1.Make sure the total number of shares outstanding is actually decreasing. In companies with large stock option grants, share repurchases sometimes don’t even cover the dilution caused by printing all those extra stock certificates. Thus, the owner isn’t in any better position as the buy back plan served to line management’s pockets. A good rule of thumb is that when investing in companies with large stock option grants, you should prefer cash dividends because it makes it more difficult for the stock price itself to rise as there is less capital at work in the business.

2.Remember that just because share repurchases are announced, that doesn’t mean the company will actually go through with the plan.

3.Beware of management that repurchases shares at any price. Buying back stock at inflated values is akin to buying $1 bills for $1.25. It’s destructive to the value of your investment.

To help you understand the traits of an excellent business, I’ve put together some resources that will give you an idea of what you should look for in a stock, and, just as vital, why it is important. Armed with this information, over time you’ll be more likely to build a portfolio of wealth creating assets that can provide financial security for you and your family.

An excellent business earns high returns on capital with little or no debt

There seems to be little doubt, based upon the evidence, that it’s easier to build a large net worth through value investing – that is, the disciplined purchase of stocks, bonds, mutual funds, and other assets that appear to be selling at a substantial discount to a reasonable person’s estimate of intrinsic value (or “the real” value.) Think of it as if you knew a local car wash had gold buried underneath it. The proprietor might be asking $800,000 for the land and enterprise, but you know full well that you could pay substantially more, not only owning the business, but also selling the gold you dug up on the open market. Thus, you had reason to believe that it was being sold for far less than its intrinsic value.
The one major shortcoming of this approach is that an asset bought cheap must be sold when it reaches intrinsic value unless it is an excellent business. As Charlie Munger has pointed out, over long periods of time, the rate of return which an investor earns is likely to be very close to the total return on capital generated by a firm, adjusted for dilution in shares outstanding. Thus, you are likely to do better paying fair value for a business that can reinvest its capital at high rates of return – say, over 15% to 20% per annum – than buying a mediocre business trading at a small discount to its liquidation value.
For more information, read Business Like Investing: Thinking Like an Owner; on the second page of the article you’ll find information on why return on capital matters.

An excellent business has durable competitive advantages

If you had unlimited funds, do you really believe that with the best pick of any manager in the world, you could unseat Coca-Cola as the undisputed leader in the soft drink industry? How about Johnson & Johnson with its myriad of patents, trademarks, and brand name products? The reason these businesses are able to succeed so well is that they have durable competitive advantages – things that their competitors can’t reproduce.

Sometimes these advantages are easy to spot – as is the case of Coca-Cola, which is the second most recognized word on Earth. However, it is possible for them to remain buried. One of the secrets to the phenomenal success of Wal-Mart is that Sam Walton built a distribution system with logistical capabilities that allowed him to lower the transportation costs of moving merchandise to his stores, allowing him to make far more profit than competitors selling at higher prices. He and his fellow shareholders won from the increased income while consumers won from the lower prices. These forces worked in combination with one another, reinforcing and accelerating the results so much that the tiny five-and-dime grew into the largest retailer the world has ever seen.

When you buy into a company through the purchase of its common stock, try to identify the durable competitive advantages it has that could stand up from attack by competitors and market forces such as outsourcing and increased globalization.

An excellent business is scalable

When businesses are highly successful, one of the key ingredients more often than not is scalability. Take American Eagle Outfitters, which has one of the best long-term investment records over the past decade. Why was it successful? Target? Wal-Mart? McDonald’s? Coca-Cola? Pepsi? Microsoft? All are excellent businesses in part because they had products or services that could be replicated in cookie-cutter fashion very, very rapidly.

Think about it. The McDonald’s in Hong Kong is very much like the McDonald’s in Chicago. And New York. And Southern California. By having the menu, layout, fixtures, and technology packaged in a way that restaurants could be rapidly opened, it made it easier for the chain to roll out across the United States and world. Coupled with its relatively high returns on equity and the cash provided by the franchisees, which footed the bill to build a huge portion of the overall business, it’s not hard to see why the shareholders might consider Ray Kroc as a hero.

