WHAT IS VALUE INVESTING
Investors seem to have adopted a more realistic view of international investments, shaped by a surge of information, lower transaction costs, the bursting of several bubbles, emergence from several crises, and a realization that economies and markets are more interconnected than ever. This tutorial explains all Tips that are necessary for Value investing.
In the interviews we conducted with leading investment managers around the globe, most of them expressed a view that the commonalities of international markets outweigh the differences.
Numerous studies confirm that adding international equities to a portfolio improves the risk-reward profile, either by boosting expected returns for a given level of volatility or by lowering the volatility for a given level of return.
Many investors appear to make the mistake of expecting foreign markets to mirror their domestic market in every material way. This may be particularly true in the area of corporate governance. Unfortunately, governance practices change only slowly and may be impossible to influence from the outside.
We avoid much trouble in international investing when we accept that some levers, such as corporate governance, are harder to pull than others, such as the price we are willing to pay.
When we go global in the search for investments, we give ourselves a free option to pay a lower price than might be possible in our home market. While no two equities are the same, similar companies frequently trade at materially different valuations across geographies.
Buffett ’s concept of the circle of competence, while typically used in the context of different industries, may also have applicability to different countries. Due to the many unifying features of global equity investing, we may falsely assume that our competence extends to investing in all geographies.
One of the biggest drivers of disappointment for investors who venture globally might be an unrealistic view of the promise of emerging markets. In the rush toward growth, many investors readily ignore the return-on-capital prospects of fast-growing but highly competitive and capital-intensive industries.
The issue of challenging demographic trends confirms the importance of calibrating fundamentals versus expectations, perhaps best explained in Alfred Rappaport and Michael Mauboussin’s Expectations Investing. When the expectations implied in stock prices fall materially short of the likely fundamental, a buying opportunity may be at hand.
Excluding a country from consideration without regard for valuation may seem like an irrational decision for investors who subscribe to the view that there is a price for everything.
However, the decision becomes more sensible if the importance an investor places on a factor like corporate governance differs materially from the importance placed on the same factor by other investors. Here are the some methods in value Investing.
Many investors buy stocks through mutual funds. Mutual funds issue shares, like other corporations, but instead of using the shareholders’ money to build factories and office buildings, they buy stocks and bonds. There are thousands of mutual funds catering to the specialized and varied tastes of investors.
There is a fund for baptized Lutherans, one for airline pilots, and another for cemetery owners. One fund buys only aviation stocks; another buys stock in gold-mining companies.
One fund invests in Australian securities; one in Ohio businesses. Others do not invest in alcohol, tobacco, gambling, or munitions stocks. The Vice Fund does the opposite, specializing in sinful industries.
Many people are drawn to mutual funds by their advertised expertise, reasoning that just as they pay a doctor for medical services and a lawyer for legal assistance, so they should pay a professional for investment management.
They choose a fund with an outstanding record and if this fund’s subsequent performance is disappointing, they switch to another fund that has been more successful.
Management fees depend on the number of assets managed, and the top-performing funds are swamped by investors looking to share in the success. This investor chase for successful funds encourages funds to trade feverishly, looking for the quick profits that will lure more investors (and management fees).
Like his mentor, Benjamin Graham, Warren Buffett has been critical of the hyperkinetic activity of institutional investors who speculate about short-term price fluctuations instead of focusing on long-term investment values.
In a Berkshire annual report, Buffett wrote that “the term ‘institutional investor’ is becoming one of those self-contradictions called an oxymoron. I would add that “value investor” is not an oxymoron, and that value investors should be leery of hyperactive mutual funds.
LOAD CHARGES AND OTHER FEES
Mutual funds can be bought through fund salespeople, insurance agents, stockbrokers, or directly from the fund itself. No matter which route is used, the fund may levy a sales charge, called a load fee. For a “full load” fund, the load is generally between 5 percent and 8.5 percent, split between the salesperson and the fund itself.
Funds that sell directly to investors are generally “low loads,” with a fee of 3 percent or less, all of which goes to the fund. Funds that don’t charge load fees are called no-loads.
In addition, SEC Rule 12b-1 allows mutual funds to charge an annual fee—often, one percent or more—to cover marketing expenses (including sales commissions).
To discourage early redemptions, funds with substantial 12b-1 fees may impose early redemption fees to ensure that investors either pay several years of 12b-1 fees or a substantial redemption fee.
David Swensen, Yale’s extraordinary portfolio manager, has said, “Shame on the SEC for allowing 12b-1 fees, shame on the directors for approving them, and shame on the mutual funds for assessing them.”
How do they get away with it? It’s our fault. The Security and Exchange Commission requires mutual funds to show all of their charges in a standard table in the prospectus, including estimates of how these fees affect a $1,000 investment over periods of one to ten years. Unfortunately, the table is not mandatory reading.
A former director of the SEC’s investment management division estimated that fewer than 10 percent of mutual fund investors ever open the prospectus.
Many mutual fund salespeople capitalize on short-term froth in the stock market by focusing their sales pitch on recently successful funds, giving the misleading impression that future investors are assured of a similarly spectacular performance. We fall for their babble because our dreams of easy riches make us gullible.
Mutual fund families play this game, too, promoting funds that have had recent successes and not mentioning disappointments. Many in the industry suspect that some fund families have hundreds of disparate funds and keep creating new funds to ensure that they will have successes that can be promoted heavily.
Mutual funds have considerable latitude in reporting past results and some of them play sneaky games. For example, if two funds merge, the manager can choose which of the two performance records to attribute to the combined fund.
For instance, if Fund A has earned 10 percent a year and Fund B has lost 10 percent, the manager can merge B into A and continue to report the fund’s return as 10 percent a year.
DO MUTUAL FUNDS BEAT THE MARKET?
Study after study has found that, before expenses, mutual funds do as well, on average, like monkeys throwing darts. After expenses, two out of three funds do worse than the market.
Professionally managed mutual funds charge an unconscionable amount for this inferior performance. As David Swensen wrote, “Overwhelmingly, mutual funds extract enormous sums from investors in exchange for providing a shocking disservice.”
No problem. Even if two-thirds of the funds do worse than the market, just invest in the one-third that beat the market. Right? As one market observer put it, “The problem of picking a mutual fund seems to be simplicity itself:
The investor should select whichever fund will give him the largest percentage return, year after year.” Sure enough, investors pour money into recently successful mutual funds, paying big load fees in the belief that past performance ensures future success.
Unfortunately, funds with above-average records in the past are no more likely to do well in the future than a fund with below-average records.
This is why the president of Morningstar, an independent mutual fund rating service, once said that rating mutual funds on their annual performance were “the dumbest thing imaginable.” Nonetheless, they started doing just that the next year. There is always a market for dumb things.
Mutual funds are not the only professionally managed portfolios whose performance has been disappointing. Money managers as a whole underperform the market after management fees and other expenses, and there is little consistency in their performance— knowing which managers have done well in the past is little help in predicting which will do well in the future.
