Alright, so you’ve decided to become a value investor. How do you go about finding stocks with an intrinsic value much higher than their prices? One place many investors start is with a screen. There are a number of tools available online. I like Zack’s stock screener. The question then is what do you screen for?
Price to book less than 0.67
The book value of a company is the accounting value of all of its assets minus the accounting value of all of the liabilities. The theory here is that if the company in questioned is worth its accounting value, then you would make 50% on your investment. As of October 25th there are 703 companies on the screen that satisfy this criteria. At this point the question becomes, are the assets that the company owns really worth their accounting value. This can be very difficult. Studies have shown that the stock price of companies with low price to book ratios outperform companies with high price to book ratios. If you think that 703 companies are too many to go through you can go ahead and add more filters. I’d be inclined to demand that the company be profitable over the last 12 months. You can do this by going to “Income Statement and Growth” and demanding that “net income is >= 0”. This reduces the number of companies from 703 to 375 companies. One thing that I generally demand is that the company is very small. I assume, perhaps incorrectly, that smaller companies are less covered by analysts and therefore I assume that it is more likely that stock prices could diverge from the true value of the company. I therefore also limit the market cap to be below $100 million. This reduces the number of the companies in the screen to a much more manageable 101.
Price to earnings of less than 10
Ultimately a share in a company is a claim on the earnings of that company. The point of owning a company is ultimately to share in the profits of that company. The lower the price to earnings ratio the less a dollar of profits costs you to buy. This seems straightforward, if you could buy one business generating $100 per year for $1000, or you could buy another business generating $100 per year for $1500. All things equal you should prefer the cheaper company. If you use the screener (under “valuations”) to screen for stocks with a trailing 12 months P/E of less than 10. The number of companies matching this screen is 599. We also don’t want negative P/E ratios as that indicates that the company is losing money, so we need to add net income > 0 as well. This drops the number of companies matching the screen to 526. If you further demand that the market cap of the companies is less than $100 million you get a list of only 137 companies.
The goal here isn’t to then put money into each of these companies, but instead to provide ourselves a starting point. My plan is to use this list to look more closely at Sorl auto parts (SORL), Skypeople fruit (SPU), and Orange City Bus (OCBB). If none of these companies prove to be interesting we come back to the list. Now, you’ll want to find more ways to screen for companies as you may miss some good bargains; companies might have highly valuable real-estate with appreciation that hasn’t been reflected in the book value. Another option is to simply run a screen for companies trading at a low P/E (price to earnings) and low P/B (price to book) and buy them all as a basket. Studies show that this approach has historically outperformed the market. I think that we can do better by studying the individual companies more carefully and using this as a starting point.
If you must invest money in something other than index funds your best bet is probably value investing. Value investing is the theory that you should invest in a stock or bond based on the value of the underlying company (imagine that). If the value of the company divided by the number of shares outstanding is greater than the price of a share, the stock is undervalued and you buy it. This is different than momentum investing, which buys stocks which are going up, figuring that they will keep going up. This is also different than investing based on “technicals” which seeks to figure out patterns from previous stock prices then make a profit buying or selling based on those patterns. Investing based on technicals (basically staring at stock charts) is a scam. I will happily bet anyone investing on a technical basis that they will under-perform when measured against a benchmark. There is some evidence that stocks exhibit some momentum. Unfortunately, the effect is small enough that after transaction costs and taxes you can’t actually make a profit off of it.
Where to start
- The Intelligent Investor by Benjamin Graham
- Benjamin Graham is known as the father of value investing, and for good reason. Benjamin Graham gives the reader with a powerful thought experiment. Many people worry when the shares of stock they own go down. Graham argues that rather than thinking of the stock market as reflecting the true value the shares of stock you own, you should instead think of the stock market as a manic depressive partner. Imagine that you are part owner of a business. Every day your partner (Mr. Market), comes to you and offers to either sell his share or buy your share at prices that fluctuate based on his mood. Graham argues that you should look at your partner as a benefit, rather than letting his mood-swings give you mood swings. When Mr. Market is too pessimistic and he offers to sell you his shares for too low a price you get the opportunity to buy them, when he is too optimistic and offers to buy your shares for more than they are worth you get to sell them.
