Andrew Hallam

When passionate investors talk about who the world’s best stock market professionals are, high profile names like Warren Buffett, Peter Lynch, George Soros and Bill Miller get uttered with reverence.

But have you ever wondered whether the guy living next door has—with his own personal investment account—destroyed the investment returns of the highest rating professionals?

I mean, how would you even know?

Meet Charles Kirk, an investor I first read about in Dick Davis’ fabulous book, The Dick Davis Dividend,  where Davis heaps praise on the youthful Kirk as the Anti-Cramer.   Where Jim Cramer is loud and obnoxious, Charles Kirk is humble.  Where Cramer’s public stock picks are relatively underwhelming,  Kirk’s annual performance is simply mind-boggling.

As a man who has beaten the S&P 500 index for 17 straight years, and fully documented it with his online blog, The Kirk Report, he has been profiled in Barron’s, Time Magazine, and Forbes.

It’s a pleasure to have the opportunity to interview him for this post:

Q1.  Andrew:
Charles, if you had a niece or nephew graduating from college, and you could recommend two finance books for him or her, what would they be and why?A.  Charles Kirk:
 Assuming they are not interested and have no experience in the market, I would probably send them copies of The New Coffeehouse Investor by Bill Schultheis and Financially Stupid People Are Everywhere, by Jason Kelly. Both are mainstream and would offer a lot of helpful advice for people at that age just starting out their careers.

Q2.  Andrew:
What does your portfolio allocation look like?  Do you have 100% stocks, or do you ever have a bond component?

A.  Charles Kirk:
Most of the time you’ll find [I own] a handful of stocks or ETFs. I don’t do bonds as my time horizon is short.

Q3.  Andrew:
You have a great track record against the S&P 500 index.  How many years have you beaten the market?
A.  Charles Kirk:
Every year since 1993. But, remember as I always say, past performance doesn’t mean anything. We are only as good as our next trade, next week, next quarter, next year and so on. And, I will be the first to tell you that I have been luckier than I have been smart.

Q4.  Andrew:
I’ve read that you are writing your own finance book.  What are some of the key concepts you are going to write about—concepts you feel people can really benefit from?

A.  Charles Kirk:
It won’t really be a finance book per se, but rather a book containing all of the experiences and research I’ve learned and collected throughout my career. The idea is that someone who has read it would have a distinct advantage in the marketplace even when read many years down the road.

 One of the reasons I’m heavily involved now in a voluntary mentorship program I started last year is to really understand how others think and learn so I could do a better job as an educator at my website and hopefully later that will be reflected also in my book.

 The plan is to retire the very day the book is published – around 11 years from now.

Q5.  Andrew:
  If you were to boil down three common investment mistakes that people make, what do you think they would be?

 A.  Charles Kirk:
There are many more than that, but these are the three that come quickly to mind:

1) Far too many don’t have a coherent strategy that they can really understand and stick to when the pressure is on.
2) Far too many invest only with their emotions and egos rather than their brains.
3) Far too many chase performance and investment fads/trends too late in their respective cycles.

Q6.  Andrew:
Do you have any particular investments (or investment moves) that you’re particularly proud of making, and why?

A.  Charles Kirk:
I suppose the times I’ve been proud of myself the most are the very times I’ve been patient and had to hold lots of cash when my approach wasn’t working as I thought it should. Knowing when to be sidelined and patient is more important than most realize. Like Warren Buffett, I’m always looking for the fat pitch and, if I don’t see it, I don’t take a swing.

Q7.  Andrew:
What are your biggest investment “lessons learned” over the years and how do you apply those lessons to avoid repeating similar mistakes?

A.  Charles Kirk:
First and foremost, we all must understand our own limitations. I have them and so do you and everyone who reads this interview. Limitations can be a variety of things (lack of skill, lack of time, lack of knowledge, lack of patience, lack of insight, lack of understanding, and so on). 

Once you come to grips with your own limitations, the next thing is to create a strategy toward investing (and trading) that takes those limitations into full account. For most people I encounter, that means just matching the market’s performance using a few index funds as the right approach until their limitations are reduced or eliminated entirely.  After all, until you’ve proven that you can match the market’s performance consistently, you’ll never really understand how to beat it. And, for many, that’s their key objective. 

My job is to help people understand what limitations they have and then figure out new ways to work with those who want to overcome them if the desire and motivation is there to do so.

Q8.  Andrew:
Are there any investors that you admire?  If so, who are they and what do you admire about them?