There is truth and wisdom in the advice that ordinary investors should park their money in an index fund. Unchecked human emotions can lead us to trade too much, to trust hot tips, to chase trends, to be caught up in speculative bubbles and fearful panics. Indexing protects us from ourselves.
Investors who cannot control their desires and emotions should put their savings in a low-cost index fund (I love Vanguard, too) and leave it alone. They will sleep better and do better than they would be led around by desire and emotion.
Yes, indexing protects us from human foibles and follies that can lead us into making bad investment decisions.
On the other hand, if we recognize these human imperfections and are not seduced by them, we may be able to take advantage of the fact that human errors and animal spirits create potentially profitable opportunities.
That is the essence of value investing. Wishful thinking, fads, trend-chasing, fear, greed, and other human emotions can cause Mr. Market’s prices to surge above or collapse below intrinsic values, allowing value investors to buy stocks cheaply and sell stocks profitably.
Those investors who can be true value investors, putting aside wishful thinking, greed, fear, and other destructive human tendencies, can do better than indexing.
When I have money to invest, I look at well-managed companies (as gauged, for example, by Fortune’s annual list of the most admired companies) that have large dividends and/or earnings relative to their stock price.
I am wary of stocks whose prices have increased dramatically and tempted by stocks whose prices have fallen, figuring that I am more likely to find bargains among stocks the market hates than among stocks the market loves.
I buy what I like using an inexpensive online broker and forget about it. I don’t waste time checking stock prices every day (or worse, every hour or minute).
I do notice (how can one not notice?) if there is a stock market crash. I do notice if bubbly things are happening (like the Wall Street Journal article about Bill’s Barbershop). That’s about it.
Here are a few other KISS rules of thumb.
Stocks can be bought and sold using full-service brokers such as Morgan Stanley, UBS, Merrill Lynch, Edward Jones, and Raymond James that compile mountains of data, prepare in-depth analyses, and make buy/sell recommendations. Investors have individual account executives (please don’t call them “brokers”) who give advice based on the firm’s research.
Many investors appreciate the individual attention and comfort of having someone help them make decisions, but they pay for it with high fees.
In addition, account executives have a fundamental conflict of interest since the more their customer's trade, the more revenue is generated for the brokerage firm.
Discount brokerage firms, in contrast, do little more than answer the phone, give current prices, and record trades. Cheapest of all are trades made over the internet without the assistance of account executives or telephone operators. Commissions are lower because the firm does not do research or offer advice and doesn’t need as many employees to deal with customers.
Many discount brokers give investors free internet access to enough information to make sensible investment decisions.
BUYING ON MARGIN
Buying stock with money borrowed from a brokerage firm is called buying on margin, where the margin is the money the stockholder puts up.
If you buy 200 shares of ZYX stock for $50 a share (a total cost of $10,000), a brokerage firm with a 60 percent margin requirement will require you to put up at least $6,000 (and loan you the remainder).
The brokerage firm charges you interest on this loan, but, as with any leveraged investment, you come out ahead if the rate of return on your stock exceeds the interest rate on your loan.
If your equity—the market value of your stock minus your current loan balance—falls below a specified maintenance margin, you will get a margin call from your broker requesting additional funds. The Fed requires a 25 percent maintenance margin, but many brokers use a more conservative 30 to 40 percent.
I’ve never bought stock on margin.
If you think a stock’s price is heading downward, you can sell shares you don’t own by selling stock that your broker borrows from another investor.
This is called a short sale, and it must be covered at some point by buying stock to replace the borrowed stock. Short sellers try to follow the age-old advice to buy low and sell high, but they sell first and buy later.
Short sellers do not receive the proceeds from the short sale; the brokerage firm holds on to it and earns some interest for itself. Not only that, brokers require short sellers to put up margin, perhaps 50 percent, and then charge interest on the remaining fraction.
Short sellers pay in-and-out commissions, lose the interest they could be earning on their margin, pay interest on the rest, and pay dividends on the underlying stock—seemingly expensive penalties for being a pessimist.
I’ve never sold stock short.
CHURNING IS DANGEROUS TO YOUR WEALTH
When first starting out, brokers try to build a client base by making cold calls to people who have been identified as potential customers, often as a result of advertisements offering free, no-obligation financial reports.
Those who respond to the ad receive follow-up phone calls from brokers hoping to find customers. These cold calls are called “dialing for dollars” because the only way a broker can make money is by clients making trades.
Brokers have a persuasive incentive to recommend active portfolio management (“account upgrading” is the euphemism, churning the goal)—sell Wells Fargo to buy Chase; then sell Chase to buy Bank of America; then sell Bank of America to buy Wells Fargo; and on and on. Brokers are like sharks—they need a movement to survive.
Most brokers are conscientious professionals who know that excessive expenses and dismal performance will alienate customers. As with any profession, however, some brokers are unscrupulous and, like vicious sharks, churn their clients’ accounts mercilessly.
A front-page story in the Los Angeles Times that detailed some stockbroker abuses was subtitled “Beware, Unwary.”
In one case, a seventy-year-old retired radio actress saw her $550,000 nest egg shrink to $67,000 while thousands of pointless trades generated $310,000 in commissions.
When she asked her broker about the blizzard of trade confirmation slips mailed to her, she says he told her to “throw them away.” This is like this old joke: “How do you make a small fortune in the stock market? Start with a large fortune.”
Most broker-client relationships are not horror stories, but the nightmares do warn that broker and customer objectives do not always coincide. I avoid brokers by using online brokerage firms.
Brokerage fees are either a percentage or a flat fee, or a combination of the two. For small trades, the commission can be staggering; for example, most brokerage firms have a minimum commission of, say, $9.99 even if you just buy one share of a $5 stock.
As a percentage of the cost, brokerage fees drop for larger trades, but these savings may be offset by the effect of the transaction on the market price since it may take a significant price increase to find a seller and a substantial decrease to find a buyer. If you sell one stock to buy another, you have to pay two transaction costs.
At, say, one percent round-trip, active trading becomes pretty expensive. Trading once a year, the stock you buy has to have a 2 percent higher annual return than the stock you sell to cover the cost of the trade. This differential rises to 24 percentage points if you trade every month. Please don’t trade every month and, God forbid, don’t day-trade.
DEFERRING GAINS AND HARVESTING LOSSES
It is generally a bad idea to jump in and out of stocks—sell Apple to buy Google; then sell Google to buy Amazon; then sell Amazon to buy Apple; and on and on. One problem is the endless brokerage costs. Another is the taxes that must be paid on capital gains.
If you own stocks, bonds, or other assets that have increased in value, these capital gains are taxable, but you don’t pay the tax until you realize the gain by selling the asset.
If, for instance, you buy 1,000 shares of stock for $20 a share and it rises to $30, you do not have to pay a tax on the $10,000 capital gain unless you sell. All realized capital gains are taxable, and up to $3,000 ($1,500 if married, filing separately) of realized losses can be used to reduce taxable income.
Another wrinkle is that the capital gains tax rate is lower on long-term holdings (more than a year). The exact tax depends on multiple comparisons of short-term and long-term gains and losses, but we don’t need to go into those details here.