- Security Analysis by Benjamin Graham
- This guy again. You may have noticed a slight problem with this whole plan. If we’re going to buy stocks when their prices are below their intrinsic value, how the heck do we calculate this intrinsic value? The value of a business in principle is the sum of all the cash you can take out of the business for the next forever, discounted to its present value. (Discounted by what you ask? The theory here is that $1 next year is worth less than $1 today. The amount that it is worth less is determined by your next best investment opportunity. If you have another way of investing money that returns 5% annually, a dollar next year is worth ~5% less than a dollar today.) Security Analysis is all about conservatively estimating how much of that future cash there will be, if there is any at all.
Read both of these books and you’ll be well on your way to understanding value investing as a strategy. There’s still a great deal more to learn. Since Graham wrote these books investing has gotten much more competitive. While if you carefully employ the tools given by Graham you will likely see a profit, we still have a long way to go in the investing world. If I may make a comparison to physics however, in order to understand how the universe works there’s Einstien and Quantum Mechanics and all kinds of complicated things, but if you understand Newton you’ll get most of the broad strokes. You also have to start with Newton. Anyone who acts like they understand quantum mechanics but don’t understand that F=ma is a liar, a charlatan, or a journalist. For investing we start with Graham.
I don’t know if its clear that I like tax shelters. They shelter your money from tax. That saves you money. Yay.
A 529 plan is a type of tax shelter that helps you save for educational expenses. So if you have kids, or you think that you’re ever going to take a cooking class or something, listen up.
No state income tax on contributions or qualified withdrawals. In Colorado the state income tax is 4.63%. Contributions to the Colorado 529 plan are deductible from your Colorado state income taxes. Many states offer similar plans. No taxes going in, no taxes going out. Colorado will also match your contributions up to $400 annually for five years. You do have to meet income limitations (~$60,000 for a couple with a kid). If you qualify for something like this, just do it. Seriously.
Earnings on money invested in a 529 plan are not subject to federal tax on qualified withdrawals, kind of like a Roth IRA. (I don’t think I need to explain how awesome this is. It’s awesome.) Additionally, even if withdrawals are ultimately used for tuition you don’t have to pay taxes until you actually withdraw the money from the account, this allows money to compound without substantial tax consequences.
The really crazy thing about these plans is that the limit for the amount you can contribute is really huge. Somewhere between $230,000 and $310,000 huge. This is a limit that is per beneficiary. So the kids get a 529 plan, the spouse gets a 529 plan, you get a 529 plan. Go completely Oprah on this. It’s absolutely insane as a tax shelter. There’s been some talk about reining these in, so keep that in mind. They’re mostly owned by older, upper-middle class folk. This helps a little bit because older, upper-middle class folk vote in droves so its very hard to take something away from them. *Cough* mortgage interest deduction *cough*.
The money has to be used for qualified education expenses. Obviously this includes tuition and fees at qualified institutions (places, like universities, that could participate in a financial aid program from the Department of Education.) This also includes books, tutoring, room and board, uniforms, and transportation. If you withdraw for another reason then you have to pay federal taxes on earnings, plus an additional 10% penalty. The notes about just giving up and paying the penalty when we talked about the Roth IRA, totally apply here too. A 10% penalty is just not that much when you consider that you get to sit on perhaps a substantial amount of tax deferred compounding. Of course if the 529 plan is in your kids name, it is still their money.
Your investment options are also pretty limited. This isn’t like an IRA where you can buy a bunch of call options if you want to (don’t do that). The strategy here is just to select a Vanguard option, put everything in a couple index funds and never look at it again. Market timing with indicies is dumb, don’t do it.
Every state has their own 529 plan. You can join other state’s 529 plans. This makes it worth it to poke around for the best option for you. In my case the tax deductibility for Colorado’s plan made a big difference. If you live in a state that doesn’t have an income tax then you might profit from looking around a little bit. I’ve seen Nevada’s 529 plan recommended quite often. The big benefit here is a huge ($370,000) contribution limit. They don’t have a match for non-residents. Unfortunately, it seems like most states aren’t keen to hand out free money to people that don’t live there. Imagine my surprise.