A.  Charles Kirk:
While I have tremendous respect for many people in this industry, the people I admire the most are those who you unfortunately never hear about until they die. You know the stories.   Some school teacher, for example, after saving and investing their whole life and who managed to leave millions through savvy investing on a meager teacher’s salary.  Those are the stories that inspire me more than anything because these people were able to earn a living the hard way by helping others for little money AND at the same time were able to squirrel away enough money and invest it well so that the fruits of their labor then made a positive impact on other people’s lives for many years following their passing. These are real heroes in my view. Nothing could be better than that. What I do for a living pales by comparison. 

Q9.  Andrew:
Have you ever been asked to run a mutual fund or a hedge fund?  And if not, would you ever be interested in doing that?  Why or why not?

A.  Charles Kirk:
I’ve been asked to join a hedge fund on a couple of occasions. But, speaking of limitations, I learned many years ago that I “don’t play well with others.”  Therefore, to go and work for someone else would not be in my best interest or anyone else’s for that matter.

I like doing my own thing, the way I like to do it. The personal freedom of having no one but myself as a boss is something that is worth more to me than anyone could afford to pay me at a hedge fund.  While I don’t make nearly as much as the hedge fund pros, I make enough. In addition, I have something none of those guys have which is a tremendous amount of personal and professional freedom to do what I want, when I want.

Q10.  Andrew:
How do you control risk in terms of size of positions, closing out at the end of the trading day, and deciding when to let go of a losing position?

A.  Charles Kirk:
I control risk in the following ways:

 1) Selective positioning – I only go for situations which are low risk, but offer high rewards. In essence, the stock or ETF must have 10 points upside and only 1 point downside if my research and analysis is correct.  In addition, I’m trading ETFs more and more both because of the inherent diversification element and  because there is no event associated risk with ETFs.

2) Careful entries – I try to buy at the point where the risk/reward is tilted heavily in my favor.  This will vary depending on the overall market condition, but generally I only look for really good setups.  I don’t trade for the sake of trading.  Most of the stocks I trade I’ve been hunting for an entry point for weeks, if not months, prior to the entry.

3) Position sizing – I scale position sizes based on market conditions.  For example, I’m more aggressive when conditions are good, very conservative when conditions are poor.  I also only add to winning positions and will often pyramid (or scale up) in positions that prove their worth.

4) Stops – before any trade is made, I know my exit point AND I stick to it. My goal always is to lose very little when wrong, but make as much as possible when correct.  Yes, I’m wrong a lot, but the key here is that when I am, I don’t usually lose much.  That’s the key.

Q11.  Andrew:
Is there a benchmark or standard that tells you that you’ve had a good period or not?   

A.  Charles Kirk:
Let’s put it this way:  5% per week (or 1% per day) is my trading goal. However, I don’t beat myself up when I fall short of that target if market conditions are poor.

As any experienced trader will tell you, even the best trader in the world who has plenty of excellent tools, strategies and experience will suffer when market conditions are poor. Understanding that, and adjusting to it, is a big part of trading well.  As traders, we never have any control over the market, but we have 100% control over ourselves. It is the latter part that most struggle with.

Charles, thanks very much for the opportunity of the interview.  With my fingers crossed, you’ll be able to keep an eye on the comments that follow and perhaps, offer your two cents to responses.

Again, good luck with everything—and thank you!

 Andrew

When watching a stock market news based television show, or reading about the stock market’s gyrations in the newspaper, you’d get the impression that the stock market was some kind of very independent, darting animal.

But nothing could be further from the truth. If you know anyone who invests in the stock market, they contribute to that wild animal’s seemingly psychotic behaviour—often without even knowing it.

The stock market’s movements are directly (and only!) related to supply and demand. When people (individuals and institutions) buy more stocks than they sell, the markets rise in value. When people do more selling than buying, the markets fall in value. It’s that simple.

Short Term—Humans are psychopathic

Short term, the stock market is fairly psychopathic, because (hold on for this) short term, humans are somewhat psychopathic.

Don’t believe me? Have you or a friend of yours ever been in an unhealthy relationship? Wrapped up in love, lust or a variety of other emotions, bizarre decisions are made that friends and family can clearly see. But ruled by emotions, it can take a long time before we can see these issues ourselves. When an ugly, unhealthy, or just plain unsuitable relationship eventually ends, the person who was in it often asks, “What was I thinking? How could I have fallen for that person at all?”

This explains most people’s relationship with the stock market. They do crazy things with their money—and often, much later, they wonder, “What was I thinking?” I’m not going to try telling you that love can be demystified. But the stock market can be.