The price still matters …

For those of you too young to remember the Nifty Fifty, this idea of buying excellent businesses was taken to such ridiculous extremes in the 1960’s that investors paid upwards of sixty and seventy times earnings! To contrast, a normal price-to-earnings ratio on Wall Street is considered fifteen; that is, for every $1 in per share profit a company generates, it would trade for $15. It didn’t take a genius to see that even if the business was all it was cracked up to be, at those prices, it would be virtually impossible to earn a satisfactory long-term rate of return.

That’s why you need to take a moment to read Price is Paramount to see an illustration of how lower growth rates can actually lead to higher rates of return in certain circumstances.

The One-Paragraph Test

The test that these two men applied was roughly the same. According to sources, Peter Lynch used to start an egg timer when on the telephone with financial analysts and traders, for forcing them to explain the basic premise of an investing idea in less than a minute. Buffett recommends that you write out a short paragraph saying something along the lines of, “I am buying $10,000 shares of Company XYZ at $25 per share because I believe (insert reason here such as profit will grow twice as fast as the current price-to-earnings ratio, hidden assets are on the balance sheet, there was a management change for the better, valuation is too low, etc.) Then, monitor the situation, always mindful of your basic thesis.

The practical result is the meat, or substance, of your argument of the matter is separated from the water down nonsense. Too often, stockbrokers and financial journalists spew dozens of facts they have regurgitated from a 10k or annual report. So many facts obscure the truly important figures such as sales growth, profit margins, expected capital expenditures, expected depreciation, and return on equity. Investors instead become bogged down in reading about a $12 million transaction at a firm generating $20 billion in sales. In a vast majority of cases, information of that kind isn’t particularly or necessarily relevant.

Avoiding Multiple Break Points

Another major advantage of the “Kiss” approach is that you factor in basic probability theory into your decisions. Which would you rather have: a stock that has a 65% change of doubling in the next five years or a stock that has a chance of quadrupling if eight different events all take place (perhaps a business license in a new state, a new factory built, etc.), each event having a 90% probable success rate? The latter, believe it or not, has an approximate 43% chance of coming true – much worse odds than the former option! With more links in a chain, you have a greater probability of something going wrong. If a stock could go up 1,000% but for it to do so, the labor unions must drop demand, fuel supplies must collapse, a bankruptcy court must force a competitor to pay its promised pension obligations, and new management to come in and cut stock option expenses, you are probably going to be disappointed. hx2kutzbs4

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What you get when you pay for a full service broker

With a discount broker, you are simply paying to get your trades executed. For those with experience, the ability to analyze financial statements, and an understanding of businesses, this is an ideal arrangement. You just need someone to place the trades you order. For those without any financial experience or who want the comfort and security of handholding – and just as importantly, don’t mind paying for it – a full service broker can be worth the cost.

Although services and products are not fully uniform and costs will vary from firm to firm, typically you should want some or all of the following from your full service broker:

Perhaps the biggest benefit for someone without experience is the opportunity to have a reputable firm guide you through the process. Although it is highly probable that the fees will cut into your returns, you may be better off in the long run because a good broker can hold your hand through turbulent markets, helping you to avoid mistakes such as selling at market bottoms or buying during speculative bubbles.

That is, of course, if you can resist the temptation to bail. It’s amazing how many investors, who are the first to admit they don’t know hide nor hare about the market, will call their broker and complain about a few percentage points drop. Just last week, I was chatting with a financial representative from a major U.S. bank in his office and he confessed that when his client accounts were up more than 20% last year, no one called. Yet, a 4% drop in the broader markets caused, no joke, what he estimated were 250 calls to his office. That is madness. As long as you have a reputable firm with a proven history of good, long-term results, stay the course.