So should I…
Do it. After you fund your other tax sheltered stuff, that is. Obviously if you haven’t already contributed to your IRA, 401k, and HSA, go ahead and contribute to those. The timing of 529 funding is really flexible, but with all investments earlier is still better. There’s some thought going around that you only get so many heartbeats in a lifetime, the same is true for tax-advantage space. It’s only $5,500 per year in your IRA, $18,000 per year in your 401k, and $3,350 in your HSA. That’s almost $27,000 per year, adding another $370,000 over a lifetime (+370K per child, woo) makes a big difference. Millionaires have taxable brokerage accounts. Thousandaire’s money lives in shelters.
Investing can be very simple or very complicated. You can just throw some money into a savings account and not worry about it. The concern here is that you may not keep up with inflation or you might not make as much of a return as you could. The stock market gives, in general, greater returns, but lacks the safety of a bank account. If you pick the wrong savings account, or decide to change savings accounts several times, you aren’t going to get much more than a headache. If you screw around like that in the stock market you could very well lose all of your money. There are a lot of ways to make and lose money in the stock market. The best ways to lose money have a lot of similar characteristics.
Don’t trade constantly
Better if you don’t trade at all. In fact, according to a study done by somebody or other, the people who did the best in the stock market are dead. When you trade you lose the commission, you also get hit with capital gains taxes when they apply. People in general seem to also trade at the exact moment it is worse for them. This makes some sense. In investing, you generally get paid the most when staying invested is the scariest. It’s hard to think of a scarier moment to invest, or stay invested, than early 2009. If you stayed invested then, and didn’t trade you have nearly tripled your money in about six and a half years. Folks who traded when they got scared would probably be pretty sad to hear that.
Don’t pay large fees
Stock market prices generally reflect an accurate estimation of the value of the companies they represent. Therefore, it probably doesn’t make a lot of sense to pay a mutual fund manager 1% per year (which is about 10% of your expected earnings) to decide what you invest in. You can get a much better deal by simply investing in an index fund which should generally charge less than 0.15%.
The easiest way to lose all of your money in the stock market is invest it all in one super-popular sure-fire stock. (Actually, that’s kind of a lie. The easiest way is invest everything in way out of the money options.) Diversification is protection against ignorance. It’s important to remember when diversifying your investments that they have to be actually different. It doesn’t do you a great deal of good to just invest in six different tiny natural gas companies. If the natural gas sector gets hit, all of your investments are in trouble. A really simple way to diversify would simply be to buy Vanguard Total World Stock Index (VTWSX). VTWSX is basically the easiest way to invest in every public company in the world. Boom! Instant diversification. You can acquire additional diversification by also buying some BND (a diversified bond fund).
Now you don’t suck
You can make a great deal of mistakes in the stock market and still come out okay if you follow these rules. Buy many different stocks or mutual funds with low fees and don’t trade them. This may not be the best possible investment plan, but its the simplest one that doesn’t suck.
I hate wasting money. I know, I can hear your gasps of shock from where I sit. For the longest time I was on Verizon. The network always worked. I was in absolute bunkers where I got signal. It was a ridiculous amount of money. I was paying something like $100 per month. To this day I’m not sure how I manged to pay that much as reasonable Verizon plans currently seem to run $50 for a phone and a gig of data. This doesn’t include the cost of the phones, which they now break out, so maybe that’s it? In any case I’ve since switched to Google’s Project Fi, which is currently in beta.
On Project Fi you get unlimited talk and text for $20 per month. After that you pay only for data you actually use, at a rate of $10 per GB. This is cheap. My cell phone bill dropped to roughly $30 per month. I use about half as much data as I used to, because I am more careful to connect to WiFi before watching television shows or something crazy (streaming pandora?). The $70 per month of savings works out to $840 per year. This is a large enough portion of my pay that I definitely notice. One major difference is that I pay for the phone rather than getting a subsidized phone from a carrier. The Verizon plan that I quoted works that way, but my old plan subsidized about $300 worth of phone every other year. That works out to only about $12 per month, so not substantial enough of a difference to make up for the extra cost.