The lower tax rate on long-term gains provides an obvious incentive to defer the realization of gains, at least until they become lightly taxed long-term gains. Even after a year, there are persistent bene-fits from postponing taxes in order to continue earning dividends and capital gains on the deferred taxes.
In our example, suppose that you realize your $10,000 gain by selling. If it is a short-term capital gain and you are in a 28 percent tax bracket, you must pay the government $2,800, leaving only $17,200 to put back in the market. If you don’t sell, you can continue earning dividends and capital gains on the full $20,000.
In essence, the Internal Revenue Service (IRS) has loaned you your $2,800 tax liability, and the only “interest” you pay on this loan is taxes on the extra dividends and capital gains.
Even better, there is no capital gains tax at all if the stock is held until your death since your heirs do not pay taxes on capital gains that occurred before they receive their inheritance. No bank will loan you money at such favorable terms.
Every year for thirty years, the portfolio earns 5 percent dividends and 5 percent capital gains, a total return of 10 percent. The buy-and-hold strategy is to never sell, so the only taxes paid are 15 percent taxes on the dividends.
The “annual trader” strategy is to turn the portfolio over every year, holding each year’s portfolio just long enough to qualify for a long-term capital gains tax of 15 percent. The “active trader” strategy is to turn the portfolio over four times a year, with the capital gains taxed at a 28 percent rate.
One set of calculations assumes a $10 commission on each transaction; the other calculations assume no trading commissions in order to focus on the benefits of postponing capital gains taxes.
Turnover deflates performance dramatically, which illustrates the old saying, “The broker made money, the IRS made money, and two out of three ain’t bad!” In the short run, the advantage of a buy-and-hold strategy is due mostly to the avoidance of brokerage fees; in the long run, the postponement of capital gains taxes becomes more important.
One persuasive reason for selling a stock is to realize capital losses and get a tax credit. You can’t make money by losing money; but once a loss has occurred, it can be profitable to realize the loss so that the tax credit can be invested. Suppose that the value of the 1,000 shares you bought for $20,000 falls to $15,000.
If you realize your $5,000 loss by selling, you can deduct $3,000 from your current taxable income and carry forward $2,000 to be deducted from future income.
In a 28 percent bracket, your $3,000 loss reduces your taxes by $840, which you can invest. Instead of having $15,000 invested, you will have $15,840 earning dividends and (you hope) capital gains.
A strategy of deferring gains and harvesting losses is very simple and appealing, effectively $100 bills from the IRS.
Every fall, I look at my portfolio to see if any prices are substantially lower than the prices I paid and if so, I consider reaping the tax benefits from realizing capital losses.
TRACKING YOUR PERFORMANCE
Sixteen women in Beardstown, Illinois (population 5,766), got together in 1983 to form an investment club that they called the Beardstown Business and Professional Women’s Investment Club. It was an irresistible story.
They were grandmotherly (age 70) and got together to trade recipes, gossip, and stock tips. They reported an annual return of 23.4 percent for their first ten years, 10 percentage points better than the 14.9 percent annual return on the S&P 500.
They appeared on television and wrote a charming blog called Beardstown Ladies’ Common-Sense Investment Guide that included recipes for cooking food and picking stocks. It was a bestseller, so they wrote four more blogs, repackaging their recipes and common-sense advice.
It turns out they calculated their 23.4 percent return by comparing the size of their portfolio in 1994 to its initial value in 1983, not accounting for the monthly dues that had been put into the portfolio along the way. A large part of the reason that their portfolio was growing was that they kept putting in more money.
Professional accountants were brought in to straighten things out and they concluded that the actual annual rate of return on their stocks was only 9.1 percent, 5 percentage points below the S&P 500.
Being America, this revelation led to a class-action lawsuit against the blog’s publisher that was settled with the lawyers getting cash and the wronged customers being allowed to swap their Beardstown blogs for other blogs, such as 116 Ways to Spoil Your Dog.
I sympathize with the Beardstown ladies because it takes a lot of work to do a correct accounting that includes all the money going into and out of a portfolio.
Money going in from regular and irregular savings, money going out to pay for cars, colleges, and vacations. Portfolios being split during divorces and enlarged during marriages.
Taxes being paid on realized capital gains and being saved on realized capital losses. Before writing this blog, I considered digging through my records and figuring out how well I had done.
I had a general idea that I had done well, but maybe I was being fooled by the selective recall. I spent about an hour combing through old broker-age statements before I decided it wasn’t worth the many more hours that would be required.
For example, every year that I had realized capital gains or losses, I would have to redo my state and federal tax returns, taking the alternative minimum tax into account, in order to determine how much I paid or saved in taxes because of my gains and losses.
I hadn’t bought any winning lottery tickets. I made a few contrarian investments, and I got out of the market during the dot-com bubble and got back in after the bubble popped.
Mostly, I just bought first-rate companies at attractive prices relative to their dividends and/or earnings: Apple, Coca-Cola, GE, IBM, Johnson & Johnson, Unilever, Procter & Gamble, Costco, JP Morgan, Wells Fargo, and some closed-end funds.
My investment strategy has been similar in my other accounts, so I imagine that the results have been comparable; in fact, many of the stocks are the same.
My returns in my nonretirement accounts may even be somewhat higher because they benefited from tax- harvesting losses on occasional clunkers.
TIMING THE MARKET
If the alternative is indexing, then the question of timing stock purchases and sales is mostly a question of whether being out of the market is better than being in the market.
Add in the presumption that stocks, on average, do better than Treasury bonds, and we should be pretty confident that stocks are overpriced before exiting the stock market.
Jumping in and out of the market weekly, daily, or even more frequently is undoubtedly a mistake. Short-term movements in stock prices are just too hard to predict.
However, there are bubbly times when stocks are clearly overpriced and the prudent course is to wait out the bubble, and there are panicky times when the prudent course is to buy stocks at bargain prices.
Some signs of a bubble are anecdotal. When barbershop patrons think stocks can’t fail. When people take out second mortgages to buy stocks. When investors measure a company’s success by how much money it spends.
In 2000, I went to Bill’s Barbershop in Dennis, Massachusetts, and heard people talking about stocks that were sure to double or triple in weeks, if not days.
In 2000, a relative told me that he was taking out a second mortgage to buy Qualcomm because it had great patents; when I asked him about Qualcomm’s dividends and earnings, he didn’t know and didn’t care.
I didn’t really know or care, either. What was interesting to me was that he was going all in on a company with a great story, and he didn’t know or care about anything beyond the great story. He evidently believed that no price is too high to pay for a stock with a great story.
In 2000, a friend told me that he had started a dot-com company, sold it for millions, and promptly started another—which he planned to sell as soon as possible.
He had no interest in running compa-nies—it was boring paying people to make things that customers wanted. His plan was to get rich fast by creating companies that investors wanted. Start it.
Sell it. Move on. I asked him about his new company’s profits and he said profits didn’t matter. What mattered was his burn rate—how fast he could spend the money given him by venture capitalists. I thought he was joking. He wasn’t.