An alternative to full service brokerage firms

There is one alternative to full service brokers that is particularly attractive if you don’t have a lot of capital to invest or you are primarily interested in buying and holding stocks for the long term (ten years or more). You aren’t likely to hear about them because there really isn’t a motivation as they don’t produce profits for any brokerage house.

It’s called a direct stock purchase plan or a dividend reinvestment plan. Basically, these low-cost plans allow you to buy shares directly from a company, paying only $1 or $2 in commissions through optional cash payments or regular, recurring withdrawals from a checking or savings account. Every quarter, you’ll likely receive a statement detailing the reinvested dividends, purchases, sales, stock splits, or any other information that resulted in changes to your account.

Put together enough of these plans, and you have a simple, cheap way to build equity in some of the biggest names in the world – Coca-Cola, General Electric, Bank of America, Home Depot, Wal-Mart, etc.

Your Level of Freedom is Closely Tied to Your Level of Debt

An excessive debt level is the life equivalent of handcuffs. One of the biggest financial dangers for young adults is taking on too many “bargain” deals such as zero-down financing, no payments for twelve months or other similar gimmicks offered at furniture stores, home improvement retailers and automobile dealerships. Often, they are deceived by the ease of credit and instant gratification of purchasing without taking the money out of pocket today. Sooner or later, however, they are going to end up paying the cost of the items and possibly much more in interest.

Teach your teen to focus on the cash flow impact of a major purchase and to avoid recurring financial commitments at all cost. A young adult with a moderate lifestyle consisting of only a cell phone bill ($50), car payment ($275), insurance ($100), and rent ($500) is looking at monthly outflows of $925! In other words, $11,100 of his or her annual income goes to merely maintaining a car, phone and roof over their head. After factoring in living expenses such as clothing, gas, cable, and food, it becomes clear a young adult in this position probably doesn’t have a lot of cash to spare if he or she has any ambition to build an investment portfolio, save for a down payment on a house or go to graduate school (for smart strategies on saving, read Pay Yourself First and 7 Rules of Wealth Building).

Avoid Credit Card Debt Above All Else

Credit card debt is brutal. If a young adult is making 4% on a passbook savings account but paying 20+% interest on his or her credit card balance, it is costing them 16% for the right to earn 4%. This is one of the stupidest things he or she can do. Instead, they should take their available resources and pay off the balances, only investing after they have extinguished double-digit rates from their life forever. Other debt, such as student loans, mortgages, etc., depend upon an individual’s specific circumstances. For help with deciding which debt must go and which can stay, read Pay Off Your Debt or Invest?.

Open an IRA and Contribute to it as Young as Possible

The day your teenager turns eighteen, he or she should open an IRA. In Six Steps to Retire Rich, I point out that a 40 year old investing $20,000 a year for retirement will end up with only half of the assets as a 21 year old who invests $5,000 a year. Even the smallest savings can turn into a respectable fortune if given enough time.

Choose Your College Wisely

In most cases, there is very little difference between a $30,000 private college and a $12,000 state university. What matters is what you do with your degree, not the name attached to it (except in highly-specialized fields such as law or medicine). Strapping yourself with an extra $64,000 in debt can seriously change your plans for life. Several months after graduation, you will be forced to make your first student loan payment. This could result in taking a sub-par job for the sake of an income at the expense of a better opportunity later.

Beware the Small Foxes

It’s been said that small foxes spoil the vine. The financial success of every young adult is largely determined by their mundane, day-to-day decisions. If he or she purchases a $500 television, they’re likely to go to several different stores, compare prices, and find the best bargain. Without thought, however, they may spend $50 at a restaurant, $5 at the gas station buying a coke and newspaper, $10 at the movies, $85 for a sweater at Banana Republic, $20 for a candle, $30 for a book, $5 for a drink at Starbucks… you get the picture. Those small expenses are fine by themselves, but over time they add up to significant amounts. Without knowing it, a young adult in this situation has unknowingly been spending his or her millions $1 at a time. By cutting only $3 a day and investing it, a young adult can be a millionaire by retirement.

