a $5.00 commission and 1% exit fee. The result is that you must make 2% just to break even. That is not an onerous hurdle. Let’s say we changed that to just $10/trade. Our total is then 4% to buy and sell a stock. That is, I think in the new normal era, perhaps too high a price to saddle yourself with. Of course, we have to balance commissions with other fees, particularly extra charges for Penny or OTC stocks.

So let’s jump in and evaluate. First, I will screen out companies for various criteria, then discuss all that passing companies. Later I will give a quick comment on each company.

From this chart I can eliminate a few companies right away simply based on price. E*Trade, TD Ameritrade, & ThinkorSwim all charge $9.95. Think or swim had other negative factors which I detail below.

OptionsHouse, Scott Trade, SogoTrade & Tradeking (my favorite broker) are eliminated because they have Penny stock charges.

That leaves Charles Schwab, Choice Trade, Fidelity, Just2Trade, TradeMonster & Zecco. Fidelity and Just2Trade have too large a minimum balance requirement, so they are out. For investors, starting with larger sum in their investment portfolio, this arbitrary cut off may not apply. Of the remaining four companies two had IRA fees, Choice Trade, and Zecco, so if that is an important factor to you. Think twice. For the Chroma Investing Small Investor Portfolio it is not.

On an absolute price perspective you would have to narrow the choice down to ChoiceTrade or Zecco, at $5.00 and $4.50 per trade respectively. But finding the best broker isn’t only about price.

O.k. so what I haven’t mentioned, because it is so hard to judge, is what is offered for this price and how customer service is when things don’t work out as expected. This is qualitative area where stats don’t tell the whole story. Before I decide between these two brokers, I would like to hear from you. Do you have any experience with either ChoiceTrade or Zecco? Tomorrow I will call both and get a sense of their customer service. Then I will make a decision. I will post soon where I decide to open the account. Maybe I will open accounts at both and see what the process is like, before I fund the account.

Below are my thoughts on the companies on the comparison chart.

Charles Schwab- The original discount broker. In recent years their prices have not been competitive with other online discount brokers, that seems to have changed this year. They are a surprise late addition, because they have recently (Jan. 2010) lowered their per trade fee form$12.95, eliminated the number of shares that would be allowed per trade without additional fees. Schwab has banking options, including checking accounts.

Choice Trade- I had not heard of them until I started my research on discount brokers. Two things intrigued me. First, their overall good price and Second, they are offering a $50 bonus if you add a margin account and open your account for $2000. That is a quick 2.5% gain on my money. They are not a good choice if this was an IRA account because of the IRA fee.

E*Trade- I was surprised they made the initial cut, that is under $10. But ultimately they would be to costly for our tiny trading account.

Fidelity- Last year trades cost over $10. This is perhaps the biggest surprise. I have read about some complaints with their trading tools, but are supposed to have a lot of free research available on more than 4500 corporations.

Just2Trade- Their low, low per commission rate would be partially offset by their IRA fee for some investors. Their reputation, however, sucks. The longest complaint I read on any forum about any broker was about Just2Trade. If you believe that poster, they could not get anything right. Two things concerned me most. First, their customer service is not great. Second their cash balances are often inaccurate.

OptionsHouse- Another low priced commission house, seemed initially promising with their $2.95 commission, but their Penny stock surcharge begins below $2.00 and is $0.005/share. Moreover, anything over 50,000 share requires a separate over and brokerage commission.

Scott Trade- I have spoken to several investors who have been happy with Scott Trade and their moderately price $7.00 trade. Their commercials at least garner attention. But Scott Trade is a terrible choice for Penny stock investors. They charge 0.5% of the value of the purchase for Penny stocks. Even on a $500 investment that adds $2.50 and makes them uncompetitive.

Sogotrade- I heard negative things about Sogotrade even before I decided to include them in the comparison. But their price of $2.95 begged inclusion. Unfortunately, they also have 0.5% charge on Penny stocks, and frequent complaints about their their online trading platform.

TDAmeritrade- Another large brokerage company that recently dropped their commission to $9.95/trade. Much better deal are possible with you are frequent trader. Eliminated for price.

Think or Swim – I have used Thinkorswim for more than a year. They are eliminated for two reasons, First they limit their $9.95/trade fixed rate to 5000 shares, above that you pay a per share fee, and Second, I hate their web based interface. It is the least intuitive I have seen. It is shocking to me anyone likes it. I feel like I am transported back to the days of early DOS, where nothing made sense.

TradeKing – A solid company, with great customer service and good reasonable $4.95 commission. Unfortunately, for the purposes of the small investor portfolio the Penny Stock Charges forces their elimination.

TradeMonster- The most promising of all the brokers I never heard of. While their $7.50 commission is higher than I like, it has no Penny stock charges, shifting the balance in its favor. The interface allows all tools to be used in Paper Trading, making this a very interesting choice for a small investor who is also a beginner. The ideal Chroma Investing reader.

Zecco – The price you can’t deny. $4.50/trade. If you are a frequent trader or have $25,000 in assets you get 10 free trades/month. On the plus side Zecco has virtual trading and FOREX trading. On the negative side they have a yearly IRA fee and on some forums some complaints about customer service. Perhaps the service is getting better.