The stock market doesn’t represent a sexy or terrifying online quotation

We have to think of the stock market as a collection of businesses because that’s what it is. It isn’t just a squiggly bunch of lines on a chart or quotes in the newspaper. When you own shares in an index fund, mutual fund or individual stock, you own something that’s as real as the land you’re standing on. You become an indirect owner of all kinds of things, via the companies you own: land, buildings, brand names, machinery, transportation systems and products. Too many people disconnect themselves from what the stock market really is—preferring not to see (or perhaps they don’t understand) that owning shares is really the same as owning businesses.

Imagine having a desire to buy the corner store down the street from your house. You’ll want to evaluate it as a business, so you can figure out what it’s worth.

The owners are motivated to sell, so they show you the store’s financial records for the past 3 years. And after paying for their products, paying their staff, paying the lease on their buildings, paying their electricity (and all other expenses) the business’ profits were as follows:

Year 1 = $50,000

Year 2 = $45,000

Year 3 = $55,000

You’re a businessperson, and most money-minded people of your ilk could come up with a reasonable price to offer for that corner store. But I’m going to use a calculation that lends itself well to understanding the stock market.

During the above 3 years, the average profits for the business were $50,000 per year. Now let’s make the assumption that a fair price to pay for that business will represent a price that’s 14X higher than the business’ profits, or $700,000 a year. ($50,000 x14 = $700,000) The current owners feel that this is a reasonable price, but they change their mind and decide to hold on to the business.

Three years later, the business owners call you up and ask if you’re still interested in buying their store.

Rising business values = Rising Stock market prices

You suggest, of course, that you’ll need to look at the business’ financial records again. And this time, you notice that the store has become more profitable, with the profits as follows:

Year 4 = $65,000

Year 5 = $60,000

Year 6 = $70,000

The average earnings for that business, over the past 3 years, now represents $65,000.

As such, the business is now 30% more profitable than it was 3 years before. And for this reason, when calculating a price based on 14X the earnings level, we get a price of $910,000 for the business ($65,000 x 14 = $910,000)

It makes perfect sense, of course. The business makes more money, so the new purchase price should represent a direct correlation between price and profits. If the profits are now consistently 30% higher, then the price offered for the business should be 30% higher.

Long term, this is exactly how the stock market works. If you own a total stock market index fund, you own a small piece of every publically traded business. From 1920 to 2010, the average American business increased its profits by about 6% a year, and it paid cash dividends to its shareholders of roughly 4% a year. This created a total increase of 10% annually (6% earnings increase + 4% dividends paid out = 10% overall increase)

Some American businesses increased their profits at a higher rate than this, some increased their profits at lower rates, and others went bankrupt. And some years were better than others. But as an average, American businesses increased profits by 6% and paid dividends of 4% annually. If you could have bought a total stock market index fund in 1920, this is what you would have made: 6% annually from price appreciation and 4% annually from dividends, for that total of 10% annually.

And this is where the “people are rational long term” argument comes in. Because those business profits increased by 6% annually, people were willing to pay 6% annually more for the rights to own shares in those businesses. As owners, they then reaped the extra 4% paid out in dividends.

Over the long term, people were willing to pay what the businesses were worth. American business earnings plus dividends increased an average of 10% annually from 1920 to 2010, and that’s why investing in the stock market from 1920 to 2010 would have produced 10% annually, with dividends reinvested.

Like the little corner store, there’s a direct relationship between the level of profits and the price that people are willing to pay.

Long term, it’s perfectly rational.

Short term, however, the markets aren’t rational. Short term, people are financially psychotic.

It’s a beautiful thing that you can take advantage of, if you keep a level head.

 

At first glance, the question answers itself.

Most people prefer a rising stock market unless they’re hoping to “short” the market (betting that it will drop in value, and financially winning if it falls)

Blogger, Financial Uproar  talks about stereotypes—ways of thinking (in many cases, financial) that have no basis of truth or common sense to them.

He jokingly questions whether we need to “beat people senseless” for believing financial concepts akin to the Earth being flat. But perhaps we should just beat on against the tide, to coin a beautiful phrase from The Great Gatsby, and forget about the foibles of others.

I wish I could. But it’s tough to ignore popular sentiments based on the stock market’s general direction—especially for those cursed with pedagogical tendencies they can’t control. My hand is up right now.

For retirees, of course, a dropping stock market is potentially devastating—-because many retirees regularly sell off their investments to put food on the table.

But if you’re a young investor, and you want to see a rising stock market, you’ll remind me a bit of the characters in the recent Leonardo DiCaprio flick, Shutter Island, where the theme involves delusion and, well….insanity.