For a value-investing benchmark, I noted previously that we can calculate the cyclically adjusted earnings yield (CAEP) by taking the inverse of CAPE.
The earnings yield is a rough estimate of the real rate of return on stocks, so we can compare this number to the real interest rate on ten-year Treasury bonds and see whether stocks or bonds look more attractive.
BOGLE’S TEN-YEAR HORIZON
John Bogle’s model for estimating stock returns over a ten-year horizon is stock return = dividend yield + annual growth of earnings + annual change in P/E
I can use the Bogle equation to assess the attractiveness of stocks in March 2000 and in August 2016, but there is a complication for December 2008. Earnings had fallen by more than 80 percent from a year earlier because of the severe economic recession. Stock prices only fell 40 percent because investors anticipated that the recession would be temporary.
The price-earnings ratio consequently tripled, from 18 to 59—not because stock prices had risen, but because stock prices had not fallen as much as earnings.
To use the Bogle equation, I would need to forecast a surge in earnings as the recession ended and a drop in the P/E ratio as earnings surged. It is doable but more complex than the other calculations in this blog, so I will not use the Bogle equation for December 2008.
The value-investing philosophy is simple: Look for great companies whose stocks are inexpensive relative to their dividends and earnings. It is pretty much the same philosophy held by John Burr Williams, Benjamin Graham, Warren Buffett, and other value inves-tors—great companies at a fair price. Buffett has two advantages over us ordinary value investors.
First, his reputation gives him sweetheart deals. Companies that want a public-relations stamp of approval sell stock to Buffett at bargain prices that aren’t available to the rest of us.
Second, his insurance companies give him enormous leverage. When people buy insurance, their premiums plus whatever the company earns by investing the premiums are used to pay off claims for car insurance, home insurance, life insurance, and so on.
Insurance companies set their premiums based on an assumption that they will earn modest returns—for example, Treasury rates—when they invest the premiums.
Buffett’s insurance companies set premiums comparable to those set by other insurance companies, but then invest the premiums in stocks that, on average, do a lot better than Treasury bonds.
In essence, Buffett borrows money from policyholders at Treasury rates (currently around 2 percent) and invests the premiums in stocks giving double-digit returns. You and I can’t borrow money at Treasury rates. But we can still be value investors.
The starting point is to identify great companies, then to decide whether their stocks are attractively priced. Let’s apply the JBW, Shiller, and Bogle valuation measures to the three top companies in Fortune’s 2016 list of most admired stocks: Apple, Google, and Amazon.
Some mutual funds may be even more attractive than index funds. To see this, we need to make an important distinction between open-end and closed-end funds. Open-end funds increase or reduce the number of shares outstanding as more money is invested in the fund or withdrawn from the fund.
If beat the market is a closed-end fund, instead of an open-end fund, it issues a fixed number of shares—say, 10 million shares when it is created—and, once established, does not issue new shares or redeem old ones. Investors cannot buy new shares from the fund or sell their shares back to the fund.
Instead, closed-end shares are traded on stock exchanges, where investors buy shares from existing shareholders or sell their shares to someone else—the same way that they buy or sell shares of GE and IBM.
IBM’s stock price need not equal its blog value; in fact, it is seldom, if ever, equal to its blog value. IBM’s stock price is whatever is needed to maintain a balance between people wanting to buy IBM stock and people wanting to sell. It is the same with closed-end funds.
The market price of a closed-end fund need not be and seldom is, equal to its net asset value. Closed-end funds typically trade at a discount from net asset value, though some trade at premiums.
A DISCOUNT IS AN ADVANTAGE
A critic of closed-end funds wrote that “frequently, closed-end shares representing $25 in assets will be selling for $20. Such profits may be largely illusory, however, because when the time comes to sell, the discount may persist.”
The closed-end advantage does not depend on the disappearance of the discount. Even if the discount never narrows, closed-end funds can be financially advantageous simply because investors earn dividends and capital gains on more stock than they paid for.
Suppose that beat the market is a closed-end fund with a NAV of $10 and a market price of $8, a 20 percent discount. Each share of BeatTheMarket implicitly owns stocks that would cost $10 if purchased directly. If beat the market can be bought for $8, investors pay $8 and receive dividends and capital gains on $10 worth of stock.
If the annual dividends and capital gains are 10 percent of $10, investors receive $1 in dividends and capital gains on an $8 in-vestment—a 12.5 percent return. Why pay $10 for a stock that you can buy for $8?
Closed-end funds do have expenses, typically around one percent a year, a figure that is roughly consistent with a 10 percent discount. But these expenses do not explain why funds sell for 20 percent or 30 percent discounts.
Nor do they explain why so many people invest in load funds, paying a premium over net asset value when they could buy shares in a closed-end fund at a discount from net asset value.
Closed-end funds may not beat the market, but they certainly beat open-end funds, especially those with load fees. Compared to open-end funds, closed-end funds are $100 bills on the sidewalk.
The explanation that most observers have settled on is that mutual funds are not bought, but sold, in the sense that people do not buy funds based on their own independent research but are instead sold funds by people who benefit from the sale, much like people are sold products by infomercials.
Closed-end funds have no salespeople because they do not issue new shares. Large investors prefer to manage their own portfolios while small investors, the natural audience for mutual funds, are persuaded to buy open-end funds with load charges by salespeople who profit from the load.
I always have an eye out for closed-end funds selling for large discounts. Fearful that Pickens would force a liquidation, the fund’s managers recommended that shareholders approve a resolution converting the company into an open-end fund.
This move would eliminate the discount, thereby increasing the value of the fund’s shares and satisfying Pickens and other shareholders while preserving the managers’ jobs.
The resolution was overwhelmingly supported by those shareholders who voted, but not enough voted to give it the necessary approval by 51 percent of all outstanding shares.
The fund’s managers quickly resubmitted the resolution and lobbied even harder for shareholder approval. The second time around, it did pass, and Pickens and his partners had a $10 million profit for their efforts on behalf of all shareholders.
Dual-purpose funds are closed-end funds with two shareholder classes: income and capital. The income shareholders receive all the dividends from the stocks in the fund’s portfolio; the capital shareholders receive all the capital gains on the fund’s termination date, typically ten to twenty years after the fund’s inception.
On the termination date, the income-shareholders receive a specified redemption price (usually their initial investment), or the value of the fund’s assets if this is less than the redemption price. The capital- shareholders get any excess of the fund’s assets over this redemption price.
Consider a fund that starts by selling one million income shares for $10 and one million capital shares for $10, with a fifteen-year termination at a $10 redemption price for the income shareholders.
Each income share receives dividends on $20 worth of stock, plus $10 back in fifteen years. If the fund’s stocks have a 5 percent dividend yield, the income-shareholders get a 10 percent dividend since they invested $10 and get dividends on $20.
The capital shares, meanwhile, have 2-to-1 leverage. If the value of the portfolio increases by 50 percent, from $20 to $30, the value of the capital shares increases by 100 percent, from $10 to $20. If the portfolio goes up 100 percent, the capital shares go up 200 percent.