Know the State of Your Flocks – Use a Software Program to Track Your Finances

King Solomon, the wealthiest man in history, once said, “Be diligent to know the state of your flocks, for riches do not endure forever”. Personally, I prefer Microsoft Money for the task. It is inexpensive, easy to use, and can automatically download stock and mutual fund quotes from the Internet, giving you up-to-date account balances.

One of the greatest economists in history once remarked, “Markets can remain irrational longer than you can remain solvent.” Take the recent case of the most royal of blue chips, General Electric and Berkshire Hathaway. Within the past year, GE has fallen from roughly $40 per share to as low as $5.87 per share and the dividends slashed from $1.24 per share to $0.40 per share. Even if you had waited until the stock fell the first 50% to $20 per share, and borrowed against your stocks, you would have long been hit by a margin call requiring you to come up with more money to avoid your broker liquidating your position. Berkshire Hathaway, likewise, has seen its Class A shares fall from $150,000 to roughly $72,000 and it Class B shares falling from $5,000 to $2,150 per share.
In both cases, you are dealing with a company that would appear to have a better than average probability of trading at substantially higher prices five years from now. Yet, if you had borrowed money, you would have been forced to sell out long before the stocks began to rise. To add insult to injury, not only would have been correct, you would have suffered the pain of losing large amounts of money because your timing was not perfect.
For more information on the subject, read Margin 101 – The Dangers of Speculating with Borrowed Money.

2. Don’t Invest Funds You Need for the Next 5 Years

As Warren Buffett pointed out in his most recent shareholder letter, the market was up 75% of the time during the past century. Trying to figure out the specific years those gains would happen is a fool’s game. If you want to buy a house, prepare for retirement, send yourself or your children to school, or expect to have large medical bills over the next five years, stocks are not an appropriate place for you to invest your money. In the long-run, they have proven to be the surest path to wealth for those who are disciplined and rational. In the short-run, they can experience nauseating volatility, fluctuating like a roller coaster.

3. Once You Have Developed a Plan, Don’t Check Stocks Daily

Have you put together a plan that works? Do you dollar cost average, reinvest your dividends, max out your 401(k), and contribute to a Traditional IRA or Roth IRA? Are your investments low cost and diversified like an index fund? If that’s the case, you simply need to follow the same instructions that appear on most shampoo bottles: Wash. Rinse. Repeat.
Over several decades, a program such as this has proven to be hugely successful, resulting in millions of dollars in wealth for those who follow it. If you have the patience, will power, and discipline to engage in such an investing plan, why make yourself sick by looking at stock prices daily? Just as a sale at the grocery store allows you to buy everything from cereal and milk cheaper, a drop in stock prices allows you to get more equity (ownership) in companies. When things recover, that means you have a right to even more earnings and dividends.

4. Don’t Rely on One Salary or Source of Income

A big danger to your investments is the risk that you will find yourself unable to pay your day-to-day bills and forced to sell assets to fund your living expenses. The most sensible way to avoid this is to follow the Berkshire Hathaway Model, which calls for multiple sources of income that are non-correlated. In other words, your income isn’t diversified if both you and your spouse work at the same factory or in the same industry. If you are a realtor and own rental properties, you are less diversified in your income sources than a dentist who owns rental properties.

5. Don’t Cut Your Health Insurance
Nothing ticks me off more than to read about a family earning $30,000 to $40,000 a year cutting off their health insurance because it isn’t affordable yet if you go into their homes, many of these people still have cable television or cigarettes or iPods. What happens if you or your children get seriously injured or sick? Health insurance is the last – read it again – the absolute last area you should cut because of the serious bankruptcy risk that can occur in the event of a disease. Even a policy with a high deductible is better than no coverage at all.