When I signed up there was only one available phone, the Nexus 6. I was fine with purchasing a used version to save on the cost but it still cost a substantial amount of money. I should start coming out ahead sometime this year, assuming I don’t drop the phone in a toilet somewhere. I ordered online and was so excited about the plan savings that I didn’t realize, this is a huge phone. I look completely ridiculous with the thing. Turns out to be quite uncomfortable to carry.
Service is terrible. Not unusably bad, but still way worse than it ought to be. Project Fi runs on the T-Mobile and Sprint networks, and in my experience it seems to prioritize T-Mobile. How do I know this? Folks with sprint phones get signal in my apartment. I find it nearly impossible to make or receive a phone call. Theoretically WiFi calling should fix this issue, and if the phone attempts to route the call through my home WiFi network things work great. Unfortunately, the phone really doesn’t want to do that. The only workaround that makes my phone usable at home is turning on airplane mode and then connecting to the WiFi network. Project Fi’s customer service was quite responsive and they were ultimately the ones to put together this workaround for me. It is a little bit annoying that I can’t control which network the phone connects to, but what are you going to do?
In all I’m quite happy with Project Fi’s service and substantial savings. I’m looking forward to the project moving out of beta and T-Mobiles expanded spectrum to improve the issues I’m currently seeing.
At some level of personal finance sophistication it isn’t necessary to follow every rule you hear religiously. That being said, if you’re regularly breaking these rules and you don’t have any good reason for why, you’re probably making terrible, terrible mistakes. But who am I to tell you what to do? These are the ten commandments, but no I don’t think I’m your personal finance god. More like Moses.
1. Thou Shalt Not Pay Interest on Credit Cards
There are two huge problems with paying interest on credit cards. First, people pretty exclusively buy consumer goods. If you can’t pay for the goods you’re buying, than you are by definition living beyond your means. Such a thing is the antithesis of good personal finance. Second, the interest you are getting charged is generally north of 10%. Paying interest at that level is a terrible idea because compounding just slaughters you. Do you know how many years it takes to double something compounding at 20%? Less than 4. Bad idea, bad idea, bad idea. Someone help your crazy, crazy brain if you’re paying interest but still using the credit cards to get points. Points are worth 1%. One month of interest will be 20%/12, and if you’re paying interest you’re not paying it for just one month!
2. Thou Shalt Not Pay Fees for Banking
Fees to do banking activities are sometimes worse than credit card interest. ATM fees are generally $2. If you pay ATM fees to withdraw, like $20, you’re giving up 10% of your money. Terrible idea. Same thing goes for overdraft fees. I once had a terrible checking account spiral when I was poor where I bought a $5 thing, but only had $4 in the account. Got slapped with a $31 fee, then deposited $10 and tried to spend the $10 thinking I now had at least $10 in my account. By the time the dust settled I owed the bank $150. I couldn’t afford the $5 thing I bought, and I sure couldn’t afford the $150 fee. If you’re otherwise careful the bank will usually let you out of the first one of these. If they don’t just switch banks. Also, if you’re still paying ATM fees switch to a high interest checking account that pays the friggin’ fees.
3. Thou Shalt Not Finance a New Car
In general if you have to take a loan to buy something, you can’t afford it. A new car is a terrible thing to buy when you can’t afford it due to depreciation and insurance. If you need something you can’t afford to replace, you must get insurance. Otherwise, one accident simply wipes you out. It’s not fun to make payments on a car you don’t own. I can hear the complaints now, “But Adam, I need a car”. You don’t need a new one. If you flatly need a car. First, try to live with a bike for a month. If your work tells you that they’re going to fire you, you can get a used beater for $500. If you just don’t like walking/biking for three hours both ways, tough. Get a closer job or move. Don’t glue yourself to your waaay too distant job with payments you can’t afford. Second complaint I expect to hear is, “But the interest is 0%, I could pay for it in cash, but why not take the loan and leave the cash in my high-yield checking account.” If you offer to pay in cash, you will get a better price. I absolutely guarantee it. Negotiate with cash, then see if they’d be willing to give you the 0% loan, will not happen. The reason for this is obvious. They assume risk with a loan and they have a cost of capital above 0%. Car dealerships have debts too, the 0% is just a method of tricking folks into paying the sticker price.