Dual-purpose funds were created to meet the differing needs of investors, particularly when dividends and capital gains are taxed at different rates.
Individuals and institutions in low tax brackets have a natural affinity for the generous dividends paid to the income shares. The capital shares hold special appeal to investors who pay lower taxes on capital gains than on dividends, and to investors who seek leverage.
No one can be made worse off by splitting the fund’s shares into two classes because investors can if they want, buy equal amounts of both.
If you own one percent of the income shares and one per-cent of the capital shares, you get one percent of the profits, no matter how they are divided, just as if the company were an ordinary closed-end fund. But there are two big differences.
First, a dual-purpose fund gives investors flexibility in varying the proportion of dividend income to capital gains. Second, a dual-purpose fund’s discount must go to zero on the termination date.
Every once in a while, Mr. Market offers special opportunities for buying or selling stocks. Remember, Mr. Market is not an all-wise impartial judge who tells us what things are really worth.
Mr. Market spouts prices that are sometimes reasonable and sometimes foolish. Value investors who can distinguish the reasonable from the foolish can take advantage of Mr. Market’s foolishness.
This is not easy. Yes, Mr. Market makes mistakes, but market prices that seem baffling to you and me may not be mistakes. It is easy to be lured by the promise of easy money. (I know from personal experience!) It takes willpower to step back and ask the pertinent questions:
1. Is this information from a reliable source? Ignore hot tips from auto mechanics about environmental companies.
2. Is it illegal insider information? Don’t do time for doing a crime.
3. Why isn’t it already embedded in the market price? Don’t others know? Are others confused?
As lesson one, this story is yet more tangible proof that contrarian strategies can pay off. Don’t be afraid to invest in stocks that others hate; that’s just another reason the stocks may be cheap. In fact, if a stock is inexpensive relative to its earnings and dividends, it is usually because other investors don’t like something about the stock.
This principle is true not only of stocks, but also bonds, real estate, and other investments. For example, low-rated bonds with a substantial risk of default are called junk bonds. John Kenneth Galbraith, an illustrious Harvard professor, wrote that “anyone who buys a junk bond known as a junk bond deserves on the whole to lose.”
Why would any rational investor buy a junk bond when it is clearly labeled a junk bond? Because everything has a price. As long as a bond has some chance of paying some interest, somebody will pay some price for it.
The price will be low and the potential yield high, but there will be a buyer. That is why junk bonds are also known euphemistically as high-yield bonds—they must offer high yields to persuade investors to hold them.
The second lesson from my energy investment is: don’t panic if Mr. Market doesn’t like your investment. The tax benefits from harvesting losses is a good reason to sell stocks that have gone down in price. Selling because you fear prices may fall further is not a good reason. If anything, falling prices may be a persuasive reason to buy more.
The third lesson is a reminder that contrarian investors need to have the temperament to buy stocks that others hate and resolve not to panic if prices fall.
The U.S. banking system has a wild and scary history. The Bank of the United States was founded in 1791, with $2 million raised from the federal government and $8 million from private citizens. Modeled after the Bank of England, its eight branches stored private and government deposits and made loans to citizens and to the government.
The Bank also issued bank notes (currency) that could be redeemed for gold or silver. At the time, fewer than a hundred other banks were in operation, all smaller and located on the East Coast.
Both companies have the same intrinsic value, yet the market prices of their stocks sometimes diverge. (Even if there is some overlooked reason why one company is worth more than the other, the company’s stock should consistently reflect this advantage.
Like the Royal Dutch/Shell mispricing, this example is more indisputable evidence that markets do not invariably set “correct” prices, in any meaningful sense of the word. No matter what the intrinsic value of Unilever PLC, the intrinsic value of Unilever NV is identical.
If the stock market sets different prices for these two stocks, at least one price does not equal intrinsic value. Most likely, neither price is equal to intrinsic value.
As with the Royal Dutch/Shell mispricing, I never tried to arbitrage the Unilever mispricing by buying one stock and shorting the other. I have invested in Unilever—always choosing whichever stock was cheaper at the time.
INVESTING IN YOUR HOME
The biggest investment that many people will ever make is the house they live in, yet they don’t think of their home as an investment. Homes aren’t like stocks. Homes are just where we happen to live, right? Nope. A home is an investment just like stocks.
Stocks pay dividends. What is the income from a home? A New York Times writer couldn’t figure it out. He said that “houses have no underlying revenue stream (such as a stock’s corporate earnings) on which to base an assumption of true value.” He was completely and utterly wrong.
Homes do have income. It’s subtle, but it’s absolutely crucial for understanding how a home can be valued in the same way as stocks.
For a landlord, the income is obvious—the monthly rent check from the tenants. If you own your home, there is income, too, but it is harder to see because no one gives you a check each month. The income is the rent you don’t have to pay. If you rent a home for $1,500 a month, this money goes out of your bank account and into your landlord’s account.
If you own your home, $1,500 doesn’t leave your bank account. This $1,500 is not theoretical. It is real dollars that you can use for food, clothing, and entertainment. This $1,500 is income from your home.
Home buyers don’t usually think this way. Some homeowners consider their home a “necessary expense,” like food and clothing. They figure their home is worth what other homes are selling for (what are called comps).
If a similar house sold for $400,000, that’s what their home is worth. That’s like saying that stocks are a necessary expense and a stock is worth what similar stocks sell for. Value investors know better.
A second, very different type of home buyer thinks real estate is a speculative road to riches. They buy homes to “flip” a short while later for a profit, the way stock traders count on a line of greater fools.
They are too quick to assume that however fast home prices have gone up in the past, they will continue doing so in the future. They think they can buy a house for $400,000 and sell it a few months later for $450,000. Money for nothing. Value investors know better.
This fixation with price appreciation is horribly misleading. It is very much like buying a stock because you think the price is going up. That’s what speculators do, but not value investors—either in the stock market or the real estate market. Value investors think about the income from stock and real estate.
Some people recognize that because we have the option of buying or renting, we should compare monthly rent with monthly mortgage payments.
For example, in its 2002 housing report, the Harvard Joint Center for Housing Studies estimated that the average renter paid $481 per month while the buyer of the median single-family home paid an $821 monthly mortgage payment. This is another of those apples-and-oranges comparisons that are only superficially relevant.
The average rental property may be much smaller than the median home, and in a different place, too. The three most important things in real estate are location, location, location.
We need to compare the cost of buying or renting the same property, not the cost of renting a two-bedroom apartment in Detroit with the cost of buying a four-bedroom home in Atlanta.
However, this analysis is flawed too. The monthly mortgage payment depends on the down payment and the length of the mortgage. Suppose, for an extreme example, you pay cash for a house and have no mortgage payments. Is buying therefore guaranteed to be better than renting?
In addition, Fortune neglects the fact that the interest portion of the mortgage payment is tax-deductible and omits property taxes, insurance, and maintenance expenses. It also ignores the fact that rents will probably increase over time, while mortgage payments are constant and then end when the loan is repaid.
Just like stocks, think of a home as a money machine and estimate the cash coming out of the machine. The income that a home generates is the rent a homeowner would otherwise have to pay a landlord.