Commissions and Fees

The most frequent frictional expense is brokerage commissions and fees. Thankfully, with the advent of the discount broker, the cost of buying and selling securities has been dramatically reduced over the past few decades. At Commerce Bancorp, for example, an investor that places a $2,500 or less trade of no more than 1,000 shares of stock will pay a commission of $29.95 if he places the order online. If, on the other hand, he opts to call the bank and have a broker execute the trade, he will pay $31 plus 1.50% of the principal value of the investment for a total of $68.50. If you had an established dollar cost averaging plan on a monthly basis, that additional commission expense of $38.55 would add up to more than $462.60 per year. Assuming the historical rate of long-term appreciation on equities remains twelve percent, over the course of forty years that would amount to $354,856 in foregone wealth!

Asset management fees can be an even greater impediment to long-term wealth building. Many firms focusing on high net-worth clients will charge fees of 1.5% of assets. A family with a $10 million net worth, under this type of arrangement, would pay $150,000 per year in fees even if they lost money on their investments. This sort of arrangement hardly seems fair. In certain situations, such as estate planning, trusts, and foundation management, however, the fee is justified by the services provided.

Spreads

When buying or selling an investment, a percentage of the investor’s principal is reallocated to the market maker. This reallocation is the spread (i.e., difference) between the bid price (what the buying is willing to pay) and the ask price (what the seller is willing to accept). Like the compounded future value of brokerage commissions, this can amount to significant foregone wealth.

Capital Gains Tax

The unique thing about the capital gains tax is that the investor is free to decide when the tax bill will come due by selling his appreciated securities. Each year that goes by without selling, the value of these deferred taxes becomes greater. To illustrate: assume Adam Smith owns 1,000 shares of Green Gables Industries which he purchased at $35 per share four years ago. Today, the stock is trading at $50 per share. The total value of his holdings is $35,000, of which $15,000 is a capital gain ($50 selling price – $35 cost = $15 per share capital gain x 1,000 shares = $15,000 capital gain). If he were to sell the stock, in addition to the money paid out as brokerage commissions and the spread taken by the market maker, he would have to pay $3,000 in capital gains tax.

This means that he now has $3,000 less in assets working for him, accruing to his benefit. Hence, it would only be intelligent to change investments if Adam believed that 1.) Green Gables Industries was overpriced, or 2.) he found a more attractive investment offering a higher rate of return. For this reason, Benjamin Graham recommended investors only change positions when they are fairly certain the alternative investment has a twenty or thirty percent advantage over their current holding. This rule, although necessarily arbitrary, should help ensure that frictional expenses are covered and the investor’s net worth increases enough to justify the time and effort required to discover the investment and to make the change.

Frictional Expense in the Mutual Funds

Frictional expenses, including management fees and sales loads, are the primary reason actively managed funds as a whole have not outperformed their non-managed counterparts such as index funds over long periods of time. In order for an actively managed fund to merely break even with the market, it would have to earn higher returns by several percentage points to pay the frictional expenses. This is especially true thanks to capital gains taxes which are not applicable to index funds which, because they are a group of non-managed stock assumed to rarely change, do not require the frequent sale of securities.

For example, you would want to see some of the following relationships:

• A higher growth rate in earnings than the “stock” of the index.
• Lower price-to-earnings ratio than the “stock” of the index.
• A higher dividend yield than the “stock” of the index.
• A much higher return on equity and invested capital than the “stock” of the index.
• If, on average, you can construct a portfolio with these characteristics, over long periods of time your results and compound annual growth rate should, judging by past history, beat the market.

Need a Little Help?
All of that statistical work can be extraordinarily difficult, time consuming, and costly. Thankfully, Morningstar, the market leader in mutual fund research and a major player in the equity markets, as well, has created a tool called X-Ray. For only $14.95 per month (the cost of a premium subscription to the company’s website), you can enter your portfolio one investment at a time. When you’re done, it will prepare a detailed report comparing your assets with the broader market. It will save you all of the time and effort and arm you with the data you need.