Now, I don’t want to go around calling people “insane”—but there’s something about investing that mystifies me.

Most people, regardless of their age, want to see the stock market increase in value.

Perhaps it’s a permeating fear of the unknown,  that Kevin explores at his blog, www.investitwisely.com.

But my thought is this. When little kids are taught to memorize their multiplication tables (I’m assuming they still do that?) they should also be taught to draw a 200 year long line graph of the stock markets of the developed world—a line graph including reinvested dividends.

Maybe then, more kids would grow up into adults who learn that the best times to invest are during dropping markets, not rising markets. They’ll conquer fear with logic.

Then, as Jason Zweig suggests, more investors will read headlines suggesting, “Investors lose as markets fall” and edit them in their own minds to something like this: “Gamblers, speculators and retirees (who are selling) lose as markets fall, but investors win.”

Warren Buffett coins it nicely with this little “test” from his 1997 Berkshire Hathaway annual report. I’d like to see this one administered to kids in schools, to encourage a far more educated investing public.

“If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.

But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period?

Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the ‘hamburgers’ they will soon be buying.

This reaction makes no sense. Only those who will be sellers of equities [stock market investments] in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.”

But I’ll open my mind to exceptions. If you plan to invest over the next five to ten years (or more) and you feel good about seeing stock markets rise, then I want to hear from you.

I love to see falling stock prices—because I’m a 40 year old long term buyer. The lower the stock market falls, the happier it makes me. I want to buy cheaply. I’ve memorized that 200 year stock chart myself, and I know that consistently (with no exceptions that I can see) the best buying times for long term investors have been during falling markets or flat markets. And the best attribute for long term investors appears to be patience.

But perhaps I’m the one who requires an education from someone else with a pedagogical urge.

If your hand is up right now, help me out and post a comment.

Nearly every stock market headline celebrates rising markets for investors. So, should I be the one condemned to Shutter Island?

 

 

The 5 and 7 Year Itches

One of my friends invests with Raymond James Financial. After reading about the merits of indexed investing, he’s going to ask his advisor what he thinks.

The advisor will suggest something like this:

“Look, index funds might be fine for part of the portfolio, but you need to adjust your risk. Plus, we can find funds that beat the indexes.”

One of the first things an advisor likes to assume is that the client doesn’t understand the concept of portfolio allocation. True, for most people, a portfolio with a 100% stock index would be risky—about as risky as having a portfolio with a handful of actively managed stock-based mutual funds.

But if the client understands “portfolio allocation”, the advisor will start to sweat…

At the investment seminars I’ve given, I’ve suggested that people keep things simple:

1. The U.S. market constitutes nearly half of the world’s total stock market valuation, so it should constitute nearly half of the stock market money in your portfolio.

2. The international market makes up the remainder of the world’s stock market capitalization, so it should constitute the remaining “equity” portion of a portfolio.

3. If the client is between the ages of 40 and 50 (and if they don’t have a pension) then they could take a page out of John Bogle’s book and have 40% to 50% of their portfolio in bonds. Respected professor, Burton Malkiel, suggests a similar bond allocation.

Just three funds would accomplish the task:

40% in a Vanguard bond index

30% in a Vanguard total stock market index

30% in a Vanguard international stock market index

People can argue the merits of whether the investor should have a higher U.S. representation, or a higher or lower bond representation or a real estate income trust component or even a precious metals component.

And that’s fine. There are loads of trains of thought to defend and attack the above position.

That said, it will be tough to find an educated investor (with a financial education) who will suggest that an advisor charging a wrap fee of at least 1%, and then buying actively managed funds for my friend, will come close to the returns of the above portfolio over a lengthy period of time.

My friend has his money in a taxable account, and this is where it will be even more costly for him to remain with Raymond James. Actively managed mutual funds are not very tax efficient, when held in taxable accounts. Index funds are tax efficient.

If the advisor is good and honest, and if my friend presents these arguments, then he’ll say to my friend: “You’re right. You really should change your account. I’m sorry. I really could have cost you tens of thousands of dollars over your investment lifetime.”

If my friend is curious to see how he would have done with the simple arrangement above, I’ve tracked the results of such an indexed portfolio.

He could do this, to make a comparison with his own portfolio. Look at where his portfolio value was 5 years ago, near the end of June, 2005 or the beginning of July, 2005. He could then look at his portfolio value today, and then subtract the contributions he has made to the portfolio over the past 5 years.