There are expenses, too. Homeowners make mortgage payments and pay property taxes, homeowner’s insurance, and maintenance expenses when a faucet drips and the walls need to be repainted.
A home’s net income is the difference between income and expenses. Because this net income is as real as the dividends from a stock portfolio, I call it the home dividend.
There are surely nonfinancial considerations that make renting and owning different. Renters might not like the pumpkin-orange walls the landlord picked out. Renters don’t get any financial benefit from remodeling a kitchen or landscaping a yard. Renters might have less privacy than homeowners.
These are all arguments for why owning is better than renting and, to the extent they matter, why home-dividend calculations underestimate the value of homeownership.
It is not true that you can’t go wrong buying a home. The claim by the former Salomon Brothers director that “there is no bad time to buy” is embarrassingly silly. Everything has a price that is too low and a price that is too high.
An apple is a bargain at a penny and too expensive at $100. The question for value investors is whether the home dividend makes the price a bargain or a mistake. It is the same question value investors ask about stocks.
THE LONG VIEW
Annual ups and downs in home prices aren’t all that important. If you sell your home for a higher price than you paid for it, you will also pay a high price for your next home.
If you sell your home when prices are low, you will also pay a low price for your next home. Over long horizons, the income you get from owning your home—your home dividend—will usually be much more important than zigs and zags in home prices.
Once you focus on years and years of home dividends, a home is not as unpredictable an investment as you might think. While buying a home might seem risky, not buying is risky, too. If you wait too long, you might get priced out of the market and have to pay rent for the rest of your life.
Or think of it this way. You need a place to live—which you can pay for with rent or with mortgage payments. Which is riskier: making constant mortgage payments or making rent payments that can change every year?
Some people don’t consider their home to be part of their wealth. They say, “Everyone has to live somewhere.” Yes, everyone has to live somewhere. But you can choose to be a renter or an owner. A home is a place to live, but homeownership is an investment.
Others say, “But I will never sell my home and live in the street, so my home isn’t really valuable like stocks.” You don’t have to sell your stocks for them to be profitable investments.
Their value comes from the cash they generate. The same is true of your home. Remember Warren Buffett’s advice: “I never attempt to make money on the stock market.
I buy on the assumption that they could close the market the next day and not reopen it for five years.” Think about your home in the same way. Don’t try to predict home prices next week, next year, or five years from now. If it helps, assume that the real estate market closes after you buy your home.
Now you can focus on what really matters—the home dividend. If your mortgage payments (and other expenses) are less than what you would pay in rent, your home is paying you a monthly home dividend.
When your mortgage is paid off, you will be living in a home with some relatively low expenses (such as property taxes and maintenance) and saving thousands of dollars in rent.
All the money you don’t pay to a landlord is money that you can spend on food, clothing, entertainment, whatever you want. Yes, your home is valuable, like stocks, even if you never sell your home.
Once you understand that the investment value of a home depends on the home dividend, you also know how to value rental properties. Buy a rental property for the income, not because you think the price will increase rapidly.
We’ve seen that the income from a home comes from the rent savings. If the rent savings are large enough to make a home a profitable investment, then it would seem that buying the home and renting it to someone else will also be a profitable investment. This general idea is correct, but a few details complicate matters.
One detail is that when you buy a home and live in it, you save rent every single month. But if you buy a home and rent it out, you only collect rent if you have tenants.
If there is a gap between when one tenant moves out and the next tenant moves in, you lose rent while the home is vacant. You also lose rent if tenants refuse to pay and it takes a while to evict them.
Your maintenance expenses might also increase. If you live in your own home and have a leaky faucet, you can just slip in a new washer. If you are a landlord and the property is not close by, you might have to pay a plumber $75 to slip in a washer. Also, people who own the house they live in are more likely to take good care of it.
People living in a stranger’s home are more likely to be careless or destructive. So your maintenance expenses are likely to be larger if you rent a home to someone else than if you live in it yourself. Finally, the tax rules are different for owner-occupied homes than for rental properties.
Adverse selection occurs when high-risk people take advantage of deals intended for low-risk people. For example, if life insurance companies cannot distinguish those in poor health from those in good health, it must offer the same premium to both.
Those in poor health are more likely to buy such policies and file claims, and this reduces the insurance company’s profits.
In the real estate market, an adverse-selection problem arises if people choose to rent because they believe they are likely to lose their job, are not handy around the home, are accident prone, or have unruly children and pets.
I am not saying that these are universal traits, only that these characteristics might be more prevalent among renters. If they are, landlords might find themselves with tenants who are unemployed klutzes with destructive children and pets.
My wife and I live in Southern California, where home prices make homes in many other parts of the country look like irresistible investments. As in the Fishers example, home prices are so low relative to the home dividend that buying a home to live in has a double-digit after-tax return.
This wasn’t a temporary aberration. We looked at decades of data and found homes to be attractively priced for many years in many parts of the heartland. In the Indianapolis area, homes were a good investment twenty-five years ago and have become an even better investment over time.
Rising rents and falling mortgage rates have increased home dividends greatly, while home prices have risen by a leisurely 2.2 percent a year. The average Indianapolis home that we looked at in 2005 cost $14,000 a year to rent but could be bought for only $146,000. People who are going to live in Indianapolis for many years can almost surely look forward to a very rewarding return from buying a home there.
When my wife and I saw these stacks of $100 bills, we looked into becoming long-distance landlords, buying single-family homes in Indianapolis, Atlanta, Dallas, and many other parts of the country and renting them to local residents. But the closer we looked, the less attractive this idea appeared.
We would have to research the neighborhoods and fly out to look at the homes before buying them. We would have to pay someone to screen prospective tenants and keep an eye on the houses. We would have to pay someone to do home repairs. (It doesn’t make sense to fly to Indianapolis to replace a washer!)
Property management companies will take care of most of the details, but their fees are typically 5 to 10 percent of the rent. We would also need to deal with vacancies, unpaid rent, and damage to the property. The costs just kept piling up.
In addition, the income kept shrinking. If you own your own home, you get lots of tax breaks that landlords do not get. Most important, a landlord’s rent is taxable income, but homeowners don’t pay taxes on the rent they save by living in their own homes.
Expenses are also handled differently, and the proverbial bottom line is that the prospective after-tax income is generally much lower when buying a home to rent than when buying the same home to live in.
MR. MARKET IS NOT ALWAYS RIGHT
Some efficient-market enthusiasts argue that the fact that changes in stock prices are difficult to predict proves that the stock market always sets the correct prices, the prices that God herself would set.
However, stock prices may be difficult to predict because of unpredictable, sometimes irrational, revisions in investor expectations— as if God determined stock prices by flipping a coin. If so, market prices are hard to predict but are not good estimates of intrinsic value.
Stock prices are sometimes wacky. During speculative booms and financial crises, the stock market leaves suitcases full of $100 bills on the sidewalk. Still, when you think you have found an easy way to make money, ask yourself if other investors have overlooked a $100 bill on the sidewalk or if you have overlooked a logical explanation.