Commissions and Fees

The most frequent frictional expense is brokerage commissions and fees. Thankfully, with the advent of the discount broker, the cost of buying and selling securities has been dramatically reduced over the past few decades. At Commerce Bancorp, for example, an investor that places a $2,500 or less trade of no more than 1,000 shares of stock will pay a commission of $29.95 if he places the order online. If, on the other hand, he opts to call the bank and have a broker execute the trade, he will pay $31 plus 1.50% of the principal value of the investment for a total of $68.50. If you had an established dollar cost averaging plan on a monthly basis, that additional commission expense of $38.55 would add up to more than $462.60 per year. Assuming the historical rate of long-term appreciation on equities remains twelve percent, over the course of forty years that would amount to $354,856 in foregone wealth!

Asset management fees can be an even greater impediment to long-term wealth building. Many firms focusing on high net-worth clients will charge fees of 1.5% of assets. A family with a $10 million net worth, under this type of arrangement, would pay $150,000 per year in fees even if they lost money on their investments. This sort of arrangement hardly seems fair. In certain situations, such as estate planning, trusts, and foundation management, however, the fee is justified by the services provided.
Spreads

When buying or selling an investment, a percentage of the investor’s principal is reallocated to the market maker. This reallocation is the spread (i.e., difference) between the bid price (what the buying is willing to pay) and the ask price (what the seller is willing to accept). Like the compounded future value of brokerage commissions, this can amount to significant foregone wealth.

Capital Gains Tax

The unique thing about the capital gains tax is that the investor is free to decide when the tax bill will come due by selling his appreciated securities. Each year that goes by without selling, the value of these deferred taxes becomes greater. To illustrate: assume Adam Smith owns 1,000 shares of Green Gables Industries which he purchased at $35 per share four years ago. Today, the stock is trading at $50 per share. The total value of his holdings is $35,000, of which $15,000 is a capital gain ($50 selling price – $35 cost = $15 per share capital gain x 1,000 shares = $15,000 capital gain). If he were to sell the stock, in addition to the money paid out as brokerage commissions and the spread taken by the market maker, he would have to pay $3,000 in capital gains tax.

This means that he now has $3,000 less in assets working for him, accruing to his benefit. Hence, it would only be intelligent to change investments if Adam believed that 1.) Green Gables Industries was overpriced, or 2.) he found a more attractive investment offering a higher rate of return. For this reason, Benjamin Graham recommended investors only change positions when they are fairly certain the alternative investment has a twenty or thirty percent advantage over their current holding. This rule, although necessarily arbitrary, should help ensure that frictional expenses are covered and the investor’s net worth increases enough to justify the time and effort required to discover the investment and to make the change.

Frictional Expense in the Mutual Funds

Frictional expenses, including management fees and sales loads, are the primary reason actively managed funds as a whole have not outperformed their non-managed counterparts such as index funds over long periods of time. In order for an actively managed fund to merely break even with the market, it would have to earn higher returns by several percentage points to pay the frictional expenses. This is especially true thanks to capital gains taxes which are not applicable to index funds which, because they are a group of non-managed stock assumed to rarely change, do not require the frequent sale of securities.

· Market orders guarantee execution but not price.

· Limit orders guarantee price but not execution.

· All-or-none orders are only executed if the broker has enough shares, as a block, to fill your order in a single transaction.

· A stop order automatically converts to a market order when a predetermined price (the stop price) is reached. A stop loss order, on the other hand, automatically converts to a limit order when the stop price is reached.

· When you sell short, your potential losses are theoretically unlimited.

· Day orders expire at the end of a trading day. Good-till-cancelled orders stay on the books until they are completely filled, cancelled, or sixty calendar days have passed.

· Due to the lower level of liquidity, extended hours orders are subject to far greater volatility than those placed during the regular market day.

· Trailing stop orders can be used to lock-in profits while potentially benefiting from the increased rise in stock price.

· Bracketed orders are the same as trailing stop orders, except that they require an upper limit trigger price which, when reached, results in the stock being sold.