For instance, if his portfolio was worth $200,000 five years ago, and if he deposited $1000 a month, then we could look at his current portfolio value, subtract $60,000 in contributions, and see what his dollar gain had been. From there, regardless of what his value was, he could work out an overall gain or a loss.

If his account was $150,000 five years ago, and if it was worth $200,000 today, we would take today’s value ($200,000) subtract his monthly contributions (say, $60,000 total) and come up with a number amounting to $140,000. In this case, my friend would have lost money over the past five years. To find out the percent lost, you’d divide 140,000 by 150,000, to get .933. This means that his account would be 93.3% of what was deposited into it, for a loss of 6.7%

I’ll be honest. The picture probably won’t look pretty for any investor. The markets are lower today than they were five years ago. But he needs to have a look.

If he had invested in Vanguard indexes in 2005, as suggested above, and if he hadn’t changed a single thing about them (and hadn’t added fresh money) his $200,000 invested five years ago would be worth $204,806.79, for a total growth of 2.4%.

You can see the portfolio here, titled “5 Year Itch”

Portfolio:	5 Year Itch
Date:	06/21/10 09:24 AM
Ticker	Company Name	Cost	Shares	% of Total	Current Value	Gain / Loss	Gain / Loss
VBMFX	Vanguard Tot Bd;Inv	$10.27	7,789.00	40.35%	$82,641.29	$2,648.26	3.31%
VGTSX	Vanguard Tot I Stk;Inv	$12.60	4,761.00	31.22%	$63,940.23	$3,951.63	6.59%
VTSMX	Vanguard T Stk Idx;Inv	$28.77	2,085.00	28.41%	$58,192.35	($1,793.10)	-2.99%
				0.02%	$32.92
						$0.00
					$204,806.79	$4,806.79	2.40%

If he had invested in the same manner at the beginning of 2003 (my friend can do the same calculation from this date, if he wants) then his $200,000 would be worth $269,599 for a total gain of 34.78%.

You can see the portfolio here, titled “7 Year Itch”

Portfolio:	7 Year Itch
Date:	06/21/10 09:23 AM
Ticker	Company Name	Cost	Shares	% of Total	Current Value	Gain / Loss	Gain / Loss
VBMFX	Vanguard Tot Bd;Inv	$10.38	7,600.00	29.91%	$80,636.00	$1,748.00	2.22%
VGTSX	Vanguard Tot I Stk;Inv	$7.72	7,772.00	38.72%	$104,377.96	$44,378.12	73.96%
VTSMX	Vanguard T Stk Idx;Inv	$20.07	2,989.00	30.95%	$83,422.99	$23,433.76	39.06%
				0.42%	$1,122.93
						$0.00
					$269,559.88	$69,559.88	34.78%

If my friend has been lucky, his performance will be similar to the indexes. If he hasn’t been lucky, his portfolio will lag the indexed portfolio considerably.

If he wants to increase the odds of future success, he’ll index the entire account, with stocks and bonds, and he’ll use a Vanguard representative to help him set up his account with the above allocations.

Then he’ll do nothing but wait, and contribute fresh money.

If he wants professional tax advice, he’ll pay out of pocket for that, and save himself a bundle in the hidden fees (and the not so hidden fees) currently charged by his advisor.

The financial service industry is rife with conflicts of interest.

Big brokerage houses like Merrill Lynch, Raymond James and Edward Jones (to name just three) end up receiving kickbacks from fund companies for referring their products to clients. Academics have coined it “pay to play” fees.

The fact that a company like Edward Jones has a publically traded fund company like Putnam on its preferred fund list is laughable, considering how poorly Putnam funds, as an aggregate, have performed over the years. It works like this:

Edward Jones Broker 1 to Edward Jones Broker 2: “Hey, these Putnam funds are pretty bad, don’t you think? Why do we recommend them to clients?”

Edward Jones Broker 2 to Edward Jones Broker 1: “You don’t know? If we recommend Putnam’s funds, Putnam can slip us cash, round the world trips, golf course memberships and more.

The practice is referred to as “Pay to play” fees. To read about these in detail (and to see who else is guilty of it!) check out David Swensen’s, Unconventional Success: A Fundamental Approach to Personal Investment.

Swensen’s book is mind-blowing. And as the revered endowment fund manager at Yale University, the man knows what he’s talking about.

To shield yourself with information on how poorly (in terms of mutual fund investment returns) publically traded fund companies do (relative to non- profit companies like Vanguard, TIAA Cref and private businesses like Dimensional Fund Advisors) as well, check out William Bernstein’s latest book, The Investor’s Manifesto:  Preparing for Prosperity, Armageddon, and Everything in Between.