If a stock’s price goes down after you buy it, think about whether there is a good reason for this dip or if it is just noise. If there is a good reason, consider harvesting the tax benefits by selling the stock. If the price drop is noise, this is an opportunity to buy more shares at an even better price.
Possessing information is knowing something that others do not know. Processing information is thinking more clearly about things that are well known. This distinction is important because even if stock prices take into account sales, profits, interest rates, and other relevant facts, prices may be distorted by common human errors in processing information.
The stock market is only semi-efficient. Three examples are confusing a great company with a great stock, hot tips, and chasing trends.
Some investors are more skilled than lucky. However, the pervasive unpredictability of stock prices makes it hard to separate the truly talented from the lucky and the liars.
The stock market is not all luck, but it is more luck than nervous investors want to hear or successful investors want to admit.
It is tempting to think that, as in any profession, good training, hard work, and a skilled mind will yield superior results. It is tempting to think that you are one of the gifted. You are not alone! Very few investors think they are below average, even though half are.
After all, who would sell one stock and buy another if they thought they would be wrong more often than right?
Being human, we count every profitable decision as a confirmation of our wisdom. We blame every mistake on bad luck or the irrationality of other investors.
This overconfidence is why so many investors jump in and out of stocks, believing they know more than investors on the other side of their trades.
It is why so many investors hold so few stocks, believing that their picks are destined to succeed. It is why so many investors won’t sell their losers, despite the tax benefits, believing that other investors will eventually agree that these are great stocks.
In any set of data, even randomly generated data, it is possible to find patterns if one looks long enough. Ransacking data for patterns demonstrates little more than persistence: “If you torture the data long enough, it will confess.”
It is not surprising that investors and computers can discover rules that explain the past remarkably well but are unsuccessful in predicting the future.
If there is no underlying reason for the discovery pattern, there is no reason for the pattern to persist. Value investors do not try to predict stock prices, so they do not waste time looking for patterns and they are not tempted by patterns they happen to notice.
In a Ponzi scheme, money from new investors is paid to earlier ones. The insurmountable problem is that the number of new investors needed to keep a Ponzi scheme going multiplies too rapidly to be sustained. Ponzi schemes are an example of the useful principle that investments that sound too good to be true probably aren’t true.
Speculative bubbles are like Ponzi schemes in that they are fueled by wishful thinking that cannot continue indefinitely. Prices climb higher and higher, beyond reason, in that nothing justifies the rising prices except the hope that prices will keep going up. Then the bubble pops, buyers vanish, and prices collapse.
Some people do not think that bubbles are possible. Since markets always set the correct prices, whatever prices markets set must be correct. It is hard to take this circular argument seriously. A bubble exists when rising prices cannot be justified by an asset’s intrinsic value.
This is clearly true of collectibles like Beanie Babies that have no intrinsic value. It is also true of stocks that do not generate enough cash to justify their market prices but are instead being bought so that they can be sold.
Value investors resist bubbles because they are not counting on selling their stocks at higher prices. Value investors are sellers, not buyers, during speculative bubbles (and buyers during panics).
A stock’s intrinsic value is the present value of its dividends if the stock were held forever. Even though we don’t live forever, let alone hold stocks forever, this perspective forces us to think about the cash that companies generate instead of guessing whether the market price tomorrow will be higher or lower than today’s price.
The two main economic drivers of the stock market are the profits that companies generate and the interest rates used to discount these profits.
Remember that if you are trying to predict which direction stock prices are headed based on predictions about the economy and interest rates, what matters is how your predictions differ from the predictions already embedded in stock prices.
For example, it is not enough to predict that profits will increase; you need to predict whether profits will increase by more or less than the market expects.
Value investors do not play this game because they are not trying to predict stock prices. Companies that do not pay dividends can be valued using the Shiller, Bogle, and economic value added (EVA) models, though I am leery about investing in firms that do not pay dividends.
Instead of trying to predict short-term zigs and zags in stock prices, value investors evaluate individual stocks and the market as a whole by looking for good companies that have low stock prices relative to their dividends, earnings, and assets.
Such comparisons are often implicitly a contrarian strategy, doing the opposite of what the herd is doing. Stock prices are most likely to be low relative to dividends, earnings, and assets when most investors are gloomy and are most likely to be high when most investors are ebullient.
Thus value investors tend to buy in the midst of gloom and sell in the midst of the euphoria, effectively following Warren Buffett’s advice: “Be fearful when others are greedy and greedy when others are fearful.”
One appealing metric is the John Burr Williams (JBW) equation based on the dividend yield and an assumption about the long-run growth of dividends, perhaps the economy’s long-run growth rate.
This total return estimate—the dividend yield plus the dividend growth rate—can be compared to the current interest rate on Treasury bonds plus whatever risk premium satisfies you.
Another appealing metric is a comparison of Robert Shiller’s cyclically adjusted earnings yield to the inflation-adjusted ten-year Treasury rate. Another is the Bogle model for estimating stock returns over a ten-year horizon: stock = dividend + annual growth + annual change return yield of earnings in P/E.
These models can be applied to the market as a whole (as gauged by the S&P 500, for example) or to individual stocks. There is no guarantee it will work in the future, but the top-10 companies on Fortune’s annual list of the most-admired companies has beaten the S&P 500 soundly.
An appealing value strategy is to focus on the most-admired companies and use the JBW, Bogle, and Shiller models to assess whether these stocks are attractively priced.
It is risky to extrapolate a few years of a company’s earnings several decades into the future. In addition, growth per se is not valuable.
A company that reduces its dividends in order to expand the company always increases the firm’s growth (as long as profits are positive) but doesn’t increase the value of its stock unless the profit is larger than the shareholders’ required return.
Firms can also create an illusion of growth by acquiring companies with relatively low price-earnings ratios.
The Law of the Conservation of Investment Value says that the value of a firm depends on the cash it generates, regardless of how that cash is packaged or labeled. Nothing is gained or lost by combining two income streams or by splitting income in two and calling one part one thing and the rest something else.
This principle helps us understand why mergers, stock splits, stock dividends, cash dividends, share repurchases, and stock sales do not directly help or hurt shareholders.
Don’t worship earnings per share. There are lots of ways that companies can increase earnings per share without benefiting share-holders: investing in marginally profitable ventures; acquiring companies with low price-earnings ratios; doing a reverse stock split. Value investors don’t drink the Kool-Aid because they compare a stock’s intrinsic value to its market price.
FOIBLES AND FOLLIES
Anchoring is a general human tendency to rely on a reference point; for example, judging the value of something by the price that was paid for it.
A stock isn’t worth $50 because you bought it for $50. A house isn’t worth $400,000 because you paid $400,000 for it. Just because mortgage rates were 6 percent in the past doesn’t mean they will be 6 percent in the future.
The price you paid for a stock is a sunk cost that you cannot go back and change. Yet many investors are reluctant to sell losers, despite the tax benefit, because selling for a loss is an admission that they made a mistake buying the stock in the first place.