Disclosure: Some of the information in this post has changed since I first wrote it. I will post an updated article. I currently have accounts with Schwab, ChoiceTrade, Zecco, TradeKing and ThinkorSwim. I have an affiliate relationship with TradeKing and Zecco, but these are based on my satisfaction with their services and not because I am making money with them (so far, not so much).

Margin of Safety – Beginning Investor Terms

chroma — Thu, 25 Feb 2010 05:39:22 +0000

Margin of Safety is a concept I write about a lot. It is the make or break for any investment. While I may fudge the amount from time to time, all investments have to have a margin of safety to be worth shelling out my cash. But what is a Margin of Safety?

It is a term that Benjamin Graham and David Dodd coined in their seminal book, Security Analysis. First Graham began with the idea of intrinsic value. Or how much a company is worth (in opposition to how much it costs). If the price of a companies’ share is lower than the intrinsic value of that share then the difference is a margin of safety. Graham argued for a minimum margin of safety of 33%. More is better, but harder to find. The purpose is to protect an investor in case some part of your analysis in determining the intrinsic value is incorrect, or to help protect if the market or luck turns against you.

In a recent example VOXX, my NCAV value was $9.82/share. By my reckoning this would be VOXX’s intrinsic value. The price when I bought VOXX was $6.60/share. This gave me a Margin of Safety of about right under 33%. Any questions? Please post in the comments or email me chroma@chromainvesting.com

New Beginning Investing Blog – The Fallible Investor

chroma — Tue, 23 Feb 2010 17:21:40 +0000

I came across a new investing blog that I think is terrific for beginning investors. It is the Fallible Investor. The writer is an Australian value investor who shares a lot of the same tastes as I do: Taleb, Montier, Klarman. I particularly like his concept of laying out scenarios for a business, good and bad and then describing the pros and cons of those scenarios. Even in a Net Net stock we need to look at the downside. Sure we may be protected by a margin of safety, but was is the likely scenario if everything goes south. IF liquidation is the likely outcome, have we really adequately calculated liquidation expenses and more importantly, would the liquidation be forced or as Klarman discusses “an orderly” liquidation. Each of these different scenarios effect the range of valuations. Also, what if our investment does better than expected? Having thought about the upside can help lead us to a better exit strategy.

The Fallible Investor recommends reading his posts from oldest first to get a sense of his investment philosophy. Enjoy!

Intrinsic Value – Beginning Investing Terms

chroma — Fri, 05 Feb 2010 04:24:39 +0000

Intrinsic value may be the most important concept in value investing. It is the foundation of everything else. Value Investors all agree that you start with the intrinsic value of a company. Now, how you arrive at that value is a different proposition, there you will have a lot of disagreement.

In their landmark book on Investing, Security Analysis, Ben Graham and Dodd describe intrinsic value in its opposition to market value. The notion of market value is clear: what the market is offering for the company today. However, intrinsic value takes a bit of work to tease out. I found the definition of intrinsic value at both investopedia and wikipedia unsatisfying. Graham describes it like this, “that value which is justified by the facts e.g., assets, earnings, dividends, definite prospects.” While the modern notion of this has been mostly relegated to Discount Cash Flow Models or “Owner Earnings,” if you follow Buffett, Graham had a more broadly based idea of Intrinsic value. You may value a company on Assets if it you are looking at traditional Net Net companies, or future earnings if you consider yourself a fundamental investor, or ability of a company to generate dividends if you are an income investor. Ultimately, you have a value of the company that is apart from price of the stock.

Ideally, you would only buy stocks whose market price is below its intrinsic value/ share. And commonly when the price of the stock reaches its fair value, or intrinsic value you might sell. Of course if the intrinsic value of a company keeps rising, you could also continue to hold it.

What happens When the Price of your Stock Declines?

chroma — Wed, 03 Feb 2010 05:16:50 +0000

This is a question that many of us faced in 2008. It is certain we will face this issue as long was we continue to invest. The answer, in short, is it depends.

First, check to see if something material has changed in the company that would effect the intrinsic value of the company. If your calculation of intrinsic value is unchanged in relationship to the stock price, you should not sell. In fact, as the price drops you may consider adding to your position. Let’s look at Qiao Xing Telephone (XING) which I purchased back in December for $1.92/share. At one point today it dropped below $1.83. Does that mean buying was a bad decision. The answer is not yet. The price has been dropping on now news. Investors hate uncertainty and no news, no communication from the company is the height of uncertainty. In the same way that I was not ready to sell when it appreciated to $2.73/share last month because it had not come close to full value. My underlying valuation had not changed. So, I hold. This kind of volatility is why many investors shy away from stocks like XING. But volatility is your friend. You can buy when a stock price retreats, decreasing your cost basis of a stock.

But not all price declines are neutral. Sometimes a price decline is associated with news such as huge losses, fraud or a company losing its largest customer. These catastrophic events would require a reevaluation of the company. And if the fundamentals have changed, if the companys instrinsic value has fallen below your the share price with your margin of saftety included, you may want to sell. Only you can decide.

Disclaimer: I own 1500 shares of XING. I am not a finance expert, I am a film and television producer. I strongly urge anyone who is interested in XING to do your own research before you invest. Make sure you understand why you are investing in a company and when you will get out of the investment. Really, no one should listen to someone on the internet without doing their own research first, even if it is me.

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