Amidst the industry’s muck, however, are a few heroes.

And Robert Wasilewski appears to be one of the good guys. Robert Wasilewski, of RW Investment Strategies is a Registered Investment Advisor and  his goal is to set investors up with index funds, charge them just 0.4% annually, and then essentially fire himself when the investor gets the hang of this very simple process. I’m guessing that the guy sleeps very well at night. (Contact Robert for more info.)

Robert’s methodology is along the same lines as the San Francisco based Aperio Group  which you can read about in the fabulous article: “The Best Investment Advice You’ll Never Get”.

I haven’t used Robert Wasilewski’s services, nor have I spoken to the people at Aperio.

But I can tell you this: they’re great places to start your research, if you’re looking for a fair investment advisory service.

If you watch the stock market, the economy, and you think bad news is bad, you’re probably a lousy investor

I’m not going to make myself popular when I say this, but investing in the stock market is pretty easy. Long term, there’s an upward trend, so it’s a lot like gambling with the odds stacked very heavily in your favour.

The stock market has always been an easy place for me to make money— because I’m not very smart.

Most smart people make terrible investors. Here are four reasons why:

1. They watch market news, talk about the economy and try to figure out where things are going next.

This is foolish move number one, but really smart people have a tough time ignoring the media and the economy. Smart people can’t help it. They want to use their brainpower, and in the process, they lose, disastrously long term to the dumb money—the stock market indexes. Buying diversified indexes on the cheap is when, to steal Buffett’s phrase, “Dumb money ceases to be dumb”

If the stock market is trading at a reasonable multiple (today it trades at roughly 14X earnings, which puts it at roughly the 100 year average) then you’ll make long term money by buying at these levels.

Valueline has a great, long term DOW Jones Industrials price chart dating back to 1920. History spells out one consistent reality. Buy when PE ratios are at or below 14X earnings, and you’ll make long term money. Buy when PE ratios are silly (like 22 or above) and the decade that follows will give you investment misery. Where’s the PE today? Roughly 14X earnings.

It doesn’t matter how you slice the pie; that’s the historical reality.

But if you were a smart person living during times when the PE ratios were below 14X earnings, and if you watched, digested and analyzed economic news, you probably wouldn’t have bought anything. You would have sat waiting for better opportunities, for the economy to turn around, for unemployment declines to abate, for prices to get cheaper. Too bad. You wouldn’t have made as much money as you could have. Your brain power would have handicapped you.

2. Many smart people like to buy what’s hot and watch current trends.

OK—sure there are people like Charles Kirk who make a fortune trading. But most traders end up sooner or later, “Blowing their Brains Out”–to use the lovable Boston stockbroker, John Spooner’s language.

3. When buying individual stocks, many smart people care what current sales trends are, and they want news of short term upwards sales growth

Again, if you’re like Charles Kirk, fair enough. You can trade your way a gazillion times and make money based on short term news. But looking at short term news is foolish for most people.

Instead, buy the greatest business you know, with the highest return on total capital, with a durable competitive advantage, with loads of customers, with products that they can increase the price of, with inflation. Ensure that the business has the least amount of debt, with a history of buying back shares only when prices are decent, and ensure that the company doesn’t overly pay its CEO. Make sure the industry’s outlook for the next five years is bleak, bleak, bleak, so you can buy loads of shares, but make sure that the industry itself is always going to be needed (ie, avoid newspapers) Then load up on shares over time, and wait, and wait and wait. Easily done. Rinse and repeat with great businesses of this ilk and you’ll make a lot of money.

4. Smart people refrain from buying indexes with bleak outlooks

I’m going to go out on a limb to suggest that smart people avoiding troubled markets will never make decent money in the stock market. That said, if you want to pound the investment returns of most “smart people”, you’ll have to discriminate. Like stock investing, you can’t just buy any beaten down stock. Likewise, you can’t just buy an index from any old economy. For instance, who knows what’s going to happen to Chile over the next 20 years? There’s a patchy track record there, poor transparency, and like most South American economies, loads of corruption. A single Chilean stock market index would be risky.

But as far as guarantees are concerned, you can’t do much better than Vanguard’s European stock market index today. Buy it now. Forget the latest news. If the index gets cheaper, buy more of it. If it gets cheaper still, back up the truck. If it drops 90%, and you can afford to borrow money to buy a six figure chunk of it, then do it.

Most smart people won’t do this, because they care too much about the short term. But if you plan on being around in 25 years, you’ll lay foundations for delicious long term profits by purchasing this index today, and continuing to average down. You’ll beat almost every “smart investor” you know.