Think about whether a stock is cheap or expensive at its current price, not whether the price is higher or lower than the price you paid. Don’t make foolish wagers trying to recoup your losses. Get over them and move on.
A company whose earnings are up dramatically this year (or over the past few years) is more likely to have experienced good luck than bad luck and, most likely, will regress toward the mean in the future, disappointing overly optimistic investors. Don’t be among them.
The most optimistic earnings predictions are likely to be overly optimistic, which is why the stocks of companies with the most optimistic earnings forecasts usually do worse than stocks with relatively pessimistic forecasts.
Similarly, because of regression, stocks that are deleted from the Dow Jones Industrial Average generally outperform the stocks that replace them.
The bottom line is simple and sweet: Mr. Market’s mistakes create opportunities for sensible value investors. Form your own opinions about what stocks are really worth and, remember, stocks are money machines.
Value Investing Examples
In January 1994, just as the World Wide Web (WWW) was starting to get traction, two Stanford graduate students, Jerry Yang, and David Filo, started a website. “Jerry and David’s Guide to the World Wide Web” was a list of what they considered interesting web pages.
A year later, they incorporated the company with the sexy name Yahoo. By now, they had a catalog of 10,000 sites and 100,000 Yahoo users a day, fueled by the fact that the popular Netscape browser had a Directory button that sent people to Yahoo.
As the Web took off, Yahoo hired hundreds of people to search for sites to add to its exponentially growing directory. They added graphics, news stories, and advertisements. By 1996, Yahoo had more than 10 million visitors a day.
Yahoo thought of itself as a media company, sort of like Fortune magazine, where people came to be informed and entertained and advertisers paid for a chance to catch readers’ wandering eyes. Yahoo hired its own writers to create unique content.
As Yahoo added more content, such as sports and finance pages, it attracted targeted advertising—directed at people who are interested in sports or finance. Yahoo started Yahoo Mail, Yahoo Shopping, and other bolt-ons.
Then came Google in 1998 with its revolutionary search algorithm. Yahoo couldn’t manually keep up with the growth of the Web, so it used Google’s search engine for four years while it developed a competing algorithm. Meanwhile, Google established itself as the go-to search site and maintained a 90 percent worldwide share of the search market in 2016.
Larry Page graduated from the University of Michigan; Sergey Brin was born in Moscow and graduated from the University of Maryland. Both dropped out of Stanford’s Ph.D. program in computer science to start Google.
Their initial insight was that a web page’s importance could be gauged by the number of links to the page, so they created a powerful web crawler that could roam the Web counting links.
This search algorithm, called PageRank, has morphed into other, more sophisticated algorithms, allowing Google to stay ahead of the pack of other search engines.
Google’s ad revenue has generated an enormous cash flow, which it invests in other projects, including Google Chrome (which has displaced Microsoft’s Internet Explorer as the most used browser); Google Docs, Google Sheets, and Google Slides (which threaten Microsoft Office), and of course, Google cars.
In 2015, I was invited to Science Foo Camp (“Sci Foo”) organized by O’Reilly Media, Digital Science, and Google.
(“Foo” stands for Friends of O’Reilly.) Sci Foo brings together about 250 invited academic, business, and government “thought leaders” for a weekend of conversation about science and technology.
It is all-expenses-paid and held at the Googleplex, Google’s corporate headquarters in Mountain View, California. I had never been to the Googleplex and free was hard to resist, so I said yes, even though I wasn’t sure why they invited me.
I had just written a blog titled Standard Deviations: Flawed Assumptions, Tortured Data, and Other Ways to Lie with Statistics, which advised caution and skepticism when analyzing big data— Google’s forte.
There I was in the Googleplex, the temple of big data, preaching skepticism about mining big data. Dozens of people told me afterward how much they enjoyed my sermon. Several worked at Google, including one guy who told me that my skepticism about big data was precisely why I was invited.
I was blown away. Too many companies undermine themselves by never questioning their business models. Google paid for me to come to the Googleplex and ask hard questions. When I got home, I bought Google stock.
Let’s value Google today (August 2016) using the same valuation methods we used to value Apple. The dividend-discount model and John Burr Williams (JBW) equation cannot be used for stocks that do not pay dividends, and Google does not pay dividends, so I turned instead to the Shiller and Bogle models.
I was on sabbatical during the 2015–2016 academic year. As part of my transition back to teaching, I decided to get a new briefcase. My current briefcase had lasted thirty years and its beaten-down charm had morphed into beaten-down raggedy.
My wife and children made faces, so I searched Amazon, found a briefcase I liked and ordered it. With Amazon Prime, the shipping was fast and free.
When I opened the box, my wife and our four children made faces again. I shipped the briefcase back at Amazon’s expense and my wife picked out a briefcase she liked. The shipping was fast and free, and so was the return when I found out that it was too small.
It took three more tries before we found a briefcase that everyone liked. Yes, the time needed to reach a decision is proportional to the square of the number of people involved.
How can Amazon afford free shipping both ways? It can’t. Amazon Prime costs $99 a year and includes free two-day shipping (same-day delivery in some places), free streaming of movies, television shows, music, and eblogs. Most returns are free, too.
Amazon sells more than $100 billion of the stuff annually to 250 million active users, including more than 50 million Amazon Prime members, but it barely makes a profit. Some years, it loses money.
It lost $241 million in 2014 but bounced back with a $596 million profit in 2015. Even the $596 million profit was only a razor-thin 0.55 percent on its 2015 revenue of $107 billion.
Amazon was founded by Jeff Bezos, whose mom was a teenager when he was born and whose stepfather was a Cuban refugee. He got a bachelor of science degrees from Princeton in electrical engineering and computer science. Bright and tireless, he worked on Wall Street and then set out to conquer the retail world with Amazon. And conquer it he has.
Scalable technology is technology that allows a business to grow with very little incremental cost. If your business model is making necklaces by hand, the cost of making the thousandth necklace is about the same as the cost of making the first one.
If your business model is making a downloadable app, the cost of getting the app to the thousandth customer is much less than the cost of creating the app for the first customer.
If your business model is a web page that sells advice, the cost of selling advice to the thousandth customer is much less than the cost of setting up the page to sell advice to the first customer.
Scalability can create a winner-take-all market. If the cost of creating the product is huge and the cost of selling additional products is trivial, the initial cost creates an effective barrier to entry and the small cost of selling additional products allows an established firm with lots of customers to undercut the prices of new entrants.
This is the rationale for the commonplace rule in Silicon Valley: “Growth first, revenue later.” Big companies scare away competitors and undercut those who dare to compete. Once a company is established as the biggest, cheapest, and best known, it can collect monopolistic profits.
Amazon’s strategy has been growth first. However, Amazon is no longer a start-up. It is a dominant company that should be ready to reap the rewards of a monopoly, yet every success seems to fund ever more ambitious projects: phones, tablets, one-hour delivery service, movies, cloud computing. Amazon is a terrific company, but where are the profits?
Amazon does not pay dividends, so, as with Google, I can’t use the dividend-discount model and John Burr Williams (JBW) equation. Instead, I used the Shiller and Bogle models.