4. If Thy Employer Offers a 401K Match, Thou Shalt Contribute
You only get to pay interest on credit cards if you are forgoing this to purchase Top Ramen in cash and pay the rent on your camping spot in Kansas. In the case where you only have needs, credit cards, and a 401k match to get, prioritize the needs (if I think a house is a luxury, you can imagine how I feel about cable), then the 401K match, then the credit card debt. Then seriously look for a better job. You’re living in a tent in friggin’ tent in Kansas!
5. Thou Shalt Invest Prudently
All of this saving does zippo good if you end up just betting it all on black in Vegas. Playing the stock market is little better. Brokerage fees will eat you alive. If you don’t know what you’re doing leave it in cash. You have a new job for the next 3-5 years. Learn everything you can about investing. Prudently generally means that you aren’t looking to make more than a 10% return, and that you’re adequately diversified. If you’re trying to double your money over a year, and you’ve got it all invested in a sure-fire thing you aren’t being anywhere close to prudent. If you’re considering buying or selling an “option” or a “future”, stop; move everything to cash; look at yourself in the mirror and feel shame.
6. Know Thy Spending
If you don’t know how much you’re spending its real hard to make sure that you’re actually going to achieve your financial goals. Furthermore, its great to know how your spending breaks down so you know where you can save the most money. (For example, if you haven’t gotten rid of cable yet, just do it. You could get netflix and hulu and amazon prime for less. Maybe there’s some sports thing out there if you really need the sports. Cable might be costing you $720 annually. Boo cable!) I use mint.com for this. No link because it’s buggy and I don’t like it (Seriously, why can’t I just split the bills for a specific credit card. I’m a programmer, I know its not that hard.) I’ve heard good things about You Need A Budget.
7. Thou Shalt Read
It’s cliche but the best return on investment has always been reading, and assuming the rest of the US population insists on pretending that they’re illiterate, it will continue to be the best return on investment. People who insist on claiming that it’s who you know and not what you know really just seem like they would prefer not to read. At some point every endeavor comes into contact with reality. Reality doesn’t care who you know, it only cares what you know. Make sure you know things. From good will hunting:
…you dropped 150 grand on a fuckin’ education you could have got for a dollar fifty in late charges at the public library!
8. Thou Shalt Use Math
This is the other part about knowing things. The easiest way to handle most problems is with numbers. Problems that are totally intractable using English can be translated to math, solved easily there, then translated back to the real world. Basically all of modern society is based on how well that trick works. If you aren’t acquainted with math, its hard to get a good handle on personal finance. You don’t even need to know a lot of math, just all of the math in human history up until 1500 AD. Oops, I mean everything up to 8th grade. Some people say that you never use it after you get out of middle school. Those people are statistically poorer.
9. Thou Shalt Minimize Thy Tax Burden
Assuming that you’re following all of the other commandments, you can go ahead and do this. Probably, don’t make less money in order to drop into a lower bracket, you’ll still end up with less. There are a couple tax credits, like the savers tax credit, with sudden cutoffs. Use your tax sheltered space, like 401K’s, IRA’s and HSA’s to hit the breakpoints on this. At the margin, don’t sell appreciated investments in high quality companies. No reason to take the tax bite now when you could let it compound much longer. Organize your business to be tax efficient. Hire an accountant if your tax situation isn’t obvious. Pay the accountant lots of money, you’ll still probably come out ahead.
10. Thou Shalt Not Covet
Maybe you’ll notice I stole this one. As a commandment it’s great. Why do people get into personal finance messes in a world where even the very poorest are far, far richer than their great-grandparents. Anyone can live as people did in 1950 with the added bonus of the internet and waaay better healthcare and be saving substantial amounts of money. My only explanation is envy, covetousness. Get a handle on that and all the rest of these are far easier…