The European index is broadly based; it isn’t Japan. This index is linked to more than one economy. Sure the European Union is somewhat linked. But that’s why it’s cheap right now. God bless you Greece, Portugal, Spain and Hungary. I love you. I truly truly love you.

Writer’s note

Truly great investors are emotionally smart. They don’t have to be intellectually smart.

Earlier this week, I bought $65,000 worth of Coca Cola shares at $50 per share, adding to the Coke shares that I bought in 2003 and 2009, for $38 and $45 respectively.

Paying $50 per share represented a fair value to me, but my energetic work-out buddy asked me why…why did I buy Coca Cola?  And why did I throw so much money behind it?

This post is intended to answer his question.

1.  Coke has brand name recognition all over the world, and it has more than 3,300 drinks under its label.   

Yes, you read that correctly:  more than 3,300 drinks.  In North America, Pepsi products can compete with Coke’s, but in nearly every other worldwide country, Coke dominates.  As a world traveller, I see that firsthand, and I marvel at it.

2.  Unlike a company like Apple, Microsoft or any tech company, Coke can increase the price of its products with inflation.  It’s also not significantly affected (as a business) by economic cycles.

For example, breaking Coke’s earnings per share into 3 year chunks dating back to 1985, there isn’t a single 3 year period where the average earnings were lower than they were for the previous three year average.

For example, if you average Coke’s earnings from 1985 to 1987, you get 26 cents per share.

• From 1988 to 1990 you get 43 cents per share.
• From 1991 to 1993 you get 72 cents per share.
• From 1994 to 1996 you get 86 cents per share.
• From 1997 to 1999 you get $1.45 per share.
• From 2000 to 2002 you get $1.57 per share
• From 2003 to 2005 you get $2.06 per share
• From 2006 to 2008 you get $2.64 per share

My guess is that Coke is the most predictable business in the world. 

And that’s one of the things that makes it easy to value.

3.  Its earnings per share have grown 11.4% annually since 1985; 8.5% annually since 1999; and 7.3% annually since 2004.  Size will always be an impediment to growth, but Coke still has plenty of room to grow as the standards of living increase in the third world—especially in India and China.  And don’t forget, they’re drinking Coca Cola in those countries today, but they’re also drinking loads of Coca Cola products that you and I have never heard of.  Think about those 3,300 drinks again.

4.  Coke is conservatively financed.  Think about this for a moment.  If you were to allocate all of your net salary (after tax) to your debts, including your mortgage, how long would it take to pay everything off?  Of course, that isn’t a practical thing to do (because you have to eat, house yourself etc) but if about 6 months of net earnings could cover it, you’d be in decent financial shape, correct?  For Coke, that’s what we’d be looking at.  Its earnings, if solely applied to net income (after all company salaries and expenses were paid out!) could pay off its long term debt in six months.

5.  Coke doesn’t need to plow loads of money into research and development.  Because of this, it can remain competitive with its products at a relatively low cost, and not have to worry about creating the next, latest tech gadget or pharmaceutical blockbuster.

6.  Its sweet, sugary syrup is cheap.  As such, Coke is hugely profitable.  Its net profit margins are above 20% every year (virtually unheard of) and its return on shareholder’s equity averages above 25% annually as well.  In a nutshell, this means that the business makes a freakish amount of money on very little capital.  It’s very efficient.

7.  Capital expenditures are low.  Think about the money an airline industry or a telecom business has to invest in its infrastructure to remain competitive.  Nobody has to maintain Coke’s products, and they don’t wear out.

8.  They probably have more “customers” than any company in the world.  If you’re a real estate investor, think of it this way:  if you have a single family home rented out, you’re like an aircraft manufacturer (OK, a lot worse) because you only have a single source of revenue.  Likewise, an aircraft manufacturer has very few customers.  As a real estate investor, if you own a triplex or a quad (or an apartment building!) then we’re talking multiple streams of revenue off a single roof.  It’s more efficient.

In business/customer terms, Coke’s customer base is probably the largest on the planet.

9.  Because its earnings are so predictable, it’s easier to put a valuation on it—it’s easier to know what price to pay for its shares.

10.  Coke earns more than 70% of its revenue from overseas.  So if the dollar continues its slide, it continues to be good for Coke.

How did I determine what price to pay for my Coca Cola shares?

There are a couple of different methods here.  First, I looked at Coke’s average level of earnings over the past five years.  It amounts to the following earnings per share levels, and then the average I’ll show you:

• 2005 = $2.17 per share
• 2006 = $2.34 per share
• 2007 = $2.57 per share
• 2008 = $3.02 per share
• 2009 = $2.92 per share

The average earnings per share level from 2005 to 2009 = $2.60

If I divide $2.60 per share by the price I paid for my shares ($50 per share) I get an earning yield of 5.2% annually.  If this figure is higher than the rate of a risk free 10 year U.S. government bond, then I’m being offered a premium to hold these shares instead of a bond.  The current U.S. 10 year government bond yield is 3.3%, so Coke is offering me a 57% premium over what a U.S. government bond would pay me.

Many investors choose to look at a single year’s earnings to determine the earnings yield.  In this case, they’d look at $2.92 per share, divided by $50, for an earnings yield of 5.8% rather than 5.2%.  That’s a 75% premium over a government bond yield (5.8 – 3.3 = 2.5 divided by 3.3 = .757)

Doing this (going with a one year example above) might work well for Coke, because of its consistent earnings and growth promises.  But for most businesses, its better to be safe and go with a five year average.  Either way, Coke’s business yield is a lot higher than that of a 10 year government bond.  What’s more is the fact that Coke is nearly certain to make more money over the following three year period, and more money again over the next three year period.  This increases the yield that a purchaser of Coke would be able to enjoy.

But what return can I expect on my investment from Coke?

The future price of a stock is related to two things:

1.  Business earnings

2.  The earnings multiple that investors are willing to pay.

Let me explain the business earnings first.

Coke’s shares, long term, will reflect its business earnings.  If the company makes more money over time, its intrinsic business value will rise over time—thus the demand for the business will reflect in the rising stock price.

Sometimes, dangerous things can occur because investors don’t always tend to be rational.  For example, in the 1990s, the share price increased by 443% (from 1990 to 2000)

But the business’ earnings only increased by 240%.

Anyone who bought Coke between roughly 1995 and 2001 had no business sense.  They bought Coke shares because they were rising in value.  This would have been an expensive education for them.  If they held their shares from 1991 until today, they would have seen their company increase its earnings by 83%—but their shares would still be down about 22%.  The stock market is no place for fools.

That said, Coke isn’t “popular” anymore—which is a good thing for investors.  Yet, it continues to churn out large business products.  At $50 per shares, you’ll pay roughly 17X business earnings.  Think of it this way.  If you had bought the ENTIRE COMPANY, it would cost you about $120 billion.  That cost exceeded Coke’s profits in 2009 by 17 times.  So if you owned 100% of the business, and you paid $50 for every share, it would take the business 17 years to pay for itself, based on last year’s net earnings income.  Of course, earnings will increase over time, that’s a near certainty, but this is how we come to the conclusion that Coke is trading at 17X earnings.

Foolish people were paying more than 55X earnings in 1998.  And of course, if those people still own the shares they paid more than $80 for, they’re still down by 40%.

We know that Coke’s growth rate has slowed.  But it’s still growing.  The past 5 years has seen growth of 7.3% annually (2004 to 2009).  It’s a far cry from the average growth rate between 1985 and 2009 (11.4%) but it’s still impressive.

So what of the future?

My guess is that Coke can keep growing at 6% annually for the next 10 years.  Valueline’s analysts seem to think that Coke can grow its earnings per share by a full 26% from 2009 to 2011. 

If that happens, great.  But as investors, it pays to always have a margin of safety.

If Coke’s earnings per share are $2.93 today, and if it grows by 6% annually over the next 10 years, then its earnings per share will amount to $5.25 in the year 2020.

If Coke trades at its current PE level of 17X earnings, Coke’s stock price will be $89.25, ten years from now.

If Coke shares become somewhat popular, and they trade at 22X earnings, Coke’s stock will trade at $115.50 per share.

Of course, prudent investors should always calculate a margin of safety.  That’s what I did by assuming a growth rate of 6% annually for Coke, despite Valueline’s rosy outlook for significant growth over the next few years.  Frankly, I’ve beaten the market over the past decade by ignoring analysts.  Following them and believing them can make you broke in a hurry.

It’s my belief that I should be able to expect roughly a $90 per share price for Coke, ten years from now.  That will give me a 6% compounding annual return on my stock price, and a further 3.5% annual dividend yield, http://finance.yahoo.com/q?s=ko

for a total pre-tax annual return of 9.5% annually.

Scoff at that if you want, but that would turn the $65,000 I invested in Coke last week, into $161,000, ten years from now.

If you want a high probability of a decent return, Coke might be it (if purchased at $50 or below)

What do you think?